UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

ANNUAL REPORT

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

 

Commission file number 001-11655

 

HearUSA, Inc.

Exact Name of Registrant as Specified in Its Charter

 

 

Registrant’s Telephone Number, Including Area Code

(561) 478-8770

 

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

 

 

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

None

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in PART III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” “and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of June 30, 2007, the aggregate market value of the registrant’s Common Stock held by non-affiliates (based upon the closing price of the Common Stock on the American Stock Exchange) was approximately $51,903,072.

 

On February 15, 2008, 38,582,918 shares of the registrant’s Common Stock including 568,761 of exchangeable shares were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of registrant’s definitive proxy statement for the 2008 Annual Meeting of the registrant’s stockholders (“2008 Proxy Statement”), to be filed with the Securities and Exchange Commission, are incorporated by reference in Part III hereof.

 

 

PART I

 

 

HearUSA, Inc. (“HearUSA” or the “Company”), was incorporated in Delaware on April 11, 1986, under the name HEARx Ltd., and formed HEARx West LLC, a fifty-percent owned joint venture with Kaiser Permanente, in 1998. In July of 2002, the Company acquired Helix Hearing Care of America Corp. (“Helix”) and changed its name from HEARx Ltd. to HearUSA, Inc.

 

At December 29, 2007, HearUSA had 185 company-owned hearing care centers in nine states and the Province of Ontario, Canada. The Company also sponsors a network of approximately 1,900 credentialed audiology providers that participate in selected hearing benefit programs contracted by the Company with employer groups, health insurers and benefit sponsors in 49 states. The center professionals and the network providers provide audiological testing, products and services for the hearing impaired.

 

HearUSA seeks to increase market share and market penetration in its center and network markets. The Company’s strategies for increasing market penetration include advertising to the non-insured self-pay market, positioning itself as the leading provider of hearing care to healthcare providers, increasing awareness of physicians about hearing care services and products in the Company’s geographic markets and seeking strategic acquisitions. The Company believes it is well positioned to successfully address the concerns of access, quality and cost for the patients of managed care and other health insurance companies, diagnostic needs of referring physicians and, ultimately, the hearing health needs of the public in general.

 

Products

 

HearUSA’s centers provide a complete range of quality hearing aids, with emphasis on the latest digital technology along with assessment and evaluation of hearing. While the centers may order a hearing aid from any manufacturer, the majority of the hearing aids sold by the centers are manufactured by Siemens Hearing Instruments, Inc. (“Siemens”) and its subsidiaries, Rexton and Electone. The Company has a supply agreement with Siemens for the HearUSA centers in the United States. The Company has agreed to sell certain minimum percentages of the centers’ hearing aid requirements of Siemens products. The centers also sell hearing aids manufactured by other manufacturers including Phonak, Oticon, Starkey, Sonic Innovations and Unitron.

 

HearUSA’s centers also offer a large selection of assistive listening devices and other products related to hearing care. Assistive listening devices are household and personal technology products designed to assist the hearing impaired in day-to-day living, including such devices as telephones and television amplifiers, telecaptioners and decoders, pocket talkers, specially adapted telephones, alarm clocks, doorbells and fire alarms. Hearing loss prevention products are designed to protect against hearing loss for people exposed to loud sounds. These ancillary products include special ear molds for musicians, hunters and specialized molds for iPods and similar devices.

 

The hearing care network providers also provide hearing aids, assistive listening devices and other products related to hearing care as well as audiology services.

 

Acquisition Program

 

In 2007, the Company continued its strategic acquisition program in order to accelerate its growth. The program consists of acquiring hearing care centers located in the Company’s core and target markets. The Company often can benefit from the synergies of combined staffing and can use advertising more efficiently. The payment terms on a specific acquisition will typically be a combination of cash and notes. The source of funds for the cash portion of the acquisition price will be cash on hand or the Siemens acquisition credit line (see Note 6 — Long-Term Debt, Notes to Consolidated Financial Statements included herein).

In order to maximize the return on its investment in acquisitions and to ensure integration of the acquired centers, the Company has established an integration program. This program covers the implementation of our center management system, including the conversion of the acquired center patient database, transfer of vendors to the Company’s existing vendors to benefit from better pricing, employee training and marketing programs. The performance of each acquired center is monitored closely for a period of three to six months or until management is fully satisfied that the center has been successfully integrated into the Company.

 

Managed Care, Institutional Contracts and Benefit Providers

 

Since 1991, the Company has entered into arrangements with institutional buyers relating to the provision of hearing care products and services. HearUSA believes that contractual relationships with institutional buyers of hearing aids are essential to the success of the Company’s business plan. These institutional buyers include managed care companies, employer groups, health insurers, benefit sponsors, senior citizen buying groups and unions. By developing contractual arrangements for the referral of patients, the plan members have access to standardized care and relationships with local area physicians are enhanced. Critical to providing care to members of these groups are the availability of distribution sites, quality and control and standardization of products and services. The Company believes its system of high quality, uniform company-owned centers meets the needs of the patients and their hearing benefit providers and that the network providers can expand available distribution sites for these patients. In the past two years, the Company has expanded its managed care contracts into areas serviced by the affiliated network providers.

 

HearUSA enters into provider agreements with benefit providers for the provision of hearing care using three different arrangements: (a) a discount arrangement on products and services which is payable by the member; (b) a fee for service arrangement which is partially subsidized by the sponsor and the member pays the balance; or (c) a per capita basis, which is a fixed payment per member per month from the benefit provider to HearUSA, determined by the benefit offered to the patient and the number of patients, and the balance, if any, paid by the individual member. When the agreement involves network providers, HearUSA pays the network provider an encounter fee, net of administration fees.

 

The terms of these provider agreements are generally renegotiated annually, and may be terminated by either party, usually on 90-days notice. The early termination of or failure to renew the agreements could adversely affect the operation of the centers located in the related market area.

 

The Company and its subsidiary, HEARx West, currently receive a per-member-per-month fee for more than 2 million managed care members. In total, HearUSA services over 400 benefit programs for hearing care with various health maintenance organizations, preferred provider organizations, insurers, benefit administrators and healthcare providers.

 

Sales Development

 

The Company has a sales development department in order to assist its professionals in developing the necessary skills to perform successfully. By providing training on methods, techniques, trouble shooting, dispensing and counseling skills, the Company believes this department helps provide a better service to patients and improves key performance indicators such as conversion, binaural fitting rates and reduced return rates.

 

Marketing

 

HearUSA’s marketing plan includes:

 

 

 

Facilities and Services

 

Each HearUSA center is staffed by a licensed and credentialed audiologist or hearing instrument specialist and at least one office manager or patient care coordinator. Experienced audiologists supervise the clinical operations. The majority of the Company’s centers are conveniently located in shopping or medical centers and the centers are typically 1,000 to 2,500 square feet in size. The Company’s goal is to have all centers similar in design and exterior marking and signage, because a uniform appearance reinforces the message of consistent service and quality of care.

 

Each center provides hearing services that meet or exceed applicable state and federal standards, including:

 

 

In some markets, a full range of audiovestibular testing is also available to assist in the diagnosis of medical and vestibular disorders.

 

Each of the 1,900 network providers operates independently from the Company. To ensure compliance with its hearing benefit programs, the Company performs annual credential verification for each of the network providers. The Company also performs random patient surveys on the quality of network providers’ services.

 

Revenues

 

For the fiscal years 2007, 2006 and 2005, HearUSA net revenues were approximately $102.8 million, $88.8 million, and $76.7 million, respectively. During these years the Company did not have revenues from a single customer which totaled 10% or more of total net revenues. Financial information about revenues by geographic area is set out in Note 20 — Segments, Notes to Consolidated Financial Statements included herein.

 

Segments

 

The Company operates three business segments: the company-owned centers, the network of independent providers and an e-commerce business line. Financial information regarding these business segments is provided in Note 20 - Segments, Notes to Consolidated Financial Statements included herein.

 

Centers

 

At the end of 2007, the Company owned 185 centers in Florida, New York, New Jersey, Massachusetts, Ohio, Michigan, Missouri, North Carolina, California (through HEARx West) and the Province of

Ontario, Canada. These centers offer patients a complete range of services and products, including diagnostic audiological testing, the latest technology in hearing aids and assistive listening devices to improve their quality of life.

 

The centers owned through HEARx West are located in California. HearUSA is responsible for the daily operation of the centers. All clinical and quality issues are the responsibility of a joint committee comprised of HearUSA and Kaiser Permanente clinicians. HEARx West centers concentrate on providing hearing aids and audiology testing to Kaiser Permanente’s members and self-pay patients in the state of California. At the end of 2007, there were 24 full-time and 3 part-time HEARx West centers.

 

Under the terms of the joint venture agreement between the Company and Kaiser Permanente, HEARx West has the right of first refusal for any new centers in southern California; Atlanta, Georgia; Hawaii; Denver, Colorado; Portland, Oregon; Cleveland, Ohio; Washington, D.C. and Baltimore, Maryland. In addition, should HearUSA make a center acquisition in any of these markets, HEARx West has the right to purchase such center. Such a sale would be done at arm’s length, with HEARx West paying HearUSA an equivalent value for any of the centers it acquires.

 

Network

 

The Company sponsors a network (known as the “HearUSA Hearing Care Network”) of approximately 1,900 credentialed audiology providers that supports hearing benefit programs with employer groups, health insurers and benefit sponsors in 49 states.

 

Unlike the company-owned centers, the network is comprised of hearing care practices owned by independent audiologists. Through the network, the Company can pursue national hearing care contracts and offer managed hearing benefits in areas outside of the company-owned center markets. The network’s revenues are derived mainly from administrative fees paid by employer groups, health insurers and benefit sponsors to administer their benefits. In addition, the network provides Provider Advantage purchasing programs, whereby affiliated providers purchase products through HearUSA volume discounts and the Company receives royalties or rebates.

 

E-commerce

 

The Company offers online information about hearing loss, hearing aids, assistive listening devices and the services offered by hearing health care professionals. The Company’s web site also offers online purchases of hearing-related products, such as batteries, hearing aid accessories and assistive listening devices. In addition to online product sales, e-commerce operations are also designed as a marketing tool to inform the public and generate referrals for centers and for network providers.

