UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) X ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [No Fee Required] For the transition period from to Commission file number 1-11151 U.S. PHYSICAL THERAPY, INC. (Name of registrant as specified in its charter) Nevada 76-0364866 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3040 Post Oak Blvd., Suite 222, Houston, Texas 77056 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (713) 297-7000 Securities registered pursuant to Section 12(b) of the Exchange Act: Not Applicable Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock, $.01 par value (Title of Class) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 X No 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 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. X State the aggregate market value of the voting stock held by non-affiliates of the registrant: $18,295,000 Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: 3,611,609 DOCUMENTS INCORPORATED BY REFERENCE Document Part of Form 10-K Portions of Definitive Proxy PART III Statement for the 1999 Annual Meeting of Shareholders Forward Looking Statements We make statements in this report that are considered forward looking statements within the meaning of the Securities Exchange Act of 1934. Sometimes these statements will contain words such as "believes,""expects,""intends,""plans," and other similar words. These statements are not guarantees of our future performance and are subject to risks, uncertainties, and other important factors that could cause our actual performance or achievements to be materially different from those we project. These risks, uncertainties, and factors include, but are not limited to: general economic, business, and regulatory conditions, competition, federal and state regulations, availability, terms, and use of capital, nuclear and environmental issues, weather, industry restructuring and cost recovery, and year 2000 readiness. Given these uncertainties, you should not place undue reliance on these forward looking statements. Please see the other sections of this report and our other periodic reports filed with the SEC for more information on these factors. These forward looking statements represent our estimates and assumptions only as of the date of this report. PART I Item 1. Description of Business. General U.S. Physical Therapy, Inc. (the "Company") operates outpatient physical and occupational therapy clinics which provide post- operative care and treatment for a variety of orthopedic-related disorders and sports-related injuries. At December 31, 1998, the Company operated 99 outpatient physical and occupational therapy clinics in 28 states. The average age of the 99 clinics in operation at December 31, 1998 was 3.2 years. Since inception of the Company, 101 clinics have been developed and six clinics have been acquired by the Company. To date, the Company has closed three facilities due to adverse clinic performance, consolidated the operations of three of its clinics with other existing clinics to more efficiently serve various geographic markets and sold certain fixed assets at two of the Company's clinics and then 2 closed such facilities. A total of 20 clinics were opened in 1998. Management presently anticipates to maintain the pace of new clinic openings in 1999. The clinics provide post-operative care and treatment for a variety of orthopedic-related disorders and sports-related injuries, treatment for neurologically-related injuries, rehabilitation of injured workers and preventative care. Each clinic's staff typically includes one or more licensed physical and/or occupational therapists and office personnel, and may also include physical and/or occupational therapy assistants, aides, exercise physiologists and athletic trainers. The clinics perform a tailored and comprehensive evaluation of each patient which is followed by a treatment plan specific to their type of injury. The treatment plan may include the use of modalities and procedures such as ultrasound, electrical stimulation, hot packs and iontophoresis, therapeutic exercise, manual therapy techniques, education on management of daily life skills and home exercise programs. The clinics' business primarily originates from physician referrals. The principal sources of payment for the clinics' services are commercial health insurance, workers' compensation insurance, managed care programs, Medicare and proceeds from personal injury cases. The Company's strategy is to develop and acquire outpatient clinics on a national basis. The Company's development strategy is to attract physical and occupational therapists who have established relationships with physicians by offering them the opportunity to acquire a partnership interest in a new clinic to be developed by the Company. In addition, the clinic partner receives a competitive salary and bonus based on his or her clinic's net revenue and profitability. The Company is presently engaged in discussions with several prospective therapist partners. While the Company is committed to the partnership program as its core business, it has begun to manage third-party physical therapy facilities for physician practices, with five such third- party facilities under management as of December 31, 1998. The Company believes that with physician groups facing declining incomes, the opportunity for enhancing the physicians' income through the ownership of in-house physical therapy facilities is becoming increasingly attractive. Since 1992, the Company has offered management and administrative services to its network of clinics owned with physical therapist partners. The Company is now offering that expertise to physician groups nationwide. 3 The Company was formed in June 1990 and operated as a subchapter S Corporation until August 1991 when, in conjunction with a $2,500,000 private placement, it reorganized into a limited partnership form of organization. In May 1992, in connection with the Company's initial public offering, the Company was reorganized into its present form, a Nevada corporation with operating subsidiaries organized in the form of limited partnerships. In such reorganization, the prior owners of the limited partnership interests and the corporate general partner corporations exchanged their interests for 2,000,000 shares of the Company's common stock. In June 1992, the Company completed its initial public offering. The offering proceeds, net of offering costs, were $7,010,350 resulting from the sale by the Company of 1,200,000 shares of its common stock in the initial offering and the subsequent sale of 140,000 over allotment shares. In June 1993, the Company completed the issuance and sale at par in a private placement of $3,050,000 of 8% Convertible Subordinated Notes due June 30, 2003. In March 1994, the Company completed the private placement of 172,000 shares of common stock at a purchase price of $7.50 per share. In May 1994, the Company completed the issuance and sale at par in a private placement of $2,000,000 of 8% Convertible Subordinated Notes, Series B due June 30, 2004 and $3,000,000 of 8% Convertible Subordinated Notes, Series C due June 30, 2004 (collectively, the initial series of Convertible Subordinated Notes, the Series B Notes and the Series C Notes are hereinafter referred to as the "Convertible Subordinated Notes"). The Convertible Subordinated Notes are convertible at the option of the holders thereof into the number of whole shares of Company common stock determined by dividing the principal amount of the Notes so converted by $10.00 (in the case of the initial series and the Series C Notes) or $12.00 (in the case of the Series B Notes), subject to adjustment under certain circumstances. Holders of Series B Notes were entitled to receive an interest enhancement payable in shares of Company common stock based upon the market value of the Company's common stock at June 30, 1996. In July 1996, the Company issued 70,965 shares of its common stock in connection with the interest enhancement provision. Net proceeds from these private placements totaled approximately $6,166,000, and were used by the Company to fund prior period deficits from operations and capital expenditures in 1993 through 1996 relating to the Company's clinic development program in those years. 4 Unless the context otherwise requires, references in this Form 10-K to the Company include the Company and all its subsidiaries. The Company's principal executive offices are located at 3040 Post Oak Blvd., Suite 222, Houston, Texas 77056, and its telephone number is (713) 297-7000. The Company's Clinics The managing physical and/or occupational therapist of each clinic owns a partial interest in the clinic he or she operates. For the majority of the clinics, this is accomplished by having each clinic structured as a separate limited partnership (the "Operating Subsidiaries"). As of December 31, 1998, the Company, through its wholly-owned subsidiaries, owned a 1% general partnership interest and limited partnership interest ranging from 59% to 99% in the clinics it operates (88% of the clinics were at 64%). For the majority of the clinics, the managing therapist of each such clinic, along with other therapists at the clinic in several of the partnerships, own the remaining limited partnership interest in the clinic which ranges from 0% to 40% (12% of the clinics were at 35%). The majority of the partnership agreements are structured such that the managing therapist begins with a 20% profit interest in his or her clinic limited partnership and, at the end of each of the first five years, the managing therapist's profit interest increases by 3% until his or her interest reaches 35%. These therapists have no interest in net losses of clinic partnerships, except to the extent of their capital accounts. The Company presently anticipates that future clinics developed by the Company will be structured in a comparable manner. In addition, each managing therapist initially enters into a five-year employment agreement with the Company providing for a covenant not to compete during his or her employment plus one to two years thereafter. Pursuant to each employment agreement, the managing therapist receives a base salary and a monthly bonus based on the net revenues or operating profit generated by his or her Operating Subsidiary. Each employment agreement provides that each managing therapist is required to sell his or her partnership interest in the Operating Subsidiary for the amount of his or her capital account if he or she terminates employment with the Operating Subsidiary during the employment term. There are no provisions for purchase by the Company of the managing therapist's interest in the Operating Subsidiary in the event of death or disability, or after the initial five-year term of employment. 5 The Company's business plan is to have each clinic maintain an independent local identity, while at the same time enjoying the benefits of national purchasing, third-party payor contracts and centralized management controls. Pursuant to a management agreement, U.S. PT Management, Ltd. ("USPTM"), a Texas limited partnership owned indirectly by the Company, provides a variety of services to each clinic, including supervision of site selection, construction, clinic design and equipment selection, establishment of accounting systems and procedures and training of office support personnel, management oversight of operations, ongoing accounting services and marketing support. The Company's typical clinic occupies approximately 2,000 to 4,000 square feet of space under a lease in an office building or shopping center. The Company seeks to obtain leases for its clinics at ground level (although it may not always be successful in obtaining such leases), in order to make access to its clinics as easy as possible for patients. The Company also attempts to make the decor in its clinics less institutional and more aesthetically pleasing than hospital clinics. The typical staff needed to operate a clinic in its initial stages is a licensed physical and/or occupational therapist and an office manager. Staffing may also include physical and/or occupational therapy assistants, aides, exercise physiologists and athletic trainers. As patient visits grow over several years, the typical staffing will be increased to include two or more additional licensed physical and/or occupational therapists and one or two additional office personnel. All therapy services provided are performed under the direct supervision of a licensed physical and/or occupational therapist. The clinics provide post-operative care and treatment for a variety of orthopedic-related disorders and sports-related injuries, treatment for neurologically-related injuries, rehabilitation of injured workers and preventative care. The clinics perform a tailored and comprehensive evaluation of each patient which is followed by a treatment plan specific to their type of injury. The treatment plan may include the use of modalities and procedures, such as ultrasound, electrical stimulation, hot packs, iontophoresis, therapeutic exercise, manual therapy techniques, education on management of daily life skills and home exercise programs. The Company currently provides its services at its clinics only on an outpatient basis. Patients requiring these types of services are usually treated for approximately one hour per day, two to five times a week. This form of treatment typically lasts two to six weeks. The Company's 6 charge for the treatment is generally on a per procedure basis. In addition to the services mentioned, the clinics will, when appropriate, develop individual maintenance exercise programs to be continued after treatment. Advice on postural improvements and changes in work habits or lifestyle is provided to promote self- management of the patient's condition. The Company continues to assess the potential for developing new services and expanding the method of providing its current services, with an emphasis on health insurance and workers' compensation insurance cost containment. Industry Background Physical and occupational therapy is the process of aiding in the restoration of individuals disabled by injury or disease or recovering from surgery. Management believes that the following factors are influencing the growth of outpatient physical and occupational therapy services: Economic Benefits of Physical and Occupational Therapy Services. Purchasers and providers of health care services, such as insurance companies, health maintenance organizations, business and industry, are seeking ways to save on traditional health care services. Management believes physical and occupational therapy services represent a cost-effective service, by attempting to prevent short-term disabilities from becoming chronic conditions, and by speeding the recovery from surgery and musculoskeletal injuries. Earlier Hospital Discharge. Changes in health insurance reimbursement, both public and private, have encouraged the early discharge of patients in order to contain and reduce costs. Management believes early hospital discharge practices foster greater numbers of individuals requiring outpatient physical and occupational therapy services. Aging Population. The elderly population, which has experienced rapid growth over the past several decades, has a greater incidence of major disability. This growth has fueled the demand for rehabilitation