Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
There were 749,550 shares of registrant’s common stock outstanding as of September 1, 2006 (all of which are privately owned and not traded on a public market).
PART I
Item 1. Business.
Company Overview
We own and operate acute care hospitals and complementary outpatient facilities principally located in urban and suburban markets. Since our inception in 1997, we have acquired or developed 19 acute care hospitals which, as of June 30, 2006, had a total of 4,587 beds in the following five locations:
• San Antonio, Texas
• metropolitan Phoenix, Arizona
• metropolitan Chicago, Illinois
• Orange County, California
• Massachusetts
Historically, we have concentrated our operations in markets with high population growth and median income in excess of the national average. Our objective is to provide high-quality, cost effective healthcare services through an integrated delivery platform serving the needs of the communities in which we operate. During the year ended June 30, 2006, we generated revenues of $2,652.7 million. During this period 85.9% of our total revenues were derived from acute care hospitals and complementary outpatient facilities.
Our general acute care hospitals offer a variety of medical and surgical services including emergency services, general surgery, internal medicine, cardiology, obstetrics, orthopedics and physical rehabilitation. In addition, certain of our facilities provide on-campus and off-campus services including outpatient surgery, physical therapy, radiation therapy, diagnostic imaging and respiratory therapy. We also own three strategically important managed care health plans: a Medicaid managed health plan, Phoenix Health Plan, that served approximately 96,700 members as of June 30, 2006 in Arizona; Abrazo Advantage Health Plan, a managed Medicare and dual-eligible health plan that served approximately 3,500 members as of June 30, 2006 who are eligible for both Medicare and Medicaid; and MacNeal Health Providers a preferred provider network that served approximately 46,000 member lives in metropolitan Chicago as of June 30, 2006 under capitated contracts covering only outpatient and physician services.
We are a Delaware corporation formed in July 1997. Our principal executive offices are located at 20 Burton Hills Boulevard, Suite 100, Nashville, Tennessee, 37215 and our telephone number at that address is (615) 665-6000. Our corporate website address is www.vanguardhealth.com. Information contained on our website does not constitute part of this Annual Report on Form 10-K. The terms “we”, “our”, “the Company”, “us”, “registrant” and “Vanguard” as used in this report refer to Vanguard Health Systems, Inc. and its subsidiaries as a consolidated entity, except where it is clear from the context that such terms mean only Vanguard Health Systems, Inc. “Subsidiaries” means direct and indirect corporate subsidiaries of Vanguard Health Systems, Inc. and partnerships, joint ventures and limited liability companies in which such subsidiaries are partners or members. The term “predecessor” as used in our consolidated financial statements refers to the Company prior to the September 23, 2004 Merger discussed immediately below.
The Merger
On July 23, 2004, Vanguard executed an agreement and plan of merger (the “Merger Agreement”) with VHS Holdings LLC (“Holdings”) and Health Systems Acquisition Corp., a newly formed Delaware corporation (“Acquisition Corp.”), pursuant to which on September 23, 2004 Acquisition Corp. merged with and into Vanguard, with Vanguard being the surviving corporation (the “Merger”). In the Merger, holders of the outstanding Vanguard
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capital stock, options to acquire Vanguard common stock and other securities convertible into Vanguard common stock received an aggregate consideration of approximately $1,248.6 million.
The Blackstone Group, together with its affiliates (collectively, “Blackstone”), funded the Merger in part by subscribing for and purchasing approximately $494.9 million aggregate amount of (1) Class A membership units in Holdings and (2) common stock of Acquisition Corp. (merged with and into Vanguard), in an amount equal to $125.0 million of such common stock. In addition, Morgan Stanley Capital Partners, together with its affiliates (collectively, “MSCP”), subscribed for and purchased Class A membership units in Holdings by contributing to Holdings a number of shares of Vanguard common stock equal to (1) $130.0 million divided by (2) the per share consideration payable for each share of Vanguard common stock in connection with the Merger. Certain senior members of management and certain other stockholders of Vanguard (the “Rollover Management Investors”) subscribed for and purchased Class A membership units in Holdings, having an aggregate purchase price of approximately $119.1 million, by (a) paying cash using the proceeds of consideration received in connection with the Merger and/or (b) contributing shares of Vanguard common stock in the same manner as MSCP. Baptist Health Services (“Baptist”), the former owner of our division, Baptist Health System of San Antonio, also purchased $5.0 million of Class A membership units in Holdings. Immediately after completion of the Merger in September 2004, Blackstone, MSCP (together with Baptist) and the Rollover Management Investors held approximately 66.1%, 18.0% and 15.9%, respectively, of the common equity of Vanguard (most of which is indirectly held through the ownership of the Class A membership units in Holdings). Certain members of senior management also purchased $5.7 million of the equity incentive units in Holdings.
Concurrently with the Merger, we consummated certain related financing transactions, including the issuance by our affiliates of $575.0 million principal amount of 9% Senior Subordinated Notes due 2014, $216.0 million principal amount at maturity of 11.25% Senior Discount Notes due 2015 and the entrance into senior credit facilities pursuant to which we borrowed $475.0 million of term loans and obtained a $250.0 million revolving loan facility and two delayed draw term loan facilities aggregating $325.0 million.
Our Competitive Strengths
Concentrated Local Market Positions in Attractive Markets. We believe that our markets are attractive because of their favorable demographics, competitive landscape, payer mix and opportunities for expansion. Fourteen of our 19 hospitals are located in markets with population growth rates in excess of the national average and all of our acute care hospitals are located in markets in which the median household income is above the national average. For the fiscal year ended June 30, 2006, we derived approximately 60.1% of our total revenues from the high-growth markets of San Antonio and metropolitan Phoenix, in which we own five hospitals and six hospitals, respectively. Our facilities in these markets primarily serve Bexar County, Texas, which encompasses most of the metropolitan San Antonio area and Maricopa County, Arizona, which encompasses most of the metropolitan Phoenix area. The U.S. Census Bureau and other data sources estimate that the population for Bexar County and Maricopa County will grow by 16.7% and 43.3%, respectively, between 2005 and 2020, rates that exceed the projected national average of 13.3%. Our strong market positions provide us with opportunities to offer integrated services to patients, receive more favorable reimbursement terms from a broader range of third party payers and realize regional operating efficiencies.
Proven Ability to Complete and Integrate Acquisitions. Including our first acquisition in 1998, we have selectively acquired 18 hospitals, 12 of which were formerly not-for-profit hospitals. We believe our success in completing acquisitions is due in large part to our disciplined approach to making acquisitions. Prior to completing an acquisition, we carefully review the operations of the target facility and develop a strategic plan to improve performance. We have routinely rejected acquisition candidates that did not meet our financial and operational criteria.
We believe our historical performance demonstrates our ability to identify underperforming facilities and improve the operations of acquired facilities. When we acquire a hospital, we generally implement a number of measures to lower costs, and we often make significant investments in the facility to expand existing services and introduce new services, strengthen the medical staff and improve our overall market position. We expect to continue to grow revenues and profitability in the markets in which we operate by increasing the depth and breadth of services provided and through the implementation of additional operational enhancements.
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Strong Management Team with Significant Equity Investment. Our senior management has an average of more than 20 years of experience in the healthcare industry at various organizations, including OrNda Healthcorp, HCA Inc. and HealthTrust, Inc. Many of our senior managers have been with Vanguard since its founding in 1997, and 12 of our 18 members of senior management have worked together managing healthcare companies for up to 20 years, either continuously or from time to time. In connection with the Merger, our management and certain other shareholders contributed in September 2004 approximately $119.1 million for an approximately 15.9% equity interest in our company. In addition, certain members of senior management also purchased $5.8 million of the equity incentive units in Holdings in September 2004.
Diversified Portfolio of Assets with a Broad Range of Services. We own and operate facilities in five separate geographic markets, which diversifies our revenue base and reduces our exposure to any one market. Our hospitals offer general acute care services, including intensive care and coronary care units, radiology, orthopedic, oncology and outpatient services and, at certain hospitals selected tertiary care services, such as open heart surgery and level II and III neonatal intensive care. We utilize our individual facilities or a network of integrated facilities in the area to meet the specific local needs of our communities. We believe that our ability to leverage our network of facilities allows us to not only provide a broad range of services in a market, but also to provide them in an efficient and cost-effective manner.
Business Strategy
The key elements of our business strategy include the following:
Continue our Commitment to Quality of Care. We have implemented and continue to implement various programs to improve the quality of care we provide. We have developed training programs for our staff and share information among our hospital management to implement best practices and assist in complying with regulatory requirements. Corporate support is provided to each hospital to assist with accreditation reviews. We have invested significant resources to develop clinical information systems to allow us to standardize compliance reporting of multiple quality indicators across our facilities. All hospitals conduct patient, physician and staff satisfaction surveys to help identify methods of improving the quality of care. We have appointed licensed physicians in each of our markets to the position of chief medical officer charged with driving best practices and clinical quality to improve the level of satisfaction among physicians and patients and promote cost-efficient provision of care.
We believe quality of care is becoming an increasingly important factor in governmental reimbursement. We continuously review patient care evaluations and maintain other quality assurance programs to support and monitor quality of care standards and to meet and exceed Medicare and Medicaid accreditation and regulatory requirements. Furthermore, as part of the Medicare Modernization Act, CMS identified three conditions, and 10 measures within those conditions, for which hospitals are encouraged to submit data in order to measure the quality of patient care. Those hospitals who submit quality data for these measures will be entitled to receive a full market basket update. We have submitted quality data reports within all three conditions at all of our hospitals to the CMS National Voluntary Hospital Reporting Initiative, and we have qualified for the maximum allowable reimbursement rate established by CMS for federal fiscal years 2005 and 2006. We expect to continue to participate in the CMS National Voluntary Hospital Reporting Initiative for federal fiscal year 2007 and the foreseeable future. However, further legislation expanded the reporting requirements and increased the penalties for non-compliance for federal fiscal years 2007 and 2008.
Expand Services to Increase Revenues and Profitability. We will continue to invest in our facilities to expand the range and improve the quality of services provided based on our understanding of the needs of the communities we serve. Our local management teams work closely with patients, payers, physicians and other medical personnel to identify and prioritize the healthcare needs of individual communities. We intend to increase our revenues and profitability by expanding the range of services we offer at certain of our hospitals. We plan to:
• expand emergency room and operating room capacity;
• improve the convenience, quality and breadth of our outpatient services;
• upgrade and expand high margin and high volume specialty services, including cardiology, oncology,
neurosurgery, orthopedics, obstetrics and other women’s services;
• update our medical equipment technology, including diagnostic and imaging equipment;
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• increase the availability of private rooms for our patients; and
• continue evaluating the construction of new facilities in underserved areas of the community.
To further these strategies, our board of directors has approved major expansion projects at six of our existing hospitals in San Antonio and metropolitan Phoenix, for which we expect to expend a total of approximately $333.5 million, including approximately $235.8 million already spent through June 30, 2006.
We believe that our disciplined expansion strategy will grow volumes, increase acuity mix, improve managed care pricing and enhance operating margins at our existing facilities, and at the same time reduce patient out-migration and satisfy unmet demand within our existing markets.
Improve Operating Margins and Efficiency. We seek to position ourselves as a cost effective provider of healthcare services in each of our markets. We intend to generate operational efficiencies and improve operating margins by:
• implementing more efficient care management, supply utilization and inventory management such as
eliminating arrangements that have built in margins, including dietary, rehabilitation, housekeeping and
plant maintenance;
• improving our billing and collection processes;
• capitalizing on purchasing efficiencies;
• optimizing staffing and outsourcing arrangements; and
• centralizing certain administrative and business office functions within a local market or at the
corporate level.
Recruit New Physicians and Maintain Strong Relationships with Existing Physicians. We recruit both primary and specialty physicians who can provide services that we believe are currently underserved and in demand in the communities we serve. In addition to providing strong local and regional management teams, we intend to sustain and strengthen our recruitment and retention initiatives by:
• providing physicians with high quality facilities in which to practice;
• providing a broad array of services within the integrated health network;
• offering quality training programs;
• providing remote access to clinical information; and
• arranging for convenient medical office space adjacent to our facilities.
Continue to Develop Favorable Managed Care Relationships. We plan to increase the number of patients at our facilities and improve our profitability by negotiating more favorable terms with managed care plans. We believe that we are attractive to managed care plans because of the geographic and demographic coverage of our facilities in their respective markets, the quality and breadth of our services and the expertise of our physicians. Further, we believe that as we increase our presence and improve our competitive position in our markets, particularly as we develop our networks of hospitals, we will be even better positioned to negotiate more favorable managed care contracts.
Grow Through Selective Acquisitions. We will continue to pursue acquisitions and enter into partnerships or affiliations with other healthcare service providers that either expand our network and presence in our existing markets or allow us to enter new urban and suburban markets. We intend to selectively pursue acquisitions of networks of hospitals and other complementary facilities or single-well positioned facilities where we believe we can improve operating performance, profitability and increase market share. We believe that we will continue to
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have substantial acquisition opportunities as other healthcare providers choose to divest facilities and as independent hospitals, particularly not-for-profit hospitals, seek to capitalize on the benefits of becoming part of a larger hospital company.
Our Markets
San Antonio, Texas
In the San Antonio market, as of June 30, 2006, we owned and operated 5 hospitals with a total of 1,495 licensed beds and related outpatient service locations complementary to the hospitals. We acquired these hospitals in January 2003 from the non-profit Baptist Health Services (formerly known as Baptist Health System) and continue to operate the hospitals as the Baptist Health System. The acquisition followed our strategy of acquiring a significant market share in a growing market, San Antonio, Texas. Our facilities primarily serve Bexar County which encompasses most of the metropolitan San Antonio area. The population in Bexar County has grown and is projected to continue to grow well in excess of the national average as illustrated in the following table.
| | | Bexar
County | % increase | | U.S.
Average | % increase |
| | |
|
| |
|
|
1990 actual population | | 1,185,000 | | | 248,710,000 | |
2000 actual population | | 1,393,000 | 17.5% | | 281,422,000 | 13.2% |
2005 estimated population | | 1,518,000 | 9.0% | | 296,410,000 | 5.3% |
2010 projected population | | 1,593,000 | 4.9% | | 308,936,000 | 4.2% |
2020 projected population | | 1,772,000 | 11.2% | | 335,805,000 | 8.7% |
During the years ended June 30, 2005 and 2006, we generated approximately 28.9% and 27.7% of our total revenues, respectively, in this market. In our acquisition agreement for the Baptist Health System we committed to fund not less than $200.0 million in capital expenditures in respect of the acquired businesses in the San Antonio metropolitan area during the first six years of our ownership, with $75.0 million of such expenditures being required in the first two years. By the end of our fiscal year ended June 30, 2005, we had funded or committed to fund all $200.0 million of this capital commitment.
Metropolitan Phoenix, Arizona
In the Phoenix market, as of June 30, 2006, we owned and operated 6 hospitals with a total of 1,089 licensed beds and related outpatient service locations complementary to the hospitals, a prepaid Medicaid managed health plan, Phoenix Health Plan (“PHP”), and a managed Medicare and dual-eligible health plan, Abrazo Advantage Health Plan (“AAHP”). Phoenix is the sixth largest city in the U.S. and has been one of the fastest growing major metropolitan areas in recent years. Our facilities primarily serve Maricopa County, which encompasses most of the metropolitan Phoenix area. The table below illustrates the significant historical and projected future growth of Maricopa County compared to the national average.
| | | Maricopa
County | % increase | | U.S.
Average | % increase |
| | |
|
| |
|
|
1990 actual population | | 2,122,000 | | | 248,710,000 | |
2000 actual population | | 3,072,000 | 44.8% | | 281,422,000 | 13.2% |
2005 estimated population | | 3,636,000 | 18.4% | | 296,410,000 | 5.3% |
2010 projected population | | 4,145,000 | 14.0% | | 308,936,000 | 4.2% |
2020 projected population | | 5,210,000 | 25.7% | | 335,805,000 | 8.7% |
During the years ended June 30, 2005 and 2006, exclusive of PHP and AAHP, we generated approximately 22.1% and 20.1% of our total revenues, respectively, in this market. Four of our hospitals in this market were formerly not-for-profit hospitals. We believe that payers will choose to contract with us in order to give their enrollees a comprehensive choice of providers in the western and northeastern Phoenix areas. There have been
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recent improvements in payer rates generally and the substantial increase in Medicaid eligibility for low income patients provided by Proposition 204, which expanded Medicaid coverage to approximately 400,000 additional individuals in Arizona since January 1, 2001. We believe our network strategy will position us to negotiate rate increases with managed care payers and to develop our six hospitals into a network providing a comprehensive range of integrated services, from primary care to tertiary hospital services, to payers and their patients. In addition, our ownership of the PHP and AAHP will allow us to enroll eligible patients, who would not otherwise be able to pay for their expenses at local hospitals, into our health plan or into other state-approved plans.
Metropolitan Chicago, Illinois
In the Chicago metropolitan area, as of June 30, 2006, we owned and operated 2 hospitals with 784 licensed beds, and related outpatient service locations complementary to the hospitals. These hospitals, MacNeal Hospital and Weiss Hospital, are located in areas serving relatively well-insured populations. Weiss Hospital is operated by us in a consolidated joint venture corporation in which we own 80.1% and the University of Chicago Hospitals owns 19.9% of the equity interests. During the years ended June 30, 2005 and 2006, we generated approximately 17.4% and 14.5%, respectively, of our total revenues in this market.
We chose MacNeal and Weiss Hospitals, both former not-for-profit facilities, as our first two entries into the largely not-for-profit metropolitan Chicago area. Both MacNeal and Weiss Hospitals are large, well-equipped, university-affiliated hospitals with strong reputations and medical staffs. We believe we have captured a large share of the patients in MacNeal Hospital’s immediate surrounding service area, which encompasses the cities of Berwyn and Cicero, Illinois. MacNeal offers tertiary services such as open heart surgery that patients would otherwise have to travel outside the local community to receive. We have also established a fully-integrated healthcare system at MacNeal and Weiss Hospitals by operating free-standing primary care and occupational medicine centers and a large commercial laboratory and by employing 79 physicians on our medical staffs there, including 42 primary care physicians. Our network of 27 primary care and occupational medicine centers allows us to draw patients to MacNeal and Weiss Hospital from around the metropolitan Chicago area. These hospitals also enjoy the distinction of being two of the few community hospitals in which the prestigious University of Chicago Medical School has placed its medical students and residents. Currently, MacNeal Hospital participates in the University of Chicago’s residency programs in internal medicine, general surgery, obstetrics/gynecology and psychiatry and Weiss Hospital participates in the University of Chicago’s residency program in surgery. In addition, MacNeal Hospital runs a successful free-standing program in family practice, one of the oldest such programs in the state of Illinois, and Weiss Hospital also runs a successful free-standing residency program in internal medicine. Our medical education programs help us to attract quality physicians to both the hospitals and our network of primary care and occupational medicine centers.
Orange County, California
In the Orange County market, as of June 30, 2006, we owned and operated 3 hospitals with a total of 491 licensed beds and related outpatient service locations complementary to the hospitals. Orange County is one of the most economically vibrant regions in the U.S. in terms of income levels and job growth. The following table illustrates the historical and projected future population growth for Orange County, which exceeds or is in line with the national average for each period presented.
| | | Orange
County | % increase | | U.S.
Average | % increase |
| | |
|
| |
|
|
1990 actual population | | 2,411,000 | | | 248,710,000 | |
2000 actual population | | 2,846,000 | 18.0% | | 281,422,000 | 13.2% |
2005 estimated population | | 2,988,000 | 5.0% | | 296,410,000 | 5.3% |
2010 projected population | | 3,267,000 | 9.3% | | 308,936,000 | 4.2% |
2020 projected population | | 3,542,000 | 8.4% | | 335,805,000 | 8.7% |
For the years ended June 30, 2005 and 2006, we generated approximately 8.1%, and 7.0% of our total revenues, respectively, in this market.
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On August 4, 2006, we entered into a definitive agreement to sell all three of our California hospitals, West Anaheim Medical Center, Huntington Beach Hospital and La Palma Intercommunity Hospital, to Prime Healthcare Services, Inc. and its affiliates for $44.0 million (up to $12.0 million of which will be deposited by the purchaser into an escrow account to be distributed to us in July 2007) excluding adjustments for certain current assets to be acquired less certain liabilities to be assumed. Closing of this transaction is currently scheduled for approximately September 30, 2006, subject to customary closing conditions. We can give you no assurance that these conditions will be fulfilled and closing will occur as planned by us.
Massachusetts
In Massachusetts, as of June 30, 2006, we owned and operated 3 hospitals with a total of 728 licensed beds and related healthcare services complementary to the hospitals. These hospitals include Saint Vincent Hospital located in Worcester and MetroWest Medical Center, a two-campus hospital system comprised of Framingham Union Hospital in Framingham and Leonard Morse Hospital in Natick. These hospitals were acquired from subsidiaries of Tenet Healthcare Corporation on December 31, 2004. We believe that opportunities for growth through increased market share exist in the Massachusetts area through the possible addition of new services, partnerships and the implementation of a strong primary care physician strategy. During the year ended June 30, 2006, the Massachusetts facilities represented 18.4% of our total revenues.
Saint Vincent Hospital, located in Worcester, is a 348-bed teaching hospital with a strong residency program. Worcester is located in central Massachusetts and is the second largest city in Massachusetts. The service area is characterized by a patient base that is older, more affluent and well-insured. Saint Vincent Hospital is focused on strengthening its payer relationships, developing its primary care physician base and expanding its offerings in cardiology, orthopedics, radiology and minimally-invasive surgery capabilities.
MetroWest Medical Center’s two campus system has a combined total of 380 licensed beds with locations in Framingham and Natick, in the suburbs west of Boston. These facilities serve communities that are generally well-insured. Framingham Union Hospital recently completed an emergency room expansion project. We are also seeking to develop strong ambulatory care capabilities in these service areas, as well as expansion of oncology, radiology and cardiology services.