 

Distinguishing Features

 

Integral to the success of HearUSA’s strategy is increased awareness of the impact of hearing loss and the medical necessity of treatment, in addition to the enhancement of consumer confidence and the differentiation of HearUSA from other hearing care providers. To this end, the Company has taken the following unique steps:

 

Joint Commission on Accreditation of Healthcare Organizations

 

During 1998, the Company distinguished itself as an accredited healthcare organization when it earned its first three-year accreditation by the Joint Commission. Shortly after the Company was re-accredited for the third time in 2005, it received notification that the Network PPO (preferred provider organization) would not be available in subsequent re-accreditation cycles through The Joint Commission. Therefore, the Company took action to continue its pursuit of distinctive quality and will undergo health network accreditation in 2008 through Utilization Review Accreditation Commission (“URAC”), an independent nonprofit organization which is a recognized leader in promoting health care quality. URAC provides a symbol of excellence for organizations to validate their commitment to quality and accountability

and ensures that all stakeholders are represented in establishing meaningful quality measures for the entire health care industry.

 

Center Management System, Medical Reporting and HearUSA Data Link

 

The Company has developed a proprietary center management and data system called the Center Management System (“CMS”). CMS primarily has two functions: to manage patient information and to process point-of-sale customer transactions. The CMS system is operated over a wide area network that links all locations with the corporate office. The Company’s wide area network leverages technologies including data and telephony deliveries. This system is only used in the company-owned centers. As the Company acquires new centers, a critical part of the integration process is the inclusion of the new center into the CMS. We added 24 centers in the CMS in 2007 and 31 in 2006.

 

The Company’s corporate system is fully integrated with CMS to provide additional benefits and functionality that can be better supported centrally. Data redundancy is built into the system architecture as data is currently stored both at the regional facilities and at the central facility. The consolidated data repository is constructed to support revenues in excess of $550 million, to accommodate approximately 500 unique business units and to manage 500,000 new patients annually.

 

One of the outputs of CMS is a computerized reporting system that provides referring physicians the test results and recommended action for every patient examined by HearUSA staff in a company-owned center. To the Company’s knowledge, no other dispenser or audiologist presently offers any referring physician similar documentation. Consistent with the Company’s mission of making hearing care a medical necessity, this reporting system makes hearing a part of the individual’s health profile, and increases awareness of hearing conditions in the medical community. Another unique aspect of CMS is its data mining capability which allows for targeted marketing to its customer base. The national call center also has the ability to access the CMS system and can directly schedule appointments.

 

Competition

 

The U.S. hearing care industry is highly fragmented with approximately 9,000 independent practitioners providing hearing care products and services. The Company competes on the basis of price and service and, as described above, tries to distinguish itself as a leading provider of hearing care to health care providers and the self-pay patient. The Company competes for the managed care customer on the basis of access, quality and cost.

 

In the Canadian Province of Ontario, the traditional hearing instrument distribution system is primarily made up of small independent practices where associations are limited to two or three centers. Most centers are relatively small and are located in medical centers, professional centers or in small shopping centers.

 

It is difficult to determine the precise number of the Company’s competitors in every market where it has operations, or the percentage of market share enjoyed by the Company. Some competitors are large distributors, including Amplifon of Italy, which owns a network of franchised centers (Miracle Ear and National Hearing Center) and company-owned centers (Sonus) in the United States and Canada, and Beltone Electronics Corp., a hearing aid manufacturer owned by Great Nordic that distributes its products primarily through a national network of “authorized” distributors in the United States and Canada. Large discount retailers, such as Costco, also sell hearing aids and present a competitive threat in selected HearUSA markets. All of these companies have greater resources than HearUSA, and there can be no assurance that one or more of these competitors will not expand and/or change their operations to capture the market targeted by HearUSA.

 

The Company’s network business will also face competition by companies offering similar network services. These companies attempt to aggregate demand for hearing products and sell marketing and other services to network participants. In addition, some of these networks are able to offer discounts to managed care payors, insurers and membership organizations. Many independent hearing care providers

belong to more than one network. In addition, contract terms for membership are typically short and may be terminated by either party at will. There can be no assurance, however, that the largely fragmented hearing care market cannot be successfully consolidated by the establishment of co-operatives, alliances, confederations or the like, which would then compete more directly with HearUSA’s network and its company-owned centers.

 

Reliance on Manufacturers

 

The Company’s supply agreement with Siemens requires that a significant portion of the company-owned centers’ sales will be of Siemens devices. Siemens has a well-diversified product line (including Rexton and Electone) with a large budget devoted to research and development. However, there can be no guarantee that Siemens’ technology or product line will remain desirable in the marketplace. Furthermore, if Siemens’ manufacturing capacity cannot keep pace with the demand of HearUSA and other customers, HearUSA’s business may be adversely affected.

 

In the event of a disruption of supply from Siemens or another of the Company’s current suppliers, the Company believes it could obtain comparable products from other manufacturers. Few manufacturers offer dramatic product differentiation. HearUSA has not experienced any significant disruptions in supply in the past.

 

Regulation

 

Federal

 

The practice of audiology and the dispensing of hearing aids are not presently regulated on the federal level in the United States. The United States Food and Drug Administration (“FDA”) is responsible for monitoring the hearing care industry. The FDA enforces regulations that deal specifically with the manufacture and sale of hearing aids. FDA requires that all dispensers meet certain conditions before selling a hearing aid relating to suitability of the patient for hearing aids and the advisability of medical evaluation prior to being fitted with a hearing aid. The FDA requires that first time hearing aid purchasers receive medical clearance from a physician prior to purchase; however, patients may sign a waiver in lieu of a physician’s examination. The FDA has mandated that states adopt a return policy for consumers offering them the right to return their products, generally within 30 days. HearUSA offers all its customers a full 30-day return period or the return period applicable to state guidelines and extends the return period to 60 days for patients who participate in the family hearing counseling program. FDA regulations require hearing aid dispensers to provide customers with certain warnings and statements regarding the use of hearing aids. Also, the FDA requires hearing aid dispensers to review instructional manuals for hearing aids with patients before the hearing aid is purchased.

 

In addition, a portion of the Company’s revenues comes from participation in Medicare and Medicaid programs. Federal laws prohibit the payment of remuneration in order to receive or induce the referral of Medicare or Medicaid patients, or in return for the sale of goods or services to Medicare or Medicaid patients. Furthermore, federal law limits physicians and other healthcare providers from referring patients to providers of certain designated services in which they have a financial interest. HearUSA believes that all of its managed care and other provider contracts and its relationships with referring physicians are in compliance with these federal laws.

 

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) requires the use of uniform electronic data transmission standards for health care claims and payment transactions submitted or received electronically. The Department of Health and Human Services (“HHS”) adopted regulations establishing electronic data transmission standards that all health care providers must use when submitting or receiving certain health care transactions electronically. In addition, HIPAA required HHS to adopt standards to protect the security and privacy of health-related information. Final regulations containing privacy standards are now effective. HearUSA believes it has taken the necessary steps to be in full compliance with these regulations.

The Company’s telemarketing activities are subject to regulation at the Federal level by the Federal Trade Commission (“FTC”) and the Federal Communications Commission (“FCC”).

 

The Telemarketing and Consumer Fraud and Abuse Protection Act of 1994 required the Federal Trade Commission (“FTC”) to develop regulations to prevent fraudulent and abusive practices by telemarketers. These regulations, known as the Telemarketing Sales Rule (“TSR”), became effective on December 31, 1995. An amended TSR was issued on January 29, 2003, that (among other things) created a national Do Not Call registry administered and enforced by the FTC; mandated a 3% abandonment rate for predictive dialers; and required all telemarketers to transmit Caller ID information. The TSR defines telemarketing (in pertinent part) as “a plan, program, or campaign which is conducted to induce the purchase of goods or services or a charitable contribution, by use of one or more telephones and which involves more than one interstate telephone call.” Provisions and restrictions of the rule apply to individuals and organizations that use interstate telephone calls to perform such sales campaigns.

 

The FCC oversees radio, television, cable, satellite, and wire communications. Under the Telephone Consumer Protection Act of 1991 (“TCPA”), the FCC promulgated regulations that mandated the creation of company-specific or “in-house” Do Not Call lists (requiring all telemarketers to honor requests by consumers to cease future calls to that consumer on behalf of a specified seller), and further regulated the use of automatic telephone dialing systems and facsimile broadcast messages. The FCC issued its own set of amendments to its TCPA rules on July 3, 2003. These amendments rules brought the FCC’s TCPA rules more in line with the FTC’s rules governing the national Do Not Call registry, the use of predictive dialers, as well as the transmission of Caller ID by telemarketers. The rules also strengthened and clarified the prohibitions governing calls via automatic telephone dialing systems (thereby prohibiting the use of predictive dialers to place telephone calls to cellular telephones) as well as facsimile broadcasts.

 

The Company adheres to policies set forth by the FTC and the FCC, and has established policies and practices to ensure its compliance with FTC and FCC regulations, including the requirements related to the national Do Not Call registry.

 

In addition, the FTC is responsible for monitoring the business practices of hearing aid dispensers and vendors. The FTC can take action against companies that mislead or deceive consumers. FTC regulations also require companies offering warranties to fully disclose all terms and conditions of their warranties.

 

The FTC is also engaged in enforcement relating to the protection of sensitive customer data. The FTC has announced a program of enforcement actions to ensure that businesses implement reasonable data security practices to protect sensitive consumer data such as Social Security numbers.

 

The CAN-SPAM Act of 2003 regulates commercial electronic mail on a nationwide basis. It imposes certain requirements on senders of commercial electronic mail. The Company adheres to the law by properly representing the nature of its commercial email messages in the subject line, not tampering with source and transmission information in the email “header,” and obtaining email addresses through lawful means. The Company adheres to the specific disclosure requirements of the law by including a physical mail address and a clearly identified and conspicuous “opt-out” mechanism in all commercial email. The Company honors all consumer requests to stop receiving future commercial emails in a timely manner.

 

The Company cannot predict the effect of future changes in federal laws, including changes that may result from proposals for federal health care reform, or the impact that changes in existing federal laws or in the interpretation of those laws might have on the Company. The Company believes it is in material compliance with all existing federal regulatory requirements.

 

State

 

State regulations of the hearing care industry exist in every state and are concerned primarily with the formal licensure of audiologists and those who dispense hearing aids, including procedures involving the fitting and dispensing of hearing aids. There can be no assurance that regulations will not exist in jurisdictions in which the Company plans to open centers or will not be promulgated in states in which the Company currently operates centers which may have a material adverse effect upon the Company. Such

regulations might include more stringent licensure requirements for dispensers of hearing aids, inspections of centers for the dispensing of hearing aids and the regulation of advertising by dispensers of hearing aids. The Company knows of no current or proposed state regulations with which it, as currently operated, could not comply.

 

Many states have laws and regulations that impose additional requirements related to telemarketing and to the use of commercial email. These include telemarketing registration requirements and anti-fraud protections related to telemarketing and email. In some cases, state laws and regulations may be more restrictive than federal laws and regulations.