services. Marketing On a local basis, the Company focuses its marketing efforts on physicians, mainly orthopedic surgeons, neurosurgeons, physiatrists, occupational medicine and general practitioners, 7 which generally account for the majority of physical and occupational therapy referrals. In marketing to the physician community, the clinics emphasize their commitment to quality patient care and communication with physicians regarding patient progress. On a national level, the Company employs a marketing director to assist the managing therapists in establishing referral relationships with health maintenance organizations, preferred provider organizations, industry and case managers and insurance companies for clinic therapy services, as well as to develop and implement marketing plans for marketing to the physician community. Sources of Revenue/Reimbursement Payor sources for the current clinics' services are primarily commercial health insurance, managed care programs, workers' compensation insurance, Medicare and proceeds from personal injury cases. Commercial health insurance and managed care programs generally provide outpatient services coverage to patients utilizing the clinics, and the patient is normally required to pay an annual deductible and a co-insurance payment. Workers' compensation is a statutorily defined employee benefit which varies on a state-by-state basis. Workers' compensation laws generally require employers to pay for employees' costs of medical rehabilitation, lost wages, legal fees and other costs associated with work-related injuries and disabilities and, in certain jurisdictions, mandatory vocational rehabilitation. These statutes generally require that these benefits be offered to employees without any deductibles, co-payments or cost sharing. Companies may provide such coverage to their employees through either the purchase of insurance from private insurance companies, participation in state-run funds or through self-insurance. Treatments for patients who are parties to personal injury cases are generally paid for from the proceeds of settlements with insurance companies or from judgements, if favorable. If an unfavorable judgement is received, collection efforts are generally not pursued against the patient and the patient's account is written off against established reserves. The Company estimates the percentage of accounts receivable relating to personal injury cases that will be uncollectible. Such percentage, which currently ranges from 10% to 20%, is periodically reviewed and adjusted by the Company. The Company's business depends to a significant extent on its relationships with physicians, commercial health insurers, workers' compensation insurers, and other referral sources, such as health maintenance organizations and preferred provider organizations. If 8 clinics are located in certain geographical areas, it is important for them to be approved as providers by certain key health maintenance organizations and preferred provider plans. If these clinics do not obtain such approval, or if they cannot maintain such approval, the Company could be adversely affected. As of December 31, 1998, 78 of the Company's clinics have been certified as Medicare providers and 11 are in the process of becoming certified. Management anticipates that, in the future, newly developed clinics will generally elect to become certified as Medicare providers. No assurance can be given that the newly developed clinics will become certified as Medicare providers. Prior to 1998, Medicare reimbursement for outpatient physical and/or occupational therapy furnished by a Medicare-certified rehabilitation agency or clinic was equal to the lesser of the provider's "reasonable costs" as allowed under Medicare regulations, or the provider's customary charges. Individual beneficiaries, or their "Medigap" insurance carriers if such coverage exists, were required to pay a deductible and co-payment amount, so that governmental payments to the Company did not exceed 80% of the reasonable cost of such services. Beginning in 1998, Medicare imposed new constraints on reimbursement for outpatient physical and/or occupational therapy services. In 1998, Medicare reimbursement for outpatient physical and/or occupational therapy furnished by a Medicare-certified rehabilitation agency or clinic was equal to the lesser of the provider's "adjusted reasonable costs" as allowed under Medicare regulations and defined in the Balanced Budget Act of 1997 ("BBA"), or the provider's charges, in each case less 20% of the amount of the charge for the services. For rehabilitation agencies and clinics, the "adjusted reasonable cost" of a service is the service's reasonable cost, as determined under Medicare regulations, less 10%. The 10% reduction does not apply to services provided by hospitals. The 20% deduction represents the co-insurance amount that an individual beneficiary, or their "Medigap" insurance carrier if such coverage exists, is required to pay in addition to the beneficiary's annual deduction. The Company files annual cost reports for each of its Medicare- certified clinics. These cost reports serve as the basis for determining the prior year's reimbursement settlements and, prior to 1999, interim Medicare payment rates for the following year. Furthermore, the BBA also provides that after 1998, outpatient rehabilitation services will be paid based on a fee schedule which has been published by the Department of Health and Human Services ("HHS"). Beginning in 1999, the total amount that is paid by 9 Medicare in any one year for outpatient physical or occupational therapy to any one patient is limited to $1,500, except for services provided in hospitals. The effect of this payment change may be to encourage patients with extensive rehabilitation needs to seek treatment in a hospital setting. The Company does not anticipate that the changes in Medicare reimbursement rates as outlined in the BBA will have a negative impact on revenues in 1999. Management believes that the average rate calculated under the cost reimbursement methodology will not be significantly different than the average rate on the fee schedule. Revenues from the Medicare program for the years ended December 31, 1998 and 1997 accounted for approximately 12% and 13% of the Company's net patient revenues, respectively. Medicare regulations require that a physician certify the need for physical and/or occupational therapy services for each patient and that these services be provided in accordance with an established plan of treatment which is periodically revised. State Medicaid programs generally do not provide coverage for outpatient physical or occupational therapy, and, therefore, Medicaid is not, nor is it expected to be, a material payor for the Company. Regulation and Health Care Reform The health care industry is subject to numerous federal, state and local regulations. Many states prohibit commercial enterprises from engaging in the corporate practice of medicine. There is a risk that the corporate practice of medicine could be interpreted in those states to also include the practice of physical and/or occupational therapy, or that the corporate practice of physical and/or occupational therapy itself could be specifically prohibited in some states. In Texas, a 1979 opinion of the State Attorney General states that corporate entities may not engage in the practice of physical therapy, unless such corporations are professional corporations with all shareholders being licensed therapists. While management believes that this opinion has generally not been followed or enforced in Texas, there can be no assurance that the Texas Attorney General will not seek to enforce this position in the future and apply the prohibition to include limited partnerships, the legal entity for each Operating Subsidiary. In the event that the Company was found to be engaged in prohibited corporate practice in any state, management believes that it could restructure its operations so as to be in compliance with applicable law. If the Company was required to restructure its operations, the Company anticipates that, in lieu of owning clinics, it could engage in clinic management and leasing of 10 equipment and clinic sites. The availability of these or other options for restructuring would depend on the requirements of applicable law. However, such restructuring could negatively impact the income of the Company, and there can be no assurance that a satisfactory restructuring could be accomplished. Certain states into which the Company may expand have laws that require facilities that employ health professionals and provide health related services to be licensed and, in some cases, to obtain a certificate of need. Pursuant to certificate of need laws, the affected entity is required to demonstrate to a state regulatory authority the need for and financial feasibility of certain expenditures related to such activities as the construction of new facilities or the commencement of new health care services. Based on its operating experience to date, the Company believes that its business, as presently conducted, does not require certificates of need or other facility approvals or licenses. There can be no assurance, however, that existing laws or regulations will not be interpreted or modified to require the Company to obtain such approvals or licenses and, if so, that such approvals or licenses could be obtained. As of December 31, 1998, 78 of the Company's clinics have become certified as Medicare providers. In order to receive Medicare reimbursement, a rehabilitation agency or clinic must meet the applicable conditions of participation set forth by HHS relating to the type of facility, its equipment, record keeping, personnel and standards of medical care as well as compliance with all state and local laws. Clinics are subject to periodic inspections or surveys to determine compliance. The Social Security Act imposes criminal and/or civil penalties upon persons who pay or receive any "remuneration" in connection with the referral of patients covered under Medicare, Medicaid or most other federally funded health care programs. The "anti- kickback" law prohibits providers and others from offering or paying (or soliciting or receiving), directly or indirectly, any remuneration to induce or in return for making a referral for, or ordering or recommending (or arranging for ordering or recommending) a service covered under such health care programs. Each violation of this law may be punished by a fine (of up to $250,000 for individuals and $500,000 for organizations, or twice the pecuniary gain to the defendant or loss to another from the illegal conduct) or imprisonment for up to five years, or both. In addition, a provider may be excluded from participation in federal healthcare programs, and other federal procurement and 11 nonprocurement programs, for violation of these prohibitions through an administrative proceeding, without the need for any criminal proceeding. Many states, including some states in which the Company operates clinics, have similar laws which apply whether or not federal health care funds are involved; and health care reform proposals in the last few years would have expanded federal law to cover all patients as well. Because the federal anti- kickback law has been broadly interpreted to apply where even one purpose (as opposed to a sole or primary purpose) of a payment is to induce referrals, it limits the relationships which the Company may have with referral sources, including any ownership relationships. The Company's managing physical therapists are limited partners in their respective clinics. Management does not believe that the ownership structure of its clinics violates the anti-kickback laws, since no direct or indirect owner of the clinics, including the partner therapists, serves as a referral source for the clinics. The anti-kickback laws may also apply to the structure of acquisitions by the Company of physician-owned physical therapy clinics, to the extent that any portion of the purchase price or terms of payment are deemed to be an inducement to the physician to make referrals to the clinic which, under a December 1992 letter by the Chief Counsel of the HHS office of Inspector General ("OIG"), could include payments for goodwill or other intangibles. The Company's new practice of offering its management services to physician-owned physical therapy facilities also raises anti-kickback law issues both under recent interpretations of the law by the OIG, which suggest that percentage-based contracts that include marketing services may implicate the law, and under some older interpretations indicating that the law may be implicated where a company in a line of business "partners" with a physician practice as a way of sharing profits with the physicians. Management considers these anti- kickback laws in planning its clinic acquisitions, marketing and other activities, and believes its operations are in compliance with applicable law, but no assurance can be given regarding compliance in any particular factual situation. In addition, another federal law, known as the "Stark law" after its original Congressional sponsor, was expanded in 1993 to impose, effective January 1, 1995, a prohibition on referrals of Medicare or Medicaid patients for, among other things, physical therapy services by physicians who have a financial relationship with the provider furnishing the services. With certain specified exceptions, the referral prohibition applies to any physician who has (or whose immediate family member has) a direct or indirect ownership or investment interest in, or compensation relationship 12 with, a provider of physical therapy services such as the Company's clinics. This law also prohibits billing for services rendered pursuant to a prohibited referral. Penalties for violation include denial of payment for the services, significant civil monetary penalties, and exclusion from Medicare and Medicaid. Several states have enacted laws similar to the Stark law, but which cover all (not just Medicare and Medicaid) patients; and many health care reform proposals in the last few years would have expanded the Stark law to cover all patients as well. The Stark law, as effective January 1, 1995, covers a management contract with a physician group and any financial relationship between the Company and referring physicians, including any financial transaction resulting from a clinic acquisition. As with the anti-kickback law, management considers the Stark law in planning its clinic acquisitions, marketing and other activities, and believes that its operations are in compliance with applicable law. However, as noted above, no assurance can be given regarding compliance in any particular factual situation. Pursuant to the recently enacted Kennedy-Kassebaum insurance reform bill, a number of new authorities to combat health care fraud and abuse became law in 1997. Among other things, the law creates a new federal crime of "health care fraud", establishes an all-payor fraud and abuse program to be directed by the U.S. Attorney General and the HHS Inspector General in cooperation with the states, creates an enforcement fund of a portion of all penalties collected under such program, and expands authority to impose penalties and Medicare/Medicaid exclusions. The Company cannot predict what effect, if any, these expanded enforcement authorities