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Our Facilities
We owned and operated 19 acute care hospitals as of June 30, 2006. The following table contains information concerning our hospitals:
Hospital | City | Licensed
Beds | | Date Acquired |
|
|
| |
|
Texas | | | | |
Baptist Medical Center | San Antonio | 612 | | January 1, 2003 |
Northeast Baptist Hospital | San Antonio | 291 | | January 1, 2003 |
North Central Baptist Hospital | San Antonio | 126 | | January 1, 2003 |
Southeast Baptist Hospital | San Antonio | 175 | | January 1, 2003 |
St. Luke’s Baptist Hospital | San Antonio | 291 | | January 1, 2003 |
| | | | |
Arizona | | | | |
Maryvale Hospital | Phoenix | 232 | | June 1, 1998 |
Arrowhead Hospital | Glendale | 193 | | June 1, 2000 |
Phoenix Baptist Hospital | Phoenix | 236 | | June 1, 2000 |
Phoenix Memorial Hospital (1) | Phoenix | 159 | | May 1, 2001 |
Paradise Valley Hospital | Phoenix | 163 | | November 1, 2001 |
West Valley Hospital (2) | Goodyear | 106 | | September 4, 2003 |
| | | | |
Illinois | | | | |
MacNeal Hospital | Berwyn | 427 | | February 1, 2000 |
Louis A. Weiss Memorial Hospital (3) | Chicago | 357 | | June 1, 2002 |
| | | | |
California | | | | |
Huntington Beach Hospital | Huntington Beach | 131 | | September 1, 1999 |
West Anaheim Medical Center | Anaheim | 219 | | September 1, 1999 |
La Palma Intercommunity Hospital (4) | La Palma | 141 | | April 1, 2000 |
| | | | |
Massachusetts | | | | |
MetroWest Medical Center – Leonard Morse Hospital | Natick | 125 | | December 31, 2004 |
MetroWest Medical Center - Framingham Union Hospital | Framingham | 255 | | December 31, 2004 |
Saint Vincent Hospital at Worcester Medical Center | Worcester | 348 | | December 31, 2004 |
| |
| | |
Total Licensed Beds | | 4,587 | | |
| |
| | |
____________________ |
(1) | | This hospital is operated by us in a limited liability company in which we own 60% of the equity interests and Medical Professional Associates of Arizona, P.C., a multi-specialty physician group, owns 40% of the equity interests. The limited liability company leases the real property of this hospital from one of our wholly-owned subsidiaries. |
| | |
(2) | | This hospital was constructed, not acquired. |
| | |
(3) | | This hospital is operated by us in a consolidated joint venture corporation in which we own 80.1% of the equity interests and the University of Chicago Hospitals owns 19.9% of the equity interests. |
| | |
(4) | | The hospital is operated by us in a limited partnership in which we own approximately 94.4% of the equity interests and a group of physician investors owns the remaining 5.6% of the equity interests. |
In addition to the hospitals listed in the table above, as of June 30, 2006, we owned certain outpatient service locations complementary to our hospitals. We also own and operate a limited number of medical office buildings in conjunction with our hospitals which are primarily occupied by physicians practicing at our hospitals.
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Our headquarters are located in approximately 40,500 square feet of leased space in one office building in Nashville, Tennessee.
Our hospitals and other facilities are suitable for their respective uses and are, in general, adequate for our present needs.
In certain circumstances involving the purchase of a not-for-profit hospital, we have agreed and in the future may agree to certain limitations on our ability to sell those facilities. In particular, when we acquired Phoenix Baptist Hospital and Arrowhead Hospital in June 2000, we agreed not to sell either hospital for five years after closing until June 1, 2005, and granted to a foundation affiliated with the seller for 10 years after closing a right of first refusal to purchase either hospital if we agreed to sell it to a third party, at the same price on which we agreed to sell that hospital to the third party. In addition, upon the purchase of the Baptist Health System hospitals, we agreed not to sell the hospitals for seven years until January 1, 2010 without the consent of the seller.
Major Expansion Projects
In May 2004 and July 2005, our board of directors approved major expansion projects at six of our existing hospitals in San Antonio and metropolitan Phoenix. We estimate that these projects will cost a total of approximately $333.5 million, including capitalized interest costs. Through June 30, 2006, we have spent approximately $235.8 million related to these projects and expect to incur the remaining $97.7 million during our next two fiscal years. All of these projects will result in additional capacity at each of the six hospitals. In addition, most of the projects will facilitate an expansion of clinical service capabilities.
The following table summarizes these major expansion projects as of September 1, 2006.
Hospital | | Estimated
Construction Period | | Approximate
Additional
Licensed Bed
Capacity | | Additional
Emergency
Room
Positions | | Additional
Operating
Rooms | | Additional
Labor &
Delivery
Rooms |
|
Begin | | Completed |
| |
| |
| |
| |
| |
| |
|
Phoenix | | | | | | | | | | | | |
Arrowhead Hospital | | Q4 FY 04 | | Q1 FY 07 | | 100 (5) | | P | | P | | P |
Paradise Valley Hospital | | Q1 FY 07 | | Q3 FY 08 | | 22 (4) | | (2) | | P | | P |
West Valley Hospital | | Q1 FY 06 | | Q4 FY 07 | | 39 | | P | | P | | (1) |
| | | | | | | | | | | | |
San Antonio | | | | | | | | | | | | |
North Central Baptist Hospital | | Q4 FY 04 | | Q1 FY 07 | | 140 | | P | | P | | P |
Northeast Baptist Hospital | | Q4 FY 04 | | Q1 FY 07 | | 33 (3) | | P | | P | | P |
St. Luke’s Baptist Hospital | | Q2 FY 06 | | Q3 FY 07 | | 27 | | | | | | |
____________________ |
(1) | | Will increase post partum capacity to better utilize labor, delivery and recovery suites. |
(2) | | An expanded emergency room was opened in July 2004, expanding capacity from 16 to 28 bays. |
(3) | | In addition to increasing the number of licensed beds by 33, the expansion project will allow for the utilization of an additional 67 previously licensed beds. |
(4) | | In addition to increasing the number of licensed beds by 22, the expansion will allow for the utilization of an additional 18 previously licensed beds. |
(5) | | 40 of these beds were added during the fourth quarter of fiscal 2005. |
Arrowhead Hospital
Arrowhead Hospital is a capacity-constrained facility with a service area that we believe is marked by significant population growth. The expansion project at this facility, which began in the fourth quarter of fiscal 2004 and which we expect to be fully constructed by the first quarter of fiscal 2007, consists of relocating and expanding the intensive care unit (ICU) to be close to the emergency room and operating rooms. In addition, the project will expand operating room capacity, emergency room capacity, medical/surgical bed capacity, obstetrics capacity and allow for increased clinical complexity at the facility. During the fourth quarter of fiscal 2005, the hospital opened 40 medical/surgical beds and increased its obstetrics capacity.
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Paradise Valley Hospital
Paradise Valley Hospital currently has capacity constraints in its labor/delivery rooms, operating rooms and ICU. This facility is located in an area that we believe has relatively high population growth and favorable demographics. In addition, recently completed highway construction improves access to this facility. This expansion project, expected to begin in the first quarter of fiscal 2007 and to be completed in the third quarter of fiscal 2008, adds significant capacity in operating room suites, critical care (ICU) and obstetrics. This project will also allow for a conversion to a largely private room model from a predominately semi-private model. In addition, the expansion will enable the hospital to add more complex clinical programs, such as interventional cardiology, to its service mix. This hospital recently completed major expansions of the emergency room and the radiology suite in separate projects.
West Valley Hospital
This project at West Valley Hospital, a facility first opened in September 2003, commenced in the first quarter of fiscal 2006 and is scheduled for completion in the fourth quarter of fiscal 2007. This expansion project will significantly expand the number of medical/surgical beds, the number of ICU beds and emergency room capacity. In addition, the project will provide the facility with the ability to offer a wider range of clinical services.
North Central Baptist Hospital
North Central Baptist Hospital is located in an area of San Antonio that we believe has relatively high population growth and favorable demographics. Several areas of the facility, the emergency room, surgery capacity, telemetry, obstetrics, and critical care beds, are currently at functional capacity. We commenced this expansion project during the fourth quarter of fiscal 2004 and it is scheduled for completion in the first quarter of fiscal 2007. This project consists of:
• expanding obstetrics;
• adding medical/surgical and critical care beds;
• expanding emergency room capacity, including a separate pediatric and adult emergency room; and
• adding new clinical services, including high risk prenatal services, invasive cardiology, pediatric
neurosurgery and other subspecialties along with appropriate operating room expansions.
Northeast Baptist Hospital
This project at Northeast Baptist Hospital has the goal of improving the layout of the facility as well as adding capacity. The project will add medical/surgical beds, ICU beds, emergency room positions, obstetrics, one operating room and a new cardiology center. Construction began on this project late in the fourth quarter of fiscal 2004 and is scheduled for completion in the first quarter of fiscal 2007. This expansion project is expected to result in more private room capacity, and to help reduce or eliminate capacity issues in the emergency room, obstetrics and the ICU.
St. Luke’s Baptist Hospital
The project at St. Luke’s Baptist Hospital consists of relocating and expanding the intensive care (ICU) and telemetry units. The new telemetry unit will consist of a central monitoring area capable of monitoring both a number of dedicated telemetry beds as well as remote beds throughout the facility. The new expanded ICU will add capacity and be equipped with the latest intensive care capabilities. This project is expected to add 27 licensed beds and to be fully completed during the third quarter of our fiscal year 2007.
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Hospital Operations
Our hospitals typically provide the full range of services commonly available in acute care hospitals, such as internal medicine, general surgery, cardiology, oncology, neurosurgery, orthopedics, obstetrics, diagnostic and emergency services, as well as select tertiary services such as open-heart surgery and level II and III neonatal intensive care. Our hospitals also generally provide outpatient and ancillary healthcare services such as outpatient surgery, laboratory, radiology, respiratory therapy and physical therapy. We also provide outpatient services at our imaging centers and ambulatory surgery centers. Certain of our hospitals have a limited number of psychiatric, skilled nursing and rehabilitation beds.
Our senior management team has extensive experience in operating multi-facility hospital networks and focuses on strategic planning for our facilities. A hospital’s local management team is generally comprised of a chief executive officer, chief financial officer and chief nursing officer. Local management teams, in consultation with our corporate staff, develop annual operating plans setting forth revenue growth strategies through the expansion of offered services and the recruitment of physicians in each community, as well as plans to improve operating efficiencies and reduce costs. We believe that the ability of each local management team to identify and meet the needs of our patients, medical staffs and the community as a whole is critical to the success of our hospitals. We base the compensation for each local management team in part on its ability to achieve the goals set forth in the annual operating plan.
Boards of trustees at each hospital, consisting of local community leaders, members of the medical staff and the hospital administrator, advise the local management teams. Members of each board of trustees are identified and recommended by our local management teams and serve three-year staggered terms. The boards of trustees establish policies concerning medical, professional and ethical practices, monitor these practices and ensure that they conform to our high standards. We maintain company-wide compliance and quality assurance programs and use patient care evaluations and other assessment methods to support and monitor quality of care standards and to meet accreditation and regulatory requirements.
We believe that the most important factors affecting the utilization of a hospital are the quality and market position of the hospital and the number, quality and specialties of physicians and medical staff caring for patients at the facility. Overall, we believe that the attractiveness of a hospital to patients, physicians and payers depends on its breadth of services, level of technology and emphasis on quality of care and convenience for patients and physicians. Other factors that affect utilization include local demographics and population growth, local economic conditions and managed care market penetration.
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The following table sets forth certain operating statistics for hospitals owned by us for the periods indicated. Acute care hospital operations are subject to certain fluctuations due to seasonal cycles of illness and weather, including increased patient utilization during the cold weather months and decreases during holiday periods.
| | | Year Ended June 30, |
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| | | 2002 | | | 2003 | | | | 2004 | | | 2005 | | | 2006 | |
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Number of hospitals at end of period | | | 10 | | | 15 | | | | 16 | | | 19 | | | 19 | |
Number of licensed beds at end of period (a) | | | 2,207 | | | 3,666 | | | | 3,784 | | | 4,557 | | | 4,587 | |
Discharges (b) | | | 75,364 | | | 114,327 | | | | 147,600 | | | 171,110 | | | 182,386 | |
Adjusted discharges - hospitals (c) | | | 111,692 | | | 167,166 | | | | 215,958 | | | 262,780 | | | 289,333 | |
Average length of stay (days) (d) | | | 4.1 | | | 4.2 | | | | 4.2 | | | 4.3 | | | 4.4 | |
Average daily census (e) | | | 837.0 | | | 1,309.0 | | | | 1,693.0 | | | 2,005.0 | | | 2,199.0 | |
Occupancy rate (f) | | | 46.1 | % | | 44.9 | % | | | 45.0 | % | | 48.1 | % | | 48.3% | |
Member lives (g) | | | 122,500 | | | 130,700 | | | | 142,200 | | | 146,700 | | | 146,200 | |
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(a) | | Licensed beds are those beds for which a facility has been granted approval to operate from the applicable state licensing agency. |
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(b) | | Represents the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatient volumes. |
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(c) | | Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined inpatient and outpatient volumes and is computed by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation enables management to assess hospital volumes by a combined measure of inpatient and outpatient volumes. |
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(d) | | Average length of stay represents the average number of days admitted patients stay in our hospitals. |
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(e) | | Average daily census represents the average number of patients in our hospitals each day during our ownership. |
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(f) | | Occupancy rate represents the percentage of hospital licensed beds occupied by patients. Both average daily census and occupancy rate provide measures of utilization of inpatient rooms. |
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(g) | | Member lives represents the total number of enrollees in our Arizona prepaid managed health plans and our Chicago capitated health plan as of the end of the respective period. |
The healthcare industry has experienced a general shift during the past few years from inpatient services to outpatient services as Medicare, Medicaid and managed care payers have sought to reduce costs by shifting lower-acuity cases to an outpatient setting. Advances in medical equipment technology and pharmacology have supported the shift to outpatient utilization, which has resulted in an increase in the acuity of inpatient admissions. However, we expect inpatient admissions to recover over the long-term as the baby boomer population reaches ages where inpatient admissions become more prevalent. We have responded to the shift to outpatient services through our ambulatory surgery centers in Orange County, California, our interests in diagnostic imaging centers in San Antonio, Texas, our outpatient diagnostic imaging centers in metropolitan Phoenix, Arizona and our network of primary care and occupational medicine centers in metropolitan Chicago, Illinois, along with continued expansion of emergency and outpatient services at our acute hospitals. We have the resources in place or are in the process of procuring the resources, including quality physicians and nursing staff and technologically advanced equipment, to support our comprehensive service offerings to capture inpatient volumes from the baby boomers and have focused on core services including cardiology, neurology, oncology and orthopedics. We have also opened sub-acute units such as rehabilitation and psychiatric services, where appropriate, to meet the needs of our patients while increasing volumes and increasing care management efficiencies.
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Phoenix Health Plan, Abrazo Advantage Health Plan and MacNeal Health Providers
Phoenix Health Plan (“PHP”) is a prepaid Medicaid managed health plan that serves Maricopa, Pinal and Gila counties in the Phoenix, Arizona area. We acquired PHP in connection with the acquisition of Phoenix Memorial Hospital, effective May 1, 2001. We are able to enroll eligible patients in our hospitals into PHP or other local Medicaid managed health plans who otherwise would not be able to pay for their hospital expenses. In addition, we believe that we will increase the availability of medically necessary services to such patients at our hospitals. We believe the volume of patients generated through our health plans will help attract quality physicians to our hospitals.
For the year ended June 30, 2006, we derived approximately $305.6 million of our total revenues from PHP. PHP had approximately 96,700 enrollees as of June 30, 2006, and derives substantially all of its revenues through a contract with the Arizona Health Care Cost Containment System (“AHCCCS”), which is Arizona’s state Medicaid program. The contract requires PHP to arrange for healthcare services for enrolled Medicaid patients in exchange for fixed periodic payments and supplemental payments from AHCCCS. PHP subcontracts with physicians, hospitals and other healthcare providers to provide services to its enrollees. These services are provided regardless of the actual costs incurred to provide these services. We receive reinsurance and other supplemental payments from AHCCCS to cover certain costs of healthcare services that exceed certain thresholds.
As part of its contract with AHCCCS, PHP is required to maintain a performance guarantee in the amount of $18.0 million. Since October 1, 2004, Vanguard has maintained this performance guarantee on behalf of PHP in the form of surety bonds totaling $18.0 million with independent third party insurers that expire on October 1, 2006. We were also required to arrange for $5.3 million in letters of credit to collateralize our $18.0 million in surety bonds with the third party insurers. The amount of the performance guaranty that AHCCCS requires is based upon the membership in the health plan and the related capitation amounts paid to us. We currently do not expect a material increase in the amount of the performance guarantee during the next fiscal year.
Our current contract with AHCCCS commenced on October 1, 2003, and ends on September 30, 2007. AHCCCS has an option to renew this contract for an additional one-year period.
Effective January 1, 2006, our subsidiary Abrazo Advantage Health Plan (“AAHP”) became a Medicare Advantage Prescription Drug Special Needs Plan provider under a contract with the Centers for Medicare & Medicaid Services (“CMS”). This allows AAHP to offer Medicare and Part D drug benefit coverage for dual-eligible members, or those that are eligible for Medicare and Medicaid. PHP has historically served this type of member through the AHCCCS Medicaid program. As of June 30, 2006, approximately 3,500 members were enrolled in AAHP, most of whom were previously enrolled in PHP. For the year ended June 30, 2006, we derived approximately $21.5 million of our total revenues from AAHP.
The operations of MacNeal Health Providers (“MHP”) are somewhat integrated with our MacNeal Hospital in Berwyn, Illinois. For the year ended June 30, 2006, we derived approximately $47.9 million of our total revenues from MHP. Substantially all of the revenues of MHP arose from its contracts with health maintenance organizations from whom it took assignment of capitated member lives. As of June 30, 2006, MHP had contracts in effect covering approximately 46,000 capitated member lives. Such capitation is limited to physician services and outpatient ancillary services and does not cover inpatient hospital services. We try to utilize MacNeal Hospital and its medical staff as much as possible for the physician and outpatient ancillary services that are required by such capitation arrangements. Revenues of MHP could decrease significantly if the health maintenance organizations in the metropolitan Chicago area move away from assigning capitated-member lives to health plans like MHP and enter into direct fee-for-service arrangements with healthcare providers.
Sources of Revenues
We receive payment for patient services from:
• the federal government, primarily under the Medicare program;
• state Medicaid programs; and
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• health maintenance organizations, preferred provider organizations, other private insurers and
individual patients.
The table below presents the approximate percentage of net patient revenues we received from the following sources for the periods indicated:
| | Year ended June 30, | |
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Payer Source | | 2004 | | | 2005 | | | 2006 | |
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Medicare | | 31% | | | 31% | | | 29% | |
Medicaid | | 7 | | | 7 | | | 7 | |
Managed care plans (1) | | 44 | | | 46 | | | 50 | |
Self-pay | | 12 | | | 11 | | | 10 | |
Commercial | | 6 | | | 5 | | | 4 | |
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Total | | 100% | | | 100% | | | 100% | |
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(1) | | Includes revenues under managed Medicare, managed Medicaid and other governmental managed plans in addition to commercial managed care plans. |
Most of our hospitals offer discounts from established charges to private managed care plans if they are large group purchasers of healthcare services. These discount programs limit our ability to increase charges in response to increasing costs. Patients generally are not responsible for any difference between established hospital charges and amounts reimbursed for such services under Medicare, Medicaid, some private insurance plans, health maintenance organizations or preferred provider organizations, but are generally responsible for exclusions, deductibles and co-insurance features of their coverages. Due to rising healthcare costs, many payers have increased the number of excluded services and the levels of deductibles and co-insurance resulting in a higher portion of the contracted rate due from the individual patients. Collecting amounts due from individual patients is typically more difficult than collecting from governmental or private managed care plans.
In June 2004, we adopted policies to expand our then existing charity care and self-pay discount policies. Our expanded policies result in decreased revenues with a somewhat lesser offsetting impact to the provision for doubtful accounts.
Competition
The hospital industry is highly competitive. We currently face competition from established, not-for-profit healthcare companies, investor-owned hospital companies, large tertiary care centers, specialty hospitals and outpatient service providers. In the future, we expect to encounter increased competition from companies, like ours, that consolidate hospitals and healthcare companies in specific geographic markets. Continued consolidation in the healthcare industry will be a leading factor contributing to increased competition in our current markets and markets we may enter in the future. Due to the shift to outpatient care and more stringent payer-imposed pre-authorization requirements during the past few years, most hospitals have significant unused capacity resulting in increased competition for patients. Many of our competitors are larger than us and have more financial resources available than we do. Other not-for-profit competitors have endowment and charitable contribution resources available to them and can purchase equipment and other assets on a tax-free basis.
One of the most important factors in the competitive position of a hospital is its location, including its geographic coverage and access to patients. A location convenient to a large population of potential patients or a wide geographic coverage area through hospital networks can make a hospital significantly more competitive. Another important factor is the scope and quality of services a hospital offers, whether at a single facility or a network of facilities, compared to the services offered by its competitors. A hospital or network of hospitals that offers a broad range of services and has a strong local market presence is more likely to obtain favorable managed care contracts. We intend to evaluate changing circumstances in the geographic areas in which we operate on an
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ongoing basis to ensure that we offer the services and have the access to patients necessary to compete in these managed care markets and, as appropriate, to form our own, or join with others to form, local hospital networks.
A hospital’s competitive position also depends in large measure on the quality and scope of the practices of physicians associated with the hospital. Physicians refer patients to a hospital primarily on the basis of the quality and scope of services provided by the hospital, the quality of the medical staff and employees affiliated with the hospital, the hospital’s location and the quality and age of the hospital’s equipment and physical plant. Although physicians may terminate their affiliation with our hospitals, we seek to retain physicians of varied specialties on our medical staffs and to recruit other qualified physicians by maintaining and improving our level of care and providing quality facilities, equipment, employees and services for physicians and their patients.
Another major factor in the competitive position of a hospital is the ability of its management to obtain contracts with managed care plans and other group payers. The importance of obtaining managed care contracts has increased in recent years and is expected to continue to increase as private and government payers and others increasingly turn to managed care organizations to help control rising healthcare costs. Our markets have experienced significant managed care penetration. The revenues and operating results of our hospitals are significantly affected by our hospitals’ ability to negotiate favorable contracts with managed care plans. Health maintenance organizations and preferred provider organizations use managed care contracts to encourage patients to use certain hospitals in exchange for discounts from the hospitals’ established charges. Traditional health insurers and large employers also are interested in containing costs through similar contracts with hospitals.
The hospital industry and our hospitals continue to have significant unused capacity. Inpatient utilization, average lengths of stay and average occupancy rates have historically been negatively affected by payer-required pre-admission authorization, utilization review and payer pressure to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Admissions constraints, payer pressures and increased competition are expected to continue. We endeavor to meet these challenges by expanding many of our facilities to include outpatient centers, offering discounts to private payer groups, upgrading facilities and equipment and offering new or expanded programs and services.