 

State regulation may include the oversight of the Company’s advertising and marketing practices as a provider of hearing aid dispensing services. The Company’s advertisements and other business promotions may be found to be in violation of these regulations from time to time, and may result in fines or other sanctions, including the prohibition of certain marketing programs that may ultimately harm financial performance.

 

The Company employs licensed audiologists and hearing aid dispensers. Under the regulatory framework of certain states, business corporations are not able to employ audiologists or offer hearing services. California has such a law, restricting the employment of audiologists to professional corporations owned by audiologists or similar licensees. The Company believes, however, that because the State of California’s Department of Consumer Affairs has indicated that speech-language pathologists may be employed by business corporations, the Company may employee audiologists. The similarity of speech-language pathology to audiology, and the fact that speech-language pathologists and audiologists are regulated under similar statutes and regulations, leads the Company to believe that business corporations and similar entities may employ audiologists. No assurance can be given that the Company’s interpretation of California’s laws will be found to be in compliance with laws and regulations governing the corporate practice of audiology or, if its activities are not in compliance, that the legal structure of the Company’s California operations can be modified to permit compliance.

 

In addition, state laws prohibit any remuneration for referrals, similar to federal laws discussed above. Generally, these laws follow the federal statues described above. State laws also frequently impose sanctions on businesses when there has been a breach of security of sensitive customer information.

 

The Company believes it is in material compliance with all applicable state regulatory requirements. However, the Company cannot predict future state legislation which may affect its operations in the states in which it does business, nor can the Company assure that interpretations of state law will remain consistent with the Company’s understanding of those laws as reflected through its operations.

 

Canada

 

Laws and regulations for the Province of Ontario, Canada are concerned primarily with the formal licensure of audiologists and dispensers who dispense hearing aids and with practices and procedures involving the fitting and dispensing of hearing aids. All Ontario audiologists must be members of the College of Audiologists and Speech and Language Pathologists of Ontario and hearing aid dispensers practicing in Ontario must be members of the Association of Hearing Instrument Practitioners. Both audiologists and hearing instrument practitioners are governed by a professional code of conduct. There can be no assurance that regulations will not be promulgated in the Province of Ontario which may have a material adverse effect upon the Company. Such regulations might include more stringent licensure requirements for dispensers of hearing aids, inspections of centers for the dispensing of hearing aids and the regulation of advertising by dispensers of hearing aids. The Company knows of no current or proposed Ontario regulations with which it, as currently operated, could not comply. The Company employs licensed audiologists and hearing aid dispensers in the Province of Ontario.

 

Ontario regulations and codes of conduct of audiologists and hearing instrument practitioners may include the oversight of the Company’s advertising and marketing practices as a provider of hearing aid dispensing services. The Company’s advertisements and other business promotions may be found to be in

violation of these regulations from time to time, and may result in fines or other sanctions, including the prohibition of certain marketing programs that may ultimately harm financial performance.

 

In addition, Ontario regulations and codes of conduct of audiologists and hearing instrument practitioners prohibit any remuneration for referrals. The Company has structured its operations in Canada to assure compliance with these regulations and codes and believes it is in full compliance with Canadian law.

 

Product and Professional Liability

 

In the ordinary course of its business, HearUSA may be subject to product and professional liability claims alleging the failure of, or adverse effects claimed to have been caused by products sold or services provided by the Company. The Company maintains insurance at a level which the Company believes to be adequate. A successful claim in excess of the policy limits of the Company’s liability insurance, however, could adversely affect the Company. As the distributor of products manufactured by others, the Company believes it would properly have recourse against the manufacturer in the event of a product liability claim; however, there can be no assurance that recourse against a manufacturer by the Company would be successful or that any manufacturer will maintain adequate insurance or otherwise be able to pay such liability.

 

Seasonality

 

The Company is subject to regional seasonality, the impact of which is minimal.

 

Employees

 

At December 29, 2007, HearUSA had 534 full-time employees and 84 part-time employees

 

Where to Find More Information

 

The Company makes information available free of charge on its website (www.hearusa.com). Through the website, interested persons can access the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K after such material is electronically filed with the SEC. In addition, interested persons can access the Company’s code of ethics and other governance documents on the Company’s website.

 

 

This Annual Report on Form 10-K, including the management discussion and analysis set out below, contains or incorporates a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Act Exchange of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. Any statements that are not statements of historical fact should be considered forward-looking statements and should be read in conjunction with our consolidated financial statements and notes to the consolidated financial statements included in this report as well as the risk factors set forth below. The statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that we are unaware of may become important factors that affect us. If any of the following risks occur, our business, financial condition and results of operations could be materially and adversely affected.

HearUSA has a history of operating losses and may never be profitable.

 

HearUSA has incurred net losses in each year since its organization, and its accumulated deficit at December 29, 2007 was approximately $113.0 million. We expect quarterly and annual operating results to fluctuate, depending primarily on the following factors:

 

 

There can be no assurance that HearUSA will achieve profitability in the near or long term or ever.

 

We may not effectively compete in the hearing care industry.

 

The hearing care industry is highly fragmented and barriers to entry are low. Approximately 9,000 practitioners provide testing and dispense products and services that compete with those sold and provided by HearUSA. We also compete with small retailers, as well as large networks of franchisees and distributors established by larger companies, such as those manufacturing and selling Miracle Ear and Beltone products. Some of the larger companies have far greater resources than HearUSA and could expand and/or change their operations to capture the market targeted by HearUSA. Large discount retailers, such as Costco Wholesale Corporation, also sell hearing aids and present a competitive threat in our markets. In addition, it is possible that the hearing care market could be effectively consolidated by the establishment of cooperatives, alliances or associations that could compete more successfully for the market targeted by us.

 

We are dependent on manufacturers who may not perform.

 

HearUSA is not a hearing aid manufacturer. We rely on major manufacturers to supply our hearing aids and to supply hearing enhancement devices. A significant disruption in supply from any or all of these manufacturers could materially adversely affect our business. Our strategic and financial relationship with Siemens Hearing Instruments, Inc. requires us to purchase from Siemens a significant portion of our requirements of hearing aids at specified prices for a period of five years (December 2006 to February 2013). Although Siemens is the world’s largest manufacturer of hearing devices, there can be no assurance that Siemens’ technology and product line will remain desirable in the marketplace. Furthermore, if Siemens’ manufacturing capacity cannot keep pace with the demand of HearUSA and other customers, our business may be adversely affected.

 

We may not be able to access funds under our credit facility with Siemens if we cannot maintain compliance with the restrictive covenants contained therein and in our supply agreement with Siemens.

 

HearUSA and Siemens Hearing Instruments Inc. are parties to a credit agreement pursuant to which HearUSA has obtained a $50 million secured credit facility from Siemens. As of December 29, 2007, an aggregate of approximately $37 million in loans was outstanding under the credit facility. To continue to access the credit facility, we are required to comply with the terms of the amended credit facility, including compliance with restrictive covenants. There can be no assurance that we will be able to comply with these restrictive covenants in the future and, accordingly, may be unable to access the funds provided under the credit facility. If we are unable to comply with these restrictive covenants, we may be found in default by Siemens and face other penalties under the credit agreement. In addition, we have entered into a supply agreement with Siemens, which imposes certain purchase requirements on us. If we fail to comply with the supply agreement, Siemens may declare us in default of the credit agreement and all loans would be immediately due and payable

We rely on qualified audiologists, without whom our business may be adversely affected.

 

HearUSA currently employs approximately 216 licensed hearing professionals, of whom approximately 167 are audiologists and 49 are licensed hearing aid specialists. If we are not able to attract and retain qualified audiologists, we will be less able to compete with networks of hearing aid retailers or with the independent audiologists who also sell hearing aids and our business may be adversely affected. Many audiologists are obtaining doctorate degrees, and the increased educational time required at the doctoral level is further restricting the pool of audiologists available for employment.

 

We may not be able to maintain existing agreements or enter into new agreements with health insurance and managed care organizations, which may result in reduced revenues.

 

HearUSA enters into provider agreements with health insurance companies and managed care organizations for the furnishing of hearing care in exchange for fees. The terms of most of these agreements are to be renegotiated annually, and these agreements may be terminated by either party, usually on 90 days or less notice at any time. There is no certainty that we will be able to maintain these agreements on favorable terms or at all. If we cannot maintain these contractual arrangements or enter into new arrangements, there will be a material adverse effect on our revenues and results of operations. In addition, the early termination of or failure to renew the agreements that provide for payment to HearUSA on a per-patient-per-month basis would cause us to lower our estimates of revenues to be received over the life of the agreements. This could have a material adverse effect on our results of operations.

 

We depend on our joint venture for our California operations and may not be able to attract sufficient patients to our California centers without it.

 

HEARx West LLC, our joint venture with Kaiser Permanente, operates 27 full-service centers in California. Since their inception, HEARx West centers have derived approximately two-thirds of their revenues from sales to Kaiser Permanente members, including revenues through an agreement between the joint venture and Kaiser Permanente’s California division servicing its hearing benefited membership. If Kaiser Permanente does not perform its obligations under the agreement, or if the agreement is not renewed upon expiration, the loss of Kaiser patients in the HEARx West centers would adversely affect our business. In addition, HEARx West centers would be adversely affected by the loss of the ability to market to Kaiser members and promote the business within Kaiser’s medical centers, including the referral of potential customers by Kaiser.

 

We rely on the efforts and success of managed care companies that may not be achieved or sustained.

 

Many managed care organizations, including some of those with whom we have contracts, have experienced and are continuing to experience significant difficulties arising from the widespread growth and reach of available plans and benefits. If the managed care organizations are unable to attract and retain covered members in our geographic markets, we may be unable to sustain the operations of our centers in those geographic areas. In addition managed care organizations are subject to changes in federal legislation affecting healthcare. Administration changes in 2008 may have an effect on the way these organizations deliver services to their members. If these changes result in contract cancellations with these organizations, there can be no assurance that we can maintain all of our centers. We will close centers where warranted and such closures could have a material adverse effect on us.

 

We may not be able to maintain JCAHO accreditation, and our revenues may suffer.

 

HearUSA has a three-year accreditation from the Joint Committee on Accreditation of Healthcare Organizations (JCAHO) that extends to 2008. This status distinguishes HearUSA from other hearing care providers and is widely used in our marketing efforts. The Company received notification that the Network PPO (preferred provider organization) accreditation as previously relied upon by us, will not be available in subsequent reaccreditation cycles through The Joint Commission. The Company is therefore pursuing

continuation of its distinctive quality assurance by undergoing health network accreditation in 2008 through the Utilization Review Accreditation Commission (URAC), although there can be no assurance it will achieve accreditation. In addition, if we are not able to maintain our accredited status, we will not be able to distinguish HearUSA on this basis and our revenues may suffer.