will have on the health care industry generally or on its business. Political, economic and regulatory influences are subjecting the health care industry in the United States to fundamental change. Although Congress has failed to pass comprehensive health care reform legislation to date, the Company anticipates that Congress, state legislatures and the private sector will continue to review and assess alternative health care delivery and payment systems. Potential approaches that have been considered include mandated basic health care benefits, controls on health care spending through limitations on the growth of private health insurance premiums and Medicare and Medicaid spending, the creation of large insurance purchasing groups, price controls and other fundamental changes to the health care delivery system. Managed care entities, which represent an ever-growing percentage of health care payors, are demanding lower costs from health care providers, 13 and in many cases, requiring or encouraging providers to accept capitated payments that may not be adequate to allow providers to cover their full costs or may reduce their profitability. Legislative debate is expected to continue in the future and market forces are expected to demand reduced costs. The Company cannot predict what impact the adoption of any federal or state health care reform measures or future private sector reform may have on its business. Competition The health care industry, generally, and the physical and occupational therapy businesses, in particular, are highly competitive and subject to continual changes in the manner in which services are delivered and in which providers are selected. The competitive factors in the physical and occupational therapy businesses are quality of care, cost, treatment outcomes, convenience of location, and relationships with and ability to meet the needs of referral and payor sources. The Company's clinics compete directly or indirectly with the physical and occupational therapy departments of acute care hospitals, physician-owned physical therapy clinics, private physical therapy clinics and chiropractors. The main sources of competition are acute care hospital outpatient therapy clinics and private therapy clinic organizations that provide therapy services. The Company will face further competition as consolidation of the therapy industry continues through the acquisition of physician-owned and other privately owned therapy practices. The Company believes that it can compete favorably with its competitors in hiring managing therapists by offering them ownership interests in their clinics. In addition, management believes that providing the managing therapist with an opportunity to participate in ownership will help to ensure commitment by local management to the success of the clinic and will minimize turnover of managing therapists. The Company also believes its competitive position is enhanced by its strategy of locating its clinics, where possible, on the ground floor in office buildings and shopping centers with nearby parking, thereby making the clinics more easily accessible to patients. The Company attempts to make the decor in its clinics less institutional and more aesthetically pleasing than hospital clinics. Management also believes it can generally provide its 14 services at a lesser cost than comparable services of hospitals, due to hospitals' higher overhead. Employees At December 31, 1998, the Company employed 716 total employees of which 475 were full-time employees. At that date, none of the Company's employees were subject to collective bargaining agreements or were members of unions. Management considers the relations between the Company and its employees to be good. In the states in which the Company's current clinics are located, persons performing physical and occupational therapy services are required to be licensed by the state. All persons currently employed by the Company and its clinics who are required to be licensed are licensed, and the Company intends that all future employees who are required to be licensed will be licensed. Management is not aware of any federal licensing requirements applicable to its employees. Insurance The Company maintains professional malpractice liability coverage on professionals employed in each of its clinics, in addition to general liability insurance and coverage for the customary risks inherent in the operation of health care facilities and businesses in general. Management believes its insurance policies in force to be adequate in amount and coverage for its current operations. Item 2. Description of Property. Property The Company presently leases, under noncancelable lease terms ranging from one to five years, all of the properties used for its clinics with the exception of two clinics located in Brownwood, Texas and Mineral Wells, Texas, for which the Company owns the facility. The Company also intends, where feasible, to lease the premises in which new clinics will be located. The Company's typical clinic occupies approximately 2,000 to 4,000 square feet of space. The Company also leases, under a five-year noncancelable operating lease beginning July 1998, its executive offices located in Houston, Texas. The executive offices currently occupy 15 approximately 18,726 square feet of space (including allocations for common areas). Item 3. Legal Proceedings. The Company is subject to litigation and other proceedings arising in the ordinary course of business. While the ultimate outcome of lawsuits or other proceedings cannot be predicted with certainty, management does not believe the impact, if any, would be material to the Company's financial statements. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders of the Company, through solicitation of proxies or otherwise, during the fourth quarter of 1998. PART II Item 5. Market for Common Equity and Related Stockholder Matters. Price Quotations On April 28, 1997, the Company's common stock began trading on the Nasdaq Stock Market, Inc. ("Nasdaq") National Market under the symbol "USPH". Prior thereto, the Company's common stock traded on The Nasdaq Small Cap Market tier of the Nasdaq Stock Market under the symbol "USPH". The range of trading prices, as reported by Nasdaq for each quarterly period, is set forth below. The reported quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions. 1998 1997 HIGH LOW HIGH LOW QUARTER First $12 1/2 $10 1/2 $10 3/4 $9 1/4 Second 13 1/2 11 1/4 9 3/4 9 Third 14 3/8 8 1/2 9 5/8 8 7/8 Fourth 10 1/8 7 12 9 1/2 16 Record Holders As of March 17, 1999, there were 52 holders of record of the Company's outstanding common stock. Dividends Since inception, the Company has not declared or paid cash dividends or made distributions on its equity securities, and the Company does not anticipate that it will pay cash dividends or make distributions in the foreseeable future. Item 6. Selected Financial Data. Year Ended December 31, 1998 1997 1996 1995 1994 (in thousands, except per share data) Net revenues $44,023 $38,807 $32,207 $24,924 $17,162 Income (loss) before income taxes $ 2,704 $ 2,481 $ 1,758 $ 819 $(2,722) Net income (loss)(1) $ 1,596 $ 2,426 $ 1,641 $ 742 $(2,775) Per common share: Basic $ 0.44 $ 0.67 $ 0.46 $ 0.21 $ (0.80) Diluted $ 0.43 $ 0.65 $ 0.45 $ 0.20 $ (0.80) Total assets $24,100 $22,548 $19,483 $15,910 $14,460 Long-term debt, less current portion $ 8,126 $ 8,239 $ 8,276 $ 8,166 $ 8,265 Working capital $13,007 $11,204 $ 9,214 $ 7,084 $ 5,673 Current ratio 5.96 5.07 4.56 4.70 4.72 Long-term debt to total capitalization 0.41 0.45 0.52 0.61 0.65 (1) Prior to 1998, the Company had available unused net operating loss carryforwards to offset any federal income tax liability. 17 Item 7. Management's Discussion and Analysis or Plan of Operation. Overview The Company operates outpatient physical and/or occupational therapy clinics which provide post-operative care and treatment for a variety of orthopedic-related disorders and sports-related injuries. At December 31, 1998, the Company operated 99 outpatient physical and/or occupational therapy clinics in 28 states. The average age of the 99 clinics in operation at December 31, 1998 was 3.2 years. Since inception of the Company, 101 clinics have been developed and six clinics have been acquired by the Company. To date, the Company has closed three facilities due to adverse clinic performance, consolidated the operations of three of its clinics with other existing clinics to more efficiently serve various geographic markets and sold certain fixed assets at two of the Company's clinics and then closed such facilities. The sale of fixed assets and the concurrent closure of two of the clinics occurred during the three months ended March 31, 1997 ("1997 First Quarter"). No loss was recognized relating to these 1997 First Quarter closures. These two clinics combined accounted for net patient revenues and clinic operating costs for the year ended December 31, 1997 of $(6,000) and $57,000, respectively, and for the year ended December 31, 1996 of $345,000 and $506,000, respectively. The closure of one of the Company's clinics, due to adverse clinic performance, occurred during the three months ended September 30, 1998 ("1998 Third Quarter"). See "Loss on Closure of Facility" for additional information. Fiscal Year 1998 Compared to Fiscal Year 1997 Net Patient Revenues Net patient revenues increased to $43,444,000 for 1998 from $38,342,000 for 1997, an increase of $5,102,000, or 13%. Net patient revenues from the 20 clinics developed since 1997 (the "1998 New Clinics") accounted for 28% of the increase, or $1,416,000. The remaining increase of $3,686,000 in net patient revenues comes from those 79 clinics opened before 1998. The majority of the $3,686,000 increase in net patient revenues from these clinics resulted from a 10% increase in the number of patient visits, while net revenues per visit remained stable. Net patient revenues are based on established billing rates less allowances and discounts for patients covered by worker's compensation programs and other contractual programs. Payments received under these programs are based on predetermined rates and are generally less than the established billing rates of the 18 clinics. Net patient revenues reflect reserves, which are evaluated quarterly by management, for contractual and other adjustments relating to patient discounts from certain payors. Net patient revenues also are reported net of estimated retrospective adjustments under Medicare. Medicare reimbursement for outpatient physical or occupational therapy services furnished by clinics or rehabilitation agencies is based on a cost reimbursement methodology. The Company is initially reimbursed at a tentative rate with final settlement determined after submission of an annual cost report by the Company and audits thereof by the Medicare fiscal intermediary. Beginning in 1998, certain changes were imposed in the method in which the Company is reimbursed for its services by Medicare as defined in the Balanced Budget Act of 1997 ("BBA"). See "Balanced Budget Act of 1997". Other Revenues Other revenues, consisting of interest, management fees, sublease and real estate commission income, increased by $114,000, or 24.5%, to $579,000 for 1998 from $465,000 for 1997. This increase was due primarily to an increase in interest income as a result of the higher average amount of cash and cash equivalents available for investment during 1998 compared to 1997 and management fees earned in connection with several contracts the Company entered into during 1998 to manage third-party physical therapy clinics. Clinic Operating Costs Clinic operating costs as a percent of net patient revenues remained stable at 76% for 1998 and 1997. Clinic Operating Costs - Salaries and Related Costs Salaries and related costs increased to $20,263,000 for 1998 from $17,624,000 for 1997, an increase of $2,639,000, or 15%. Approximately 36% of the increase, or $956,000, was due to the 1998 New Clinics. The remaining 64% increase, or $1,683,000, was due principally to increased staffing to meet the increase in patient visits for the clinics opened prior to 1998, coupled with an increase in bonuses earned by the managing therapists at the clinics opened prior to 1998. Such bonuses are based on the net revenues or operating profit generated by the individual clinics. Salaries and related costs as a percent of net patient revenues increased slightly to 47% for 1998 compared to 46% for 1997. Clinic Operating Costs - Rent, Clinic Supplies and Other Rent, clinic supplies and other increased to $11,454,000 for 1998 from $10,562,000 for 1997, an increase of $892,000, or 8%. Approximately 97% of the increase, or $867,000, was due to the 1998 19 New Clinics, while 3%, or $25,000, of the increase was due to the clinics opened prior to 1998. Rent, clinic supplies and other as a percent of net patient revenues has declined slightly to 26% for 1998 compared to 28% for 1997. Clinic Operating Costs - Provision for Doubtful Accounts The provision for doubtful accounts increased to $1,143,000 for 1998 from $1,050,000 for 1997, an increase of 9%, or $93,000. Approximately 31% of the increase, or $29,000, was due to the 1998 New Clinics, while 69%, or $64,000, of the increase relates to the clinics opened prior to 1998. The provision for doubtful accounts as a percent of net patient revenues remained stable at 3% for 1998 and 1997. Corporate Office Costs - General & Administrative General and administrative costs, consisting primarily of salaries and benefits of corporate office personnel, rent, insurance costs, depreciation and amortization, travel and legal and professional fees increased to $4,240,000 for 1998 from $3,666,000 for 1997, an increase of $574,000, or 16%. General and administrative costs increased primarily as a result of salaries and benefits related to additional personnel hired to support an increasing number of clinics. Coupled with this increase was an increase in legal and professional fees associated with opening an increased number of clinics in 1998. In addition, in July 1998, the Company increased the square footage occupied at its corporate office in Houston, Texas and extended the lease for a five-year period ending July 2003. In connection with these changes to the lease, rent for 1998 increased substantially. General and administrative costs as a percent of net patient revenues remained stable at 10% for 1998 and 1997. Corporate Office Costs - Recruitment & Development Recruitment and development costs primarily represent salaries and benefits of recruitment and development personnel, rent, travel, marketing and recruiting fees attributed directly to the Company's activities in the development and acquisition of new clinics. All recruitment and development personnel are located at the corporate office in Houston, Texas. Once a clinic has opened, these personnel are not involved with the clinic. Recruitment and development costs increased $291,000, or 26%, to $1,396,000 in 1998 from $1,105,000 in 1997. The majority of this increase relates to an increase in salaries and benefits of recruitment and development personnel which were added to facilitate the acceleration of new clinic openings during 1998 from the level of 13 new clinics opened during 1997. Coupled with the increase in salaries and benefits is 20 an increase in travel expenses and recruiting and marketing fees which also correlate with the higher number of clinics in operation at December 31, 1998. Recruitment and development costs as a percent of net patient revenues has remained stable at 3% for 1998 and 1997. Loss on Closure of Facility In August 1998, the Company closed its clinic located in Corpus Christi, Texas due to adverse clinic performance. During 1998, the Company recognized a $230,000 loss relating to this closure. Of the $230,000 loss, $18,000 represented lease commitments, $99,000 was due to the write-off of goodwill, fixed assets, leasehold improvements and a non-compete agreement and the remainder was costs incurred in connection with closing the facility. The Corpus Christi, Texas clinic accounted for net patient revenues for 1998 and 1997 of $218,000 and $407,000, respectively. This clinic accounted for clinic operating costs for 1998 and 1997 of $603,000 and $575,000, respectively. Management may close clinics in the future that are not operating at satisfactory levels. Interest Expense Interest expense of $730,000 for 1998 relates primarily to $244,000 of interest expense on the $3,050,000 aggregate principal amount of 8% Convertible Subordinated Notes issued by the Company in June 1993 and $400,000 of interest expense on the $5,000,000 aggregate principal amount of 8% Series B and Series C Notes issued by the Company in May 1994. In addition, $75,000 of interest expense was recorded in 1998 relating to the Contingent Interest Enhancement provision of the Series B Notes. This provision allowed Series B Note holders to receive an interest enhancement payable in shares of Company common stock based upon the market value of the Company's shares for the month of June 1996. A total of 70,965 shares of Company common stock were issued in 1996 in connection with the Contingent Interest Enhancement provision. Minority Interests in Subsidiary Limited Partnerships Minority interests in subsidiary limited partnerships increased $285,000, or 18%, to $1,863,000 in 1998 from $1,578,000 in 1997 due to the increase in aggregate profitability of those clinics in which partners have achieved positive retained earnings and are accruing partnership income. 