A number of other factors affect our competitive position, including:
• our reputation;
• the amounts we charge for our services;
• parking availability or access to public transportation; and
• the restrictions of state Certificate of Need laws.
Employees and Medical Staff
As of June 30, 2006, we had approximately 19,500 employees, including approximately 2,150 part-time employees. Approximately 1,550 of our employees at our three Massachusetts hospitals are unionized. Overall, we consider our employee relations to be good. While some of our non-unionized hospitals experience union organizing activity from time to time, we do not expect these efforts to materially affect our future operations. Our hospitals, like most hospitals, have experienced labor costs rising faster than the general inflation rate.
In the industry as a whole, and in our markets, there is currently a shortage of nurses and other medical support personnel. To address the nursing shortage, we have implemented comprehensive recruiting and retention plans for nurses. As part of this plan, we have expanded our nursing schools in San Antonio and Phoenix to attract new students and to provide options for current nurses to advance their careers. We also increased our involvement with other colleges, participated in more job fairs and recruited nurses from abroad. Our recruiting and retention plan also focuses on mentoring, flexible work hours, performance leadership training, quality of care and patient safety and competitive pay and benefits. We anticipate that demand for nurses will continue to exceed supply especially as the baby boomer population reaches the ages where inpatient stays become more frequent. However, we expect our initiatives to help stabilize our nursing resources over time.
Our hospitals grant staff privileges to licensed physicians who may serve on the medical staffs of multiple hospitals, including hospitals not owned by us. A physician who is not an employee can terminate his or her
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affiliation with our hospital at any time. Although we employ a limited number of physicians, a physician does not have to be an employee of ours to be a member of the medical staff of one of our hospitals. Any licensed physician may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by each hospital’s medical staff and board of trustees in accordance with established credentialing criteria.
Compliance Program
We voluntarily maintain a company-wide compliance program designed to ensure that we maintain high standards of ethics and conduct in the operation of our business and implement policies and procedures so that all our employees act in compliance with all applicable laws, regulations and company policies. The organizational structure of our compliance program includes oversight by our board of directors and a high-level corporate management compliance committee. The board of directors and compliance committee are responsible for ensuring that the compliance program meets its stated goals and remains up-to-date to address the current regulatory environment and other issues affecting the healthcare industry. Our Senior Vice President of Compliance and Ethics reports jointly to our Chairman and Chief Executive Officer and to our board of directors, serves as Chief Compliance Officer and is charged with direct responsibility for the day-to-day management of our compliance program. Other features of our compliance program include Regional Compliance Officers who report to our Chief Compliance Officer in all five of our operating regions, initial and periodic ethics and compliance training and effectiveness reviews, a toll-free hotline for employees to report, without fear of retaliation, any suspected legal or ethical violations, annual “fraud and abuse” audits to examine all of our payments to physicians and other referral sources and annual “coding audits” to make sure our hospitals bill the proper service codes in respect of obtaining payment from the Medicare and Medicaid programs.
A recent focus of our compliance program is the interpretation and implementation of the standards set forth by the Health Insurance Portability and Accountability Act (“HIPAA”) for privacy and security. To facilitate reporting of potential HIPAA compliance concerns by patients, family or employees, we have established a second toll-free hotline dedicated to HIPAA and other privacy matters and placed it in service in April 2003. Corporate HIPAA compliance staff monitors all reports to the privacy hotline and each phone call is responded to appropriately. Ongoing HIPAA compliance also includes self-monitoring of HIPAA policy and procedure implementation by each of our healthcare facilities and corporate compliance oversight.
Our Information Systems
We believe that our information systems must cost-effectively meet the needs of our hospital management, medical staff and nurses in the following areas of our business operations:
• patient accounting, including billing and collection of revenues;
• accounting, financial reporting and payroll;
• coding and compliance;
• laboratory, radiology and pharmacy systems;
• medical records and document storage;
• materials and asset management; and
• negotiating, pricing and administering our managed care contracts.
Although we map the information systems from each of our hospitals to one centralized database, we do not automatically standardize our information systems among all of our hospitals. We carefully review existing systems at the hospitals we acquire and, if a particular information system is unable to cost-effectively meet the operational needs of the hospital, we will convert or upgrade the information system at that hospital to one of several standardized information systems that can cost-effectively meet these needs.
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Insurance
As is typical in the healthcare industry, we are subject to claims and legal actions by patients and others in the ordinary course of business. For claims incurred on or after June 1, 2002 through May 31, 2006, our wholly owned captive subsidiary insured our professional and general liability risks at a $10.0 million retention level. For professional and general liability claims incurred on or after June 1, 2006, we self-insure the first $9.0 million of each claim, and the captive subsidiary insures the next $1.0 million. We maintain excess coverage from independent third-party carriers for individual claims exceeding $10.0 million per occurrence up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. The captive insurance subsidiary funds its portion of claims costs from proceeds of premium payments received from us.
The malpractice insurance environment remains volatile. However, some states, including Illinois and Texas, have in recent years passed tort reform legislation to place limits on non-economic damages. Absent significant additional legislation to curb the size of malpractice judgments in the other states, we expect insurance costs to remain volatile for the foreseeable future.
Reimbursement
�� Medicare Overview
Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease. All of our hospitals are certified as providers of Medicare services. Under the Medicare program, acute care hospitals receive reimbursement under a prospective payment system for inpatient and outpatient hospital services.
Under the inpatient prospective payment system, a hospital receives a fixed payment based on the patient’s assigned diagnosis related group (“DRG”). The DRG classifies categories of illnesses according to the estimated intensity of hospital resources necessary to furnish care for each principal diagnosis. The DRG rates for acute care hospitals are based upon a statistically normal distribution of severity. When treatments for patients fall well outside the normal distribution, providers may receive additional payments known as outlier payments. The DRG payments do not consider a specific hospital’s actual costs but are adjusted for geographic area wage differentials. Inpatient capital costs for acute care hospitals are reimbursed on a prospective system based on DRG weights multiplied by geographically adjusted federal weights. In the Medicare Modernization Act, Congress equalized the DRG payment rate for urban and rural hospitals at the large urban rate for all hospitals for discharges on or after April 1, 2003.
Pursuant to regulation, the DRG rates are to be adjusted each federal fiscal year for inflation, but such adjustment has often been affected by new federal legislation. The index used to adjust the DRG rates, known as the “market basket index,” gives consideration to the inflation experienced by hospitals and entities outside of the healthcare industry in purchasing goods and services. However, for several years the percentage increases to the DRG rates have been lower than the percentage increases in the costs of goods and services purchased by hospitals. Under the Medicare, Medicaid, and SCHIP Benefit Improvement and Protection Act of 2000, the DRG rate increased in the amount of the market basket minus 0.55% for federal fiscal year 2002, the market basket minus 0.55% for federal fiscal year 2003, and the market basket for federal fiscal year 2004. However, the Medicare Modernization Act provides for DRG rate increases for federal fiscal years 2005, 2006 and 2007 at the full market basket, but only if the facility submits data for 10 patient care indicators to the Secretary of Health and Human Services. We currently have the ability to monitor our compliance with the quality indicators and have submitted or intend to submit the quality data required to receive the full market basket pricing update during federal fiscal years 2005, 2006 and 2007. Those hospitals not submitting data on the quality indicators will receive an increase equal to the market basket rate minus 0.40%. Consistent with this law, CMS issued final rules in August 2004 and August 2005 that increased the hospital DRG payment rates by the full market basket of 3.30% for federal fiscal year 2005 and the full market basket of 3.70% for federal fiscal year 2006 for those hospitals submitting data on the 10 quality indicators. Our hospitals met all of the quality requirements necessary to receive the full market basket increase of 3.30% during federal fiscal year 2005 and the full market basket of 3.70% for federal fiscal year 2006.
For federal fiscal year 2007, the Medicare Moderinzation Act provides for a full market basket update but the Medicare Payment Advisory Commission (“MedPAC”) adopted a recommendation that Congress update
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inpatient diagnostic related group rate payments for federal fiscal year 2007 by the market basket minus 0.45 percentage points. However, in August 2006, CMS issued a final rule that prescribed the full market basket update of 3.4% for federal fiscal year 2007. On February 8, 2006, the Deficit Reduction Act of 2005 (“DRA 2005”) was enacted by Congress and expanded the number of quality measures that must be reported to receive a full market basket update for federal fiscal year 2007 to 22. DRA 2005 also provides that for federal fiscal year 2008, CMS must add additional quality measures for hospitals to report to receive the maximum payment update available. Also, in federal fiscal year 2008 hospitals would be required to identify cases assigned to DRGs that have higher payments when a hospital-acquired infection is present. Failure to submit the required quality indicators will result in a two percentage point reduction to the market basket update, or as currently estimated, an update in rates equal to 1.4% rather than the full market basket of 3.4% for federal fiscal year 2007. We will attempt to comply with the DRA 2005 reporting requirements in federal fiscal years 2007 and 2008, but we are unable to predict if all our hospitals will be able to comply. Based on the historical adjustments to the market baskets, future legislation may decrease the future rate of increase for diagnosis related group payments, but we are unable to predict the amount of the reduction.
In addition to DRG inpatient payments, in certain high-cost situations CMS makes additional payments to acute care hospitals, commonly referred to as “outlier payments”, for those DRG cases where the cost of the case exceeds the total DRG payments plus a fixed threshold amount. Historically, the Medicare program has set aside 5.1% of Medicare inpatient payments to pay for outlier cases. During federal fiscal years 2001, 2002 and 2003, the CMS payments for outlier cases far exceeded the 5.1% set aside. As a result CMS increased the threshold amount from $16,350 at the end of federal fiscal year 2001, to $21,025 for 2002 and to $33,560 for 2003. Additionally, on June 9, 2003, CMS published a final rule substantially modifying the methodology for determining Medicare outlier payments in order to ensure that only the highest cost cases are entitled to receive additional payments under the inpatient prospective payment system. For discharges occurring on or after October 1, 2003, outlier payments are based on either a provider’s most recent tentatively settled cost report or the most recent settled cost report, whichever is from the latest cost reporting period. Previously, outlier payments had been based on the most recent settled cost report, resulting in excessive outlier payments for some hospitals. The final rule requires, in most cases, the use of hospital-specific cost to charge ratios instead of a statewide ratio. Further, outlier payments may be adjusted retroactively to recoup any past outlier overpayments plus interest or to return any underpayments plus interest. We believe that these 2003 changes to the outlier payment methodology have not and will not have a material adverse effect on our business, financial position or results of operations. Indeed, we believe that as a result of these 2003 changes to the outlier payment methodology, CMS reduced the outlier threshold amounts to $31,000 for federal fiscal year 2004; to $25,800 for federal fiscal year 2005; to $23,600 for federal fiscal year 2006; but has increased the threshold to $24,475 in federal fiscal year 2007. This proposed increase for federal fiscal year 2007, according to CMS, is based on data suggesting a consistent pattern of inflation in hospital charges which affect hospital cost-to-charge ratios used in determining eligibility for outlier payments and the increased FY 2007 threshold is expected to keep aggregate hospital outlier payments within the target of 5.1% of total Medicare inpatient payments. Decreasing the outlier threshold amounts has and will increase both the number of our cases that qualify for outlier payments and the amount of payments for qualifying outlier cases, compared to the “peak” year of federal fiscal year 2003 when the threshold amount was $33,560. The most recent cost reports filed for each of our facilities as of June 30, 2004, 2005 and 2006 reflected outlier payments of $2.2 million, $4.7 million and $5.9 million for those respective cost report periods. These amounts represent 1.2%, 1.9% and 1.8% of our Medicare inpatient DRG reimbursements during those cost report years.
In August 2005 CMS made certain DRG changes for federal fiscal year 2006 that decreased our reimbursement during our 2006 fiscal year and will decrease our reimbursement in future years. The most significant change that decreased our Medicare reimbursement was that CMS greatly expanded the number of DRGs that are subject to CMS’ post-acute care transfer policy. This policy reduces payment to acute care hospitals when the patient is transferred after a short stay to a post-acute care setting that provides most of the patient’s care. The purpose of this policy is to protect Medicare from paying for the same care twice: once as part of a hospital’s payment for the DRG, and then as a separate payment to the post-acute facility. CMS had proposed to make 231 DRGs subject to this policy. However, in response to public comments, CMS reduced the number of DRGs that would be subject to the post-acute transfer policy to 182 from 30 DRGs subject to the policy in federal fiscal year 2005. CMS estimated that the change to Medicare’s post-acute transfer policy alone would save taxpayers $780.0 million in Medicare payments in federal fiscal year 2006. We estimate that this policy change alone resulted in an estimated $6.0 million reduction in our Medicare inpatient payments during federal fiscal year 2006.
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On April 12, 2006, CMS issued a notice of proposed rulemaking for federal fiscal year 2007 which would have significantly revised how DRGs are classified and recalibrated. First, the proposed rule recalibrated the DRG weights using a hospital-specific relative value cost weighting methodology, which is a major departure from prior years’ recalibration methodology that was based primarily on hospital charges. To accomplish this change for federal fiscal year 2007 (which begins on October 1, 2006), CMS proposed to develop hospital specific relative values for 10 cost centers to compute new DRG relative weights. It was anticipated that this change would have tended to favor medical condition DRGs and to disfavor procedure DRGs like cardiovascular, orthopedic, neurosurgical and general surgery service lines since the ancillary service costs typically associated with procedure DRGs are oftentimes substantially below a provider’s charges for such services. Second, the proposed rule outlined a plan, expected to be implemented in federal fiscal year 2008 (if not earlier), to further modify the inpatient prospective payment system by incorporating severity of illness adjustors into the system which will reflect the severity and/or acuity of a particular medical condition or surgical procedure. Based upon this proposed rule the hospital-specific relative value cost-based weight recalibration methodology and the severity adjustment were expected not to save money, but to result in a substantial redistribution of payments among hospitals across the country.
However, on August 1, 2006, CMS announced a final rule in respect of DRG recalibration which will moderate significantly the immediate impact of its adoption of the new DRG weighting system which it proposed in April 2006. As stated above, the payment reforms consist of two major parts which do not save money, but better align payment with the costs of care by increasing payments for some admissions and decreasing payments for others. The first part will begin a transition to using estimated hospital costs, rather than list charges, to set payment. The reform will eliminate biases in the current system arising from the hospital practice of having list charges that disproportionately exceed costs for some services. Based on public comments to the proposed rule, in the final rule CMS refined the methods used to determine average costs per case at the DRG level. For example, CMS expanded the number of distinct hospital departments used in the calculations from 10 to 13, included more hospital data in the final calculations by applying less stringent criteria for eliminating statistical outliers and accounted for hospital size when evaluating the mark-up of charges over costs. Moreover, while this change will go into effect October 1, 2006, it will now be phased in over a 3-year period rather than fully convert to the cost-based system as of October 1, 2007, as previously proposed. Together, these refinements will result in substantially smaller changes in DRG payments to hospitals than CMS proposed earlier in April 2006. In addition, CMS announced in August 2006 steps to further evaluate hospital charging practices - particularly for expensive items like medical devices - - as part of considering further improvements for federal fiscal year 2008. The second major part of the DRG payment reforms finalized by CMS in August 2006 involves more accurate accounting for the severity of a patient’s illness, which has a significant impact on costs of care. In the final rule, CMS provided that in federal fiscal year 2007 it will begin the process of moving to more complete severity adjustment by adding 20 new DRGs and redefining 32 existing DRGs. This was a much less drastic change for federal fiscal year 2007 than the proposed rule where CMS had proposed replacing all of the current DRGs with a system of 861 “consolidated severity-adjusted” DRGs. In addition, in preparation for federal fiscal year 2008, the final rule provided that CMS will conduct an evaluation, with public input, of alternative systems for more comprehensive severity adjustment as a prelude to making more comprehensive changes to better account for severity in the DRG system by the start of federal fiscal year 2008 on October 1, 2007. About 2% of hospitals will see their payments fall as a result of this new weighting system, CMS Administrator Mark McClellan estimated during a August 1, 2006 news conference on the final inpatient DRG rule. Presumably, as stated above, those hospitals seeing their payments fall will be specialty hospitals and those general hospitals that principally perform cardiovascular, orthopedic, neurosurgical and general surgery services where payment rates significantly exceed costs. As finalized, we do not think that these DRG payment changes will have a material adverse effect on our results of operations or cash flows in federal fiscal year 2007.
Outpatient services traditionally were paid at the lower of established charges or on a reasonable cost basis. However, on August 1, 2000, CMS began reimbursing hospital outpatient services and certain Medicare Part B services furnished to hospital inpatients who have no Part A coverage on a prospective payment system basis. CMS will continue to use existing fee schedules to pay for physical, occupational and speech therapies, durable medical equipment, clinical diagnostic laboratory services and nonimplantable orthotics and prosthetics. Freestanding surgery centers are also reimbursed on a fee schedule.
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All services paid under the prospective payment system for hospital outpatient services are classified into groups called ambulatory payment classifications (“APCs”). Services in each APC are similar clinically and in terms of the resources they require. A payment rate is established for each APC. Depending on the services provided, a hospital may be paid for more than one APC for a patient visit. The APC payment rates were updated for calendar years 2004 and 2005 by the full market baskets of 3.40% and 3.30%, respectively. The update for calendar year 2006 is the full market basket of 3.70%. However, as a result of the expiration of additional payments for drugs that were being paid in calendar year 2005, for calendar year 2006 there has been an effective 2.25% reduction to the market basket of 3.70%. For calendar year 2007, the Medicare Modernization Act provides a full market basket update. MedPAC has adopted a recommendation that Congress update outpatient APC payment rates for calendar year 2007 by the market basket minus 0.45 percentage points. It is uncertain whether Congress will adopt this recommendation. Meanwhile, on August 8, 2006, CMS proposed a rule to update outpatient prospective payment system payments for calendar year 2007 by 3.4%, which is the full market basket. However, after taking into account other factors that affect the level of payments, CMS estimated in its proposed rule that hospitals will receive an overall average increase of 3.0 percent in Medicare payments for outpatient department services in calendar 2007 due to other outpatient reimbursement changes which CMS made in its proposed rule. In addition, the rule proposes for the first time to tie payment rate increases to the reporting of quality measures beginning in 2007. In the approach proposed in the rule, hospitals that report quality measures for purposes of the update in the inpatient prospective payment system would receive a full update on outpatient payments as well. Those hospitals required to report quality measures for inpatient services in order to receive the full inpatient update (such as our hospitals), but fail to do so, would receive the proposed outpatient rate update minus 2.0 percentage points. Because many of these inpatient measures involve the same hospital activities as in outpatient care – for example, appropriate administration of medications in the emergency department and surgical procedures to prevent complications – CMS said in the proposed rule that it anticipates that the collection and submission of performance data and public reporting of comparative information about hospital performance will encourage quality improvement for all hospital services. CMS also stated in the proposed rule its intent to move to the use of additional quality measures that are specifically appropriate for hospital outpatient care, as such measures are developed.
Hospitals that treat a disproportionately large number of low-income patients (Medicare and Medicaid patients eligible to receive supplemental Social Security income) currently receive additional payments from the federal government in the form of disproportionate share payments. CMS has recommended changes to the present formula used to calculate these payments. One recommended change would give greater weight to the amount of uncompensated care provided by a hospital than it would to the number of low-income patients treated. The Medicare Modernization Act increased disproportionate share payments effective April 1, 2004 for rural hospitals and some urban hospitals. During fiscal year 2006 all of our hospitals qualified for disproportionate share payments.
Rehabilitation Units
Inpatient rehabilitation hospitals and designated units were fully transitioned from a reasonable cost reimbursement system to a prospective payment system for cost reporting periods beginning on or after October 1, 2002. Under this prospective payment system, patients are classified into case mix groups based upon impairment, age, comorbidities and functional capability. Inpatient rehabilitation facilities and units are paid a predetermined amount per discharge that reflects the patient’s case mix group and is adjusted for area wage levels, low-income patients, rural areas and high-cost outliers. For federal fiscal years 2004 and 2005, CMS updated the payment rate for inpatient rehabilitation facilities and units by the full market basket rates of 3.2% and 3.1%, respectively. The update for federal fiscal year 2006 is the full market basket rate of 3.6%. However, CMS also applied a reduction to the standard payment amount of 1.9% to account for improved coding under the system. For fiscal year 2007, payment rates are to be updated by full market basket under current law. In August 2006 CMS issued a final rule providing for a full market basket increase of 3.3% in payment rates for federal fiscal year 2007. However, again, CMS proposed applying a coding reduction to the payment amount, but this time the reduction was 2.6% to offset coding changes that, in CMS’ opinion, do not reflect real changes in patient acuity. As of June 30, 2006 we operated five inpatient rehabilitation units within our acute care hospitals.
Skilled Nursing Units
Medicare historically reimbursed skilled nursing units within hospitals on the basis of actual costs, subject to limits. CMS has established a prospective payment system for Medicare skilled nursing units, under which units
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are paid a federal per diem rate for virtually all covered services. The effect of the new payment system generally has been to significantly reduce reimbursement for skilled nursing services, which has led many hospitals to close such units. We will monitor closely and evaluate the few remaining skilled nursing units in our hospitals and related facilities to determine whether it is feasible to continue to offer such services under the new reimbursement system. As of June 30, 2006, we operated three skilled nursing units within our acute care hospitals.
Psychiatric Units
Payments to prospective payment system-exempt psychiatric hospitals and psychiatric units, for cost reporting periods beginning before January 1, 2005, are based upon reasonable cost, subject to a cost-per-discharge target. These limits are updated annually by a market basket index. The update rate for federal fiscal year 2005 was 3.3% and for federal fiscal year 2006 is 3.8% for psychiatric hospitals and units that are being paid under the three year transition to the new prospective payment system.
On November 15, 2004 CMS published a final regulation to implement a new Medicare prospective payment system for inpatient psychiatric hospitals and units. The new system replaces the current cost-based payment system with a per diem prospective payment system for reporting periods beginning on or after January 1, 2005. The new system is a per diem prospective payment system with adjustments to account for certain patient and facility characteristics. The final rule includes several provisions to ease the transition to the new payment system. For example, CMS is phasing in the new system over a three-year period so that full payment under the new system would not begin until the fourth year. Additionally, CMS has included in the final rule a stop-loss provision, an “outlier” policy authorizing additional payments for extraordinarily costly cases and an adjustment to the base payment if the facility maintains a full-service emergency department which all of our units should qualify for. In May 2006, CMS published its final rule for the annual increase to the federal component of the psychiatric prospective payment system per diem rate. This increase includes the effects of market basket updates resulting in a 4.5% increase in total payments for the new psychiatric rate year of July 1, 2006 to June 30, 2007.