 

We are exposed to potential product and professional liability that could adversely affect us if a successful claim is made in excess of insurance policy limits.

 

In the ordinary course of its business, HearUSA may be subject to product and professional liability claims alleging that products sold or services provided by the company failed or had adverse effects. We maintain liability insurance at a level which we believe to be adequate. A successful claim in excess of the policy limits of the liability insurance could materially adversely affect our business. As the distributor of products manufactured by others, we believe we would properly have recourse against the manufacturer in the event of a product liability claim. There can be no assurance, however, that recourse against a manufacturer by HearUSA would be successful, or that any manufacturer will maintain adequate insurance or otherwise be able to pay such liability.

 

Risks Relating to HearUSA Common Stock

 

The price of our common stock is volatile and could decline.

 

The price of HearUSA common stock could fluctuate significantly, and you may be unable to sell your shares at a profit. There are significant price and volume fluctuations in the market generally that may be unrelated to our operating performance, but which nonetheless may adversely affect the market price for HearUSA common stock. The price of our common stock could change suddenly due to factors such as:

 

 

Any of these conditions may cause the price of HearUSA common stock to fall, which may reduce business and financing opportunities available to us and reduce your ability to sell your shares at a profit, or at all.

 

HearUSA might fail to maintain a listing for its common stock on the American Stock Exchange, making it more difficult for stockholders to dispose of or to obtain accurate quotations as to the value of their HearUSA stock.

 

HearUSA common stock is presently listed on the American Stock Exchange. The American Stock Exchange will consider delisting a company’s securities if, among other things,

 

 

HearUSA may not be able to maintain its listing on the American Stock Exchange, and there may be no public market for the HearUSA common stock. In the event the HearUSA common stock were delisted from the American Stock Exchange, trading, if any, in the common stock would be conducted in the over-the-counter market. As a result, you would likely find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, your HearUSA common stock.

 

If “penny stock” regulations apply to HearUSA common stock, you may not be able to sell or dispose of your shares.

 

If HearUSA common stock were delisted from the American Stock Exchange, the “penny stock” regulations of the Securities and Exchange Commission might apply to transactions in the common stock. A “penny stock” generally includes any over-the-counter equity security that has a market price of less than $5.00 per share. The Commission regulations require the delivery, prior to any transaction in a penny stock, of a disclosure schedule prescribed by the Commission relating to the penny stock. A broker-dealer effecting transactions in penny stocks must make disclosures, including disclosure of commissions, and provide monthly statements to the customer with information on the limited market in penny stocks. These requirements may discourage broker-dealers from effecting transactions in penny stocks. If the penny stock regulations were to become applicable to transactions in shares of HearUSA common stock, they could adversely affect your ability to sell or otherwise dispose of your shares.

 

Conversion of outstanding HearUSA convertible instruments and exercise of outstanding HearUSA options and warrants could cause substantial dilution.

 

As of December 29, 2007, outstanding convertible note, convertible subordinated notes, warrants and options of HearUSA included:

 

 

To the extent outstanding subordinated notes are converted, options or warrants are exercised or additional shares of capital stock are issued, stockholders will incur additional dilution.

 

Future sales of shares may depress the price of HearUSA common stock.

 

If substantial stockholders sell shares of HearUSA common stock into the public market, or investors become concerned that substantial sales might occur, the market price of HearUSA common stock could decrease. Such a decrease could make it difficult for HearUSA to raise capital by selling stock or to pay for acquisitions using stock. In addition, HearUSA employees hold a significant number of options to purchase shares, many of which are presently exercisable. Employees may exercise their options and sell shares soon after such options become exercisable, particularly if they need to raise funds to pay for the exercise of such options or to satisfy tax liabilities that they may incur in connection with exercising their options.

 

Because of the HearUSA rights agreement and the related rights plan for the exchangeable shares, a third party may be discouraged from making a takeover offer which could be beneficial to HearUSA and its stockholders.

 

HearUSA has entered into a rights agreement with The Bank of New York, as rights agent. HEARx Canada Inc. has adopted a similar rights plan relating to the exchangeable shares of HEARx Canada Inc. issued in connection with the acquisition of Helix. The rights agreements contain provisions that could delay or prevent a third party from acquiring HearUSA or replacing members of the HearUSA board of directors, even if the acquisition or the replacements would be beneficial to HearUSA stockholders. The rights agreements could also result in reducing the price that certain investors might be willing to pay for

shares of the common stock of HearUSA and making the market price lower than it would be without the rights agreement.

 

Because HearUSA stockholders do not receive dividends, stockholders must rely on stock appreciation for any return on their investment in HearUSA.

 

We have never declared or paid cash dividends on any of our capital stock. Payment of dividends is restricted pursuant to our agreement with Siemens. We currently intend to retain any earnings for future growth and, therefore, do not anticipate paying cash dividends in the future. As a result, only appreciation of the price of HearUSA common stock will provide a return to investors who purchase or acquire common stock.

 

Other Risks Relating to the Business of HearUSA

 

We may not be able to obtain additional capital on reasonable terms, or at all, to fund our operations.

 

If capital requirements vary from those currently planned or losses are greater than expected, HearUSA may require additional financing. If additional funds are raised through the issuance of convertible debt or equity securities, the percentage ownership of existing stockholders may be diluted, the securities issued may have rights and preferences senior to those of stockholders, and the terms of the securities may impose restrictions on operations. If adequate funds are not available on reasonable terms, or at all, we will be unable to take advantage of future opportunities to develop or enhance our business or respond to competitive pressures and possibly even to remain in business.

 

Future acquisitions or investments could negatively affect our operations and financial results or dilute the ownership percentage of our stockholders.

 

We have initiated a strategic acquisition program. We may have to devote substantial time and resources in order to complete potential acquisitions. We may not identify or complete acquisitions in a timely manner, on a cost-effective basis, or at all. Acquired operations may not be effectively integrated into our operations and may fail.

 

In the event of any future acquisitions, HearUSA could:

 

 

These transactions involve numerous risks that could harm operating results and cause the price of HearUSA common stock price to decline, including:

 

 

Any of these risks could harm the business and operating results of HearUSA

Increased exposure to currency fluctuations could have adverse effects on our reported earnings.

 

Most of HearUSA’s revenues and expenses are denominated in U.S. dollars. Some of our revenues and expenses are denominated in Canadian dollars and, therefore, we are exposed to fluctuations in the Canadian dollar. As a result, our earnings will be affected by increases or decreases in the Canadian dollar. Increases in the value of the Canadian dollar versus the U.S. dollar would tend to increase reported earnings (or reduce losses) in U.S. dollar terms, and decreases in the value of the Canadian dollar versus the U.S. dollar would tend to reduce reported earnings (or increase losses).

 

 

None

 

 

HearUSA’s corporate offices, network management and national call center are located in West Palm Beach, Florida. The leases on these properties are for ten years and expire in 2016. As of December 29, 2007, the Company operated 44 centers in Florida, 15 in New Jersey, 29 in New York, 7 in Massachusetts, 7 in Ohio, 18 in Michigan, 8 in Missouri, 6 in North Carolina and 27 HEARx West centers in California. HearUSA also operates 24 centers in the Province of Ontario. All of the locations are leased for one to ten year terms pursuant to generally non-cancelable leases (with renewal options in some cases). The Company believes these locations are suitable to serve its patients’ needs. The network is operated from the Company’s corporate office in West Palm Beach. The Company has no interest or involvement in the network providers’ properties or leases. The e-commerce business is operated from the Company’s corporate office in West Palm Beach.

 

 

The Company has from time to time been a party to lawsuits and claims arising in the normal course of business. In the opinion of management, there are no pending claims or litigation, in which the outcome would have a material effect on the Company’s consolidated financial position or results of operations.

 

 

None

 

EXECUTIVE OFFICERS OF THE COMPANY

 

The following sets forth certain information as of the date hereof with respect to the Company’s executive officers. The two executive officers named below are serving pursuant to employment agreements with 3-year terms expiring in 2011, which will be renewed for successive one-year terms unless a party provides notice of non renewal.

 

 

There are no family relationships among any of the executive officers and directors of the Company.

 

Stephen J. Hansbrough, Chief Executive Officer and Director, was formerly the Senior Vice President of Dart Drug Corporation and was instrumental in starting their affiliated group of companies (Crown Books and Trak Auto). Mr. Hansbrough subsequently became Chairman and CEO of Dart Drug Stores. After leaving Dart, Mr. Hansbrough was an independent consultant specializing in turnaround and start-up operations, primarily in the retail field, until he joined HearUSA in December 1993.

 

Gino Chouinard, Executive Vice President and Chief Financial Officer, joined HearUSA in July 2002 with its acquisition of Helix. Mr. Chouinard served as Helix’s Chief Financial Officer from November 1999 until its acquisition by HearUSA. Mr. Chouinard is a Chartered Accountant who previously worked for Ernst & Young LLP, an international accounting firm, as Manager from 1996 until 1999 and as Senior Accountant from 1994 until 1996.

 

PART II

 

 

The common stock of the Company is traded on the American Stock Exchange (AMEX) under the symbol “EAR” and the exchangeable shares of HEARx Canada Inc. are traded on the Toronto Stock Exchange under the symbol “HUX.” Holders of exchangeable shares may tender their holdings for common stock on a one-for-one basis at any time. As of February 15, 2008, the Company had 38,014,157 shares of common stock and 568,761 exchangeable shares outstanding. The closing price on February 15, 2008 was US$1.43 for the common stock and CDN$1.15 for the exchangeable shares. The following table sets forth the high and low sales prices for the common stock as reported by the AMEX for the fiscal quarters indicated:

 

 

As of February 15, 2008, there were 1,152 holders of record of the common stock.

 

Dividend Policy

 

HearUSA has never paid and does not anticipate paying any dividends on the common stock in the foreseeable future but intends to retain any earnings for use in the Company’s business operations. Payment of dividends is restricted under the terms of the Company’s credit agreement with Siemens.

 

 

The following selected financial data of the Company should be read in conjunction with the consolidated financial statements and notes thereto and the following Management’s Discussion and Analysis of Financial Condition and Results of Operations. The financial data set forth on the next two pages has been derived from the audited consolidated financial statements of the Company.