21 Income Before Income Taxes The Company's income before income taxes for 1998 of $2,704,000 exceeded 1997's income before income taxes of $2,481,000 principally due to the $5,216,000 increase in net revenues, offset, in part, by the $3,624,000 increase in clinic operating costs, the $865,000 increase in corporate office costs, the $230,000 loss on closure of facility, and the $285,000 increase in minority interests in subsidiary limited partnerships. Provision for Income Taxes The provision for income taxes increased $1,053,000 to $1,108,000 for 1998 from $55,000 for 1997. During 1997, the Company utilized its unused net operating loss carryforwards to offset any federal income tax expense. During 1998, the Company accrued income taxes at a tax rate of 41.0% which exceeded the U.S. statutory tax rate of 34.0% due primarily to state income taxes. Net Income The Company's net income for 1998 of $1,596,000 was less than 1997's net income of $2,426,000 principally due to the fact that during 1997, the Company utilized its remaining tax operating loss carryforwards to offset any federal income tax expense. The impact on net income from the increase in income tax expense was offset, in part, by the factors affecting income before income taxes. See "Income Before Income Taxes". Fiscal Year 1997 Compared to Fiscal Year 1996 Net Patient Revenues Net patient revenues increased to $38,342,000 for 1997 from $32,029,000 for 1996, an increase of $6,313,000, or 20%. Net patient revenues from the 13 clinics developed since 1996 (the "1997 New Clinics") accounted for 28% of the increase or $1,743,000. The remaining increase of $4,570,000 in net patient revenues came from those 67 clinics opened before 1997. The majority of the $4,570,000 increase in net patient revenues from these clinics resulted from a 14% increase in the number of patient visits, while net revenues per visit remained stable. Other Revenues Other revenues increased by $287,000, or 161%, to $465,000 for 1997 from $178,000 for 1996. This increase was due primarily to management fees earned in connection with a contract the Company entered into during the three months ended March 31, 1997 to manage a third-party physical therapy clinic, an increase in interest income as a result of the higher average amount of cash and cash 22 equivalents available for investment during 1997 compared to 1996 and an increase in real estate commission income. Clinic Operating Costs Clinic operating costs as a percent of net patient revenues declined slightly to 76% for 1997 compared to 77% for 1996. Clinic Operating Costs - Salaries and Related Costs Salaries and related costs increased to $17,624,000 for 1997 from $14,743,000 for 1996, an increase of $2,881,000, or 20%. Approximately 31% of the increase, or $887,000, was due to the 1997 New Clinics. The remaining 69% increase, or $1,994,000, was due principally to increased staffing to meet the increase in patient visits for the clinics opened prior to 1997, coupled with an increase in bonuses earned by the managing therapists at the clinics opened prior to 1997. Such bonuses are based on the net revenues or operating profit generated by the individual clinics. Salaries and related costs as a percent of net patient revenues remained stable at 46% for 1997 and 1996. Clinic Operating Costs - Rent, Clinic Supplies and Other Rent, clinic supplies and other increased to $10,562,000 for 1997 from $9,144,000 for 1996, an increase of $1,418,000, or 16%. Approximately 55% of the increase, or $786,000, was due to the 1997 New Clinics, while 45%, or $632,000, of the increase was due to the clinics opened prior to 1997. Rent, clinic supplies and other as a percent of net patient revenues declined slightly from 29% for 1996 to 28% for 1997. Clinic Operating Costs - Provision for Doubtful Accounts The provision for doubtful accounts increased to $1,050,000 for 1997 from $929,000 for 1996, an increase of 13%, or $121,000. Approximately 32% of the increase, or $39,000, was due to the 1997 New Clinics, while 68%, or $82,000, of the increase relates to the clinics opened prior to 1997. The provision for doubtful accounts as a percent of net patient revenues remained stable at 3% for 1997 and 1996. Corporate Office Costs - General & Administrative General and administrative costs increased to $3,666,000 for 1997 from $3,097,000 for 1996, an increase of $569,000, or 18%. General and administrative costs increased primarily as a result of salaries and benefits related to additional personnel hired in 1997 to oversee the operations of an increasing number of clinics in operation and to establish a corporate compliance program. Coupled with this increase was an increase in legal and professional fees 23 associated with opening an increased number of clinics in 1997. General and administrative costs as a percent of net patient revenues remained stable at 10% for 1997 and 1996. Corporate Office Costs - Recruitment & Development Recruitment and development costs increased $321,000, or 41%, to $1,105,000 in 1997 from $784,000 in 1996. The majority of this increase relates to an increase in salaries and benefits of recruitment and development personnel associated with opening an increased number of clinics in 1997 and personnel added in response to management's intention to accelerate the pace of new clinic openings in future years. Coupled with the increase in salaries and benefits is an increase in travel expenses and recruiting fees which also correlate with the higher number of clinics in operation at December 31, 1997, and an increase in rent due to an expansion of office space needed to support additional personnel. In addition, in conjunction with the accelerated clinic opening schedule, management has implemented an aggressive marketing approach resulting in increased marketing costs during 1997. Recruitment and development costs as a percent of net patient revenues increased slightly to 3% for 1997 from 2% for 1996. Interest Expense Interest expense of $741,000 for 1997 relates primarily to $244,000 of interest expense on the $3,050,000 aggregate principal amount of 8% Convertible Subordinated Notes issued by the Company in June 1993 and $400,000 of interest expense on the $5,000,000 aggregate principal amount of 8% Series B and Series C Notes issued by the Company in May 1994. In addition, $75,000 of interest expense was recorded in 1997 relating to the Contingent Interest Enhancement provision of the Series B Notes. This provision allowed Series B Note holders to receive an interest enhancement payable in shares of Company common stock based upon the market value of the Company's shares for the month of June 1996. A total of 70,965 shares of Company common stock were issued in 1996 in connection with the Contingent Interest Enhancement provision. Minority Interests in Subsidiary Limited Partnerships Minority interests in subsidiary limited partnerships increased $571,000, or 57%, to $1,578,000 in 1997 from $1,007,000 in 1996 due to the increase in aggregate profitability of those clinics in which partners have achieved positive retained earnings and are accruing partnership income. 24 Provision for Income Taxes The provision for income taxes decreased to $55,000 for 1997 compared to $117,000 for 1996, a decrease of $62,000, or 53%. The decrease in federal income tax expense to $(203,000) in 1997 from $74,000 in 1996 is due to the Company's recognition during 1997 of its net deferred federal income tax asset of $833,000, offset, in part, by an increase in current federal income tax expense of $556,000. State income taxes increased to $258,000 in 1997 from $43,000 in 1996. The increase in current federal and state income taxes corresponds to the increase in profitability of the clinics. Net Income The Company's net income for 1997 of $2,426,000 exceeded 1996 net income of $1,641,000 principally due to the $6,600,000 increase in net revenues, which more than offset the $4,420,000 increase in clinic operating costs, the $890,000 increase in corporate office costs and the $571,000 increase in minority interests in subsidiary limited partnerships. In addition, during 1997, the Company recognized its net deferred federal tax asset of $833,000 which was offset by current federal income tax expense of $630,000 and current state income tax expense of $258,000. Liquidity and Capital Resources At December 31, 1998, the Company had $6,328,000 in cash and cash equivalents, which is available to fund the working capital needs of its operating subsidiaries, future clinic developments and acquisitions and the Company's repurchase of shares of its common stock. Included in cash and cash equivalents at December 31, 1998 is $4,700,000 of short-term U.S. government agency securities and $415,000 in a money market fund invested in short-term debt instruments issued by an agency of the U.S. Government. The market value of the U.S. government agency securities and the money market fund approximated the carrying value as of December 31, 1998. The increase in cash of $772,000 from December 31, 1997 to December 31, 1998 is due primarily to cash provided by operating activities of $5,000,000, offset, in part, by the Company's use of cash to fund capital expenditures, primarily for physical therapy equipment, leasehold improvements and intangibles in the amount of $2,520,000, distributions to minority partners in subsidiary limited partnerships of $1,692,000, and principal payments on notes payable of $55,000. The Company's current ratio increased to 5.96 to 1.00 at December 31, 1998 compared to 5.07 to 1.00 at December 31, 1997 and 4.56 to 25 1.00 at December 31, 1996. The increase in the current ratio is due primarily to an increase in net patient revenues, which, in turn, have caused an increase in patient accounts receivable. In addition, estimated third-party payor (Medicare) settlements decreased as a result of a reduction by Medicare in the Company's reimbursement rates due to lower costs per visit in the older clinics. In May of each year when the Company files its cost reports with Medicare for the previous year, Medicare adjusts the Company's reimbursement rates so that the percent of charges paid by Medicare during the remainder of the year will more closely reflect the actual cost realized by the Company. After a clinic has been in operation for several years, the actual cost per visit stabilizes and the reimbursement rates paid by Medicare generally approximate reimbursable costs. At December 31, 1998, the Company had a debt-to-equity ratio of 0.70 to 1.00 compared to 0.83 to 1.00 at December 31, 1997 and 1.10 to 1.00 at December 31, 1996. The improvement in the debt-to-equity ratio each year relates primarily to the increase in equity as a result of net income of $1,596,000 for 1998 and $2,426,000 for 1997. The quarterly interest obligation on the outstanding 8% Convertible Subordinated Notes, the 8% Convertible Subordinated Notes, Series B and the 8% Convertible Subordinated Notes, Series C is $61,000, $40,000 and $60,000, respectively, through June 30, 2003, June 30, 2004 and June 30, 2004, respectively. In January 1997, the Company's Board of Directors authorized the use of available cash to repurchase up to 200,000 shares of Company common stock. The timing and the actual number of shares purchased will depend on market conditions. The repurchased shares will be held as treasury shares and be available for general corporate purposes. As of December 31, 1998, 4,900 shares have been repurchased at a cost of $47,000. Management believes that existing funds, supplemented by cash flows from existing operations, will be sufficient to meet its current operating needs and its development plans. The Balanced Budget Act of 1997 Beginning in 1998, Medicare imposed new interim constraints on reimbursement for outpatient physical and/or occupational therapy services and has published a fee schedule pursuant to which the Company's clinics will be paid for care provided to Medicare patients in 1999. In 1998, Medicare reimbursement for outpatient physical and/or occupational therapy furnished by a Medicare- certified rehabilitation agency or clinic was equal to the lesser 26 of the provider's "adjusted reasonable costs" as allowed under Medicare regulations and defined in the BBA, or the provider's charges, in each case less 20% of the amount of the charge imposed for the services. For rehabilitation agencies and clinics, the "adjusted reasonable cost" of a service is the service's reasonable cost, as determined under Medicare regulations, less 10%. The 20% deduction represents the co-insurance amount that an individual beneficiary, or their "Medigap" insurance carrier if such coverage exists, is required to pay in addition to the beneficiary's annual deduction. The impact of the BBA on the Company's operations has been to reduce the estimated reimbursement from Medicare on services rendered to Medicare patients during 1998 by approximately $581,000. The BBA also provides that after 1998, outpatient rehabilitation services will be paid based on a fee schedule which has been published by the Secretary of Health and Human Services ("HHS"). Beginning in 1999, the total amount that may be paid by Medicare in any one year for outpatient physical or occupational therapy to any one patient is limited to $1,500, except for