At the current time we continue to believe that the new psychiatric payment system will not materially negatively impact our Medicare reimbursement in respect of our psychiatric units. As of June 30, 2006, we operated ten psychiatric units within our acute care hospitals.
Home Health
On October 1, 2000, a prospective payment system became effective for home health services. The Benefits Improvement and Protection Act of 2000 delayed a 15.0% payment reduction for home health services, originally expected to take effect upon implementation of the prospective payment system, until October 1, 2002. The 15.0% payment reduction was adopted on October 1, 2002 and was included in the prospective payment system rates established for 2003. The Medicare Modernization Act established a Home Health prospective payment system update of 100% of the home health market basket through the first quarter of calendar 2004, 100% of the home health market basket minus 0.8% through calendar year 2006 and 100% of the home health market basket for 2007 and thereafter. As of June 30, 2006, we operated two entities providing home health services.
Contractor Reform
CMS has a significant initiative underway that could affect the administration of the Medicare program and impact how hospitals bill and receive payment for covered Medicare services. In accordance with the Medicare Modernization Act, CMS will implement contractor reform whereby CMS will competitively bid the Medicare fiscal intermediary and Medicare carrier functions to Medicare Administrative Contractors (“MACs”). CMS is awarding the first of the 15 multi-state jurisdictions in 2006, seven jurisdictions are planned to be awarded in 2007, with the remaining seven jurisdictions being planned to be awarded in 2008. All of these changes could impact claim processing functions and our resulting cash flows. We are unable, at the current time, to predict the impact that these changes could have, if any, to cash flows.
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Medicaid
Medicaid is a federal-state program, administered by the states, which provides hospital and medical benefits to qualifying individuals who are unable to afford healthcare. Most state Medicaid payments are made under a prospective payment system or under programs that negotiate payment levels with individual hospitals. Medicaid reimbursement is often less than a hospital’s cost of services. The federal government and each state government currently jointly fund Medicaid in each state.
Federal funding of the Medicaid program is currently under considerable budgetary pressure. On April 28, 2005, a budget resolution was approved by both houses of Congress in which the congressional committees with jurisdiction over Medicaid were directed to cut $10.0 billion in federal funding from the Medicaid program over 5 years, beginning in October 2006. Also, Bush administration officials have established a Medicaid reform commission to study the challenges facing Medicaid, to recommend improvements to the program and to find ways to reduce Medicaid spending by $10.0 billion over 5 years, as set forth in the budget resolution. The commission is to submit two reports to the Secretary of the Department of Health and Human Services in September 2005 and December 2006. On September 1, 2005, the commission provided six recommendations to the Secretary on options to cut $11.0 billion from the Medicaid program. The six recommendations of the Commission were as follows:
• | | Reform the prescription drug reimbursement formula |
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• | | Extend the Medicaid drug rebate program to Medicaid managed care |
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• | | Further restrict persons from transferring assets to obtain Medicaid eligibility by moving later the date of commencement of Medicaid coverage where assets have been transferred |
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• | | Further restrict persons from transferring assets to obtain Medicaid eligibility by increasing the “look-back” period for asset transfers from 3 to 5 years |
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• | | Allow the states to increase co-payments on non-preferred drugs (“tiered co-payments”) |
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• | | Further restrict the use of provider taxes to obtain federal matching funds by requiring that managed care organizations be treated the same as other classes of health care providers with respect to provider tax uniformity requirements |
By December 31, 2006, the commission is to make longer-term recommendations on the future of Medicaid to ensure the program’s “long-term sustainability.”
Also, in the President’s budget for federal fiscal year 2007 which was proposed to Congress in February 2006, the Bush Administration proposed a series of Medicaid budget cuts. Most of these cuts would require legislation. As of September 1, 2006 the Congress has not enacted any of these cuts in the Medicaid program. However, it has publicly been reported that Bush Administration officials have signaled their intention to proceed with approximately $6.0 billion dollars of federal Medicaid cuts over the next five years that can apparently be implemented by regulation. Specifically, the new regulations would reduce federal Medicaid reimbursement to publicly owned hospitals and nursing homes.
State funding of the Medicaid program is also currently under considerable budgetary pressure. Many states, including certain states in which we operate, have reported budget deficits as a result of increased costs and lower than expected tax collections. Medicaid funding represents a significant component of state spending. To address these budgetary concerns, certain states have proposed and others may propose a restructuring of Medicaid or decreased state funding for Medicaid. We continuously monitor the budgetary crisis and political environments in those states in which we operate in respect of their Medicaid funding.
Annual Cost Reports
All hospitals participating in the Medicare and Medicaid programs are required to meet specific financial reporting requirements. Federal and, where applicable, state regulations require submission of annual cost reports
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identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients. Moreover, annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. The audit process takes several years to reach the final determination of allowable amounts under the programs. Providers also have the right of appeal, and it is common to contest issues raised in audits of prior years’ reports.
Many prior year cost reports of our facilities are still open. If any of our facilities are found to have been in violation of federal or state laws relating to preparing and filing of Medicare or Medicaid cost reports, whether prior to or after our ownership of these facilities, we and our facilities could be subject to substantial monetary fines, civil and criminal penalties and exclusion from participation in the Medicare and Medicaid programs. If an allegation is lodged against one of our facilities for a violation occurring during the time period before we acquired the facility, we may have indemnification rights against the seller of the facility to us. In each of our acquisitions, we have negotiated customary indemnification and hold harmless provisions for any damages we may incur in these areas.
Managed Care
Managed care providers, including health maintenance organizations and preferred provider organizations, are organizations that provide insurance coverage and a network of healthcare providers to members for a fixed monthly premium. During the past few years, the hospital industry has experienced a shift in admissions and revenues from commercial insurance payers to managed care payers due to pressures to control the cost of healthcare services. We expect this industry trend to continue although its effect on us may be mitigated due to the heavy managed care penetration that currently exists in the markets we serve. Generally, we receive lower payments from managed care plans than from traditional commercial or indemnity insurers; however, as part of our business strategy, we have been able to renegotiate payment rates on many of our managed care contracts to improve our operating margin. While we generally received annual average payment increases of 6 to 12 percent from managed care payers during fiscal year 2006, there can be no assurance that we will continue to receive increases in the future. While the majority of our admissions and revenues are generated from patients covered by managed care plans, the percentage may decrease in the future due to increased Medicare utilization associated with the aging U.S. population. We experienced a slight increase in managed care utilization of inpatient days as a percentage of total inpatient days during the year ended June 30, 2006 compared to the year ended June 30, 2005.
Commercial Insurance
Our hospitals also provide services to a decreasing number of individuals covered by private healthcare insurance. Private insurance carriers make direct payments to a hospital or, in some cases, reimburse their policy holders, based upon the hospital’s established charges and the particular coverage provided in the insurance policy.
Commercial insurers are continuing efforts to limit the payments for hospital services by adopting discounted payment mechanisms, including prospective payment or diagnosis related group-based payment systems, for more inpatient and outpatient services. To the extent that such efforts are successful and reduce the insurers’ reimbursement to hospitals for the costs of providing services to their beneficiaries, such reduced levels of reimbursement may have a negative impact on our operating results.
Self-Pay Patients
Self-pay patients are patients who do not qualify for government programs payments, such as Medicare and Medicaid, and who do not have some form of private insurance, and are, therefore, responsible for their own medical bills. We also include in our self-pay accounts those unpaid co-insurance and deductible amounts for which payment has been received from the primary payer. A significant portion of our self-pay patients are admitted through our hospitals' emergency departments and often require high-acuity treatment. High-acuity treatment is more costly to provide and, therefore, results in higher billings, which are the least collectible of all accounts. We believe self-pay patient volumes and revenues have been higher in the last two years than previous periods due to a combination of broad economic factors, including reductions in state Medicaid budgets, increasing numbers of individuals and employers who choose not to purchase insurance and an increased burden of co-payments and deductibles to be made by patients instead of insurers.
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Self-pay accounts pose significant collectibility problems. At June 30, 2005 and 2006, approximately 11.1% and 11.2%, respectively, of our net accounts receivable are due from self-pay patients. The majority of our provision for doubtful accounts relates to self-pay patients. We are taking multiple actions in an effort to mitigate the effect on us of the high number of uninsured patients and the related economic impact. These initiatives include conducting detailed reviews of intake procedures in hospitals facing the greatest pressures and enhancing and updating intake best practices for all of our hospitals. We developed hospital-specific reports detailing collection rates by type of patient to help the hospital management teams better identify areas of vulnerability and opportunities for improvement. Also, we completely redesigned our self-pay collection workflows, enhanced technology and improved staff training in an effort to increase collections.
We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We exclude charity care accounts from revenues when we determine that the account meets our charity care guidelines. We provide expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. During the fiscal years ended June 30, 2005 and 2006, we deducted $55.6 million and $77.8 million of charity care from gross charges, respectively.
Government Regulation and Other Factors
Overview
All participants in the healthcare industry are required to comply with extensive government regulation at the federal, state and local levels. In addition, these laws, rules and regulations are extremely complex and the healthcare industry has had the benefit of little or no regulatory or judicial interpretation of many of them. Although we believe we are in compliance in all material respects with such laws, rules and regulations, if a determination is made that we were in material violation of such laws, rules or regulations, our business, financial condition or results of operations could be materially adversely affected. If we fail to comply with applicable laws and regulations, we can be subject to criminal penalties and civil sanctions, our hospitals can lose their licenses and their ability to participate in the Medicare and Medicaid programs.
Licensing, Certification and Accreditation
Healthcare facility construction and operation is subject to federal, state and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, rate-setting and compliance with building codes and environmental protection laws. Our facilities also are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation. We believe that all of our operating healthcare facilities are properly licensed under appropriate state healthcare laws.
All of our operating hospitals are certified under the Medicare program and are accredited by the Joint Commission on Accreditation of Healthcare Organizations (“JCAHO”), the effect of which is to permit the facilities to participate in the Medicare and Medicaid programs. If any facility loses its accreditation by JCAHO, or otherwise loses its certification under the Medicare program, then the facility will be unable to receive reimbursement from the Medicare and Medicaid programs. We intend to conduct our operations in compliance with current applicable federal, state, local and independent review body regulations and standards. The requirements for licensure, certification and accreditation are subject to change and, in order to remain qualified, we may need to make changes in our facilities, equipment, personnel and services.
Certificates of Need
In some states, the construction of new facilities, acquisition of existing facilities or addition of new beds or services may be subject to review by state regulatory agencies under a Certificate of Need program. Illinois and Massachusetts are the only states in which we currently operate that require approval under a Certificate of Need program. These laws generally require appropriate state agency determination of public need and approval prior to
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the addition of beds or services or other capital expenditures. Failure to obtain necessary state approval can result in the inability to expand facilities, add services, acquire a facility or change ownership. Further, violation of such laws may result in the imposition of civil sanctions or the revocation of a facility’s license.
Utilization Review
Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of diagnosis related group classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department of Health and Human Services that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.
Federal and State Fraud and Abuse Provisions
Participation in any federal healthcare program, such as the Medicare and Medicaid programs, is regulated heavily by statute and regulation. If a hospital provider fails to substantially comply with the numerous conditions of participation in the Medicare or Medicaid program or performs specific prohibited acts, the hospital’s participation in the Medicare program may be terminated or civil or criminal penalties may be imposed upon it under provisions of the Social Security Act and other statutes.
Among these statutes is a section of the Social Security Act known as the federal Anti-Kickback Statute. This law prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent of generating referrals or orders for services or items covered by a federal healthcare program. Violation of this statute is a felony, including criminal penalties of imprisonment or criminal fines up to $25,000 for each violation, civil money penalties up to $50,000 per violation, damages up to three times the total amount of the improper payment to the referral source and exclusion from participation in Medicare, Medicaid or other federal healthcare programs.
The Office of the Inspector General of the Department of Health and Human Services (the “OIG”) has published final safe harbor regulations that outline categories of activities that are deemed protected from prosecution under the Anti-Kickback Statute. Currently there are safe harbors for various activities, including the following: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, ambulatory surgery centers and referral agreements for specialty services.
The fact that conduct or a business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the Anti-Kickback Statute. The conduct or business arrangement, however, does increase the risk of scrutiny by government enforcement authorities. We may be less willing than some of our competitors to take actions or enter into business arrangements that do not clearly satisfy the safe harbors. As a result, this unwillingness may put us at a competitive disadvantage.
The OIG, among other regulatory agencies, is responsible for identifying and eliminating fraud, abuse and waste. The OIG carries out this mission through a nationwide program of audits, investigations and inspections. In order to provide guidance to healthcare providers, the OIG has from time to time issued “fraud alerts” that, although they do not have the force of law, identify features of a transaction that may indicate that the transaction could violate the Anti-Kickback Statute or other federal healthcare laws. The OIG has identified several incentive arrangements as potential violations, including:
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• | | payment of any incentive by the hospital when a physician refers a patient to the hospital; |
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• | | use of free or significantly discounted office space or equipment for physicians in facilities usually located close to the hospital; |
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• | | provision of free or significantly discounted billing, nursing or other staff services; |
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• | | free training for a physician’s office staff, including management and laboratory techniques; |
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• | | guarantees that provide that, if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder; |
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• | | low-interest or interest-free loans, or loans which may be forgiven if a physician refers patients to the hospital; |
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• | | payment of the costs of a physician’s travel and expenses for conferences or a physician’s continuing education courses; |
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• | | coverage on the hospital’s group health insurance plans at an inappropriately low cost to the physician; |
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• | | rental of space in physician offices, at other than fair market value terms, by persons or entities to which physicians refer; |
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• | | payment of services which require few, if any, substantive duties by the physician, or payment for services in excess of the fair market value of the services rendered; or |
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• | | “gain sharing,” the practice of giving physicians a share of any reduction in a hospital’s costs for patient care attributable in part to the physician’s efforts. |
Also, the OIG has encouraged persons having information about hospitals who offer the above types of incentives to physicians to report such information to the OIG.
The OIG also issues “Special Advisory Bulletins” as a means of providing guidance to healthcare providers. These bulletins, along with other “fraud alerts”, have focused on certain arrangements between physicians and providers that could be subject to heightened scrutiny by government enforcement authorities, including, “suspect” joint ventures where physicians may become investors with the provider in a newly formed joint venture entity where the investors refer their patients to this new entity, and are paid by the entity in the form of “profit distributions.” These subject joint ventures may be intended not so much to raise investment capital legitimately to start a business, but to lock up a stream of referrals from the physician investors and to compensate them indirectly for these referrals. Because physician investors can benefit financially from their referrals, unnecessary procedures and tests may be ordered or performed, resulting in unnecessary Medicare expenditures.
Similarly, in a Special Advisory Bulletin issued in April 2003, the OIG focused on “questionable” contractual arrangements where a healthcare provider in one line of business (the “Owner”) expands into a related healthcare business by contracting with an existing provider of a related item or service (the “Manager/Supplier”) to provide the new item or service to the Owner’s existing patient population, including federal healthcare program patients (so called “suspect Contractual Joint Ventures”). The Manager/Supplier not only manages the new line of business, but may also supply it with inventory, employees, space, billing, and other services. In other words, the Owner contracts out substantially the entire operation of the related line of business to the Manager/Supplier – otherwise a potential competitor – receiving in return the profits of the business as remuneration for its federal program referrals. The Bulletin lists the following features of these “questionable” contractual relationships. First, the Owner expands into a related line of business, which is dependent on referrals from, or other business generated by, the Owner’s existing business. Second, the Owner neither operates the new business itself nor commits substantial financial, capital or human resources to the venture. Instead, it contracts out substantially all the operations of the new business. The Manager/Supplier typically agrees to provide not only management services, but also a range of other services, such as the inventory necessary to run the business, office and healthcare
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personnel, billing support, and space. Third, the Manager/Supplier is an established provider of the same services as the Owner’s new line of business. In other words, absent the contractual arrangement, the Manager/Supplier would be a competitor of the new line of business, providing items and services in its own right, billing insurers and patients in its own name, and collecting reimbursement. Fourth, the Owner and the Manager/Supplier share in the economic benefit of the Owner’s new business. The Manager/Supplier takes its share in the form of payments under the various contracts with the Owner; the Owner receives its share in the form of the residual profit from the new business. Fifth, aggregate payments to the Manager/Supplier typically vary with the value or volume of business generated for the new business by the Owner. We monitor carefully our contracts with other healthcare providers and attempt to not allow our facilities to enter into these suspect Contractual Joint Ventures.
In addition to issuing fraud alerts and Special Advisory Bulletins, the OIG from time to time issues compliance program guidance for certain types of healthcare providers. In January 2005, the OIG published a Supplemental Compliance Guidance for Hospitals, supplementing its 1998 guidance for the hospital industry. In the supplemental guidance, the OIG identifies a number of risk areas under federal fraud and abuse statutes and regulations. These areas of risk include compensation arrangements with physicians, recruitment arrangements with physicians and joint venture relationships with physicians.
We have a variety of financial relationships with physicians who refer patients to our hospitals. As of June 30, 2006, physicians owned interests in two of our free-standing surgery centers, two of our hospitals and five of our diagnostic imaging centers. We may sell ownership interests in certain other of our facilities to physicians and other qualified investors in the future. We also have contracts with physicians providing for a variety of financial arrangements, including employment contracts, leases and professional service agreements. We have provided financial incentives to recruit physicians to relocate to communities served by our hospitals, including income and collection guarantees and reimbursement of relocation costs, and will continue to provide recruitment packages in the future. Although we have established policies and procedures to ensure that our arrangements with physicians comply with current law and available interpretations, we cannot assure you that regulatory authorities that enforce these laws will not determine that some of these arrangements violate the Anti-Kickback Statute or other applicable laws. An adverse determination could subject us to liabilities under the Social Security Act, including criminal penalties, civil monetary penalties and exclusion from participation in Medicare, Medicaid or other federal health care programs, any of which could have a material adverse effect in our business, financial condition or results of operations.
The Social Security Act also imposes criminal and civil penalties for submitting false claims to Medicare and Medicaid. False claims include, but are not limited to, billing for services not rendered, misrepresenting actual services rendered in order to obtain higher reimbursement and cost report fraud. Like the Anti-Kickback Statute, these provisions are very broad. Further, the Social Security Act contains civil penalties for conduct including improper coding and billing for unnecessary goods and services. Careful and accurate preparation and submission of claims for reimbursement must be performed in order to avoid liability.
The Health Insurance Portability and Accountability Act of 1996 broadened the scope of the fraud and abuse laws by adding several criminal provisions for healthcare fraud offenses that apply to all health benefit programs. This act also created new enforcement mechanisms to combat fraud and abuse, including the Medicaid Integrity Program and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. In addition, federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers and managing employees associated with business entities that have committed healthcare fraud. Additionally, this act establishes a violation for the payment of inducements to Medicare or Medicaid beneficiaries in order to influence those beneficiaries to order or receive services from a particular provider or practitioner.
The Social Security Act also includes a provision commonly known as the “Stark Law.” This law prohibits physicians from referring Medicare and (to an extent) Medicaid patients to entities with which they or any of their immediate family members have a financial relationship for the provision of certain designated health services that are reimbursable by Medicare or Medicaid, including inpatient and outpatient hospital services. The law also prohibits the entity from billing the Medicare program for any items or services that stem from a prohibited referral. Sanctions for violating the Stark Law include civil money penalties up to $15,000 per item or service improperly billed and exclusion from the federal healthcare programs. The statute also provides for a penalty of up to $100,000
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for a circumvention scheme. There are a number of exceptions to the self-referral prohibition, including an exception for a physician’s ownership interest in an entire hospital as opposed to an ownership interest in a hospital department. There are also exceptions for many of the customary financial arrangements between physicians and providers, including employment contracts, leases, professional services agreements, non-cash gifts having an annual value of less than $322 in calendar 2006 and recruitment agreements.
On January 4, 2001, CMS issued a final rule subject to a comment period intended to clarify parts of the Stark Law and some of the exceptions to it. The majority of these regulations became effective on or before January 4, 2002. On March 26, 2004, CMS issued an interim final rule subject to a comment period intended to clarify the remaining portions of the Stark Law. These rules, known as “phase two” of the Stark Law rulemaking, became effective July 26, 2004. While these regulations help clarify the requirements of the exceptions to the Stark Law, it is still unclear how the government will enforce them in practice.
Evolving interpretations of current, or the adoption of new, federal or state laws or regulations could affect many of the arrangements entered into by each of our hospitals. In addition, law enforcement authorities, including the OIG, the courts and Congress are increasing scrutiny of arrangements between healthcare providers and potential referral sources to ensure that the arrangements are not designed as a mechanism to improperly pay for patient referrals and or other business.
Investigators also have demonstrated a willingness to look behind the formalities of a business transaction to determine the underlying purpose of payments between healthcare providers and potential referral sources.
Many of the states in which we operate also have adopted laws that prohibit payments to physicians in exchange for referrals similar to the federal Anti-Kickback Statute or that otherwise prohibit fraud and abuse activities. Many states also have passed self-referral legislation, similar to the Stark Law, prohibiting the referral of patients to entities with which the physician has a financial relationship. Often these state laws are broad in scope and they may apply regardless of the source of payment for care. These statutes typically provide criminal and civil penalties, as well as loss of licensure. Little precedent exists for the interpretation or enforcement of these state laws.
Our operations could be adversely affected by the failure of our arrangements to comply with the Anti-Kickback Statute, the Stark Law, billing laws and regulations, current state laws or other legislation or regulations in these areas adopted in the future. We are unable to predict whether other legislation or regulations at the federal or state level in any of these areas will be adopted, what form such legislation or regulations may take or how they may impact our operations. We are continuing to enter into new financial arrangements with physicians and other providers in a manner structured to comply in all material respects with these laws. We cannot assure you, however, that governmental officials responsible for enforcing these laws will not assert that we are in violation of them or that such statutes or regulations ultimately will be interpreted by the courts in a manner consistent with our interpretation.
The Federal False Claims Act and Similar Laws
Another trend affecting the healthcare industry today is the increased use of the federal False Claims Act, and, in particular, actions being brought by individuals on the government’s behalf under the False Claims Act’s “qui tam” or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. If the government intervenes in the action and prevails, the party filing the initial complaint may share in any settlement or judgment. If the government does not intervene in the action, the whistleblower plaintiff may pursue the action independently, and may receive a larger share of any settlement or judgment. When a private party brings a qui tam action under the False Claims Act, the defendant generally will not be made aware of the lawsuit until the government makes a determination whether it will intervene.