 

CONSOLIDATED STATEMENT OF OPERATIONS DATA:

 

 

 

 

BALANCE SHEET DATA:

 

 

 

 

GENERAL

 

In 2007, the Company continued to focus on its acquisition program and closed on 17 transactions representing 24 centers with annual estimated revenues of approximately $12.9 million. Since the beginning of the acquisition program in 2005, the Company has acquired a total of 60 centers, representing $31.7 million of annual estimated revenues. Revenues resulting from the centers acquired in 2006 (for those that were not owned for the entire year in 2006) and from centers acquired in 2007, combined, were approximately $12.8 million. From centers acquired in 2007, only approximately $4.6 million of revenues were recorded in 2007 due to the timing of the acquisition closings throughout the year. Toward the end of 2007, the Company entered into the North Carolina market with two acquisitions representing five centers with total aggregate annual estimated revenues of approximately $2.4 million. As a result of the acquisition program, the average number of centers increased from 146 in 2006 to 173 in 2007. The number of centers at the end of 2007 was 185.

 

Early in 2007, the Company signed Don Shula as its spokesperson and at the end of the second quarter launched its television campaign “Just Find Out” featuring Coach Shula. The expenditures related to this new campaign were approximately $700,000 in the second quarter of 2007. Management estimates that this campaign was a significant contributor to the 8% increase in revenues from comparable centers (which includes network revenues changes and the impact related to the fluctuation of the Canadian exchange rate) during the second half of the year over the same period of last year.

 

Also earlier in 2007 the Company entered into an agreement with the holders of the 2003 notes pursuant to which all of the notes were converted, the Company paying down some principal and interest in cash and the holders converting the balance into shares of common stock. In addition, the holders of the notes agreed to exercise all of their warrants at a reduced exercise price. As a result, we took a charge of approximately $2.6 million related to this transaction (see Note 7 — Convertible Subordinated Notes, Notes to the Consolidated Financial Statements included herein).

 

In September of 2007, we amended our agreements with Siemens to defer repayment of approximately $4.2 million from September 2007 to December 29, 2008. In the amendments, interest on our Tranche D was increased but Siemens agreed to provide the Company with marketing expense reimbursements to support developing and promoting our business and advertising Siemens products. Siemens also agreed to provide an additional $3 million for operating expenses on an as-needed basis through the end of 2008 (see Note 6 — Long-term Debt, Notes to Consolidated Financial Statements included herein).

 

During the second half of the year, the Company restructured its management team by reducing its size and realigning responsibilities in order to be more efficient with its current operations and in facing anticipated growth in the years to come. This restructuring resulted in reduction in wages exceeding $1 million on an annualized basis before severance charges of approximately $518,000 recorded in the third and fourth quarter of 2007. Also during that restructuring, the Company implemented changes with its regional management team in order to increase their responsibilities related to the profitability of their specific region by putting in place new incentive compensations based on profitability. Furthermore, the Company realigned some of its marketing, professional incentive compensation, products offering and pricing strategy to provide regional management with greater flexibilities in tailoring programs to specific regions.

 

Overall in 2007 we increased revenues from both acquisitions and organic growth and we benefited from a significant increase in our rebate credits from Siemens. Those, combined with strong control over operation and administrative expenses resulted in improvement of our income from operations and margin of 6.7% of total net revenues (compared to 4.3% in 2006), notwithstanding the inclusion in 2007 of charges related to the Shula television campaign, costs associated with the restatement of 2006’s financial statement and severance costs, all totaling 1.4% of total net revenues.

The net loss of $3.4 million or $0.09 per share in 2007 includes the write-offs associated with the conversion of the 2003 notes and warrants and other charges totaling approximately $4.0 million or $0.11 per share. These specific charges will not recur in 2008.

 

RESULTS OF OPERATIONS

 

2007 compared to 2006 (in thousands of dollars)

 

Revenues

 

 

 

 

 

The $14.0 million or 15.8% increase in net revenues over 2006 is principally a result of revenues from acquired centers which generated approximately $12.8 million or 14.4% over 2006 revenues and a slight increase in revenues from comparable centers of approximately 1.4% above the 2006 total net revenues level. The comparable centers total net revenues also include a favorable impact of $736,000 related to fluctuations in the Canadian exchange rate from 2006 to 2007.

 

In 2007 the 4.9% increase in number of hearing aids sold over 2006 included an increase of 7.9% from acquired centers which was offset by a decrease in the number of hearing aids sold in comparable centers from 2006 levels. The impact of the decrease in the number of hearing aids sold from comparable centers was however offset by an increase in the average unit selling price of 9.8% over 2006 average unit selling price. The increase in average unit selling price is primarily due to a different mix of products resulting from patients selecting higher technology hearing aids. The decrease in the number of units sold is in part attributable to the lower volume of Florida Medicaid business. Service revenues increased approximately $902,000, or 15.1%, over last year consistent with the increase in hearing aid revenues.

Cost of Products Sold and Services

 

 

The cost of products sold includes the effect of rebate credits pursuant to our agreements with Siemens.

 

The following table reflects the components of the rebate credits which are included in the above cost of products sold for hearing aids (see Note 6 — Long-term Debt, Notes to Consolidated Financial Statements included herein):

 

 

As indicated in the table above, the decrease of total cost of products sold and services, as a percentage of total net revenues, is due to the additional Siemens rebate credits provided for in the new agreements signed in December 2006. Cost of products sold before the impact of the Siemens rebate credits, as a percent of total net revenues, were 34.3% in both 2007 and 2006.

 

Following the amendments made at the end of September 2007, the base required payment on Siemens Tranche C subject to the rebate credits was reduced from $730,000 to $500,000 per quarter beginning in the fourth quarter of 2007 until the end of the term of the agreements (see Note 6 — Long-term Debt, Notes to Consolidated Financial Statements included herein).

 

In 2008, management expects that the total cost of products sold and services, excluding the Siemens rebate credits, should remain constant as compared to 2007 as a percentage of total net revenues. Management expects a reduction of $690,000 (three quarters at $230,000 per quarter in 2008) in the total amount of Siemens rebate credits when compared to 2007 due to the changes in Tranche C payments referenced above. Management expects this reduction will be partially offset by an increase in the rebate credits related to the forgiveness of the required principal payment on Tranche B due to an estimated increase in the number of Siemens hearing aids sold from acquired centers in 2008 compared to 2007.

 

Expenses

 

The increase in center operating expenses in 2007 is mainly attributable to additional expenses of approximately $5.3 million related to the centers acquired and owned for less than twelve months during the year. The remaining increase relates to an increase in incentive compensation of approximately $277,000 due to additional comparable centers total net revenues, an investment in marketing expense related to the television campaign launched in the second quarter of 2007 of approximately $700,000 and other normal annual increases. The average center operating expenses cost per center remained stable at $283,000. As a percent of total net revenues, however, they increased from 47.6% in 2006 to 49.0% in 2007. This increase is mostly attributable to the investment in marketing discussed above and to the fact that the increase in comparable centers revenues from one year to another of 1.5% was lower than the normal annual percentage increase in center operating expenses. Center operating expenses related to acquired centers of 42% of related total net revenues, were in line with management expectations. Management expects that center operating expenses will increase in total dollars during 2008 due to additional centers acquired in 2007 that were not owned for the entire year as well as expected 2008 acquisitions, additional incentives on additional revenues and annual normal increases. It is also expected that these increases will be partially offset by additional marketing reimbursement allowances from Siemens (see Note 6 — Long-term Debt, Notes to Consolidated Financial Statements included herein).

 

General and administrative expenses increased by approximately $1.2 million in 2007 as compared to the same period of 2006. The increase in general and administrative expenses is primarily attributable to charges due to employee severances related to the management restructuring discussed above in the amount of $518,000 and the cost of professional services related to restatement of prior year financial statements of approximately $200,000, and due to increases in business interruption and directors’ and officers’ insurance premium of approximately $283,000 as well as to normal annual increases of the general and administrative expenses. These increases were partially offset by a decrease in the non-cash stock-based compensation expenses of approximately $370,000. Management expects general and administrative expenses to continue to decrease in 2008 as a percentage of total net revenues following the cost reductions resulting from the management restructuring implemented toward the end of 2007. This does not, however, include the impact of the charge of approximately $720,000 related to Dr. Browns’ retirement agreement that will be recorded in the first quarter of 2008.

 

Depreciation and amortization expense increased by approximately $260,000 in 2007 compared to the same period in 2006. Depreciation was $1.3 million in the 2007 and $1.2 million in 2006. Amortization expense was $896,000 in 2007 and $815,000 in 2006. Most of the amortization expense comes from the amortization of intangible assets related to the acquisitions made by the Company.

 

Interest Expense

 

 

 

 

 

The increase in interest expense in 2007 is attributable to the overall increase in the Siemens average loan balances resulting from monies drawn under Tranche D at the beginning of the year for working capital purposes and under Tranches B and C for new acquisitions as well as an increase in the average balance of the notes payable from business acquisitions and others, which in total contributed to a net increase in the interest expense of approximately $1.7 million. The remaining increase of approximately $359,000 relates to the non-cash interest charges of approximately $2.6 million for the early conversion of the 2003 Convertible Subordinated Notes (see Note 7 — Convertible Subordinated Notes, Notes to Consolidated Financial Statements included herein), partially offset by reductions due to lower principal balances following the conversion of these notes in common shares in April 2007 and the quarterly repayments made on the 2005 subordinated notes. 2006 also benefited from a reduction on interest due to reduction in value of the warrant liability related to the 2005 subordinated notes, which did not exist in 2007.

 

Management expects interest expense to decrease in 2008 as a result of the conversion of the 2003 Convertible Subordinated Notes in April 2007, in loan balance due to note repayment and reductions of the Siemens loans with rebate credits. These reductions will however be partially offset by increases resulting

from the issuance of additional notes payable for business acquisitions and increases in the Siemens loans balances following additional draws on the line of credit to finance the cash component of these acquisitions.

 

Income Taxes

 

The Company has net operating loss carryforwards of approximately $57 million for U.S. income tax purposes. In addition, the Company has temporary differences between the financial statement and tax reporting arising primarily from differences in the amortization of intangible assets and goodwill and depreciation of fixed assets. The deferred tax assets for US purposes have been offset by a valuation allowance because it was determined that these assets were not likely to be realized. The deferred tax assets for Canadian tax purposes are recorded as a reduction of the deferred income tax liability on the Company’s balance sheet and were approximately $517,000 at December 29, 2007 and $680,000 at December 30, 2006.