services provided in hospitals. The effect of this payment change may be to encourage patients with extensive rehabilitation needs to seek treatment in a hospital setting. The Company does not anticipate that the changes in Medicare reimbursement rates as outlined in the BBA will have a negative impact on revenues in 1999. Management believes that the average rate calculated under the cost reimbursement methodology will not be significantly different than the average rate on the fee schedule. Recently Promulgated Accounting Standards In February 1997, the Financial Accounting Standards Board, "FASB", issued Statement No. 128, Earnings per Share, which required the Company to change the method used to compute earnings per share and to restate all prior period amounts. Statement No. 128 replaced primary and fully diluted earnings per share with basic and diluted earnings per share. Under the new requirements for calculating earnings per share, the dilutive effect of stock options is excluded from basic earnings per share but included in the computation of diluted earnings per share. The new standard did not have a material impact on the basic or fully diluted earnings per share computations for 1997 and 1996. In June 1997, the FASB issued Statement No. 131, Disclosures About Segments of an Enterprise and Related Information, which requires public companies to use the "Management Approach" for disclosing segment information. This replaces the "Industry Approach" 27 required by Statement No. 14. The new standard did not have a material impact on the Company since the Company's management approach is to view the Company as one reportable segment. Factors Affecting Future Results Clinic Development As of December 31, 1998, the Company had 99 clinics in operation, 20 of which opened in 1998. The Company expects to continue opening new clinics at the same pace it did in 1998, subject to, among other things, the Company's ability to identify suitable geographic locations and physical therapy clinic partners. The Company's operating results will be impacted by initial operating losses from the new clinics. During the initial period of operation, operating margins for newly opened clinics tend to be lower than more seasoned clinics due to the start-up costs of newly opened clinics (salaries and related costs of the physical therapist and other clinic personnel, rent and equipment and other supplies required to open the clinic) and the fact that patient revenues tend to be lower in the first year of a new clinic's operation and increase significantly over the next three to five years. Based on the historical performance of the Company's new clinics, the clinics opened in 1998 should favorably impact the Company's results of operations for 1999 and beyond. Growth in Physical Therapy Management In July 1998, the Company entered into an agreement with an orthopedic group to manage a physical therapy facility in New England, bringing third-party facilities under management to five. Management believes that with physician groups facing declining incomes, the opportunity for enhancing the physicians' income through the ownership of in-house physical therapy facilities is becoming increasingly attractive. Since 1992, the Company has offered management and administrative services to its network of clinics owned with physical therapist partners. The Company is now offering that expertise to physician groups nationwide. The Company believes it has adequate internally generated funds to support its planned growth in this area. The Balanced Budget Act of 1997 The BBA provides that beginning in 1999, outpatient rehabilitation services will be paid based on a fee schedule which has been published by HHS. The BBA also provides that beginning in 1999, the total amount that may be paid by Medicare in any one year for outpatient physical or occupational therapy to any one patient will be limited to $1,500, except for services provided in hospitals. 28 The effect of this payment change may be to encourage patients with extensive rehabilitation needs to seek treatment in a hospital setting. The Company does not anticipate that the changes in Medicare reimbursement rates as outlined in the BBA will have a negative impact on revenues in 1999. Management believes that the average rate calculated under the cost reimbursement methodology will not be significantly different than the average rate on the fee schedule. Year 2000 The Year 2000 problem is the result of two potential malfunctions that could have an impact on the Company's systems and equipment. The first problem arises due to computers being programmed to use two rather than four digits to define the applicable year. The second problem arises in embedded chips, where microchips and micro controllers have been designed using two rather than four digits to define the applicable year. Certain of the Company's computer programs, building infrastructure components (e.g. alarm systems and HVAC systems) and medical devices that are date sensitive, may recognize a date using "00" as the year 1900 rather than the year 2000. If uncorrected, the problem could result in computer system and program failures or equipment and medical device malfunctions that could result in a disruption of business operations or that could affect patient treatment. With respect to the information technology ("IT") portions of the Company's Year 2000 project, which address the assessment, remediation, testing and implementation of software, the Company, which uses only third-party software applications, has identified third-party software applications and has begun remediation for all these purchased software applications and is testing the software applications where remediation has been completed. The Company anticipates completing, in all material respects, remediation, testing and implementation for third-party software by June 1999. The Company's efforts are currently on schedule. With respect to the IT infrastructure portion of the Company's Year 2000 project, the Company has undertaken a program to inventory, assess and correct, replace or otherwise address impacted vendor products (hardware and telecommunication equipment). The Company has implemented a program to contact vendors, analyze information provided, and to remediate, replace or otherwise address IT products that pose a material Year 2000 impact. The Company anticipates completion, in all material respects, of the IT infrastructure portion of its program by June 1999. The IT infrastructure portion of the Company's Year 2000 project is currently on schedule. 29 The Company presently believes that with modifications to existing software or the installation of upgraded software under the IT infrastructure portion, the Year 2000 will not pose material operational problems for its computer systems. However, if such modifications or upgrades are not accomplished in a timely manner, Year 2000 related failures may present a material adverse impact on the operations of the Company. Contingency planning will be established and implemented in an effort to minimize any impact from Year 2000 related failures. With respect to the non-IT infrastructure portion of the Company's Year 2000 project, the Company believes that it will not be significantly affected by the Year 2000 since most of the Company's physical and occupational equipment is manual in operation, rather than being computerized. The Company will contact vendors as needed to remediate, replace or otherwise address devices or equipment that pose a Year 2000 impact. The Company relies on third-party payors and intermediaries, including government payors and intermediaries, for accurate and timely reimbursement of claims, often through the use of electronic data interfaces. Failure of these third-party systems could have a material adverse affect on the Company's results of operations. The Company is utilizing both internal and external resources to manage and implement its Year 2000 program. With the assistance of such resources, the Company has recently undertaken the development of contingency plans in the event that its Year 2000 efforts are not accurately or timely completed, or upon the failure of third- party systems upon which the Company relies. This development phase has continued into 1999 with the implementation of contingency plans occurring later in 1999. The Year 2000 project is currently estimated to have a minimum total cost of $114,000, of which the Company has incurred $48,000 through 1998. The Company recognizes that the total cost may increase as it continues its remediation and testing of IT systems. The majority of the costs related to the Year 2000 project relate to purchases of equipment and software which will be capitalized and expensed over a useful life of three years and funded through operating cash flows. The costs of the project and estimated completion dates for the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third- 30 party modification plans and other factors. However, there can be no guarantees that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. As of December 31, 1998, the Company had outstanding $3,050,000 aggregate principal amount of 8% Convertible Subordinated Notes due June 30, 2003, $2,000,000 aggregate principal amount of 8% Convertible Subordinated Notes, Series B, due June 30, 2004 and $3,000,000 aggregate principal amount of 8% Convertible Subordinated Notes, Series C, due June 30, 2004 (collectively, "the Notes"). The Notes, which were issued in private placement transactions, bear interest at 8% per annum, payable quarterly, and are convertible at the option of the Note holders into common stock of the Company at any time during the life of the Notes. The conversion price ranges from $10.00 to $12.00 per share, subject to adjustment as provided in the Notes. The fair value of the Notes is not currently determinable due primarily to the convertibility provision of the Notes and the fact that the Notes are not readily marketable. 31 Item 8. Financial Statements. U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Auditors 33 Audited Financial Statements Consolidated Balance Sheets as of December 31, 1998 and 1997 34 Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996 36 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996 37 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 38 Notes to Consolidated Financial Statements 40 32 REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders U.S. Physical Therapy, Inc. We have audited the accompanying consolidated balance sheets of U.S. Physical Therapy, Inc., and subsidiaries (the "Company") as of December 31, 1998 and 1997, and the related consolidated statements of operations, shareholders' equity, and cash flows for the years ended December 31, 1998, 1997 and 1996. Our audits also included the financial statement schedule listed in the index at Item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of U.S. Physical Therapy, Inc. and subsidiaries at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for the years ended December 31, 1998, 1997 and 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Houston, Texas March 16, 1999 33 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) December 31, 1998 1997 ASSETS Current assets: Cash and cash equivalents $ 6,328 $ 5,556 Patient accounts receivable, less allowance for doubtful accounts of $1,692 and $1,595, respectively 8,505 7,707 Accounts receivable-other 183 187 Other current assets 614 504 Total current assets 15,630 13,954 Fixed assets: Furniture and equipment 9,523 8,111 Leasehold improvements 4,537 3,869 14,060 11,980 Less accumulated depreciation 7,636 5,951 6,424 6,029 Noncompete agreements, net of amortization of $340, and $501, respectively 41 124 Goodwill, net of amortization of $169, and $138, respectively 1,000 1,042 Other assets 1,005 1,399 $ 24,100 $ 22,548 See notes to consolidated financial statements. 34 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) December 31, 1998 1997 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable - trade $ 553 $ 250 Accrued expenses 1,094 1,333 Estimated third-party payor (Medicare) settlements 944 1,095 Notes payable 32 72 Total current liabilities 2,623 2,750 Notes payable - long-term portion 76 189 Convertible subordinated notes payable 8,050 8,050 Minority interests in subsidiary limited partnerships 1,746 1,557 Commitments - - Shareholders' equity: Preferred stock, $.01 par value, 500,000 shares authorized, -0- shares outstanding - - Common stock, $.01 par value, 10,000,000 shares authorized, 3,616,509 and 3,615,634 shares outstanding at December 31, 1998 and 1997, respectively 36 36 Additional paid-in capital 11,696 11,689 Accumulated deficit (80) (1,676) Treasury stock at cost, 4,900 shares held at December 31, 1998 and and 1997, respectively (47) (47) Total shareholders' equity 11,605 10,002 $ 24,100 $ 22,548 See notes to consolidated financial statements. 35 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Year Ended December 31, 1998 1997 1996 Net patient revenues $ 43,444 $ 38,342 $ 32,029 Other revenues 579 465 178 Net revenues 44,023 38,807 32,207 Clinic operating costs: Salaries and related costs 20,263 17,624 14,743 Rent, clinic supplies and other 11,454 10,562 9,144 Provision for doubtful accounts 1,143 1,050 929 32,860 29,236 24,816 Corporate office costs: General and administrative 4,240 3,666 3,097 Recruitment and development 1,396 1,105 784 5,636 4,771 3,881 Loss on closure of facility 230 - - Operating income before non- operating expenses 5,297 4,800 3,510 Interest expense 730 741 745 Minority interests in subsidiary limited partnerships 1,863 1,578 1,007 Income before income taxes 2,704 2,481 1,758 Provision for income taxes 1,108 55 117 Net income $ 1,596 $ 2,426 $ 1,641 Basic earnings per common share $ .44 $ .67 $ .46 Earnings per common share-assuming dilution $ .43 $ .65 $ .45 See notes to consolidated financial statements. 36 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) <TABLE> <CAPTION> Add'l Total Common Stock Paid-In Accumulated Treasury Stock Shareholders' Shares Amount Capital Deficit Shares Amount Equity <S> <C> <C> <C> <C> <C> <C> <C> <C> Balance at January 1, 1996 3,520 $ 35 $10,870 $(5,743) - $ - $ 5,162 Proceeds from exercise of stock options 4 - 27 - - - 27 Interest enhancement on 8% Convertible Subordinated Notes, Series B 71 1 764 - - - 765 Net income - - - 1,641 - - 1,641 Balance at December 31, 1996 3,595 36 11,661 (4,102) - - 7,595 Proceeds from exercise of stock options 4 - 28 - - - 28 Proceeds from exercise of warrants 17 - - - - - - Repurchase of treasury shares - - - - (5) (47) (47) Net income - - - 2,426 - - 2,426 Balance at December 31, 1997 3,616 36 11,689 (1,676) (5) (47) 10,002 Proceeds from exercise of stock options 1 - 7 - - - 7 Net income - - - 1,596 - - 1,596 Balance at December 31, 1998 3,617$ 36 $11,696 $ (80) (5) $ (47) $ 11,605 </TABLE> See notes to consolidated financial statements. 37 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended December 31, 1998 1997 1996 Operating activities Net income $ 1,596 $ 2,426 $ 1,641 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,071 1,880 1,735 Minority interests in earnings of subsidiary limited partnerships 1,863 1,578 1,007 Provision for bad debts 1,143 1,050 929 Deferred income taxes 320 (833) - Loss on sale of fixed assets - 28 2 Loss on disposal of certain assets in closure of facility 144 - - Changes in operating assets and liabilities: Increase in patient accounts receivable (1,941) (2,398) (1,415) Decrease (increase) in accounts receivable-other 4 (60) (19) Decrease (increase) in other assets (84) (34) 43 Increase in accounts payable and accrued expenses 64 337 234 Increase (decrease) in estimated third-party payor (Medicare) settlements (151) (182) 562 Net cash provided by operating activities 5,029 3,792 4,719 See notes to consolidated financial statements. 