When a defendant is determined by a court of law to be liable under the False Claims Act, the defendant must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 to $11,000 for each separate false claim. Settlements entered into prior to litigation usually involve a less severe calculation of damages. There are many potential bases for liability under the False Claims Act. Although liability often arises when an entity knowingly submits a false claim for reimbursement to the federal government,
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the False Claims Act defines the term “knowingly” broadly. Thus, simple negligence will not give rise to liability under the False Claims Act, but submitting a claim with reckless disregard to its truth or falsity can constitute “knowingly” submitting a false claim and result in liability. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the Anti-Kickback Statute or the Stark Law, have thereby submitted false claims under the False Claims Act.
A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. From time to time, companies in the healthcare industry, including ours, may be subject to actions under the False Claims Act or similar state laws.
Medicaid Integrity Program
In July 2006 CMS launched a new effort to track and prevent Medicaid fraud, the Medicaid Integrity Program, by issuing a 5-year Comprehensive Medicare Integrity Plan for the Program. The new Medicaid Integrity Program was created by the DEFRA 2005 with funds that will rise from $5.0 million in 2007 to $75.0 million by fiscal year 2009 and each year thereafter. There are two broad operational responsibilities under this new program:
• Reviewing the actions of those providing Medicaid services.
• Providing support and assistance to the States to combat Medicaid fraud, waste, and abuse.
Congress specifically required the use of contractors to review the actions of those seeking payment from Medicaid, conduct audits, identify overpayments and educate providers and others on payment integrity and quality of care. Congress also mandated in DEFRA 2005 that CMS devote at least 100 full-time staff employees to the Medicaid Integrity Program to provide support to the States.
Corporate Practice of Medicine and Fee Splitting
The states in which we operate have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians or laws that prohibit certain direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements that may violate these restrictions. These statutes vary from state to state, are often vague and seldom have been interpreted by the courts or regulatory agencies. Although we exercise care to structure our arrangements with healthcare providers to comply with the relevant state law, and believe these arrangements comply with applicable laws in all material respects, we cannot assure you that governmental officials responsible for enforcing these laws will not assert that we, or transactions in which we are involved, are in violation of such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretations.
The Health Insurance Portability and Accountability Act of 1996
The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) requires the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce in the healthcare industry. On August 17, 2000, the Department of Health and Human Services published final regulations establishing electronic data transmission standards that all healthcare providers must use when submitting or receiving certain healthcare transactions electronically. Compliance with these standards became mandatory on October 16, 2003. However, the Department of Health and Human Services agreed to accept noncompliant Medicare claims until October 1, 2005 to assist providers that were not yet able to process compliant transactions. Thus, commencing on October 1, 2005, fee-for-service Medicare claims that did not meet the standards required by HIPAA were returned to the filer for resubmission as compliant claims and non-compliant claims were not processed by Medicare. As of October 1, 2005, all of our facilities were filing compliant Medicare claims and continue doing so as of the date of this report.
HIPAA also requires the Department of Health and Human Services to adopt standards to protect the security and privacy of health-related information. The Department of Health and Human Services released final regulations containing privacy standards in December 2000 and published revisions to the final regulations in
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August 2002. Compliance with these regulations became mandatory on April 14, 2003. The privacy regulations extensively regulate the use and disclosure of individually identifiable health-related information. The privacy regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed. The Department of Health and Human Services released final security regulations on February 20, 2003. The security regulations became mandatory on April 20, 2005 and require healthcare providers to implement administrative, physical and technical practices to protect the security of individually identifiable health information that is electronically maintained or transmitted.
Violations of HIPAA could result in civil penalties of up to $25,000 per type of violation in each calendar year and criminal penalties of up to $250,000 per violation. In addition, our facilities will continue to remain subject to any privacy-related federal or state laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary by jurisdiction and could impose additional penalties.
Compliance with these standards has and will continue to require significant commitment and action by us. We have appointed members of our management team to direct our compliance with these standards. Implementation has and will continue to require us to engage in extensive preparation and make significant expenditures. At this time we have appointed a corporate privacy officer and a privacy officer at each of our facilities, prepared privacy policies, trained our workforce on these policies and entered into business associate agreements with the appropriate vendors. However, failure by us or third parties on which we rely, including payers, to resolve HIPAA-related implementation or operational issues could have a material adverse effect on our results of operations and our ability to provide healthcare services. Consequently, we can give you no assurance that issues related to the full implementation of, or our operations under, HIPAA will not have a material adverse effect on our financial condition or future results of operations.
Conversion Legislation
Many states have enacted laws affecting the conversion or sale of not-for-profit hospitals. These laws generally include provisions relating to attorney general approval, advance notification and community involvement. In addition, attorneys general in states without specific conversion legislation may exercise authority over these transactions based upon existing law. In many states, there has been an increased interest in the oversight of not-for-profit conversions. The adoption of conversion legislation and the increased review of not-for-profit hospital conversions may increase the cost and difficulty or prevent the completion of transactions with or acquisitions of not-for-profit organizations in various states.
The Emergency Medical Treatment and Active Labor Act
The Federal Emergency Medical Treatment and Active Labor Act (“EMTALA”) was adopted by Congress in response to reports of a widespread hospital emergency room practice of “patient dumping.” At the time of the enactment, patient dumping was considered to have occurred when a hospital capable of providing the needed care sent a patient to another facility or simply turned the patient away based on such patient’s inability to pay for his or her care. The law imposes requirements upon physicians, hospitals and other facilities that provide emergency medical services. Such requirements pertain to what care must be provided to anyone who comes to such facilities seeking care before they may be transferred to another facility or otherwise denied care. The government broadly interprets the law to cover situations in which patients do not actually present to a hospital’s emergency department, but present to a hospital-based clinic that treats emergency medical conditions on an urgent basis or are transported in a hospital-owned ambulance, subject to certain exceptions. EMTALA does not generally apply to patients admitted for inpatient services. Sanctions for violations of this statute include termination of a hospital’s Medicare provider agreement, exclusion of a physician from participation in Medicare and Medicaid programs and civil monetary penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law, and a medical facility that suffers a financial loss as a direct result of another participating hospital’s violation of the law, to sue the offending hospital for damages and equitable relief. Although we believe that our practices are in material compliance with the law, we cannot assure you that governmental officials responsible for enforcing the law will not assert from time to time that our facilities are in violation of this statute.
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Antitrust Laws
The federal government and most states have enacted antitrust laws that prohibit certain types of conduct deemed to be anti-competitive. These laws prohibit price fixing, agreements to fix wages, concerted refusal to deal, market monopolization, price discrimination, tying arrangements, acquisitions of competitors and other practices that have, or may have, an adverse effect on competition. Violations of federal or state antitrust laws can result in various sanctions, including criminal and civil penalties. Antitrust enforcement in the healthcare industry is currently a priority of the Federal Trade Commission. We believe we are in compliance with such federal and state laws, but there can be no assurance that a review of our practices by courts or regulatory authorities will not result in a determination that could adversely affect our operations.
Healthcare Reform
The healthcare industry, as one of the largest industries in the United States, continues to attract much legislative interest and public attention. Changes in Medicare, Medicaid and other programs, hospital cost-containment initiatives by public and private payers, proposals to limit payments and healthcare spending and industry-wide competitive factors are highly significant to the healthcare industry. In addition, a framework of extremely complex federal and state laws, rules and regulations governs the healthcare industry and, for many provisions, there is little history of regulatory or judicial interpretation on which to rely.
Both the federal government and many states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures and change private healthcare insurance. Most states, including the states in which we operate, have applied for and been granted federal waivers from current Medicaid regulations to allow them to serve some or all of their Medicaid participants through managed care providers. We are unable to predict the future course of federal, state or local healthcare legislation. Further changes in the law or regulatory framework that reduce our revenues or increase our costs could have a material adverse effect on our business, financial condition or results of operations.
Healthcare Industry Investigations
Significant media and public attention has focused in recent years on the hospital industry. Recently, increased attention has been paid to hospitals with high Medicare outlier payments and to recruitment arrangements with physicians. Further, there are numerous ongoing federal and state investigations regarding multiple issues. These investigations have targeted hospital companies as well as their executives and managers. Like other hospital companies, we have substantial Medicare, Medicaid and other governmental billings and we engage in various arrangements with physicians, which could result in scrutiny of our operations. We continue to monitor these and all other aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices are consistent with both legal principles and current industry standards. However, because the law in this area is complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations that are inconsistent with industry practices, including ours. In public statements surrounding current investigations, governmental authorities have taken positions on a number of issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some instances, government investigations that have in the past been conducted under the civil provisions of federal law may now be conducted as criminal investigations.
Many current healthcare investigations are national initiatives in which federal agencies target an entire segment of the healthcare industry. One example is the federal government’s initiative regarding hospital providers’ improper requests for separate payments for services rendered to a patient on an outpatient basis within three days prior to the patient’s admission to the hospital, where reimbursement for such services is included as part of the reimbursement for services furnished during an inpatient stay. In particular, the government has targeted all hospital providers to ensure conformity with this reimbursement rule. The federal government also has undertaken a national investigative initiative targeting the billing of claims for inpatient services related to bacterial pneumonia, as the government has found that many hospital providers have attempted to bill for pneumonia cases under more complex and higher reimbursed diagnosis related groups codes. Further, the federal government continues to investigate Medicare overpayments to prospective payment hospitals that incorrectly report transfers of patients to other
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prospective payment system hospitals as discharges. We are aware that prior to our acquisition of them, several of our hospitals were contacted in relation to certain government investigations relating to their operations. Although we take the position that, under the terms of the acquisition agreements, the prior owners of these hospitals retained any liability resulting from these government investigations, we cannot assure you that the prior owners’ resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, will not have a material adverse effect on our operations. Further, under the federal False Claims Act, private parties have the right to bring “qui tam” whistleblower lawsuits against companies that submit false claims for payments to the government. Some states have adopted similar state whistleblower and false claims provisions.
In addition to national enforcement initiatives, federal and state investigations commonly relate to a wide variety of routine healthcare operations such as: cost reporting and billing practices; financial arrangements with referral sources; physician recruitment activities; physician joint ventures; and hospital charges and collection practices for self-pay patients. We engage in many of these routine healthcare operations and other activities that could be the subject of governmental investigations or inquiries from time to time. For example, we have significant Medicare and Medicaid billings, we have numerous financial arrangements with physicians who are referral sources to our hospitals and we have joint venture arrangements involving physician investors.
It is possible that governmental entities may conduct investigations at facilities operated by us and that such investigations could result in significant penalties to us, as well as adverse publicity. It is also possible that our executives and managers, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. The positions taken by authorities in any future investigations of us, our executives or managers or other healthcare providers and the liabilities or penalties that may be imposed could have a material adverse effect on our business, financial condition and results of operations.
Health Plan Regulatory Matters
Our health plans are subject to state and federal laws and regulations. CMS has the right to audit our health plans to determine the plans’ compliance with such standards. In addition, AHCCCS has the right to audit PHP to determine PHP’s compliance with such standards. Also, PHP is required to file periodic reports with AHCCCS, meet certain financial viability standards, provide its enrollees with certain mandated benefits and meet certain quality assurance and improvement requirements. Our health plans also have to comply with the standardized formats for electronic transmissions and privacy and security standards set forth in the Administrative Simplifications Provisions of HIPAA. Our health plans have implemented the necessary policies and procedures to comply with the final federal regulations on these matters and were in compliance with them by their deadlines.
The Anti-Kickback Statute has been interpreted to prohibit the payment, solicitation, offering or receipt of any form of remuneration in return for the referral of federal health program patients or any item or service that is reimbursed, in whole or in part, by any federal healthcare program. Similar statutes have been adopted in Illinois and Arizona that apply regardless of the source of reimbursement. The Department of Health and Human Services has adopted safe harbor regulations specifying certain relationships and activities that are deemed not to violate the Anti-Kickback Statute which specifically relate to managed care including:
• | | waivers by health maintenance organizations of Medicare and Medicaid beneficiaries’ obligations to pay cost-sharing amounts or to provide other incentives in order to attract Medicare and Medicaid enrollees; |
• | | certain discounts offered to prepaid health plans by contracting providers; |
• | | certain price reductions offered to eligible managed care organizations; and |
• | | certain price reductions offered by contractors with substantial financial risk to managed care organizations. |
We believe that the incentives offered by our health plans to their enrollees and the discounts they receive contracting with healthcare providers satisfy the requirements of the safe harbor regulations. However, the failure to satisfy each criterion of the applicable safe harbor does not mean that the arrangement constitutes a violation of the law; rather, the safe harbor regulations provide that an arrangement which does not fit within a safe harbor must be analyzed on the basis of its specific facts and circumstances. We believe that our health plans’ arrangements comply in all material respects with the federal Anti-Kickback Statute and similar state statutes.
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Environmental Matters
We are subject to various federal, state and local laws and regulations relating to environmental protection. Our hospitals are not highly regulated under environmental laws because we do not engage in any industrial activities at those locations. The principal environmental requirements and concerns applicable to our operations relate to:
• | | the proper handling and disposal of hazardous and low level medical radioactive waste; |
• | | ownership or historical use of underground and above-ground storage tanks; |
• | | management of impacts from leaks of hydraulic fluid or oil associated with elevators, chiller units or incinerators; |
• | | appropriate management of asbestos-containing materials present or likely to be present at some locations; and |
• | | the potential acquisition of, or maintenance of air emission permits for, boilers or other equipment. |
We do not expect our compliance with environmental laws and regulations to have a material effect on us. We may also be subject to requirements related to the remediation of substances that have been released into the environment at properties owned or operated by us or at properties where substances were sent for off-site treatment or disposal. These remediation requirements may be imposed without regard to fault and whether or not we owned or operated the property at the time that the relevant releases or discharges occurred. Liability for environmental remediation can be substantial.
Item 1A. Risk Factors.
If any of the following events discussed in the following risks were to occur, our business, results of operations, financial condition, cash flows or prospects could be materially adversely affected. Additional risks and uncertainties not presently known, or currently deemed immaterial by us, may also constrain our business and operations.
Risks Relating to our Capital Structure
Our high level of debt and significant leverage may adversely affect our operations and our ability to grow and otherwise execute our business strategy.
We have a substantial amount of debt. As of June 30, 2006, we had $1,519.2 million of outstanding debt, excluding letters of credit and guarantees. This represented 68.8% of our total capitalization as of June 30, 2006. The amount of our outstanding indebtedness is large compared to the net book value of our assets, and we have significant repayment obligations under our outstanding indebtedness.
Our substantial indebtedness could:
• | | limit our ability to obtain additional financing to fund future capital expenditures, working capital, acquisitions or other needs; |
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• | | increase our vulnerability to general adverse economic, market and industry conditions and limit our flexibility in planning for, or reacting to, these conditions; |
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• | | make us vulnerable to increases in interest rates since $789.7 million of our borrowings under our senior credit facilities as of August 31, 2006 are, and additional borrowings may be, at variable interest rates; |
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• | | our flexibility to adjust to changing market conditions and ability to withstand competitive pressures could be limited, and we may be more vulnerable to a downturn in general economic conditions or our business or be unable to carry out capital spending that is necessary or important to our growth strategy and our efforts to improve operating margins; |
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• | | limit our ability to use operating cash in other areas of our business because we must use a substantial |
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| | portion of these funds to make principal and interest payments; and |
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• | | limit our ability to compete with others who are not as highly-leveraged. |
Our ability to make scheduled payments of principal and interest or to satisfy our other debt obligations, to refinance our indebtedness or to fund capital expenditures will depend on our future operating performance. Prevailing economic conditions (including interest rates) and financial, business and other factors, many of which are beyond our control, will also affect our ability to meet these needs. We may not be able to generate sufficient cash flows from operations or realize anticipated revenue growth or operating improvements, or obtain future borrowings in an amount sufficient to enable us to pay our debt, or to fund our other liquidity needs. We may need to refinance all or a portion of our debt on or before maturity. We may not be able to refinance any of our debt when needed on commercially reasonable terms or at all.
Despite our current significant leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks that we and our subsidiaries face.
We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indentures and the senior credit facilities do not fully prohibit us or our subsidiaries from doing so. Our revolving credit facility provides commitments of up to $250.0 million (not giving effect to any outstanding letters of credit, which would reduce the amount available under our revolving credit facility), of which $207.2 million was available for future borrowings as of August 31, 2006. In addition, upon the occurrence of certain events, we may request an incremental term loan facility or facilities be added to our current senior credit facilities in an amount not to exceed $300.0 million in the aggregate, subject to receipt of commitments by existing lenders or other financing institutions and to the satisfaction of certain other conditions. We may in the future borrow all available amounts under the revolving credit facility, under the incremental term loan facility and in addition, we may borrow substantial additional indebtedness in the future under new debt agreements. If new debt is added to our current debt levels, the related risks that we and our subsidiaries now face could intensify.
Operating and financial restrictions in our debt agreements limit our operational and financial flexibility.
The senior credit facilities and the indentures under which $575.0 million aggregate principal amount of our 9.0% senior subordinated notes due 2014 and $216.0 million aggregate principal amount of our 11.25% senior discount notes due 2015 were issued (collectively, the “Public Notes”) contain a number of significant covenants that, among other things, restrict our ability to:
• | | incur additional indebtedness or issue preferred stock; |
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• | | pay dividends on or make other distributions or repurchase our capital stock or make other restricted payments; |
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• | | make investments; |
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• | | enter into certain transactions with affiliates; |
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• | | limit dividends or other payments by restricted subsidiaries to our restricted subsidiaries; |
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• | | create liens on pari passu or subordinated indebtedness without securing the Public Notes; |
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• | | designate our subsidiaries as unrestricted subsidiaries; and |
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• | | sell certain assets or merge with or into other companies or otherwise dispose of all or substantially all of our assets. |
In addition, under the senior credit facilities, we are required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect our ability to comply with those provisions and we may not be
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able to meet those ratios and tests. The breach of any of these covenants would result in a default under the senior credit facilities and the lenders could elect to declare all amounts borrowed under the senior credit facilities, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior credit facilities are senior in right of payment to the Public Notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the Public Notes.
Our capital expenditure and acquisition strategy requires substantial capital resources. The building of new hospitals and the operations of our existing hospitals and newly acquired hospitals require ongoing capital expenditures for construction, renovation, expansion and the addition of medical equipment and technology. More specifically, we may in the future be contractually obligated to make significant capital expenditures relating to the facilities we acquire. Also, construction costs to build new hospitals are substantial. Our debt agreements may restrict our ability to incur additional indebtedness to fund these expenditures.
A breach of any of the restrictions or covenants in our debt agreements could cause a cross-default under other debt agreements. A significant portion of our indebtedness then may become immediately due and payable. We are not certain whether we would have, or be able to obtain, sufficient funds to make these accelerated payments. If any senior debt is accelerated, our assets may not be sufficient to repay in full such indebtedness and our other indebtedness.
We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.
Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness. In addition, the indentures governing the Public Notes allow us to make significant dividend payments, investments and other restricted payments. The making of these payments could decrease available cash and adversely affect our ability to make principal and interest payments on our indebtedness.
If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. The senior credit facilities and the indentures restrict our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair and proceeds that we do receive may not be adequate to meet any debt service obligations then due.
An increase in interest rates would increase the cost of servicing our debt and could reduce our profitability.
The substantial borrowings under our Senior Credit Facilities bear interest at variable rates. As a result, an increase in interest rates, whether because of an increase in market interest rates or an increase in our own cost of borrowing, would increase the cost of servicing our debt and could materially reduce our profitability. The impact of such an increase would be more significant than it would be for some other companies because of our substantial debt. For a discussion of how we manage our exposure to changes in interest rates through the use of interest rate swap agreements on certain portions of our outstanding debt, see “Item 7A. – Quantitave and Qualitative Disclosure About Market Risks.”
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Risks Related to our Business
If we are unable to enter into favorable contracts with managed care plans, our operating revenues may be reduced.
Our ability to negotiate favorable contracts with health maintenance organizations, insurers offering preferred provider arrangements and other managed care plans significantly affects the revenues and operating results of our hospitals. Revenues derived from health maintenance organizations, insurers offering preferred provider arrangements and other managed care plans, including Medicare and Medicaid managed care plans, accounted for approximately 50% of our net patient revenues for the year ended June 30, 2006. Managed care organizations offering prepaid and discounted medical services packages represent an increasing portion of our admissions, a general trend in the industry which has limited hospital revenue growth nationwide and a trend that may continue if the Medicare Modernization Act increases enrollment in Medicare managed care plans. In addition, private payers are increasingly attempting to control healthcare costs through direct contracting with hospitals to provide services on a discounted basis, increased utilization review, including the use of hospitalists, and greater enrollment in managed care programs such as health maintenance organizations and preferred provider organizations. In most cases, we negotiate our managed care contracts annually as they come up for renewal at various times during the year. Our future success will depend, in part, on our ability to renew existing managed care contracts and enter into new managed care contracts on terms favorable to us. Other healthcare companies, including some with greater financial resources, greater geographic coverage or a wider range of services, may compete with us for these opportunities. If we are unable to contain costs through increased operational efficiencies or to obtain higher reimbursements and payments from managed care payers, our results of operations and cash flows will be adversely affected.
Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies reduce our reimbursements.
Approximately 36% of our net patient revenues for the year ended June 30, 2006 came from Medicare and Medicaid programs, excluding Medicare and Medicaid managed plans. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. Some of those changes adversely affect the reimbursement we receive for certain services. In addition, due to budget deficits in many states, significant decreases in state funding for Medicaid programs have occurred or are being proposed.
In recent years, Congress and some state legislatures have introduced a number of other proposals to make major changes in the healthcare system. For instance, Medicare-reimbursed, hospital outpatient services converted to a prospective payment system on August 1, 2000. This system creates limitations on levels of payment for a substantial portion of hospital outpatient procedures. Future federal and state legislation may further reduce the payments we receive for our services.
A number of states have adopted legislation designed to reduce their Medicaid expenditures. Some states have enrolled Medicaid recipients in managed care programs (which generally tend to reduce the level of hospital utilization) and have imposed additional taxes on hospitals to help finance or expand the states’ Medicaid systems. Some states have also reduced the scope of Medicaid eligibility and coverage, making an increasing number of residents unable to pay for their care. Other states have proposed to take similar steps.
In addition, insurance and managed care companies and other third parties from whom we receive payment for our services increasingly attempt to control healthcare costs by requiring that hospitals discount their fees in exchange for exclusive or preferred participation in their benefit plans. We believe that this trend may continue and may reduce the payments we receive for our services.