 

During 2007, the Company recorded a deferred tax expense of approximately $769,000 compared to approximately $741,000 in 2006 related to estimated taxable income generated by the Canadian operations and the estimated deduction of tax deductible goodwill from its US operations. The deferred income tax expense related to the Canadian operations of approximately $174,000 is due to the estimated utilization of deferred tax benefit previously recorded as discussed above. The additional deferred income tax expense recorded of approximately $595,000 ($438,000 in 2006) was recorded because it cannot be offset by other temporary differences as it relates to infinite-lived assets and that the timing of reversing the liability is unknown. Deferred income tax expense will continue to be recorded for these two items as long as the Canadian operations generate taxable income and/or tax deductible goodwill exist for US tax purposes. Tax deductible goodwill with a balance of approximately $30.7 million at December 29, 2007, will continue to increase as we continue to purchase the assets of businesses.

 

Minority Interest

 

During 2007 and 2006 the Company’s fifty percent owned joint venture, HEARx West generated net income of approximately $3.0 million and $3.2 million, respectively. According to the Company’s agreement with its joint venture partner, The Permanente Federation, the Company had included in its statement of operations 100% of the losses incurred by the joint venture since its inception and then received 100% of the net income of the joint venture until the accumulated deficit was eliminated which was completely eliminated at the end of the second quarter of 2006. The Company now records 50% of the venture’s net income as minority interest in income of consolidated subsidiary in the Company’s consolidated statements of operations with a corresponding liability on its consolidated balance sheets. Such amount for the year 2007 was approximately $1.5 million, compared to $633,000 in 2006.

 

2006 compared to 2005 (in thousands of dollars)

 

Revenues

 

 

 

 

 

The $12.1 million or 15.8% increase in net revenues over 2005 is a result of acquired centers, which combined, generated approximately $6.7 million in revenues or 8.7% and an increase of approximately $6.8 million or 9.1% in revenues from comparable centers. The comparable center total net revenues total include a favorable impact of $608,000 related to fluctuations in the Canadian exchange rate from 2005 to 2006. Also, 2005 benefited from an additional week due to the timing of the Company’s accounting calendar. In 2006 there was a 19.6% increase in the number of hearing aids sold over 2005, which increase was partially offset by a 2.7% decrease in the average unit selling price. Service revenues increased approximately $740,000 due to additional network managed care contracts and increase in hearing aids revenues in general.

 

The increase in the number of units sold in 2006 is due to the additional number of centers in 2006 from 2005 resulting from the acquisitions made (the weighted average number of centers in 2006 was 146 compared to 132 in 2005), a more efficient marketing campaign and a better response from our patients related to new products released by Siemens at the end of 2005 and the beginning of 2006 and additional revenues from our existing managed care contracts resulting from additional membership in their programs. The decrease in the average selling price was primarily due to lower prices on hearing aids sold in our Florida centers caused by the reinstatement of free hearing aids to the participants in the Florida Medicaid program. These free hearing aids are provided at a very low reimbursement rate to the Company by the state and therefore affect the Company’s average selling price. This program which was eliminated three years ago and reinstated on July 1, 2006, now covers two hearing aids instead of one. Revenues in the last six months were affected by this new program as the Company had to service a built up demand. Toward the end of 2006 and early 2007, the demand decreased and is now at normal levels.

 

Cost of Products Sold and Services

 

 

The cost of products sold as reflected above includes the effect of the rebate credits pursuant to our agreements with Siemens. The following table reflects the components of the rebate credits which are

included in the above costs of products sold for hearing aids (see Note 6 — Long-term Debt, Notes to Consolidated Financial Statements included herein):

 

 

The increase of total cost of products sold and services, as a percentage of total net revenues, is primarily due to a change in product mix, promotions and the reduction in average selling prices discussed above. Cost of services remained flat from 2005 compared to 2006, as the increase in services net revenues related to network managed care contracts did not include any related cost of services. The increase in the rebate credits from Siemens is due to the forgiveness of interest on Tranche B which did not exist in 2005 and more interest being forgiven by Siemens in 2006 compared to 2005 as the interest on Tranche C began in the fourth quarter of 2006.

 

Expenses

 

 

 

 

The increase in center operating expenses in 2006 is mainly attributable to additional expenses of approximately $3.2 million related to the acquired centers. In addition, the increase relates to an increase in incentive compensation related to additional net revenues, increased wages due to normal merit increases and increases in center and managerial staff and additional advertising expenses. As a percent of total net revenues, center operating expenses remained flat at 47.6% in both 2005 and 2006. These increases were offset by a reduction of one week worth of expenses as 2005 included an extra week. Center operating expenses related to centers acquired in the last twelve months, at 48% of related net revenues, were in line with management expectations.

 

The increase in general and administrative expenses is attributable to the recognition of compensation expense related to employee stock-based compensation awards of approximately $976,000 which did not exist in 2005 (see Note 11 — Stock-based Benefit Plan, Notes to Consolidated Financial Statements included herein) and increases in wages due to normal merit increases and additional employees. These increases were offset by a decrease in professional fees of approximately $278,000 and one week less of expenses as discussed above. As a percentage of total net revenues, the Company achieved positive leverage reducing the expense in percentage of total net revenues, however, this improvement was offset by the employee stock-based compensation expense under 123R representing approximately 1.1% of total net revenues in 2006.

Depreciation and amortization expense in 2006 remained stable compared to the same period in 2005. Decreases due to certain property and equipment becoming fully depreciated were offset by increases due to the acquisition of fixed assets and intangible assets during 2006. Depreciation was $1.2 million in 2006 compared to $1.4 million in 2005. Amortization expense was $815,000 in 2006 compared to $618,000 in 2005. Most of the amortization expense comes from the amortization of intangible assets related to the acquisitions made by the Company.

 

The gain from insurance proceeds of approximately $203,000 in 2006 represents insurance proceeds resulting from business interruption claims from 2005 hurricanes sustained in Florida hearing care centers. There was no hurricane affecting the Company’s operations in 2006.

 

Interest Expense

 

 

 

 

The increase in interest expense in 2006 is attributable to the 2005 subordinated notes, which were issued in August 2005 to repay in full the mandatorily redeemable convertible preferred stock and therefore were outstanding for a full year in 2006 compared to approximately 4 months in 2005, the additional $5 million financing on Tranche C2 from Siemens issued at the end of December 2005 and the issuance of promissory notes related to business acquisitions made during the last six months of 2005 and in 2006. A lower reduction of interest expense in 2006 compared to 2005 related to the warrant liability also contributed to the increase from 2005. This reduction in the warrant liability adjustment was due to an increase in the stock price from last year as well as a decrease in the remaining term of the warrants. These increases were offset in part by reductions in loan balances due to principal payments made during the year as well as amortization of the non-cash debt discount.

Dividends

 

The increase in interest expense was also partially offset by a reduction in dividend expense of approximately $563,000 due to the payment in full of the mandatorily redeemable convertible preferred stock in August of 2005.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Siemens Transaction

 

On December 30, 2006, the Company entered into a Second Amended and Restated Credit Agreement, Amended and Restated Supply Agreement, Amendment No. 1 to Amended and Restated Security Agreement and an Investor Rights Agreement with Siemens Hearing Instruments, Inc.

 

Pursuant to these agreements, the parties increased and restructured the credit facility, extended the term of the credit facility and the supply arrangements, increased the rebates to which the Company may be entitled upon the sale of Siemens hearing aids and granted Siemens certain conversion rights with respect to the debt. On the December 2006 closing date, $2.2 million of accounts payable was transferred to the newly available credit and the Company drew down an additional $5 million in cash in January 2007. Effective on September 28, 2007 the parties made several additional changes to the credit and supply agreements (see Note 6 — Long-term Debt, Notes to Consolidated Financial Statements included herein).

 

Financing and rebate arrangement

 

HearUSA has a $50 million revolving credit facility which expires in February 2013. All outstanding amounts bear annual interest of 9.5%, are subject to varying repayment terms, and are secured by substantially all of the Company’s assets.

 

The first portion of the revolving credit facility is a line of credit of $30 million (Tranches B and C). Approximately $29 million of this first portion is outstanding as of December 29, 2007. $5.4 million has been borrowed under Tranche B for acquisitions and $23.7 million has been borrowed under Tranche C. Borrowing for acquisitions under Tranche B is generally based upon a formula equal to 1/3 of 70% of the acquisition’s trailing 12 months revenues and any amount greater than that may be borrowed from Tranche C with Siemens’ approval. Amounts borrowed under Tranche B are repaid quarterly at a rate of $65 per Siemens’ units sold by the acquisition plus interest and amounts borrowed under Tranche C are repaid quarterly at $500,000 plus interest.

 

The required quarterly principal and interest payments are forgiven by Siemens through a rebate of similar amounts as long as 90% of our hearing aid units sold are Siemens’ products. All amounts rebated reduce the Siemens’ outstanding debt and accrued interest and are accounted for as a reduction of cost of products sold. If HearUSA does not maintain the minimum 90% sales requirement, those amounts are not rebated and must be paid quarterly. The minimum 90% requirement is based on a cumulative twelve month calculation. Since HearUSA entered into this arrangement with Siemens, in December 2001, $25.6 million has been rebated. During 2007 this amount was $7.2 million and the Company expects this amount will be $6.5 million to $7.2 million during 2008.

 

Additionally, in any fiscal quarter, if the Company has complied with the minimum 90% sales requirement and has equaled or exceeded the total number of units sold in the same quarter of the prior year (“quarterly volume test”), additional volume rebates of $312,500 per quarter are earned by the Company and the rebates reduce the Siemens’ outstanding debt and reduce the cost of products sold for that quarter. If the Company has complied with the minimum 90% sales requirement and has sold less than the quarterly volume test but more than ninety-five percent of the quarterly volume test, additional volume rebates of $156,250 per quarter are earned (instead of the $312,500) by the Company and the rebates reduce the Siemens’ outstanding debt and reduce the cost of products sold for that quarter. If the Company exceeds by twenty-five percent or more the quarterly volume test for any fiscal quarter, additional volume

rebates of $156,250 for such quarter are earned (in addition to the $312,500) and the rebates reduce the Siemens’ outstanding debt and reduce the cost of products sold for that quarter.

 

The following table summarizes the rebate structure:

 

 

 

 

The second portion of the revolving credit facility totals $20 million and may be used for acquisitions (Tranche D) once the first $30 million portion is fully utilized. The second portion also includes a $3 million line of credit (Tranche E) for working capital purposes. The amount available for acquisition is equal to $20 million less the amount borrowed under Tranche E. There is $7.9 million outstanding as of December 29, 2007 under Tranche D. None is outstanding under Tranche E. Interest on this portion is paid monthly. $4.2 million of the Tranche D balance is due on December 8, 2008 and the balance of $3.7 million (or any future outstanding balance on Tranche D) in February, 2013. If any amounts are drawn down under Tranche E, they are due on December 19, 2008. Tranche E will not be available beyond December 19, 2008.