38 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended December 31, 1998 1997 1996 Investing activities Purchase of fixed assets (2,357) (1,844) (1,677) Purchase of intangibles (192) (276) (301) Proceeds on sale of fixed assets 26 67 11 Net cash used in investing activities (2,523) (2,053) (1,967) Financing activities Proceeds from notes payable - 40 215 Payment of notes payable (55) (73) (61) Acquisition of treasury stock - (47) - Proceeds from investment of minority investors in subsidiary limited partnerships 6 1 11 Proceeds from exercise of stock options 7 28 27 Distributions to minority investors in subsidiary limited partnerships (1,692) (1,044) (666) Net cash used in financing activities (1,734) (1,095) (474) Net increase in cash and cash equivalents 772 644 2,278 Cash and cash equivalents - beginning of year 5,556 4,912 2,634 Cash and cash equivalents - end of year $6,328 $5,556 $4,912 Supplemental disclosures of cash flow information Cash paid during the year for: Income taxes $ 816 $ 735 $ 137 Interest $ 657 $ 667 $ 667 See notes to consolidated financial statements. 39 U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1998 1. Organization, Nature of Operations and Basis of Presentation U.S. Physical Therapy, Inc. and its subsidiaries (the "Company") is engaged in the business of developing, owning and operating outpatient physical therapy and occupational therapy clinics. As of December 31, 1998, the Company was operating 99 clinics in 28 states. The clinics provide post-operative care and treatment for a variety of orthopedic-related disorders and sports-related injuries, treatment for neurologically related injuries, rehabilitation of injured workers and preventative care. The clinics' business primarily originates from physician referrals. The principal sources of payment for the clinics' services are commercial health insurance, workers' compensation insurance, managed care programs, Medicare and proceeds from personal injury cases. The consolidated financial statements include the accounts of U.S. Physical Therapy, Inc. and its subsidiaries. All significant intercompany transactions and balances have been eliminated. The Company, through its wholly-owned subsidiaries, currently owns a 1% general partnership interest and limited partnership interest ranging from 59% to 99% in the clinics it operates. For the majority of the clinics, the managing therapist of each such clinic, along with other therapists at the clinic in several of the partnerships, own the remaining limited partnership interest in the clinic which ranges from 0% to 40%. The minority interest in the equity and earnings of the subsidiary clinic limited partnerships is presented separately in the consolidated financial statements. 2. Significant Accounting Policies Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less, when purchased, to be cash equivalents. The Company, pursuant to its investment policy, invests its cash in deposits with major financial institutions, in highly rated commercial paper, Eurodollar deposits and short-term treasury and United States government agency securities. Included in cash and cash equivalents at December 31, 1998 is $4,700,000 of short-term 40 U.S. government agency securities and $415,000 in a money market fund invested in short-term debt securities issued by U.S. government agencies. Long-Lived Assets Fixed assets are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the related assets. Estimated useful lives for furniture and equipment range from three to eight years. Leasehold improvements are amortized over the estimated useful lives of the assets or the related lease terms, whichever is shorter. Non-compete agreements are being amortized on a straight-line basis over their respective six- or seven-year terms. Goodwill is being amortized on a straight-line basis over twenty years. In August 1998, the Company closed its clinic located in Corpus Christi, Texas due to adverse clinic performance. During 1998, the Company recognized a $230,000 loss relating to this closure. Of the $230,000 loss, $18,000 represented lease commitments, $99,000 was due to the write-off of goodwill, fixed assets, leasehold improvements and a non-compete agreement and the remainder was costs incurred in connection with closing the facility. Net Patient Revenues Net patient revenues are reported at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retrospective adjustments under Medicare. Retrospective adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in future periods as final settlements are determined. The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. Medicare reimbursement for outpatient physical therapy or occupational therapy services furnished by clinics or rehabilitation agencies is based on a cost reimbursement methodology. The Company is initially reimbursed at a tentative rate with final settlement determined after submission of an annual cost report by the Company and audits thereof by the Medicare fiscal intermediary. The majority of the Company's Medicare cost reports have been audited by the Medicare fiscal intermediary through December 31, 1997. Revenues from the Medicare program accounted for approximately 12% and 13% of the Company's net 41 patient revenues for the years ended December 31, 1998 and 1997, respectively. Laws and regulations governing the Medicare program are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare program. The Company has also entered into payment agreements with certain commercial insurance carriers and health maintenance organizations. The basis for payment to the Company under these agreements is primarily based on discounts from established rates. Income Taxes The Company uses the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Fair Values The carrying amounts reported in the balance sheet for cash and cash equivalents approximate their fair values. The fair values of the majority of long-term borrowings are not readily determinable due to the features of the borrowings which are described fully in Note 4. Net Income Per Share In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share. Statement No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement No. 128 requirements. 42 Use of Estimates Management is required to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Reclassifications Certain amounts presented in the accompanying financial statements for 1997 have been reclassified to conform with the presentation used for 1998. This reclassification had no effect on net income. 3. Non-Cash Transaction In May 1994, the Company issued $2,000,000 aggregate principal amount of 8% Convertible Subordinated Notes, Series B ("the Series B Notes"). The Series B Notes contained a Contingent Interest Enhancement provision which allowed the Series B Note holders to receive an interest enhancement payable in shares of Company common stock based upon the market value of the Company's shares for the month of June 1996. In 1996, a total of 70,965 shares of the Company's common stock were issued in connection with the Contingent Interest Enhancement provision. Deferred financing costs, included in "Other Assets" on the balance sheet and being amortized over the life of the Series B Notes, totaling $765,000 were recorded in connection with the issuance of the 70,965 shares. As of December 31, 1998, 1997 and 1996, interest expense included $351,000, $276,000 and $200,000, respectively, of amortization relating to the deferred financing costs. 4. Notes Payable On June 2, 1993, the Company completed the issuance and sale of $3,050,000 aggregate principal amount of the Company's 8% Convertible Subordinated Notes due June 30, 2003 (the "Notes"). The Notes, which are subordinated to any indebtedness for borrowed money, were issued at par in a private placement transaction to a total of six investors, including two directors who purchased a total of $175,000 of the Notes and a company controlled by one of the Company's directors, Mr. Richard C.W. Mauran, who purchased $2,000,000 of the Notes. The Notes bear interest at 8% per annum, payable quarterly, and are convertible at the option of the Note holders into common stock of the Company at any time during the life of the Notes. The conversion price is $10.00 per share (subject to adjustment as provided in the Notes). The Company can 43 require the Note holders to convert the Notes into shares of common stock at any time that the average trading price of the Company's common stock equals or exceeds $20.00 per share (subject to adjustment as provided in the Notes) during the immediately preceding 90-day period. As of December 31, 1998, none of the Notes had been converted into common stock of the Company. On May 5, 1994, the Company completed the issuance and sale of $2,000,000 aggregate principal amount of 8% Convertible Subordinated Notes, Series B, due June 30, 2004 (the "Series B Notes"). The Series B Notes were issued at par in a private placement. The Series B Notes are convertible at the option of the holder, into the number of whole shares of the Company's common stock, determined by dividing the principal amount so converted by $12.00 (the "Conversion Price"), subject to adjustment upon the occurrence of certain events. The Company may require conversion, in whole or in part, at any time at the Conversion Price then in effect if, during the preceding 90-day period, the average market price of the Company's common stock equals or exceeds $20.00 per share. The Series B Notes bear interest from the date of issuance at a rate of 8% per annum, payable quarterly. Holders of Series B Notes were entitled to receive an interest enhancement payable in shares of Company common stock based upon the market value of the Company's common stock at June 30, 1996, which was two years from the date of issuance of the Series B Notes. In July 1996, the Company issued 70,965 shares of its common stock in connection with the interest enhancement provision. The Company also completed on May 5, 1994, the issuance and sale of $3,000,000 aggregate principal amount of 8% Convertible Subordinated Notes, Series C due June 30, 2004 (the "Series C Notes"). The Series C Notes were issued at par in a private placement to a company controlled by one of the Company's directors, Mr. Richard C.W. Mauran. The Series C Notes are convertible, at the option of the holder, into the number of whole shares of common stock, determined by dividing the principal amount so converted by $10.00, subject to adjustment upon the occurrence of certain events. The Series C Notes bear interest from the date of issuance at a rate of 8% per annum, payable quarterly. Both Series B Notes and Series C Notes are unsecured subordinated obligations of the Company and rank pari passu with the Company's 8% Convertible Subordinated Notes due June 30, 2003. Each of the Notes are subordinated in right of payment to all other indebtedness for borrowed money incurred by the Company. 44 Holders of the Notes have piggy-back registration rights as set forth in the Registration Agreement relating to the Notes. Holders of the Series B Notes and Series C Notes each have demand and piggy-back registration rights as set forth in the Registration Agreements relating to the Notes. Notes payable as of December 31, 1998 and 1997 consist of the following: December 31, 1998 1997 Promissory note at a floating interest rate of 1% above prime, payable in semi-annual installments beginning January 31, 1993 until the earlier of payment of the entire principal and accrued interest due or 30 days from the sixth anniversary of the date of this note. Each installment of principal is equal to the greater of $9,375 or 4.5% of the net patient revenues of one of the Company's clinics for the six months of the calendar year immediately preceding each installment date. This note is secured by certain furniture and equipment with a net book value of approximately -0-. $ - $ 51,000 Promissory note at a floating interest rate of 1% above prime, payable in monthly installments through November 1, 2001. This note is secured by the facility, with a net book value of approximately $74,000, of one of the Company's clinics. 25,000 32,000 Promissory note with an 8% interest rate payable in equal monthly installments through March 19, 2007. This note is secured by the facility, with a net book value of approximately $49,000, of one of the Company's clinics. 35,000 38,000 Unsecured promissory notes with a 7% interest rate payable in equal monthly installments through December 31, 2000. 48,000 140,000 45 December 31, 1998 1997 8% Convertible Subordinated Notes due June 30, 2003 with interest payable quarterly. 3,050,000 3,050,000 8% Convertible Subordinated Notes, Series B, due June 30, 2004, with interest payable quarterly. 2,000,000 2,000,000 8% Convertible Subordinated Notes, Series C, due June 30, 2004, with interest payable quarterly. 3,000,000 3,000,000 8,158,000 8,311,000 Less current portion (32,000) (72,000) $8,126,000 $8,239,000 Scheduled maturities for the next five years and thereafter as of December 31, 1998 are as follows: 1999 $ 32,000 2000 39,000 2001 12,000 2002 4,000 2003 3,054,000 Thereafter 5,017,000 $8,158,000 5. Related Party Transactions During 1998, 1997 and 1996, the Company recognized interest expense of $414,000 per year relating to Convertible Subordinated Notes held by directors of the Company. See Note 4 for additional related party transactions. 46 6. Income Taxes Significant components of the Company's deferred tax assets at December 31 were as follows: 1998 1997 Deferred tax assets: Accrued liabilities $ 157,000 $ 130,000 Allowance for bad debt 375,000 353,000 Minimum tax credit carryforward - 297,000 Other 7,000 100,000 Total 539,000 880,000 Deferred tax liabilities: Depreciation (26,000) (47,000) Net deferred tax assets $ 513,000 $ 833,000 The differences between the federal tax rate and the Company's effective tax rate, at December 31 were as follows: <TABLE> <CAPTION> 1998 1997 1996 <S> <C> <C> <C> <C> <C> <C> U.S. tax at statutory rate $ 919,000 34.00% $ 844,000 34.00% $574,000 35.00% Reduction in valuation allowance - - (1,087,000)(43.80) (557,000)(33.95) State income taxes 156,000 5.77 170,000 6.87 43,000 2.62 Nondeductible expenses 32,000 1.18 16,000 0.63 29,000 1.76 Other - net 1,000 0.03 112,000 4.52 28,000 1.70 $1,108,000 40.98% $ 55,000 2.22% $117,000 7.13% </TABLE> Significant components of the provision/(benefit) for income taxes, for the years ended December 31, were as follows: 1998 1997 1996 Current: Federal $ 552,000 $ 630,000 $ 74,000 State 236,000 258,000 43,000 Total current 788,000 888,000 117,000 Deferred: Federal 320,000 (833,000) - State - - - Total deferred 320,000 (833,000) - Total income tax provision $1,108,000 $ 55,000 $ 117,000 Income taxes paid during 1998, 1997 and 1996 were approximately $816,000, $735,000 and $137,000, respectively. 