Recently, both the Medicare Program and several large managed care companies have changed our reimbursement to link some of their payments, especially their annual increases in payments, to performance of quality of care measures. We expect this trend to “pay-for-performance” to increase in the future. If we are unable to meet these performance measures, our results of operations and cash flow will be materially adversely affected.
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We conduct business in a heavily regulated industry, and changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce our revenues and profitability.
The healthcare industry is subject to extensive federal, state and local laws and regulations relating to licensing, the conduct of operations, the ownership of facilities, the addition of facilities and services, financial arrangements with physicians and other referral sources, confidentiality, maintenance and security issues associated with medical records, billing for services and prices for services. If a determination were made that we were in material violation of such laws or regulations, our operations and financial results could be materially adversely affected.
In many instances, the industry does not have the benefit of significant regulatory or judicial interpretations of these laws and regulations. This is particularly true in the case of Medicare and Medicaid statute codified under section 1128B(b) of the Social Security Act and known as the “Anti-Kickback Statute.” This law prohibits providers and other person or entities from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent to generate referrals of orders for services or items reimbursable under Medicare, Medicaid and other federal healthcare programs. As authorized by Congress, the United States Department of Health and Human Services has issued regulations which describe some of the conduct and business relationships immune from prosecution under the Anti-Kickback Statute. The fact that a given business arrangement does not fall within one of these “safe harbor” provisions does not render the arrangement illegal, but business arrangements of healthcare service providers that fail to satisfy the applicable safe harbor criteria risk increased scrutiny by enforcement authorities.
Some of the financial arrangements that our facilities maintain with physicians do not meet all of the requirements for safe harbor protection. The regulatory authorities that enforce the Anti-Kickback Statute may in the future determine that one or more of these arrangements violate the Anti-Kickback Statute or other federal or state laws. A determination that a facility has violated the Anti-Kickback Statute or other federal laws could subject us to liability under the Social Security Act, including criminal and civil penalties, as well as exclusion of the facility from participation in government programs such as Medicare and Medicaid or other federal healthcare programs.
In addition, the portion of the Social Security Act commonly known as the “Stark Law” prohibits physicians from referring Medicare and (to an extent) Medicaid patients to providers of certain “designated health services” if the physician or a member of his or her immediate family has an ownership or investment interest in, or compensation arrangement with, that provider. In addition, the provider in such arrangements is prohibited from billing for all of the designated health services referred by the physician. Many of the services furnished by our facilities are “designated health services” for Stark Law purposes. There are multiple exceptions to the Stark Law, among others, for physicians maintaining an ownership interest in an entire hospital or having a compensation relationship with the facility as a result of employment agreements, leases, physician recruitment and certain other arrangements. However, each of these exceptions applies only if detailed conditions are met. These conditions were the subject of regulations which became effective in July 2004, and little precedent exists for their interpretation or enforcement. An arrangement subject to the Stark Law must qualify for an exception in order for the services to be lawfully referred by the physician and billed by the provider.
All of the states in which we operate have adopted or have considered adopting similar anti-kickback and physician self-referral legislation, some of which extends beyond the scope of the federal law to prohibit the payment or receipt of remuneration for the referral of patients and physician self-referrals, regardless of the source of payment for the care. Little precedent exists for the interpretation or enforcement of these laws. Both federal and state government agencies have announced heightened and coordinated civil and criminal enforcement efforts.
Government officials responsible for enforcing healthcare laws could assert that one or more of our facilities, or any of the transactions in which we are involved, are in violation of the Anti-Kickback Statute or the Stark Law and related state law exceptions. It is also possible that the courts could ultimately interpret these laws in a manner that is different from our interpretations. Moreover, other healthcare companies, alleged to have violated these laws, have paid significant sums to settle such allegations and entered into “corporate integrity agreements” because of concern that the government might exercise its authority to exclude those providers from governmental payment programs (Medicare, Medicaid, TRICARE). A determination that one or more of our facilities has violated these laws, or the public announcement that we are being investigated for possible violations of these laws, could
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have a material adverse effect on our business, financial condition, results of operations or prospects, and our business reputation could suffer significantly.
Illinois and Massachusetts require governmental determinations of need (“Certificates of Need”) prior to the purchase of major medical equipment or the construction, expansion, closure, sale or change of control of healthcare facilities. We believe our facilities have obtained appropriate certificates wherever applicable. However, if a determination were made that we were in material violation of such laws, our operations and financial results could be materially adversely affected. The governmental determinations, embodied in Certificates of Need, can also affect our facilities’ ability to add bed capacity or important services. We cannot predict whether we will be able to obtain required Certificates of Need in the future. A failure to obtain any required Certificates of Need may impair our ability to operate the affected facility profitably.
The laws, rules and regulations described above are complex and subject to interpretation. If we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed. For a more detailed discussion of the laws, rules and regulations described above, see “Business – Government Regulation and Other Factors.”
Providers in the healthcare industry have been the subject of federal and state investigations, whistleblower lawsuits and class action litigation, and we may become subject to investigations, whistleblower lawsuits or class action litigation in the future.
Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies, as well as their executives and managers. These investigations relate to a wide variety of topics, including:
• | | cost reporting and billing practices; |
• | | laboratory and home healthcare services; |
• | | physician ownership of, and joint ventures with, hospitals; |
• | | physician recruitment activities; and |
• | | other financial arrangements with referral sources |
In addition, the federal False Claims Act permits private parties to bring qui tam, or whistleblower, lawsuits against companies. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under false claims may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes and have submitted claims to a governmental payer during the time period they allegedly violated these other statutes, have thereby submitted false claims under the False Claims Act. Some states have adopted similar whistleblower and false claims provisions.
The Office of the Inspector General of the Department of Health and Human Services and the Department of Justice have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Initiatives include a focus on hospital billing for outpatient charges associated with inpatient services, as well as hospital laboratory billing practices. As a result of these regulations and initiatives, some of our activities could become the subject of governmental investigations or inquiries. For example, we have significant Medicare and Medicaid billings, we provide some durable medical equipment and home healthcare services, and we have joint venture arrangements involving physician investors. We also have a variety of other financial arrangements with physicians and other potential referral sources including recruitment arrangements and leases. In addition, our executives and managers, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. We are aware that several of our hospitals or their related healthcare operations were and may still be under investigation in connection with activities
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conducted prior to our acquisition of them. Under the terms of our various acquisition agreements, the prior owners of our hospitals are responsible for any liabilities arising from pre-closing violations. The prior owners’ resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, may have a material adverse effect on our business, financial condition or results of operations. Any investigations of us, our executives, managers, facilities or operations could result in significant liabilities or penalties to us, as well as adverse publicity.
We maintain a voluntary compliance program to address health regulatory and other compliance requirements. This program includes initial and periodic ethics and compliance training and effectiveness reviews, a toll-free hotline for employees to report, without fear of retaliation, any suspected legal or ethical violations, annual “fraud and abuse” audits to look at all of our financial relationships with physicians and other referral sources and annual “coding audits” to make sure our hospitals bill the proper service codes in respect of obtaining payment from the Medicare and Medicaid programs.
As an element of our corporate compliance program and our internal compliance audits, from time to time we make voluntary disclosures and repayments to the Medicare and Medicaid programs and/or to the federal and/or state regulators for these programs in the ordinary course of business. At the current time, we know of no active investigations by any of these programs or regulators in respect of our disclosures or repayments, except as set forth below. All of these voluntary actions on our part could lead to an investigation by the regulators to determine whether any of our facilities have violated the Stark Law, the Anti-Kickback Statute, the False Claims Act or similar state law. Either an investigation or initiation of administrative or judicial actions could result in a public announcement of possible violations of the Stark Law, the Anti-Kickback Statute or the False Claims Act or similar state law. Such determination or announcements could have a material adverse effect on our business, financial condition, results of operations or prospects, and our business reputation could suffer significantly.
Additionally, several hospital companies have recently been named defendants in class action litigation alleging, among other things, that their charge structures are fraudulent and, under state law, unfair or deceptive practices, insofar as those hospitals charge insurers lower rates than those charged to uninsured patients. We cannot assure you that we will not be named as a defendant in litigation of this type. Furthermore, the outcome of these suits may affect the industry standard for charity care policies and any response we take may have a material adverse effect on our financial results.
In June 2006 we and two other hospital systems operating in San Antonio, Texas had a putative class action lawsuit brought against all of us alleging that we and the other defendants has conspired with each other and with other unidentified San Antonio area hospitals to depress the compensation levels of registered nurses employed at the competing hospitals within the San Antonio area by engaging in certain activities that violated the federal antitrust laws. See “Item 3- Legal Proceedings” for further discussion of this litigation. On the same day that this litigation was brought against us and two other hospital systems in San Antonio, substantially similar litigation was brought against multiple hospitals in three other cities.
Competition from other hospitals or healthcare providers (especially specialty hospitals) may reduce our patient volumes and profitability.
The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years. Generally, other hospitals in the local communities served by most of our hospitals provide services similar to those offered by our hospitals. In addition, we believe the number of freestanding specialty hospitals and surgery and diagnostic centers in the geographic areas in which we operate has increased significantly in recent years. As a result, most of our hospitals operate in an increasingly competitive environment. Some of the hospitals that compete with our hospitals are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Increasingly, we are facing competition from physician-owned specialty hospitals and freestanding surgery centers that compete for market share in high margin services and for quality physicians and personnel. If our competitors are better able to attract patients, recruit physicians, expand services or obtain favorable managed contracts at their facilities, we may experience a decline in patient volumes.
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PHP also faces competition within the Arizona market that it serves. As in the case of our hospitals, some of our competitors in this market are owned by governmental agencies or not-for-profit corporations that have greater financial resources than we do. Other competitors have larger membership bases, are more established and have greater geographic coverage areas that give them an advantage in competing for a limited pool of eligible health plan members. The revenues we derive from PHP could significantly decrease if new plans operating under AHCCCS enter the market or other existing AHCCCS plans increase their number of enrollees. Moreover, a failure to attract future enrollees may negatively impact our ability to maintain our profitability in this market.
Our hospitals face a growth in uncompensated care as the result of the inability of uninsured patients to pay for healthcare services and difficulties in collecting patient portions of insured accounts.
Like others in the hospital industry, we have experienced an increase in uncompensated care. Our combined provision for doubtful accounts and charity care deductions as a percentage of patient service revenues increased from 10.4% during fiscal 2004, to 10.7% during fiscal 2005 and to 11.2% during fiscal 2006. While our self pay discharges as a percentage of total discharges decreased from 3.3% during fiscal 2004 to 3.1% during fiscal 2005, they increased to 3.3% during fiscal 2006. Our hospitals remain at risk for increases in uncompensated care as a result of price increases, the continuing trend of increases in co-payment and deductible portions of managed care accounts and increases in uninsured patients as a result of potential state Medicaid funding cuts or general economic weakness.
Our performance depends on our ability to recruit and retain quality physicians.
The success of our hospitals depends in part on the following factors:
• | | the number and quality of the physicians on the medical staffs of our hospitals; |
• | | the admitting practices of those physicians; and |
• | | the maintenance of good relations with those physicians. |
We generally do not employ physicians. Most physicians at our hospitals also have admitting privileges at other hospitals. If facilities are not staffed with adequate support personnel or technologically advanced equipment that meets the needs of patients, physicians may be discouraged from referring patients to our facilities, which could adversely affect our profitability.
We may be unable to achieve our acquisition and growth strategy and we may have difficulty acquiring not-for-profit hospitals due to regulatory scrutiny.
An important element of our business strategy is expansion by acquiring hospitals in our existing and in new urban and suburban markets and by entering into partnerships or affiliations with other healthcare service providers. The competition to acquire hospitals is significant, including competition from healthcare companies with greater financial resources than ours, and we may not be able to make suitable acquisitions on favorable terms, and we may have difficulty obtaining financing, if necessary, for such acquisitions on satisfactory terms. We sometimes agree not to sell an acquired hospital for some period of time (currently no longer than 10 years) after closing and/or grant the seller a right of first refusal to purchase the hospital if we agree to sell it to a third party. In addition, we may not be able to effectively integrate any acquired facilities with our operations. Even if we continue to acquire additional facilities and/or enter into partnerships or affiliations with other healthcare service providers, federal and state regulatory agencies may constrain our ability to grow.
Additionally, many states, including some where we have hospitals and others where we may in the future attempt to acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the sale proceeds by the not-for-profit seller. These review and approval processes can add time to the consummation of an acquisition of a not-for profit hospital, and future actions on the state level could seriously delay or even prevent future acquisitions of not-for-profit hospitals. Furthermore, as a condition to approving an acquisition, the attorney general of the state in which the hospital is located may require us to maintain specific
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services, such as emergency departments, or to continue to provide specific levels of charity care, which may affect our decision to acquire or the terms upon which we acquire one of these hospitals.
Difficulties with integrating our acquisitions may disrupt our ongoing operations.
We may not be able to profitably or effectively integrate the operations of, or otherwise achieve the intended benefits from, any acquisitions we make or partnerships or affiliations we may form. The process of integrating acquired hospitals may require a disproportionate amount of management’s time and attention, potentially distracting management from its day-to-day responsibilities. This process may be even more difficult in the case of hospitals we may acquire out of bankruptcy or otherwise in financial distress. In addition, poor integration of acquired facilities could cause interruptions to our business activities, including those of the acquired facilities. As a result, we may incur significant costs related to acquiring or integrating these facilities and may not realize the anticipated benefits.
Moreover, acquired businesses may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations. We could in the future become liable for past activities of acquired businesses and these liabilities could be material.
Our hospitals face competition for staffing, which may increase our labor costs and reduce profitability.
We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In the healthcare industry generally, including in our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel or to hire more expensive temporary personnel. We have raised on several occasions in the past, and expect to raise in the future, wages for our nurses and other medical support personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. In addition, to the extent that a significant additional portion of our employee base unionizes, or attempts to unionize, our labor costs could increase materially. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because approximately 86% of our net patient revenues for the year ended June 30, 2006, consisted of payments based on fixed or negotiated rates, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have a material adverse effect on our profitability.
The cost of our malpractice insurance and the malpractice insurance of physicians who practice at our facilities remains volatile. Successful malpractice or tort claims asserted against us, our physicians or our employees could materially adversely affect our financial condition and profitability.
In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large monetary claims and significant defense costs. Hospitals and physicians have typically maintained a special type of insurance (commonly called malpractice or professional liability insurance) to protect against the costs of these types of legal actions. Due to unfavorable pricing and availability trends, we created a captive insurance subsidiary on June 1, 2002, to assume a substantial portion of the professional and general liability risks of our facilities. For claims incurred during the period June 1, 2002 to May 31, 2006, we maintain all of our professional and general liability insurance through this captive insurance subsidiary in respect of losses up to $10.0 million per occurrence. For claims incurred subsequent to May 31, 2006, we self-insure the first $9.0 million per occurrence, and our captive subsidiary insures the next $1.0 million per occurrence. We have also purchased an umbrella excess policy for professional and general liability insurance for the period June 1, 2006 to May 31, 2007 with unrelated commercial carriers. This policy covers losses in excess of $10.0 million per occurrence up to $75.0 million, but is limited to total annual payments of $65.0 million in the aggregate. While premium prices have declined during the past two years, the total cost of professional and general liability insurance remains sensitive to the volume and severity of cases reported. There is no guarantee that excess insurance coverage will continue to be available in the future at a cost allowing us to maintain adequate levels of such insurance. Moreover, due to the
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increased retention limits insured by us and our captive subsidiary, if actual payments of claims materially exceed our projected estimates of malpractice claims, our financial condition could be materially adversely affected.
In addition, physicians’ professional liability insurance costs have dramatically increased to the point where some physicians are either choosing to retire early or leave certain markets. If physician professional liability insurance costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volumes and revenues. Our hospitals may also incur a greater percentage of the amounts paid to claimants if physicians are unable to obtain adequate malpractice coverage.
We are subject to uncertainties regarding healthcare reform that could materially and adversely affect our business.
In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would result in major changes in the healthcare system, either nationally or at the state level. Among the proposals that have been introduced are price controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of a government health insurance plan or plans that would cover all citizens and increase payments by beneficiaries. Increased regulations, mandated benefits and more oversight, audits and investigations and changes in laws allowing access to federal and state courts to challenge healthcare decisions may increase our administrative, litigation and healthcare costs. We cannot predict whether any of the above proposals or any other proposals will be adopted, and if adopted, we cannot assure you that the implementation of these reforms will not have a material adverse effect on our business, financial position or results of operations.
A reduction in inpatient services may reduce our revenues.
Technological advances have enabled procedures that were previously performed on an inpatient basis to now be provided on an outpatient basis. In addition, through a process known as “utilization review”, third party payers focus on reducing inpatient admissions and lengths of stay to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. The resulting increase in surgeries performed on an outpatient basis has reduced inpatient utilization, average lengths of stay and occupancy rates at our hospitals and, as a result, has adversely affected hospital revenues. We expect this trend of migration to outpatient settings to continue for certain inpatient procedures and anticipate that efforts to impose more stringent controls and competition for outpatient services will remain intense during the foreseeable future. However, we expect the aging of the baby boomer population to help offset this decrease in inpatient utilization.
Our facilities are concentrated in a small number of regions. If any one of the regions in which we operate experiences a regulatory change, economic downturn or other material change, our overall business results may suffer.
Among our operations as of June 30, 2006, five hospitals and various related healthcare businesses were located in San Antonio, Texas; six hospitals and related healthcare businesses were located in metropolitan Phoenix, Arizona; two hospitals and related healthcare businesses were located in metropolitan Chicago, Illinois; three hospitals and related healthcare businesses were located in Orange County, California; and three hospitals and related healthcare businesses were located in Massachusetts. For the year ended June 30, 2006, our total revenues were generated as follows:
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| | Year Ended
June 30, 2006 | |
| |
| |
San Antonio | | 27.7 | % | |
Metropolitan Phoenix, excluding Phoenix Health Plan and Abrazo
Advantage Health Plan | | 20.1 | | |
Phoenix Health Plan and Abrazo Advantage Health Plan | | 12.3 | | |
Metropolitan Chicago (1) | | 14.5 | | |
Orange County | | 7.0 | | |
Massachusetts | | 18.4 | | |
| |
| |
| | 100.0 | % | |
____________________ | | | | |
(1) Includes MacNeal Health Providers. | |
Any material change in the current demographic, economic, competitive or regulatory conditions in any of these regions could adversely affect our overall business results because of the significance of our operations in each of these regions to our overall operating performance. Moreover, due to the concentration of our revenues in only five regions, our business is less diversified and, accordingly, is subject to greater regional risk than that of some of our larger competitors.
California has statutes and regulations that require hospitals to meet seismic performance standards, and hospitals that do not meet the standards may be required to retrofit their facilities. Assuming the expected sale of the California hospitals is not completed, our estimated cost to comply with the seismic regulations and standards required by 2013 is $14.8 million. Upon completion of the $14.8 million in improvements, our California facilities would be compliant with the requirements of the seismic regulations through 2029. We estimate that the majority of the square footage in our facilities would be compliant with the seismic regulations and standards required by 2030 once we had completed such $14.8 million in improvements, but we are unable at this time to estimate our costs for full compliance with the 2030 requirements. Moreover, in the event that our California facilities are found not to be in compliance with these seismic standards, we may be required to make significant capital expenditures to bring the California facilities into compliance, which could impact our financial position negatively.
If we are unable to control our healthcare costs at Phoenix Health Plan and Abrazo Advantage Health Plan, if the health plans should lose their governmental contracts or if budgetary cuts reduce the scope of Medicaid or dual-eligibility coverage, our profitability may be adversely affected.
For the year ended June 30, 2006, PHP generated approximately 11.5% of our total revenues. PHP derives substantially all of its revenues through a contract with AHCCCS. AHCCCS pays capitated rates to PHP, and PHP subcontracts with physicians, hospitals and other healthcare providers to provide services to its enrollees. If we fail to effectively manage our healthcare costs, these costs may exceed the payments we receive. Many factors can cause actual healthcare costs to exceed the capitated rates paid by AHCCCS, including:
• | | our ability to contract with cost-effective healthcare providers; |
• | | the increased cost of individual healthcare services; |
• | | the type and number of individual healthcare services delivered; and |
• | | the occurrence of catastrophes, epidemics or other unforeseen occurrences |
Our current contract with AHCCCS expires September 30, 2007 with one additional one-year renewal and is terminable without cause on 90 days’ written notice from AHCCCS or for cause upon written notice from AHCCCS if we fail to comply with any term or condition of the contract or fail to take corrective action as required to comply with the terms of the contract. AHCCCS may also terminate the contract with PHP in the event of unavailability of state or federal funding. As other health plans attempt to enter the Arizona market, we may face increased competition. If we are unable to renew, successfully rebid or compete for our contract with AHCCCS, or if our contract is terminated, our profitability would be adversely affected by the loss of these revenues and cash flows. Also, should the scope of the Medicaid program be reduced as a result of state budgetary cuts or other political factors, our results of operations could be adversely affected.
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For the year ended June 30, 2006, AAHP generated 0.8% of our total revenues. AAHP began providing healthcare coverage to Medicare and Medicaid dual-eligible enrollees on January 1, 2006. Most of AAHP’s members were formerly enrolled in PHP. AAHP’s contract with CMS went into effect on January 1, 2006, for a term of one year, with a provisions for successive one year renewals. If we fail to effectively manage AAHP’s healthcare costs, these costs may exceed the payments we receive.
We may fail to comply with the privacy, security and electronic transaction requirements under the Health Insurance Portability and Accountability Act of 1996 and we may be materially adversely affected as a result.
Enforcement of the final regulations governing the privacy of health information under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) began in April 2003. The enforcing agency, the Office of Civil Rights (“OCR”) of the Department of Health and Human Services, has announced a complaint based and compliance improvement type enforcement program. A violation of the HIPAA regulations could result in civil monetary penalties of $100 per incident, up to a maximum of $25,000 per person per year per standard. HIPAA also provides for criminal penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for commercial advantage, personal gain or malicious harm. Since there is no significant history of enforcement efforts by the OCR at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with the HIPAA regulations or the potential for fines and penalties that may result from the violation of the regulations.
The HIPAA regulations establishing standardized code sets and formats for financial and clinical electronic data interchange (“EDI”) transactions among health plans and providers required compliance by October 1, 2005. As of the date of this report, we believe that we can receive and make the specified transmissions in HIPAA compliant format and all of our facilities are filing their Medicare claims in HIPAA compliant format. However, there is no assurance that we can continue making these compliant transactions.