 

At such time as there is no amount outstanding under the Tranche B and C, Siemens will continue to provide a $500,000 quarterly rebate, provided that HearUSA complies with the minimum 90% sales requirement, and will provide the additional volume rebates (see table above) if the Siemens’ unit sales targets are met. These rebates will reduce the outstanding balance of the second $20 million balance and cost of products sold. If there is no outstanding balance the rebates will be paid in cash.

 

Marketing arrangement

 

HearUSA receives monthly cooperative marketing payments from Siemens to reimburse the Company for marketing and advertising expenses for promoting its business and Siemens’ products in an amount equal to up to $200,000 plus 3.5% of the amount outstanding under Tranche D, until the $4 million due on December 8, 2008 is fully repaid and 4.5% of the amount outstanding under Tranche D thereafter. These advertising reimbursements reimburse specific incremental, identifiable advertising costs and are recorded as offsets to advertising expense. At December 29, 2007 this amount was approximately $220,000 per month.

 

Investor and other rights arrangement

 

After December 30, 2009 Siemens has the right to convert the outstanding debt, but in no event more than approximately $21.2 million, into HearUSA common shares at a price of $3.30 per share, representing approximately 6.4 million shares of the Company’s outstanding common stock. These conversion rights are accelerated in the event of a change of control or default by HearUSA.

 

The default and change of control conversion rights may entitle Siemens to a lower conversion price, but in all events Siemens will be limited to approximately 6.4 million shares of common stock. The parties

have entered into an Investor Rights Agreement pursuant to which the Company granted Siemens resale registration rights for the common stock underlying the debt. On June 30, 2007, the Company filed the required Form S-3 registration statement to register the shares for resale and the registration statement was declared effective September 27, 2007.

 

In addition, the Company has granted to Siemens certain rights of first refusal in the event the Company chooses to engage in a capital raising transaction or if there is a change of control transaction involving a person in the hearing aid industry.

 

The Siemens credit facility imposes certain financial and other covenants on the Company which are customary for loans of this size and nature, including restrictions on the conduct of the Company’s business, the incurrence of indebtedness, merger or sale of assets, the modification of material agreements, changes in capital structure and making certain payments. If the Company cannot maintain compliance with these covenants, Siemens may terminate future funding under the credit facility and declare all then outstanding amounts under the facility immediately due and payable. In addition, a material breach of the supply agreement or a willful breach of certain of the Company’s obligations under the Investor Rights Agreement may be declared to be a breach of the credit agreement and Siemens would have the right to declare all amounts outstanding under the credit facility immediately due and payable. Any non-compliance with the supply agreement could have a material adverse effect on the Company’s financial condition and continued operations.

 

Working Capital

 

During 2007, the working capital deficit increased $1.1 million to $16.0 million at December 29, 2007 from $14.9 million at December 30, 2006. The increase in the deficit is mostly attributable to an increase in current maturities of long-term debt which arose from the issuance of additional notes for business acquisitions and the $4.2 million amount owed to Siemens by December 19, 2008 that was not outstanding at the end of 2006. These additional current maturities were however partially offset by the elimination of the current maturities of convertible subordinated notes following the conversion of these notes into common shares on April 9, 2007 which positively impacted working capital by $2.5 million (see Note 7 — Convertible Subordinated Notes, Notes to Consolidated Financial Statements included herein).

 

The working capital deficit of $16.0 million includes approximately $2.6 million representing the current maturities of the long-term debt to Siemens which may be repaid through rebate credits. In 2007, the Company generated income from operations of approximately $6.9 million (including approximately $606,000 of non-cash employee stock-based compensation expense and approximately $896,000 of amortization of intangible assets) compared to $3.8 million (including approximately $976,000 of non-cash employee stock-based compensation and approximately $815,000 of amortization of intangible assets) in 2006. Cash and cash equivalents as of December 29, 2007 were approximately $3.4 million.

 

Cash Flows

 

Net cash provided by operating activities in 2007 decreased approximately $2.8 million compared to 2006. This decrease is mainly attributable to a decrease in cash provided by operating activities before changes in non-cash working capital items of approximately $660,000 from one period to another and a decrease in cash due to changes in non-cash working capital items of approximately $2.2 million. Accounts and notes receivables have increased $1.2 million from December 30, 2006 to December 29, 2007 or 16%. This increase is in line with the increase in total net revenues in the fourth quarter of 2007 compared to 2006 of approximately 21%. The number of days of sales outstanding in accounts receivable at December 29, 2007 compares favorably to the 2006 ratio. Accounts payable, accrued expenses and accrued salaries and other compensation increased $2.7 million from December 30, 2006 to December 29, 2007 or 17.2%. This increase is also attributable to the increase in total net revenues, which consequently had an impact on increasing expenditures and related payables.

 

During 2007, cash of approximately $7.0 million was used to complete the acquisition of centers, a decrease of approximately $2.6 million over the $9.6 million spent on acquisitions in 2006 as there were

fewer acquisitions in 2007. It is expected that these funds will continue to be used for acquisitions during 2008 and the source of these funds is expected to be primarily the Siemens’ acquisition line of credit. The reduction of approximately $464,000 in the purchase of property and equipment is due in part to the use of capital leases for approximately $414,000 in 2007 and lower expenditures related to upgrades of centers or relocations in 2007 compared to 2006. Management expects to continue the use of capital leases to finance its purchase of property and equipment when appropriate and cost effective.

 

In 2007, funds of approximately $6.3 million were used to repay long-term debt, subordinated and convertible subordinated notes. In 2007, proceeds of $5 million were received from the Siemens Tranche D and $7.0 million from the Siemens Tranches B and C which was used for acquisitions. The Company expects to continue to draw additional funds from the Siemens acquisition line of credit, as indicated above, in order to cover the cash portion of its 2008 acquisitions. The Company also made distributions to minority interest related to its HEARx West joint venture with Kaiser in the amount of approximately $890,000. Such distribution did not exist in prior years.

 

The Company believes that cash and cash equivalents and cash flow from operations, at current net revenue levels, will be sufficient to support the Company’s operational needs for 2008. However, there can be no assurance that the Company can maintain compliance with the Siemens loan covenants, that net revenue levels will remain at or higher than current levels or that unexpected cash needs will not arise for which the cash, cash equivalents and cash flow from operations will not be sufficient. In the event of a shortfall in cash, the Company might consider short-term debt, or additional equity or debt offerings. There can be no assurance however, that such financing will be available to the Company on favorable terms or at all. The Company also is continuing its aggressive cost controls and sales and gross margin improvements.

 

Contractual Obligations

 

Below is a chart setting forth the Company’s contractual cash payment obligations, which have been aggregated to facilitate a basic understanding of the Company’s liquidity as of December 29, 2007.

 

 

 

 

 

OUTLOOK

 

The Company’s target for 2008 is to exceed $120 million in net revenues. In 2008 management expects to improve its operating margin primarily from increases in total net revenues and strong control over center operating expenses and general and administrative expenses. These measures are anticipated to improve profitability. The Company is adjusting its EPS guidance, previously at $0.10 and $0.13 before the announced retirement of Dr. Paul Brown and related costs which will be taken in the first quarter of 2008. After factoring in this charge of approximately $720,000, the company expects 2008 EPS in the range of $0.08 to $0.11.

 

The Company’s long-term objective is to continue to grow 15% to 20% per year and reach an operating margin of 10% to 12%. Management believes the Company is on its way to achieve that goal as long as growth from comparable centers (including network revenues and the effect of the change in the Canadian exchange rate) remains healthy and costs continue to be under control.

 

SUBSEQUENT EVENT

 

Effective February 4, 2008, Paul A. Brown, M.D., the founder and chairman of the board of directors of HearUSA, Inc. (the “Company”), retired as chairman of the Company. In honor of Dr. Brown’s service to the Company and in recognition of his industry knowledge and expertise, the Board has designated Dr. Brown as chairman emeritus of the board of directors and he will be paid $30,000 annually in such role. On February 4, 2008, the Company and Dr. Brown entered into a retirement agreement pursuant to which the parties set forth the terms of Dr. Brown’s retirement from the Company. This retirement agreement was approved by the board of directors on February 1, 2008. The retirement agreement provides for the termination of his employment agreement dated August 31, 2005 and the payment of a sum equal to $720,000 over three years, provision of continuing health and life insurance benefits for three years and extension of the post-termination exercise period for his options.

 

Stephen J. Hansbrough, president and chief executive officer assumed the role of chairman of the board and Dave McLachlan assumed the role of lead of independent directors.

 

CRITICAL ACCOUNTING POLICIES

 

Management believes the following critical accounting policies affect the significant judgments and estimates used in the preparation of the consolidated financial statements:

 

Goodwill

 

The Company’s goodwill resulted from the combination with Helix in 2002 and the acquisitions made since the inception of its acquisition program in 2005. On at least an annual basis, the Company is required to assess whether its goodwill is impaired. The Company elected to perform this analysis on the first day of its fourth quarter. In order to do this, management applied judgment in determining its “reporting units”, which represent distinct parts of the Company’s business. The reporting units determined by management are the centers, the network and e-commerce. The definition of the reporting units affects the Company’s goodwill impairment assessments. The annual goodwill impairment assessment involves estimating the fair value of a reporting unit and comparing it with its carrying amount. If the carrying value of the reporting unit exceeds its fair value, additional steps are required to calculate an impairment charge. Calculating the fair value of the reporting units requires significant estimates and long-term assumptions. The Company utilized an independent appraisal firm to test goodwill for impairment as of the first day of the Company’s fourth quarter during 2007 and 2006, and each of these tests indicated no impairment. The Company estimates the fair value of its reporting units by applying a weighted average of three methods: quoted market price, external transactions, and discounted cash flow. Significant changes in key assumptions

about the business and its prospects, or changes in market conditions, stock price, interest rates or other externalities, could result in an impairment charge.

 

Revenue recognition

 

HearUSA has company-owned centers in its core markets and a network of affiliated providers who provide products and services to customers that are located outside its core markets. HearUSA enters into provider agreements with benefit providers (third party payors such as insurance companies, managed care companies, employer groups, etc.) under (a) a discount arrangement on products and service; (b) a fee for service arrangement; and (c) a per capita basis or capitation arrangements, which is a fixed per member per month fee received from the benefit providers.

 

All contracts are for one calendar year and are and cancelable with ninety days notice by either party. Under the discount arrangements, the Company provides the products and services to the eligible members of a benefit provider at a pre-determined discount or customary price and the member pays the Company directly for the products and services. Under the fee for service arrangements, the Company provides the products and services to the eligible members at its customary price less the benefit they are allowed (a specific dollar amount), which the member pays directly to the Company. The Company then bills the benefit provider the agreed upon benefit for the service.