47 7. Stock Option Plans The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"(APB 25) and related interpretations in accounting for its employee stock options. Pro forma information regarding net income and earnings per share is required by FASB Statement No. 123, "Accounting and Disclosure of Stock-Based Compensation", and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model. 1992 Stock Option Plan, as Amended The Company has a 1992 Stock Option Plan, as amended (the "Option Plan") which permits the Company to grant to key employees and outside directors of the Company options to purchase shares of common stock (subject to proportionate adjustments in the event of stock dividends, splits, and similar corporate transactions). During 1998, the Option Plan was amended to (i) increase by 350,000 (from 645,000 to 995,000) the number of shares of common stock reserved for issuance upon exercise of options granted under the Option Plan and (ii) increase the number of stock options that may be granted to any one eligible individual in any one calendar year from 50,000 to 100,000 (in each case, subject to adjustments for stock dividends, stock splits and the like as provided in the Option Plan). Incentive stock options (those intended to satisfy the requirements of the Internal Revenue Code) granted under the Option Plan are granted at an exercise price of not less than the fair market value of the shares of common stock on the date of grant. The exercise prices of non-incentive options granted under the Option Plan are determined by the committee which administers the Option Plan upon each grant. The period within which each option will be exercisable is determined by the committee which administers the Option Plan (in no event may the exercise period of an incentive stock option extend beyond 10 years from the date of grant). As of December 31, 1998, 1997 and 1996, 78,750, 78,750 and 78,750 incentive stock options and 776,175, 520,375 and 416,000 non- incentive stock options have been granted. Incentive stock options of 3,750, 3,750 and 3,750 and non-incentive stock options of 13,000, 12,125 and 8,000 have been exercised as of December 31, 1998, 1997 and 1996, respectively. 48 Outstanding incentive stock options vest one-fourth on each of the second, third, fourth and fifth anniversaries of the date of grant. Of the 763,175 non-incentive stock options granted, but not yet exercised as of December 31, 1998, 263,000 options vest 100% on the date of grant, and 500,175 options vest one-fourth on each of the second, third, fourth and fifth anniversaries of the date of grant. The following weighted-average assumptions for 1998, 1997 and 1996 were used in estimating the fair value of the options granted under the Option Plan: risk-free interest rates ranging from 4.65% to 6.36%; dividend yield rate of 0%; volatility factors of the expected market price of the Company's common stock ranging from .245 to .251; and a weighted-average expected life of the option of eight years for those options which vest one-fourth on each of the second, third, fourth and fifth anniversaries of the date of grant and weighted-average expected lives of five to eight years for the remaining options. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The pro forma effect on net income for 1998, 1997 and 1996 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995. The Company's pro forma information follows (in thousands except for earnings per share information): 1998 1997 1996 Pro forma net income $1,347 $2,249 $1,426 Pro forma earnings per share $ 0.37 $ 0.62 $ 0.40 49 A summary of the Company's Option Plan activity and related information for the years ended December 31 follows: 1998 1997 1996 Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price Outstanding- beginning of year 583,250 $8.92 483,000 $8.68 381,500 $8.41 Granted 262,800 10.60 111,250 9.89 105,750 9.59 Exercised (875) 8.89 (4,125) 7.19 (4,000) 6.75 Forfeited (7,000) 9.77 (6,875) 8.78 (250) 8.63 Outstanding- end of year 838,175 $9.44 583,250 $8.92 483,000 $8.68 Exercisable at end of year 427,281 $8.89 329,063 $8.89 241,625 $8.66 Weighted- average fair value of options granted during the year $ 4.41 $ 3.99 $ 4.12 Exercise prices for options outstanding as of December 31, 1998 ranged from $6.25 to $12.19. The weighted-average remaining contractual life of those options is 7.46 years. Executive Option Plan The Executive Option Plan (the "Executive Plan") was adopted by the Board of Directors of the Company on March 2, 1993 and was approved by the Company's stockholders on May 24, 1993. The Executive Plan permits the Company to grant to any officer of the Company or its affiliates, options to purchase up to 200,000 shares of common stock (subject to adjustments in the event of stock dividends, splits and similar corporate transactions). No further grants of options will be made under the Executive Plan as a result of the amendment to the 1992 Stock Option Plan (see Note 7, 1992 Stock Option Plan, as Amended). The exercise prices of the options 50 granted under the Executive Plan are determined by the committee which administers the Executive Plan upon each grant, and in the case of incentive and non-incentive options, may not be less than the greater of 175% of the fair market value of a share of common stock on the date of grant of the option or the par value per share of the stock. The period within which each option will be exercisable is determined by the committee which administers the Executive Plan (in no event may the exercise period extend beyond 10 years from the date of grant). The outstanding options vest one-third on each of the third, fourth and fifth anniversaries of the date of grant. A summary of the Company's Executive Plan activity and related information for the years ended December 31 follows: 1998 1997 1996 Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price Outstanding- beginning of year 105,000 $13.31 105,000 $13.31 105,000 $13.31 Granted - - - - - - Exercised - - - - - - Forfeited - - - - - - Outstanding- end of year 105,000 $13.31 105,000 $13.31 105,000 $13.31 Exercisable at end of year 95,000 $13.15 60,000 $13.05 25,000 $12.69 Exercise prices for options outstanding as of December 31, 1998 ranged from $12.69 to $14.88. The weighted-average remaining contractual life of those options is 4.71 years. In total, the Company has 1,854,917 shares which are reserved for issuance under the 1992 Stock Option Plan, the Executive Option Plan, the 8% Convertible Subordinated Notes, the Series B Notes and the Series C Notes. 51 8. Warrants In connection with the Company's initial public offering of its stock effective May 28, 1992, the Company agreed to sell to the managing underwriter, for nominal consideration, warrants to purchase from the Company 120,000 shares of common stock (the "Representative's Warrants"). The Representative's Warrants were initially exercisable at a price of $8.125 per share of common stock for a period of four years, commencing one year from the initial public offering date. In May 1997, 96,000 of the Representative's Warrants were exercised by surrendering the Warrants in exchange for 16,794 shares of Company common stock. The remaining 24,000 of the Representative's Warrants expired. 9. Preferred Stock The Board of Directors of the Company is empowered, without approval of the stockholders, to cause shares of Preferred Stock to be issued in one or more series and to establish the number of shares to be included in each such series and the rights, powers, preferences and limitations of each series. There are no provisions in the Company's Articles of Incorporation specifying the vote required by the holders of Preferred Stock to take action. All such provisions would be set out in the designation of any series of Preferred Stock established by the Board of Directors. The bylaws of the Company specify that, when a quorum is present at any meeting, the vote of the holders of at least a majority of the outstanding shares entitled to vote who are present, in person or by proxy, shall decide any question brought before the meeting, unless a different vote is required by law or the Company's Articles of Incorporation. Because the Board of Directors has the power to establish the preferences and rights of each series, it may afford the holders of any series of Preferred Stock, preferences, powers, and rights, voting or otherwise, senior to the right of holders of common stock. The issuance of the Preferred Stock could have the effect of delaying or preventing a change in control of the Company. The Board of Directors has no present plans to issue any of the Preferred Stock. 52 10. Defined Contribution Plan The Company has a 401(k) profit sharing plan covering all employees with three months of service. The Company may make discretionary contributions of up to 50% of employee contributions. The Company recognized $-0- in contribution expense for the years ended December 31, 1998, 1997 and 1996, respectively. 11. Commitments and Contingencies Operating Leases The Company has entered into operating leases for its executive offices and clinic facilities. In connection with these agreements, the Company incurred rent expense of $3,125,000, $2,831,000 and $2,415,000 for the years ended December 31, 1998, 1997 and 1996, respectively. Several of the leases provide for an annual increase in the rental payment based upon the Consumer Price Index for each particular year. The leases also provide for renewal periods ranging from one to five years. The agreements to extend the leases specify that rental rates would be adjusted to market rates as of each renewal date. The future minimum lease commitments for the next five years and in the aggregate are as follows: 1999 $3,105,000 2000 2,378,000 2001 2,023,000 2002 1,430,000 2003 704,000 Thereafter 101,000 $9,741,000 Employment Agreements At December 31, 1998, the Company had an outstanding employment agreement with one of its executive officers for $180,000 annually, subject to adjustment to reflect positive performance, for a term extending through February 2002. In addition, the Company has outstanding employment agreements with the managing physical therapist partners of the Company's physical therapy clinics and with certain other clinic employees which 53 obligate subsidiaries of the Company to pay compensation of $7,126,000 in 1999 and $12,559,000 in the aggregate through 2003. In addition, each employment agreement with the managing physical therapists provides for monthly bonus payments calculated as a percentage of each clinic's net revenues (not in excess of operating profits) or operating profits. The Company recognized salaries and bonus expense for the managing physical therapist partners of $7,044,000, $5,810,000 and $4,852,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The employment agreements generally include a non-competition provision which extends through the term of the agreement and for one to two years thereafter. Minority Interest in Outpatient Physical Therapy Clinic Limited Partnerships The managing physical and/or occupational therapist of each clinic owns a partial interest in the clinic he or she operates. This is accomplished by having each clinic structured as a separate limited partnership (the "Operating Subsidiaries"). The Company, through its wholly-owned subsidiaries, currently owns a 1% general partnership interest and limited partnership interest ranging from 59% to 99% in the clinics it operates. For the majority of the clinics, the managing therapist of each such clinic, along with other therapists at the clinic in several of the partnerships, own the remaining limited partnership interest in the clinic which ranges from 0% to 40%. The majority of the partnership agreements are structured such that the managing therapist begins with a 20% profit interest in his or her clinic limited partnership and, at the end of each of the first five years, the managing therapist's profit interest increases by 3% until his or her interest reaches 35%. These therapists have no interest in net losses of clinic partnerships, except to the extent of their capital accounts. The Company presently anticipates that future clinics developed by the Company will be structured in a comparable manner. 54 12. Earnings per Share The following table sets forth the computation of basic and diluted earnings per share: 1998 1997 1996 Numerator: Net income $1,596,000 $2,426,000 $1,641,000 Numerator for basic earnings per share and diluted earnings per share $1,596,000 $2,426,000 $1,641,000 Denominator: Denominator for basic earnings per share-- weighted-average shares 3,611,039 3,603,159 3,557,113 Effect of dilutive securities: Stock options 132,490 94,346 92,463 Warrants - 10,803 30,010 Dilutive potential common shares 132,490 105,149 122,473 Denominator for diluted earnings per share-- adjusted weighted- average shares and assumed conversions 3,743,529 3,708,308 3,679,586 Basic earnings per share $ 0.44 $ 0.67 $ 0.46 Diluted earnings per share $ 0.43 $ 0.65 $ 0.45 For additional disclosures regarding the stock options and warrants, see Notes 7 and 8, respectively. The Notes, the Series B Notes and the Series C Notes were all outstanding during 1996, 1997 and 1998, but were not included in the computation of diluted earnings per share because the effect on the computation was anti-dilutive. Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure. None 55 PART III Item 10. Directors, Executive Officers, Promoters and Control Persons; Compliance With Section 16(a) of the Exchange Act. The information required by Items 401 and 405 of Regulation S-K is omitted from this Report as the Company intends to file its definitive annual meeting proxy materials within 120 days after its fiscal year-end and the information to be included therein in response to such Items is incorporated herein by reference. Item 11. Executive Compensation. The information required by Item 402 of Regulation S-K is omitted from this Report as the Company intends to file its definitive annual meeting proxy materials within 120 days after its fiscal year-end and the information to be included therein in response to such Item is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by Item 403 of Regulation S-K is omitted from this Report as the Company intends to file its definitive annual meeting proxy materials within 120 days after its fiscal year-end and the information to be included therein in response to such Item is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions. The information required by Item 404 of Regulation S-K is omitted from this Report as the Company intends to file its definitive annual meeting proxy materials within 120 days after its fiscal year-end and the information to be included therein in response to such Item is incorporated herein by reference. 56 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)(1) The following consolidated financial statements of U.S. Physical Therapy, Inc. and subsidiaries are included in Item 8: Consolidated balance sheets - December 31, 1998 and 1997 Consolidated statements of operations - Years ended December 31, 1998, 1997 and 1996 Consolidated statements of shareholders' equity - Years ended December 31, 1998, 1997 and 1996 Consolidated statements of cash flows - Years ended December 31, 1998, 1997 and 1996 Notes to consolidated financial statements - December 31, 1998 (2) The following consolidated financial statement schedule of U.S. Physical Therapy, Inc. is included in Item 14(d): Schedule II - Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. (3) List of Exhibits 3.1 Articles of Incorporation of the Company (filed as an exhibit to the Company's Registration Statement on Form S-1 (33-47019) and incorporated herein by reference). 