The compliance date of HIPAA regulations requiring us to establish administrative, physical and technical safeguards to protect the confidentiality, integrity and availability of electronic protected health information pursuant to the findings of our risk analyses was April 21, 2005. While we think we are in compliance with such regulations, we are continually in the process of conducting the mandated risk analyses and determining whether any gaps in safeguards exist. Significant administrative and financial resources could be required to address any such gaps, including costs from making changes to our information systems.
We are dependent on our senior management team and local management personnel, and the loss of the services of one or more of our senior management team or key local management personnel could have a material adverse effect on our business.
The success of our business is largely dependent upon the services and management experience of our senior management team, which includes Charles N. Martin, Jr., our Chairman and Chief Executive Officer; Kent H. Wallace, our President and Chief Operating Officer; Joseph D. Moore, our Executive Vice President, Chief Financial Officer and Treasurer; and Keith B. Pitts, our Vice Chairman. In addition, we depend on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our senior officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. We do not maintain key man life insurance policies on any of our officers. If we were to lose any of our senior management team or members of our local management teams, or if we are unable to attract other necessary personnel in the future, it could have a material adverse effect on our business, financial condition and results of operations. If we were to lose the services of one or more members of our senior management team or a significant portion of our hospital management staff at one or more of our hospitals, we would likely experience a significant disruption in our operations and failure of the affected hospitals to adhere to their respective business plans.
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Changes in legislation may significantly reduce government healthcare spending and our revenues.
Governmental healthcare programs, principally Medicare and Medicaid, accounted for 38% and 36% of our net patient revenues (excluding managed Medicare and Medicaid programs) for the years ended June 30, 2005 and 2006, respectively. In recent years, legislative changes have resulted in limitations on and, in some cases, reductions in levels of, payments to healthcare providers for certain services under many of these government programs. Further, legislative changes have altered the method of payment for various services under the Medicare and Medicaid programs. We believe that hospital operating margins across the country, including ours, have been and may continue to be under pressure because of limited pricing flexibility and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. The fiscal year 2006 budget approved by Congress contemplates an approximately $10 billion reduction in federal Medicaid funding over five years. DRA 2005 passed in February 2006 reduces federal funding for Medicare and Medicaid by approximately $11 billion over the next five years. In addition, a number of states are experiencing budget problems and have adopted or are considering legislation designed to reduce their Medicaid expenditures and to provide universal coverage and additional care, including enrolling Medicaid recipients in managed care programs and imposing additional taxes on hospitals to help finance or expand states’ Medicaid systems.
If we continue to experience growth in self-pay volumes and revenues, our financial condition or results of operations could be adversely affected.
Like others in the hospital industry, we have experienced an increase in our combined provision for bad debts and charity care as a percentage of patient service revenues due to a growth in self-pay volumes and revenues resulting in large part from an increase in the number of uninsured patients, along with an increase in the amount of co-payments and deductibles passed on by employers to employees. Although we continue to seek ways to improve point of service collection efforts and implement appropriate payment plans with our patients, if we continue to experience growth in self-pay volumes and revenues, our results of operations could be adversely affected. Further, our ability to improve collections for self-pay patients may be limited by regulatory and investigatory initiatives, including private lawsuits directed at hospital charges and collection practices for uninsured and underinsured patients.
Controls designed to reduce inpatient services may reduce our revenues.
Controls imposed by third-party payers designed to reduce admissions and lengths of stay, commonly referred to as “utilization review,” have affected and are expected to continue to affect our facilities. Utilization review entails the review of the admission and course of treatment of a patient by managed care plans. Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payer-required preadmission authorization and utilization review and by payer pressures to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Efforts to impose more stringent cost controls are expected to continue. Although we are unable to predict the effect these changes will have on our operations, significant limits on the scope of services reimbursed and on reimbursement rates and fees could have a material, adverse effect on our business, financial position and results of operations.
If we fail to continually enhance our hospitals with the most recent technological advances in diagnostic and surgical equipment, our ability to maintain and expand our markets will be adversely affected.
Technological advances with respect to computed axial tomography (CT), magnetic resonance imaging (MRI) and positron emission tomography (PET) equipment, as well as other equipment used in our facilities, are continually evolving. In an effort to compete with other healthcare providers, we must constantly evaluate our equipment needs and upgrade equipment as a result of technological improvements. Such equipment costs typically range from $1.0 million to $3.0 million, exclusive of construction or build-out costs.
Compliance with section 404 of the Sarbanes-Oxley Act may negatively impact our results of operations and failure to comply may subject us to regulatory scrutiny and a loss of investors’ confidence in our internal control over financial reporting.
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Section 404 of the Sarbanes-Oxley Act of 2002 requires us to perform an evaluation of our internal control over financial reporting and our auditor to attest to such evaluation beginning with our fiscal year 2008. Compliance with these requirements, and any changes in our internal control over financial reporting in response to our internal evaluations, may be expensive and time-consuming and may negatively impact our results of operations. In addition, we cannot assure you that we will be able to meet the required deadlines for compliance with Section 404. Any failure on our part to meet the required compliance deadlines may subject us to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting.
A failure of our information systems would adversely affect our ability to properly manage our operations.
We rely on our advanced information systems and our ability to successfully use these systems in our operations. These systems are essential to the following areas of our business operations, among others:
• | | patient accounting, including billing and collection of patient service revenues; |
| | |
• | | financial, accounting, reporting and payroll; coding and compliance; |
| | |
• | | laboratory, radiology and pharmacy systems; |
| | |
• | | negotiating, pricing and administering managed care contracts; and |
| | |
• | | monitoring quality of care. |
If we are unable to use these systems effectively, we may experience delays in collection of patient service revenues and may not be able to properly manage our operations or oversee the compliance with laws or regulations.
Abrazo Advantage’s contract with CMS to become a Medicare advantage prescription drug special needs plan may result in reduced profitability.
Effective January 1, 2006, CMS awarded AAHP a contract to become a Medicare Advantage Prescription Drug Special Needs Plan. The contract allows AAHP to offer Medicare coverage for its approximately 3,500 dual-eligible members, or those that are eligible for Medicare and Medicaid. In calendar year 2005 PHP served substantially all of these members through the AHCCCS Medicaid program. AAHP offers its members Medicare and Part D drug benefit coverage under this new contract as well as coverage under the AHCCCS Medicaid program.
As with any new product line, there are risks and uncertainties. For example, in these types of health plans, members are allowed to change health plans on a monthly basis, making it difficult to project whether AAHP will be able to retain its current membership throughout the next year. Additionally, the payment structure for paying Medicare claims under this type of health plan differs from Arizona Medicaid claims, making it difficult to project the cost of providing care under this new plan.
Difficulties with current construction projects or new construction projects such as additional hospitals or major expansion projects may involve significant capital expenditures which could have an adverse impact on our liquidity.
We currently are constructing six major expansion projects at our hospitals. The total budgeted cost to construct these projects is currently estimated to be approximately $333.5 million, of which as of June 30, 2006 we have spent approximately $235.8 million. Thus, we currently expect to incur approximately an additional $97.7 million in capital expenditures through fiscal 2008 related to completion of the construction of these six projects. In addition, we may decide to construct an additional hospital or hospitals in the future or construct additional major expansion projects. Our ability to complete construction of these six current construction projects on our anticipated budget and schedule or to complete the construction of new hospitals or new expansion projects on budget and schedule would depend on a number of factors, including, but not limited to:
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• | | our ability to control construction costs; |
| | |
• | | the failure of general contractors or subcontractors to perform under their contracts; |
| | |
• | | adverse weather conditions; |
| | |
• | | shortages of labor or materials; |
| | |
• | | our ability to obtain necessary licensing and other required governmental authorizations; and |
| | |
• | | other unforeseen problems and delays. |
As a result of these and other factors, we cannot assure you that we will not experience increased construction costs on our construction projects or that we will be able to construct our current or any future construction projects as originally planned. In addition, our current and any future major construction projects has and would involve a significant commitment of capital with no revenues associated with the projects during construction, which also could have in the future an adverse impact on our liquidity.
The costs for construction materials and labor continue to rise, and such increased costs could have an adverse impact on the return on investment relating to our new hospital and other expansion projects.
The cost of construction materials and labor has significantly increased recently as a result of global and domestic events. We have experienced significant increases in the cost of steel due to the demand in China for such materials and an increase in the cost of lumber due to multiple catastrophic hurricanes in the United States. As we continue to invest in modern technologies, emergency rooms and operating room expansions, we expend large sums of cash generated from operating activities. We evaluate the financial viability of such projects based on whether the projected cash flow return on investment exceeds our cost of capital. Such returns may not be achieved if the cost of construction continues to rise significantly or anticipated volumes do not materialize.
State efforts to regulate the construction or expansion of hospitals could impair our ability to operate and expand our operations.
Some states require healthcare providers to obtain prior approval, known as certificates of need, for:
• | | the purchase, construction or expansion of healthcare facilities; |
| | |
• | | capital expenditures exceeding a prescribed amount; or |
| | |
• | | changes in services or bed capacity. |
In giving approval, these states consider the need for additional or expanded healthcare facilities or services. Illinois and Massachusetts are the only states in which we currently own hospitals that have certificate of need laws. The failure to obtain any required certificate of need could impair our ability to operate or expand operations.
If the fair value of our reporting units declines, a material non-cash charge to earnings from impairment of our goodwill could result.
Blackstone acquired our predecessor company during fiscal 2005. We recorded a significant portion of the purchase price as goodwill. At June 30, 2006, we had approximately $815.8 million of goodwill recorded on our books. We expect to recover the carrying value of this goodwill through our future cash flows. On an ongoing basis, we evaluate, based on the fair value of our reporting units, whether the carrying value of our goodwill is impaired. If the carrying value of our goodwill is impaired, we may incur a material non-cash charge to earnings.
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Additional Risk Factors
See the additional risks related to our business in “Item 7 – Management’s Discussion and Analysis of Financial Conditions and Results of Operations – General Trends” which are incorporated by reference in this Item 1A as if fully set forth herein.
Available Information
Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports are available free of charge on our internet website at www.vanguardhealth.com under “Investor Relations-SEC Filings-SEC Filings on the Edgar Database” as soon as reasonably practicable after such reports are electronically filed with or furnished to the Securities and Exchange Commission.
Item 1B. Unresolved Staff Comments.
Not applicable.
Item 2. Properties.
A listing of our owned acute hospitals is included in Item 1 of this report under the caption “Business-Our Facilities”. We also own or lease space for outpatient service facilities complementary to our hospitals and own and operate a limited number of medical office buildings (some of which are joint ventures) associated with our hospitals that are occupied primarily by physicians who practice at our hospitals. The most significant of these complementary outpatient healthcare facilities are two surgery centers in Orange County, California, five diagnostic imaging centers in metropolitan Phoenix, Arizona and a 50% interest in five diagnostic imaging centers in San Antonio, Texas. Most of these outpatient facilities are in leased facilities, and the diagnostic imaging centers in San Antonio are owned and operated in joint ventures where we have minority partners.
We currently lease approximately 40,500 square feet of office space at 20 Burton Hills Boulevard, Nashville, Tennessee, for our corporate headquarters.
Our headquarters, hospitals and other facilities are suitable for their respective uses and are, in general, adequate for our present needs. Our obligations under our senior credit facilities are secured by a pledge of substantially all of our assets, including first priority mortgages on each of our hospitals. Also, our properties are subject to various federal, state and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our financial position or results from operations.
Item 3. Legal Proceedings.
We operate in a highly regulated and litigious industry. As a result, various lawsuits, claims and legal and regulatory proceedings have been instituted or asserted against us. While we cannot predict the likelihood of future claims or inquiries, we expect that new matters may be initiated against us from time to time. The results of claims, lawsuits and investigations cannot be predicted, and it is possible that the ultimate resolution of these matters, individually or in the aggregate, may have a material adverse effect on our business (both in the near and long term), financial position, results of operations or cash flows. We recognize that, where appropriate, our interests may be best served by resolving certain matters without litigation. If non-litigated resolution is not possible or appropriate with respect to a particular matter, we will continue to defend ourselves vigorously.
Currently pending and recently settled legal proceedings and investigations that are not in the ordinary course of business are set forth below. Where specific amounts are sought in any pending legal proceeding, those amounts are disclosed. For all other matters, where the possible loss or range of loss is reasonably estimable, an estimate is provided. Where no estimate is provided, the possible amount of loss is not reasonably estimable at this time. We record reserves for claims and lawsuits when they are probable and reasonably estimable. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, we have not recognized in
48
our consolidated financial statements all potential liabilities that may result. We undertake no obligation to update the following disclosures for any new developments.
Settlement with OIG Prior to Litigation of Physician Lease Issues at One Hospital Voluntarily Disclosed to the OIG by Vanguard in September 2004
In accordance with our established compliance program policies, in September 2004 we made a voluntary disclosure to the Office of Inspector General of the U.S. Department of Health and Human Services (“OIG”) and to the local U.S. Attorney’s Office regarding certain physician lease documentation discrepancies at one of our hospitals. On September 20, 2004 we were accepted by the OIG into its self-disclosure program in connection with this matter. Although we never determined that a violation of any laws or regulations had occurred at this hospital, the OIG contended as the result of our investigation that the lease documentation discrepancies led to our hospital violating certain federal laws that would subject that hospital to civil monetary penalties, assessments and possible exclusion from participation in the federal healthcare programs. In order to avoid the uncertainty and expense of litigation and without admitting any liability, we settled the matter with the OIG in April 2006 by (1) making a settlement payment of approximately $0.8 million to the OIG and (2) entering into with the OIG both a settlement agreement and a certificate of compliance agreement subjecting our hospital to certain integrity requirements for the three year period ending April 2009 (continued implementation of its current compliance program, an annual report to the OIG in respect of compliance matters and immediate reporting of federal overpayments, certain violations of law and initiation of certain governmental investigations or legal proceedings as well as prompt repayment of federal overpayments). The settlement payment, net of taxes, is considered part of the Merger purchase price allocation and is reflected in goodwill on the accompanying consolidated balance sheet as of June 30, 2006. Except for this settled OIG investigation, we are not aware of any other material regulatory proceeding or investigation underway or threatened involving allegations of potential wrongdoing.
Sherman Act Antitrust Class Action Litigation – Maderazo, et al v. VHS San Antonio Partners, L.P. d/b/a Baptist Health Systems, et al, Case No. 5:06cv00535 (United States District Court, Western District of Texas, San Antonio Division, filed June 20, 2006 and amended August 29, 2006)
On June 20, 2006, a federal antitrust class action suit was filed in San Antonio, Texas against our Baptist Health System subsidiary in San Antonio, Texas and two other large hospital systems in San Antonio. In the complaint, plaintiffs allege that the three hospital system defendants conspired with each other and with other unidentified San Antonio area hospitals to depress the compensation levels of registered nurses employed at the conspiring hospitals within the San Antonio area by engaging in certain activities that violated the federal antitrust laws. The complaint alleges two separate claims. The first count asserts that the defendant hospitals violated Section 1 of the federal Sherman Act, which prohibits agreements that unreasonably restrain competition, by conspiring to depress nurses’ compensation. The second count alleges that the defendant hospital systems also violated Section 1 of the Sherman Act by participating in wage, salary and benefits surveys for the purpose, and having the effect, of depressing registered nurses’ compensation or limiting competition for nurses based on their compensation. The class on whose behalf the plaintiffs filed the complaint is alleged to comprise all registered nurses employed by the defendant hospitals since June 20, 2002. The suit seeks unspecified damages, trebling of this damage amount pursuant to federal law, interest, costs and attorneys fees. We believe that the allegations contained within this putative class action suit are without merit, and we intend to vigorously defend against the litigation.
On the same date that this suit was filed against us in federal district court in San Antonio, the same attorneys filed three other substantially similar putative class action lawsuits in federal district courts in Chicago, Illinois, Albany, New York and Memphis, Tennessee against some of the hospitals in those cities (none of which hospitals being owned by us). The attorneys representing the plaintiffs in all four of these cases have said that they may file similar complaints in other jurisdictions. Since representatives of the Service Employees International Union joined plaintiffs’ attorneys in announcing the filing of all four complaints on June 20, 2006, and as has been reported in the media, we believe that SEIU’s involvement in these actions appears to be part of a corporate campaign to attempt to organize nurses in these cities, including San Antonio. The nurses in our hospitals in San Antonio are currently not members of any union.
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Medicare Secondary Payor Act Litigation - Brockovich, on behalf of the United States of America v. Vanguard Health Systems, Inc., et al. Case No. SACV06-547 JVS(MLGx) (United States District Court, Central District of California, Southern Division, filed June 9, 2006)
In June 2006, Plaintiff Erin Brockovich, purportedly on behalf of the United States of America, filed a civil complaint in United States District Court in California claiming our violation of the Medicare Secondary Payer Act. In the complaint plaintiff alleged that we have inappropriately received and retained reimbursement from Medicare for treatment given to certain unidentified patients of our facilities whose injuries were caused by us as a result of unidentified and unadjudicated incidents of medical malpractice. Also, in June 2006 this same plaintiff filed identical lawsuits against more than 20 other companies that own hospitals and convalescent homes in California. In the case against us, plaintiff is seeking damages of twice the amount that defendants were allegedly obligated to pay or reimburse Medicare in connection with the treatment in question under the Medicare Secondary Payor Act, plus interest, together with plaintiff’s costs and fees, including attorneys’ fees. On July 25, 2006, we filed with the court a motion to dismiss this litigation (1) for failure to state a claim in so far as plaintiff has no standing to bring this action since she alleges no injury to herself as a result of our alleged acts and (2) for failure to state a cause of action since no court has ever held that claims may be brought under the Medicare Secondary Payer Act based upon unadjudicated and unidentified tort claims. We believe the allegations contained in this suit are without merit, and we intend to vigorously defend against the litigation.
Claims in the ordinary course of business.
We are also subject to claims and lawsuits arising in the ordinary course of business, including potential claims related to care and treatment provided at our hospitals and outpatient services facilities. Although the results of these claims and lawsuits cannot be predicted with certainty, we believe that the ultimate resolution of these ordinary course claims and lawsuits will not have a material adverse effect on our business, financial condition or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of stockholders during the fourth quarter ended June 30, 2006, except that the holders of 100% of our outstanding common stock approved our 2004 Stock Incentive Plan pursuant to a written consent dated May 9, 2006.
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
There is no established public trading market for our common stock. At September 1, 2006, there were five holders of record of our common stock. These holders are VHS Holdings LLC and four investment funds affiliated with Blackstone.
The Company has not declared or paid any dividends on its common stock in its two most recent fiscal years. We intend to retain all current and foreseeable future earnings to support operations and finance expansion. Our senior secured credit facility and the indentures governing our long-term indebtedness restrict our ability to pay cash dividends on our common stock. For information in respect of securities authorized under our equity compensation plans, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters – Equity Compensation Plan Information.”
During the quarterly period ended June 30, 2006, we issued the securities described in the next paragraph below that were not registered under the Securities Act of 1933. The transactions described below were conducted in reliance upon the exemption from registration provided in Rule 701 of the Securities Act for a sale of securities under a written compensatory benefit plan established by the issuer for the participation of its current and former employees. These sales were made without the use of an underwriter, and the certificate evidencing the securities issued in connection with each such transaction bears a restrictive legend permitting transfer of the securities only upon registration under the Securities Act or pursuant to an exemption from registration.
On April 17, 2006, for an aggregate purchase price of $36,000, we issued 36 shares of our common stock to a former employee upon his exercise of vested options which would have otherwise expired 90 days after his termination of employment. On May 10, 2006, for an aggregate purchase price of $29,000, we issued 29 shares of our common stock to a former employee upon his exercise of vested options which would have otherwise expired 90 days after his termination of employment.
Information regarding our equity compensation plans is set forth in this report under “Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters – Equity Compensation Plan Information”, which information is incorporated herein by reference.
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Item 6. Selected Financial Data.