 

Under the capitation agreements, the Company agrees with the benefit provider to provide their eligible members with a pre-determined discount. Revenue under capitation agreements is derived from the sales of products and services to members of the plan and from a capitation fee paid to the Company by the benefit provider at the beginning of each month. The members that are purchasing products and services pay the customary price less the pre-determined discount. This revenue from the sales of products to these members is recorded at the customary price less applicable discount in the period that the product is delivered. The direct expenses consisting primarily of the cost of goods sold and commissions on sales are recorded in the same period. Other indirect operating expenses are recorded in the period which they are incurred.

 

The capitation fee revenue is calculated based on the total members in the benefit provider’s plan at the beginning of each month and is non-refundable. Only a small percentage of these members may ever purchase product or services from the Company. The capitation fee revenue is earned as a result of agreeing to provide services to members without regard to the actual amount of service provided. That revenue is recorded monthly in the period that the Company has agreed to see any eligible members.

 

The Company records each transaction at its customary price for the three types of arrangements, less any applicable discounts from the arrangements in the center business segment. The products sold are recorded under the hearing aids and other products line item and the services are recorded under the service line item on the consolidated statement of operations. Revenue and expense are recorded when the product has been delivered, net of an estimate for return allowances. Revenue and expense from services and repairs are recorded when the services or repairs have been performed. Capitation revenue is recorded as revenue from hearing aids since it relates to the discount given to the members.

 

Revenues are considered earned by the Company at the time delivery of product or services have been provided to its customers (when the Company is entitled to the benefits of the revenues).

 

When the arrangements are related to members of benefit providers that are located outside the Company-owned centers’ territories, the revenues generated under these arrangements are included under the network business segment. The Company records a receivable for the amounts due from the benefit providers and a payable for the amounts owed to the affiliated providers. The Company only pays the affiliated provider when the funds are received from the benefit provider. The Company records revenue equal to the minimal fee for processing and administrative fees. The costs associated with these services are operating costs, mostly for the labor of the network support staff and are recorded when incurred.

 

No contract costs are capitalized by the Company.

Allowance for doubtful accounts

 

Certain of the accounts receivable of the Company are from health insurance and managed care organizations and government agencies. These organizations could take up to nine months before paying a claim made by the Company and also impose a limit on the time the claim can be billed. The Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. That estimate is based on historical collection experience, current economic and market conditions, and a review of the current status of each customer’s trade accounts receivable.

 

In order to calculate that allowance, the Company first identifies any known uncollectible amounts in its accounts receivable listing and charges them against the allowance for doubtful accounts. Then a specific percent per plan and per aging categories is applied against the remaining receivables to estimate the needed allowance. Any changes in the percent assumptions per plan and aging categories results in a change in the allowance for doubtful accounts. For example, an increase of 10% in the percent applied against the remaining receivables would increase the allowance for doubtful accounts by approximately $34,000.

 

Sales returns

 

The Company provides to all patients purchasing hearing aids a specific return period of at least 30 days, or as mandated by state guidelines if the patient is dissatisfied with the product. The Company provides an allowance in accrued expenses for returns. The return period can be extended to 60 days if the patient attends the Company’s H.E.L.P. classes. The Company calculates its allowance for returns using estimates based upon actual historical returns. The cost of the hearing aid is reimbursed to the Company by the manufacturer.

 

Vendor rebates

 

The Company receives various pricing rebates from Siemens recorded based on the earning of such rebates by meeting the compliance levels of the Supply Agreement. Those levels relate to quarterly purchases of hearing aid products net of returns, known as “minimum purchase requirements’ and also referred to as the “minimum 90% sales requirement.” At the end of each quarter, to establish compliance with those minimum purchase requirements, the Company and Siemens calculate the number of hearing aids sold by HearUSA in the last four quarters and the percentage of those sales which were Siemens products. If at least 90% of those sales were of Siemens products, the Company has earned the rebates equal to the required payments of principal and interest of Tranche B and C and the rebates then reduce the outstanding balance on Tranche B and C and accrued interest and reduce the cost of products sold for that quarter. If in any fiscal quarter if the Company has complied with the minimum 90% sales requirement and has equaled or exceeded the total number of units sold in the same quarter of the prior year (“quarterly volume test”), additional volume rebates of $312,500 per quarter are earned by the Company and the rebates reduce the outstanding balance of Tranches B or C and reduce the cost of products sold for that quarter. These rebates are recorded monthly on a systematic basis based on supporting historical information that the Company has met these compliance levels. However if the Company has complied with the minimum 90% sales requirement and has sold less than but more than ninety-five percent of the quarterly volume test, additional volume rebates of $156,250 per quarter are earned (instead of the $312,500) by the Company and the rebates reduce the outstanding balance of Tranches B or C and reduce the cost of products sold for that quarter. If the Company exceeds by twenty-five percent or more the quarterly volume test for any fiscal quarter, additional volume rebates of $156,250 for such quarter are earned (in addition to the $312,500) and the rebates reduce the outstanding balance of Tranches B or C and reduce the cost of products sold for that quarter. The Company does not currently record this rebate on a systematic basis because the compliance level has not historically been met. If the Company meets this compliance level in the future it will record the rebate on a quarterly basis when earned.

 

Marketing allowances

 

The Company receives a monthly marketing allowance from Siemens to reimburse the Company for marketing and advertising expenses for promoting its business and Siemens’ products. The Company’s

advertising rebates, which represent a reimbursement of specific incremental, identifiable advertising costs, are recorded as an offset to advertising expense. If the cash consideration exceeds the allocated cost of advertising, the excess would be recorded as a reduction of cost of products sold.

 

Impairment of Long-Lived Assets

 

Long-lived assets are subject to a review for impairment if events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the future undiscounted cash flows generated by an asset or asset group is less than its carrying amount, it is considered to be impaired and would be written down to its fair value. Currently we have not experienced any events that would indicate a potential impairment of these assets, but if circumstances change we could be required to record a loss for the impairment of long-lived assets.

 

Stock-based compensation

 

Share-based payments are accounted for in accordance with the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123(R)”). To determine the fair value of our stock option awards, we use the Black-Scholes option pricing model, which requires management to apply judgment and make assumptions to determine the fair value of our awards. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected term”), the estimated volatility of the price of our common stock over the expected term and an estimate of the number of options that will ultimately be forfeited.

 

The expected term is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. Expected stock price volatility is based on a historical volatility of our common stock for a period at least equal to the expected term. Estimated forfeitures are calculated based on historical experience. Changes in these assumptions can materially affect the estimate of the fair value of our share-based payments and the related amount recognized in our Consolidated Financial Statements.

 

Income taxes

 

Income taxes are calculated in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”), which requires the use of the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on the difference between the carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the enacted tax rates. A valuation allowance is established against the deferred tax assets when it is more likely than not that some portion or all of the deferred taxes may not be realized.

 

Both the calculation of the deferred tax assets and liabilities, as well as the decision to establish a valuation allowance requires management to make estimates and assumptions. Although we do not believe there is a reasonable likelihood that there will be a material change in the estimates and assumptions used, if actual results are not consistent with the estimates and assumptions, the balances of the deferred tax assets, liabilities and valuation allowance could be adversely affected.

 

Effective January 1, 2007, we adopted the provisions of FIN 48, which clarifies the accounting for income tax positions by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition of previously recognized deferred tax items, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under FIN 48, we recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the tax position. The tax benefits recognized in our consolidated financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution.

 

We recognize interest relating to unrecognized tax benefits within our provision for income taxes.

RECENT ACCOUNTING PRONOUNCEMENTS

 

In December 2007, the FASB issued SFAS No 160 (“SFAS 160”), “Non-controlling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51,” which requires all entities to report minority interests in subsidiaries as equity in the consolidated financial statements, and requires that transactions between entities and non-controlling interests be treated as equity. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008, and will be applied prospectively. We are currently evaluating the effect of SFAS 160, and the impact it will have on our financial position and results of operations.

 

In December 2007, the FASB issued SFAS No. 141(R) (“SFAS 141R”), “Business Combinations,” which will significantly change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. Some of the changes, such as the accounting for contingent consideration, will introduce more volatility into earnings, and may impact a company’s acquisition strategy. SFAS 141R is effective for fiscal years beginning on or after December 15, 2008, and will be applied prospectively. We are currently evaluating the effect of SFAS 141R, and the impact it will have on our financial position and results of operations.

 

In February 2007, the FASB issued SFAS No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets or Financial Liabilities,” which provides companies with an option to report selected financial assets and liabilities at fair value. The objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. We do not expect the adoption of SFAS 159 to have a material impact on our financial position and results of operations.

 

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements.”, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. On February 12, 2008, the FASB issued FSP SFAS 157-2, “Effective Date of FASB Statement No 157,” which defers the effective date for adoption of fair value measurements for nonfinancial assets and liabilities to fiscal years beginning after November 15, 2008. We do not expect the adoption of SFAS 157 to have a material impact on our financial position and results of operations.

 

The Company does not engage in derivative transactions. The Company does become exposed to foreign currency transactions as a result of its operations in Canada. The Company does not hedge such exposure. Differences in the fair value of investment securities are not material; therefore, the related market risk is not significant. The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s long-term debt and subordinated notes. The following table presents the Company’s financial instruments for which fair value and cash flows are subject to changing market interest rates:

 

 

 

Board of Directors

HearUSA, Inc.

West Palm Beach, Florida

 

We have audited the accompanying consolidated balance sheets of HearUSA, Inc. and subsidiaries as of December 29, 2007 and December 30, 2006, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three fiscal years in the period ended December 29, 2007. In connection with our audits of the financial statements we have also audited the financial statement schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. 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 HearUSA, Inc. and subsidiaries at December 29, 2007 and December 30, 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 29, 2007 in conformity with accounting principles generally accepted in the United States of America.

 

Also in our opinion the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

 

As discussed in Note 2 to the consolidated financial statements, effective January 1, 2007, the Company adopted Financial Accounting Standard Board (FASB) Interpretation No. 48 “Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)” FASB Staff Position No. FIN 48-1 “Definition of Settlement in FASB Interpretation No. 48.” and FSP-EITF 00-19-2 “Accounting for Registration Payments.” Additionally, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment.”

 

BDO Seidman, LLP

 

West Palm Beach, Florida

March 28, 2008

HearUSA, Inc.

Consolidated Balance Sheets

 

 

See accompanying notes to consolidated financial statements

HearUSA, Inc.

Consolidated Statements of Operations