3.2 Bylaws of the Company, as amended (filed as an exhibit to the Company's Form 10-KSB for the year ended December 31, 1993 and incorporated herein by reference). 57 10.1 Convertible Subordinated Note Purchase Agreement dated June 2, 1993 (filed as an exhibit to the Company's Form 8-K dated June 10, 1993 and incorporated herein by reference). 10.2 Form of U.S. Physical Therapy, Inc. 8% Convertible Subordinated Notes (filed as an exhibit to the Company's Form 8-K dated June 2, 1993 and incorporated herein by reference). 10.3 Amendment to Convertible Subordinated Note Purchase Agreement dated March 10, 1994 (filed as an exhibit to the Company's Form 8-K dated March 25, 1994 and incorporated herein by reference). 10.4 Form of 8% Convertible Subordinated Notes, Series C (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). 10.5 Registration Agreement for Series B Notes (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). 10.6 Form of 8% Convertible Subordinated Notes, Series C (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). 10.7 Registration Agreement for Series C Notes (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). 10.8 1992 Stock Option Plan, as amended (filed as an exhibit to the Company's Registration Statement on Form S-8 (333- 64159) and incorporated herein by reference). 10.9 Executive Option Plan (filed as an exhibit to the Company's Registration Statement on Form S-8 (33-63444) and incorporated herein by reference). 10.10 Amended and Restated Employment Agreement between the Company and Roy W. Spradlin (filed as an exhibit to the Company's Form 10-KSB for the year ended December 31, 1997 and incorporated herein by reference). 21 Subsidiaries of the Company. 58 23 Consent of Ernst & Young LLP (Registration Nos. 33-63446, 33-63444, 33-91004, 33-93040, 333-30071 and 333-64159). 27 Financial Data Schedule. (b) Reports on Form 8-K No Form 8-K was filed for the quarter ended December 31, 1998. 59 Item 14. (d)SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS U.S. PHYSICAL THERAPY, INC. AND SUBSIDIARIES <TABLE> <CAPTION> COL. A COL. B COL. C COL. D COL. E Additions Balance Charged to at Charged to Other Balance Beginning Costs and Accounts- Deductions- at End Description of Period Expenses Describe Describe of Period <S> <C> <C> <C> <C> YEAR ENDED DECEMBER 31, 1998: Reserves and allowances deducted from asset accounts: Allowance for uncollectible accounts $1,595,000 $1,143,000 $1,046,000(1) $1,692,000 YEAR ENDED DECEMBER 31, 1997: Reserves and allowances deducted from asset accounts: Allowance for uncollectible accounts $1,159,000 $1,050,000 $ 614,000(1) $1,595,000 YEAR ENDED DECEMBER 31, 1996: Reserves and allowances deducted from asset accounts: Allowance for uncollectible accounts $ 727,000 $ 929,000 $ 497,000(1) $1,159,000 <FN> <F1> (1)Uncollectible accounts written off, net of recoveries. <FN> </TABLE> 60 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. U.S. PHYSICAL THERAPY, INC. By: /s/ J. Michael Mullin (Registrant) J. Michael Mullin, Chief Financial Officer (principal financial and accounting officer) Date: March 30, 1999 In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities as of the date indicated above. By:/s/ J. Livingston Kosberg By: /s/ Marlin W. Johnston J. Livingston Kosberg, Marlin W. Johnston, Chairman of the Board Director By: /s/ Mark J. Brookner By: /s/ James B. Hoover Mark J. Brookner, James B. Hoover, Vice Chairman of the Board Director By: /s/ Roy W. Spradlin By: /s/ Richard C.W. Mauran Roy W. Spradlin, President, Richard C.W. Mauran, Chief Executive Officer and Director Director (principal executive officer) By: /s/ Daniel C. Arnold By: Daniel C. Arnold, Albert L. Rosen, Director Director 61 INDEX OF EXHIBITS EXHIBIT NO. IDENTITY OF EXHIBIT PAGE NO. 3.1 Articles of Incorporation of the Company (filed as an exhibit to the Company's Registration State- ment on Form S-1 (33-47019) and incorporated herein by reference). -- 3.2 Bylaws of the Company, as amended (filed as an exhibit to the Company's Form 10-KSB for the year ended December 31, 1993 and incorporated herein by reference). -- 10.1 Convertible Subordinated Note Purchase Agreement dated June 2, 1993 (filed as an exhibit to the Company's Form 8-K dated June 10, 1993 and incorporated herein by reference). -- 10.2 Form of U.S. Physical Therapy, Inc. 8% Convertible Subordinated Notes (filed as an exhibit to the Company's Form 8-K dated June 2, 1993 and incorporated herein by reference). -- 10.3 Amendment to Convertible Subordinated Note Purchase Agreement dated March 10, 1994 (filed as an exhibit to the Company's Form 8-K dated March 25, 1994 and incorporated herein by reference). -- 10.4 Form of 8% Convertible Subordinated Notes, Series C (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). -- 10.5 Registration Agreement for Series B Notes (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). -- 62 INDEX OF EXHIBITS EXHIBIT NO. IDENTITY OF EXHIBIT PAGE NO. 10.6 Form of 8% Convertible Subordinated Notes, Series C (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). -- 10.7 Registration Agreement for Series C Notes (filed as an exhibit to the Company's Form 8-K dated May 5, 1995 and incorporated herein by reference). -- 10.8 1992 Stock Option Plan, as amended (filed as an exhibit to the Company's Registration Statement on Form S-8 (333-64159) and incorporated herein by reference). -- 10.9 Executive Option Plan (filed as an exhibit to the Company's Registration Statement on Form S-8 (33-63444) and incorporated herein by reference). -- 10.10 Amended and Restated Employment Agreement between the Company and Roy W. Spradlin (filed as an exhibit to the Company's Form 10-KSB for the year ended December 31, 1997 and incorporated herein by reference). -- 21 Subsidiaries of the Company. 64 23 Consent of Ernst & Young LLP (Registra- tion Nos. 33-63446, 33-63444, 33-91004, 33-93040, 333-30071 and 333-64159). 70 27 Financial Data Schedule. 71 63 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT STATE OF NAME OF TYPE OF INCORPORATION SUBSIDIARY ENTITY OR FORMATION U.S. PT - Delaware, Inc. Corporation Delaware U.S. Therapy, Inc. Corporation Texas National Rehab GP, Inc. Corporation Texas National Rehab Delaware, Inc. Corporation Delaware U.S. PT - Michigan, Inc. Corporation Delaware HH Rehab Associates, Inc. dba Genesee Valley Physical Therapy Corporation Michigan Professional Rehab Services, Inc. dba Northwoods Physical Therapy dba Thibodeau Physical Therapy Corporation Michigan U.S. Physical Therapy, Ltd. Limited Partnership Texas U.S. PT Management, Ltd. Limited Partnership Texas National Rehab Management GP, Inc. Corporation Texas Rehab Partners #1, Inc. Corporation Texas Rehab Partners #2, Inc. Corporation Texas Rehab Partners #3, Inc. Corporation Texas Rehab Partners #4, Inc. Corporation Texas Rehab Partners #5, Inc. Corporation Texas Rehab Partners #6, Inc. Corporation Texas Rehab Partners #7, Inc. Corporation Texas Rehab Partners Acquisition #1, Inc. Corporation Texas Southeastern Hand Rehabilitation, Inc. dba Reist Hand Therapy Corporation Florida The Browning Realty Group, Inc. Corporation Texas Action Physical Therapy Clinic, Ltd. Limited Partnership Texas Cypresswood Physical Therapy Centre, Ltd. Limited Partnership Texas Progressive Physical Therapy Clinic, Ltd. Limited Partnership Texas Virginia Parc Physical Therapy, Ltd. dba McKinney Physical Therapy Associates, Limited Partnership Limited Partnership Texas 64 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT STATE OF NAME OF TYPE OF INCORPORATION SUBSIDIARY ENTITY OR FORMATION Dearborn Physical Therapy, Ltd. dba Advanced Physical Therapy Limited Partnership Texas Saline Physical Therapy of Michigan, Ltd. Limited Partnership Texas R. Clair Physical Therapy, Limited Partnership Limited Partnership Texas Roepke Physical Therapy, Limited Partnership Limited Partnership Texas Merrill Physical Therapy, Limited Partnership Limited Partnership Texas Genesee Valley Physical Therapy, Limited Partnership (canceled effective 5/13/98) Limited Partnership Texas Joan Ostermeier Physical Therapy, Limited Partnership dba Sport & Spine Clinic of Wittenberg Limited Partnership Texas Crossroads Physical Therapy, Limited Partnership Limited Partnership Texas Kelly Lynch Physical Therapy, Limited Partnership Limited Partnership Texas U.S. PT Michigan #1, Limited Partnership Limited Partnership Texas Spracklen Physical Therapy, Limited Partnership Limited Partnership Texas Bosque River Physical Therapy and Rehabilitation, Limited Partnership Limited Partnership Texas Kingwood Physical Therapy, Ltd. Limited Partnership Texas Enid Therapy Center, Limited Partnership Limited Partnership Texas Dynamic Physical Therapy of Round Rock, Ltd. Limited Partnership Texas Active Physical Therapy, Limited Partnership Limited Partnership Texas Southwind Physical Therapy, Limited Partnership Limited Partnership Texas 65 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT STATE OF NAME OF TYPE OF INCORPORATION SUBSIDIARY ENTITY OR FORMATION Genesis Rehabilitation and Sports Center - Jackson, Limited Partnership Limited Partnership Texas Cleveland Physical Therapy, Ltd. Limited Partnership Texas Aquatic and Orthopedic Rehab Specialists, Limited Partnership Limited Partnership Texas Vileno Therapy of Treasure Coast, Limited Partnership Limited Partnership Texas Trussell Physical Therapy, Limited Partnership dba GenTech Industrial Physical Therapy Services (dissolved effective 3/31/98) Limited Partnership Texas Comprehensive Hand & Physical Therapy, Limited Partnership Limited Partnership Texas Tom Melko Physical Therapy, Limited Partnership Limited Partnership Texas Debra Dent Physical Therapy, Limited Partnership Limited Partnership Texas Hands Plus Therapy Center, Limited Partnership Limited Partnership Texas South Tulsa Physical Therapy, Limited Partnership Limited Partnership Texas Hands On Therapy, Limited Partnership Limited Partnership Texas U.S. PT Michigan #2, Limited Partnership Limited Partnership Texas Maine Physical Therapy, Limited Partnership Limited Partnership Texas Brentwood Physical Therapy, Limited Partnership Limited Partnership Texas Saginaw Valley Sport and Spine, Limited Partnership dba Saginaw Valley Sport & Spine, Bay City Sport & Spine and Midland Sport & Spine Limited Partnership Texas Brazos Valley Physical Therapy, Limited Partnership Limited Partnership Texas 66 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT STATE OF NAME OF TYPE OF INCORPORATION SUBSIDIARY ENTITY OR FORMATION Plymouth Physical Therapy Specialists, Limited Limited Partnership Texas Partnership Brick Hand & Rehabilitative Services, Limited Partnership Limited Partnership Texas Heartland Physical Therapy, Limited Partnership Limited Partnership Texas Bay View Physical Therapy, Ltd. Limited Partnership Texas Rio Grande Physical Therapy, Limited Partnership Limited Partnership Texas Thomas Hand and Rehabilitation Specialists, Limited Partnership Limited Partnership Texas Excel Occupational and Physical Therapy, Limited Partnership Limited Partnership Texas Hand Health and Rehabilitation, Limited Partnership Limited Partnership Texas Flannery Physical Therapy, Limited Partnership dba Physical Therapy Plus Limited Partnership Texas Port City Physical Therapy, Limited Partnership Limited Partnership Texas Brownwood Physical Therapy, Limited Partnership dba Pecan Valley Physical Therapy Limited Partnership Texas Quantum Physical Therapy, Limited Partnership (formerly Abbott & Baird Physical Therapy Associates, Limited Partnership) Limited Partnership Texas Spine & Sport Physical Therapy, Limited Partnership (formerly Southern Orthopaedic & Sports Physical Therapy, Limited Partnership) Limited Partnership Texas Norman Physical Therapy, Limited Partnership Limited Partnership Texas Rice Rehabilitation Associates, Limited Partnership Limited Partnership Texas 67 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT STATE OF NAME OF TYPE OF INCORPORATION SUBSIDIARY ENTITY OR FORMATION Physical Therapy and Spine Institute, Limited Partnership Limited Partnership Texas Forest City Physical Therapy, Limited Partnership Limited Partnership Texas Leader Physical Therapy, Limited Partnership Limited Partnership Texas Functions by Fletchall, Limited Partnership Limited Partnership Texas C.A.R.E. Physical Therapy Center, Limited Partnership Limited Partnership Texas Ankeny Physical & Sports Therapy, Limited Partnership Limited Partnership Texas Twin Cities Physical Therapy, Limited Partnership Limited Partnership Texas Brem Physical Therapy Associates, Limited Partnership Limited Partnership Texas Penn's Wood Physical Therapy, Limited Partnership Limited Partnership Texas Regional Physical Therapy Center, Limited Partnership Limited Partnership Texas Wyman Physical Therapy, Limited Partnership Limited Partnership Texas Adams County Physical Therapy, Limited Partnership Limited Partnership Texas Coppell Spine & Sports Rehab, Limited Partnership Limited Partnership Texas Julie Emond Physical Therapy, Limited Partnership dba Maple Valley Physical Therapy Limited Partnership Texas City of Lakes Physical Therapy, Limited Partnership Limited Partnership Texas Radtke Physical Therapy, Limited Partnership Limited Partnership Texas Flint Physical Therapy, Limited Partnership Limited Partnership Texas Pelican State Physical Therapy, Limited Partnership Limited Partnership Texas 68 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT STATE OF NAME OF TYPE OF INCORPORATION SUBSIDIARY ENTITY OR FORMATION Airpark Physical Therapy, Limited Partnership (formerly Therapy Partners, Limited Partnership which was formerly North Hills Physical Therapy, Limited Partnership) Limited Partnership Texas Capital Hand and Physical Therapy, Limited Partnership Limited Partnership Texas Maines & Dean Physical Therapy, Limited Partnership Limited Partnership Texas Edge Physical Therapy, Limited Partnership dba River's Edge Physical Therapy Limited Partnership Texas Laurel Physical Therapy, Limited Partnership Limited Partnership Texas Riverwest Physical Therapy, Limited Partnership Limited Partnership Texas Scott Black Physical Therapy, Limited Partnership Limited Partnership Texas Mountain View Physical Therapy, Limited Partnership Limited Partnership Texas Intermountain Physical Therapy, Limited Partnership Limited Partnership Texas Staunton Hand & Rehab Services, Limited Partnership Limited Partnership Texas White Mountain Physical Therapy, Limited Partnership Limited Partnership Texas Battle Physical Therapy, Limited Partnership Limited Partnership Texas Covington Rehabilitation and Hand Therapy, Limited Partnership Limited Partnership Texas Crawford Physical Therapy, Limited Partnership Limited Partnership Texas Sport & Spine Clinic, L.P. Limited Partnership Texas Physical Therapy & Rehab Ctr., L.P. (dissolved effective 12/31/98) Limited Partnership Texas 69 Exhibit 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 33-63446, 33-63444, 33-91004, 33- 93040, 333-30071, 333-64159) of our report dated March 16, 1999 with respect to the consolidated financial statements and schedule of U.S. Physical Therapy, Inc. and subsidiaries included in this Annual Report on Form 10-K for the year ended December 31, 1998. Houston, Texas March 30, 1999 ERNST & YOUNG LLP 70