The following table sets forth our selected historical financial and operating data for, or as of the end of, each of the five years ended June 30, 2006 (including the predecessor and successor periods). The selected historical financial data as of and for each of the predecessor years ended June 30, 2002, 2003, and 2004, the combined predecessor and successor year ended June 30, 2005 and the year ended June 30, 2006 were derived from our audited consolidated financial statements that have been audited by Ernst & Young LLP, an independent registered public accounting firm. Comparability of the selected historical financial and operating data has been impacted by the timing of acquisitions completed during fiscal 2002, 2003, 2004 and 2005. Please read the section on “Impact of Acquisitions” included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” This table should be read in conjunction with the consolidated financial statements and notes thereto.
| | Predecessor | | | Combined
Basis
Year
Ended
June 30,
2005 | | | Year ended
June 30,
2006 | | Predecessor
July 1, 2004
through
September
22,
2004 | | Successor
September 23,
2004
through
June 30, 2005 |
|
Year Ended June 30, |
|
2002 | 2003 | 2004 |
| |
| | |
| | |
| | |
| | |
| |
| |
|
| | (Dollars in millions, except Operating Data) |
Statement of Operations Data: | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Total revenues | | $ | 910.6 | | | $ | 1,340.5 | | | $ | 1,782.8 | | | $ | 2,268.9 | | | $ | 2,652.7 | | | $ | 449.6 | | | $ | 1,819.3 | |
Costs and expenses: | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Salaries and benefits (includes stock compensation
of $0, $0, $0.1, $97.4, $1.7, $96.7 and $0.7,
respectively) | | | 384.4 | | | | 578.4 | | | | 740.9 | | | | 1,033.4 | | | | 1,118.6 | | | | 275.4 | | | | 758.0 | |
Supplies | | | 116.1 | | | | 202.6 | | | | 283.0 | | | | 374.2 | | | | 428.9 | | | | 72.3 | | | | 301.9 | |
Medical claims expense | | | 132.0 | | | | 160.8 | | | | 211.8 | | | | 237.2 | | | | 270.3 | | | | 55.0 | | | | 182.2 | |
Provision for doubtful accounts | | | 53.3 | | | | 73.4 | | | | 118.2 | | | | 151.3 | | | | 178.1 | | | | 31.5 | | | | 119.8 | |
Other operating expenses | | | 152.8 | | | | 216.6 | | | | 256.0 | | | | 325.4 | | | | 401.9 | | | | 65.0 | | | | 260.4 | |
Depreciation and amortization | | | 29.5 | | | | 46.9 | | | | 64.7 | | | | 82.0 | | | | 107.5 | | | | 17.4 | | | | 64.6 | |
Interest, net | | | 26.7 | | | | 34.9 | | | | 43.1 | | | | 88.3 | | | | 111.0 | | | | 9.8 | | | | 78.5 | |
Debt extinguishment costs | | | 6.6 | | | | — | | | | 4.9 | | | | 62.2 | | | | 0.1 | | | | 62.2 | | | | — | |
Minority interests | | | 0.8 | | | | 0.7 | | | | (2.5 | ) | | | (0.4 | ) | | | 2.5 | | | | (0.5 | ) | | | 0.1 | |
Merger expenses | | | — | | | | — | | | | — | | | | 23.3 | | | | — | | | | 23.1 | | | | 0.2 | |
Impairment expense | | | — | | | | — | | | | — | | | | — | | | | 15.0 | | | | — | | | | — | |
Other expenses | | | (1.3 | ) | | | (1.6 | ) | | | (2.3 | ) | | | 3.7 | | | | (4.5 | ) | | | 0.4 | | | | 3.3 | |
| | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| |
Subtotal | | | 900.9 | | | | 1,312.7 | | | | 1,717.8 | | | | 2,380.6 | | | | 2,629.4 | | | | 611.6 | | | | 1,769.0 | |
| | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| |
Income (loss) before income taxes | | | 9.7 | | | | 27.8 | | | | 65.0 | | | | (111.7 | ) | | | 23.3 | | | | (162.0 | ) | | | 50.3 | |
Income tax expense (benefit) | | | 2.9 | | | | 10.9 | | | | 24.9 | | | | (33.6 | ) | | | 10.4 | | | | (51.3 | ) | | | 17.7 | |
| | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| |
Net income (loss) | | | 6.8 | | | | 16.9 | | | | 40.1 | | | | (78.1 | ) | | | 12.9 | | | | (110.7 | ) | | | 32.6 | |
Preferred dividends | | | (1.8 | ) | | | (2.8 | ) | | | (4.0 | ) | | | (1.0 | ) | | | — | | | | (1.0 | ) | | | — | |
| | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| |
Net income (loss) attributable to common
stockholders | | $ | 5.0 | | | $ | 14.1 | | | $ | 36.1 | | | $ | (79.1 | ) | | $ | 12.9 | | | $ | (111.7 | ) | | $ | 32.6 | |
| | |
| | | |
| | | |
| | | |
| | | |
| | | |
| | | |
| |
Balance Sheet Data: | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Assets | | $ | 851.9 | | | $ | 1,226.9 | | | $ | 1,427.8 | | | $ | 2,471.7 | | | $ | 2,650.5 | | | | | | | $ | 2,471.7 | |
Long-term debt, including current portion | | | 314.8 | | | | 479.4 | | | | 623.5 | | | | 1,357.1 | | | | 1,519.2 | | | | | | | | 1,357.1 | |
Payable-in-Kind Preferred Stock | | | 24.1 | | | | 57.0 | | | | 61.0 | | | | — | | | | — | | | | | | | | — | |
Working capital | | | 87.9 | | | | 37.1 | | | | 162.7 | | | | 77.7 | | | | 149.7 | | | | | | | | 77.7 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Other Financial Data: | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Capital expenditures | | $ | 35.1 | | | $ | 98.5 | | | $ | 151.0 | | | $ | 238.2 | | | $ | 284.5 | | | $ | 29.8 | | | $ | 208.4 | |
Cash provided by operating activities | | | 44.7 | | | | 117.7 | | | | 109.0 | | | | 201.8 | | | | 149.3 | | | | 78.8 | | | | 123.0 | |
Cash used in investing activities | | | (135.4 | ) | | | (344.0 | ) | | | (225.1 | ) | | | (324.3 | ) | | | (245.4 | ) | | | (50.0 | ) | | | (274.3 | ) |
Cash provided by (used in) financing activities | | | 134.0 | | | | 198.1 | | | | 139.0 | | | | 151.6 | | | | 140.5 | | | | (20.0 | ) | | | 171.6 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Operating Data: (unaudited) | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Number of hospitals at end of period | | | 10 | | | | 15 | | | | 16 | | | | 19 | | | | 19 | | | | | | | | | |
Number of licensed beds at end of period (a) | | | 2,207 | | | | 3,666 | | | | 3,784 | | | | 4,557 | | | | 4,587 | | | | | | | | | |
Discharges (b) | | | 75,364 | | | | 114,327 | | | | 147,600 | | | | 171,110 | | | | 182,386 | | | | | | | | | |
Adjusted discharges - hospitals (c) | | | 111,692 | | | | 167,166 | | | | 215,958 | | | | 262,780 | | | | 289,333 | | | | | | | | | |
Net revenue per adjusted discharge – hospitals (d) | | $ | 6,006 | | | $ | 6,290 | | | $ | 6,477 | | | $ | 6,899 | | | $ | 7,421 | | | | | | | | | |
Patient days (e) | | | 305,370 | | | | 477,791 | | | | 619,465 | | | | 731,797 | | | | 802,650 | | | | | | | | | |
Adjusted patient days – hospitals (f) | | | 452,768 | | | | 691,286 | | | | 906,358 | | | | 1,123,846 | | | | 1,273,304 | | | | | | | | | |
Average length of stay (days) (g) | | | 4.1 | | | | 4.2 | | | | 4.2 | | | | 4.3 | | | | 4.4 | | | | | | | | | |
Outpatient surgeries (h) | | | 37,245 | | | | 49,745 | | | | 60,717 | | | | 73,921 | | | | 81,240 | | | | | | | | | |
Emergency room visits (i) | | | 296,732 | | | | 392,972 | | | | 511,066 | | | | 591,886 | | | | 645,539 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
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| | Predecessor | | | Combined
Basis
Year
Ended
June 30,
2005 | | | Year ended
June 30,
2006 | | Predecessor
July 1, 2004
through
September
22,
2004 | | Successor
September 23,
2004
through
June 30, 2005 |
|
Year Ended June 30, |
|
2002 | 2003 | 2004 |
| |
| | |
| | |
| | |
| | |
| |
| |
|
| | (Dollars in millions, except Operating Data) |
Occupancy rate (j) | | | 46.1% | | | | 44.9% | | | | 45.0% | | | | 48.1% | | | | 48.3% | | | | | | | | | |
Average daily census (k) | | | 837.0 | | | | 1,309.0 | | | | 1,693.0 | | | | 2,005.0 | | | | 2,199.0 | | | | | | | | | |
Member lives (l) | | | 122,500 | | | | 130,700 | | | | 142,200 | | | | 146,700 | | | | 146,200 | | | | | | | | | |
Medical claims expense percentage (m) | | | 71.4% | | | | 73.5% | | | | 72.1% | | | | 71.1% | | | | 72.1% | | | | | | | | | |
____________________ |
(a) | | Licensed beds are those beds for which a facility has been granted approval to operate from the applicable state licensing agency. |
| | |
(b) | | Discharges represent the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatient volumes. |
| | |
(c) | | Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined inpatient and outpatient volumes. Adjusted discharges-hospitals is computed by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation enables management to assess hospital volumes by a combined measure of inpatient and outpatient utilization. |
| | |
(d) | | Net revenue per adjusted discharge-hospitals is calculated by dividing hospital net patient revenues by adjusted discharges-hospitals and measures the average net payment expected to be received for a patient’s stay in the hospital. |
| | |
(e) | | Patient days represent the number of days (calculated as overnight stays) our beds were occupied by patients during the periods. |
| | |
(f) | | Adjusted patient days-hospitals is calculated by multiplying patient days by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation is an indicator of combined inpatient and outpatient volumes. |
| | |
(g) | | Average length of stay represents the average number of days an admitted patient stays in our hospitals. |
| | |
(h) | | Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stays not necessary). |
| | |
(i) | | Emergency room visits represent the number of patient visits to a hospital or freestanding emergency room where treatment is received, regardless of whether an overnight stay is subsequently required. |
| | |
(j) | | Occupancy rate represents the percentage of hospital licensed beds occupied by patients. Occupancy rate provides a measure of the utilization of inpatient rooms. |
| | |
(k) | | Average daily census represents the average number of patients in our hospitals each day during our ownership. |
| | |
(l) | | Member lives represent the total number of enrollees in PHP, AAHP and MHP as of the end of the respective period. |
| | |
(m) | | Medical claims expense percentage is calculated by dividing medical claims expense by premium revenues. |
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Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations.
The following discussion and analysis of our financial condition and results of operations covers periods both prior to and subsequent to the Merger (as discussed below). Accordingly, the discussion and analysis of historical periods do not reflect the significant impact of the Merger. We have presented the information for the year ended June 30, 2005 on a predecessor period and successor period combined basis to facilitate meaningful comparisons of those operating results to the years ended June 30, 2004 and June 30, 2006. You should read the following discussion together with our historical financial statements and related notes included elsewhere herein and the information set forth under “Item 6. Selected Financial Data.”
The discussion contains forward-looking statements that involve risks and uncertainties. For additional information regarding some of the risks and uncertainties that affect our business and the industry in which we operate, please read “Item 1A. - Risk Factors” included elsewhere herein. Our actual results may differ materially from those estimated or projected in any of these forward-looking statements.
Merger Transaction
On September 23, 2004, The Blackstone Group and certain of its affiliates (collectively “Blackstone”) purchased approximately 66% of our equity interests (the “Merger”). Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively “MSCP”) and certain of our senior members of management and other shareholders (collectively the “Rollover Management Investors”) purchased the remaining 34% of our equity interests. The transaction was treated as a leveraged buyout purchase for accounting purposes. In connection with the Merger, we repaid $299.0 million of our outstanding $300.0 million 9.75% senior subordinated notes (we repaid the remaining $1.0 million in October 2005), our outstanding $17.6 million 8.18% subordinated notes and the $300.0 million Term B loans outstanding under our 2004 senior secured credit facility. We financed the Merger by issuing $575.0 million of 9.0% senior subordinated notes (the “9.0% Notes”), by issuing 11.25% senior discount notes (the “11.25% Notes”) having an aggregate principal amount at maturity of $216.0 million, by borrowing $475.0 million of initial Term B loans under new senior secured credit facilities (the “merger credit facilities”) and with equity proceeds totaling approximately $749.0 million (valued at approximately $635.7 million for accounting purposes). Certain members of senior management also purchased $5.7 million of the equity incentive units in VHS Holdings LLC. The merger credit facilities include a $250.0 million revolving credit facility, of which $42.8 million of capacity was utilized for letters of credit (with no outstanding borrowings) as of June 30, 2006. The merger credit facilities also included $325.0 million in delayed draw term loan facilities. We borrowed $60.0 million under the delayed draw term loan facilities to finance the acquisition of three acute-care hospitals and related healthcare businesses in Massachusetts from subsidiaries of Tenet Healthcare Corporation on December 31, 2004, and we borrowed $90.0 million on February 18, 2005 to fund the working capital buildup of the Massachusetts hospitals and to fund capital expenditures. We borrowed the remaining $175.0 million under the delayed draw term loan facilities during September 2005.
Executive Overview
We own and operate 19 hospitals with a total of 4,587 licensed beds, and related outpatient service facilities complementary to the hospitals in San Antonio, Texas, metropolitan Phoenix, Arizona, metropolitan Chicago, Illinois, Orange County, California, and Massachusetts. We own three health plans as detailed in the following table.
Health Plan | | | Location | | June 2006
Membership | |
| | | |
| |
| |
Phoenix Health Plan (“PHP”) – managed Medicaid | | | Arizona | | 96,700 | |
Abrazo Advantage Health Plan (“AAHP”) – managed Medicare and Dual Eligible | | | Arizona | | 3,500 | |
MacNeal Health Providers (“MHP”) – capitated outpatient services | | | Illinois | | 46,000 | |
| | | | |
| |
| | | | | 146,200 | |
| | | | |
| |
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Our objective is to provide high-quality, cost-effective healthcare services through an integrated delivery platform serving the needs of the communities in which we operate. We focus our business development efforts and capital resource investments on geographic markets and individual hospitals where we see an opportunity to expand services, improve operating performance and achieve a competitive position in the market. We were incorporated in July 1997 and acquired our first hospital, Maryvale Hospital, on June 1, 1998.
We have implemented multiple operating strategies to achieve our mission of providing high-quality, cost-effective healthcare services in the communities we serve. We consider the following to be the most important of these strategies: quality of care and patient safety; expansion of services; nurse and physician relations; compliance and ethics; and resource allocation. We believe the successful implementation of these strategies and initiatives will improve our operating results and our competitive position in the communities we serve. However, there are many risks and uncertainties, including those discussed in the “Risk Factors” section of this document, that make it more difficult for us to achieve our objectives and could limit our ability to realize improved operating results.
Business Strategies
Specific action steps we are taking to implement our business strategies are set forth below.
• | | Commitment to quality of care and safety. We believe that our success will be determined by the quality of care we provide and our ability to provide a safe environment for our patients to receive care. We believe our commitment to quality of care and safety must start at the top. We have employed chief medical officers at the regional level to review and improve clinical protocols and have maintained an active role on hospital governing boards to promote quality initiatives and staff education programs. We have implemented or are in the process of implementing the following initiatives: 1) investing in clinical information systems that will allow us to standardize compliance reporting of more than 40 quality and safety indicators across our hospitals including quality dashboard metrics; 2) dedicating resources such as rapid response teams to make the delivery of care more efficient; 3) revising clinical protocols where needed to minimize patient falls and worker injuries, 4) developing expanded peer groups against which to measure our progress and success; and 5) utilizing CAHPS patient satisfaction surveys at our hospitals. Our goal is to achieve a top 10% compliance rate with quality and safety standards. |
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• | | Expanding the range of healthcare services provided by our facilities. Each of the markets we serve is unique. We believe that a key factor in increasing patient volumes is to provide the range of services that our patients need. Our strategy of developing market-focused regional healthcare systems provides us greater flexibility in improving the quality, convenience and efficiency of healthcare services. As we expand our service offerings and grow patient volumes, we seek to recruit and retain physicians and nurses and to invest resources in capital projects including upgrading our existing facility framework and expanding facilities. Expanding facilities may include constructing new facilities or increasing capacities at existing facilities. By the end of calendar 2006, we expect to have completed construction at two San Antonio hospitals and one Arizona hospital to expand emergency services, surgery and labor and delivery units. We have also begun expansion projects at three other hospitals that we expect to complete during fiscal 2007 and 2008. |
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• | | Becoming the employer of choice in the markets we serve and attracting quality physicians. Providing high-quality, efficient healthcare services to our patients begins with having skilled physicians, nurses and employees at our hospitals who share our ideals and beliefs. We plan to continue to invest heavily in training programs to provide upward mobility for our employees. These programs include expanded degree and designation programs in our nursing schools in San Antonio and Phoenix and development of a senior management training program intended to attract candidates both within and external to our existing hospitals. We believe the best physicians want to work with hospital management and nurses who are proven leaders and who are dedicated to service excellence. |
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| | Our goal is to recruit over 150 physicians to our facilities during fiscal 2007 with primary emphasis on family practice and internal medicine, internists, obstetrics and gynecology, cardiology and orthopedics. This recruiting effort will include many employed physicians, and we may provide incentives for many of the non-employed physicians to move their practices to our communities where primary or specialty care is needed. We maintain residency programs at certain of our hospitals including a residency arrangement with the University of Chicago School of Medicine at our MacNeal and Weiss hospitals. We also intend to increase our participation, consistent with applicable laws, in the development of joint venture partnerships with physicians in those situations where such relationships fit our strategic objectives. |
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• | | Furthering our commitment to ethics and compliance. We are committed to respecting the privacy of our patients and delivering care in all of our facilities that is founded on a common set of ethical beliefs and behaviors. We expect all of our employees and physicians to share in this commitment. During the past twelve months we allocated significant resources to strengthen our comprehensive corporate compliance program. We employed regional compliance officers to monitor employee compliance training, physician relations and compliance with state and federal regulations. The regional compliance officers report directly to our Chief Compliance Officer who reports jointly to our Chairman and Chief Executive Officer and to our board of directors. We also plan to make our employee orientation process more comprehensive to reinforce our commitment to ethics and compliance and to promote ownership in these values to our employees. |
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• | | Allocating resources to strategic geographical markets. We expect to continue allocating resources to existing markets or to acquire hospitals in new markets where we can obtain significant market share and capture additional business from the aging U.S. population. According to the U.S. Census Bureau there were approximately 35 million Americans aged 65 or older in the United States in 2000, comprising approximately 12.4% of the total U.S. population. The number of these elderly persons is expected to climb to 40 million, or 13.0% of the total population by 2010 and to nearly 55 million or 16.3% of the total population by 2020. We believe our capital investment initiatives will position us to capitalize on this demographic trend. Growing our presence in the communities we serve will make our delivery of care more efficient, will provide greater flexibility in negotiations with managed care and other third party payers and will aid in our recruiting initiatives. |
Impact of Acquisitions
Acquiring acute care hospitals in urban and suburban markets that fit our strategic objectives is a key part of our business strategy. Since we have grown most years through acquisitions, it is difficult to make meaningful comparisons between our financial statements for certain of the fiscal periods presented. In addition, since we own a relatively small number of hospitals, even a single hospital acquisition can have a material effect on our overall operating performance. When we acquire a hospital, we generally implement a number of measures to lower costs, and we often make significant investments in the facility to expand services, strengthen the medical staff and improve our overall market position. The effects of these initiatives are not generally realized immediately. Therefore, the financial performance of a newly acquired hospital may adversely affect our overall performance in the short term.
On December 31, 2004, we acquired three acute-care hospitals with a then total of 768 licensed beds and related healthcare businesses located in or around Worcester, Framingham and Natick, Massachusetts (the “Massachusetts hospitals”) from subsidiaries of Tenet Healthcare Corporation for $87.7 million. We funded the purchase price and the subsequent buildup of working capital by borrowing $150.0 million in acquisition delayed draw term loans during December 2004 and February 2005. The acquisition of these hospitals gave us an established presence in the suburban Boston and central Massachusetts areas with an opportunity to grow the hospitals by adding new services. Operating results for the Massachusetts hospitals are included in our consolidated statements of operations for the second half of our fiscal year ended June 30, 2005 and all of our fiscal year ended June 30, 2006.
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Revenue/Volume Trends
Our revenues depend upon inpatient occupancy levels, outpatient procedures performed at our facilities, the ancillary services and therapy programs ordered by physicians and provided to patients and our ability to successfully negotiate appropriate rates for these services with third party payers. During the year ended June 30, 2006, we experienced a 6.6% increase in discharges and a 10.1% increase in hospital adjusted discharges compared to the same period in fiscal 2005 due to the acquisition of the Massachusetts hospitals. On a same hospital basis, period over period discharges and hospital adjusted discharges decreased by 2.5% and 1.7%, respectively.
The following table provides details of discharges by payer for the years ended June 30, 2004, 2005 and 2006.
| | Year ended June 30, | |
| |
| |
| | 2004 | | 2005 | | 2006 | |
| |
| |
| |
| |
Medicare | | 45,236 | | 52,543 | | 53,704 | |
Medicaid | | 16,421 | | 20,871 | | 23,880 | |
Managed care(1) | | 79,309 | | 89,938 | | 95,994 | |
Self pay | | 4,816 | | 5,247 | | 5,932 | |
Other | | 1,818 | | 2,511 | | 2,876 | |
| |
| |
| |
| |
Total | | 147,600 | | 171,110 | | 182,386 | |
| |
| |
| |
| |
____________________ |
(1) | | Includes discharges under managed Medicare, managed Medicaid and other governmental managed plans in addition to commercial managed care plans. |
We attribute the decrease in same hospital discharges to a general reduction in demand for inpatient healthcare services during the current year period as a result of fewer admissions for respiratory illnesses and decreases in rehabilitation discharges as a result of regulatory changes. We expect our inpatient volumes to improve over the long-term as a result of service expansion initiatives, new contracts negotiated with managed care providers and our market-driven management strategies. We also expect that as we complete our significant expansion projects, patient volumes will improve at those facilities where growth is currently constrained by physical plant limitations and patient throughput inefficiencies. However, the success of our growth initiatives is dependent upon maintaining the community’s confidence in our services and staying ahead of the competition in the markets we serve. Continued weakened demand for hospital healthcare services could negate these growth initiatives in the short-term.
The majority of our patient service revenues are based on negotiated, per diem or pre-determined payment structures. Our facilities’ gross charges typically do not reflect what the facilities are actually paid. In addition to volume factors described above, patient mix, acuity factors and pricing trends affect our patient service revenues. Net patient revenues per adjusted hospital discharge increased 7.6% from $6,899 during fiscal 2005 to $7,421 during fiscal 2006. This increase reflects improved reimbursement for services provided under negotiated managed care contracts, improved Medicare reimbursements and changes in the mix of services provided. Increases in levels of charity care and negotiated self-pay discounts also impact this statistic by decreasing revenues and decreasing the provision for doubtful accounts. On a same hospital basis, net patient revenues per adjusted hospital discharge increased by 8.1% to $7,468 during fiscal 2006 from $6,907 during fiscal 2005. We cannot assure you that future reimbursement rates, even if improved, will sufficiently cover potential increases in the cost of providing healthcare services to our patients.
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We recognize premium revenues from our three health plans, PHP, AAHP and MHP. AAHP commenced operations on January 1, 2006 to provide healthcare services for Medicare Part D recipients and for those individuals eligible for Medicare who also receive full Medicaid benefits. As of June 30, 2006, approximately 3,500 members were enrolled in this program, most of whom were previously enrolled in PHP. PHP’s membership decreased to approximately 96,700 at June 30, 2006 compared to approximately 100,200 at June 30, 2005. Premium revenues from these three plans increased by $41.5 million or 12.4% during the year ended June 30, 2006 compared to the prior year period. This increase resulted primarily from the increased per member per month reimbursement from AAHP during our third and fourth fiscal quarters. PHP’s per member per month reimbursement rate also increased effective October 1, 2005. We do not anticipate a significant increase in membership for our health plan reporting segment during our fiscal year ending June 30, 2007 but could realize significant membership increases during future fiscal years. PHP’s contract with the Arizona Health Care Cost Containment System (“AHCCCS”) commenced on October 1, 2003 and ends of September 30, 2007 with an option for AHCCCS to renew the contract for an additional one-year period. AAHP’s contract with the Centers for Medicare and Medicaid Services (“CMS”) went into effect on January 1, 2006 for a term of one year with a provision for successive year renewals. Should the PHP contract terminate, our future operating results and cash flows could be materially reduced.
General Trends
The following paragraphs discuss recent trends that we believe are significant factors in our current and/or future operating results and cash flows. While these trends may involve certain factors that are outside of our control, the extent to which these trends affect us and our ability to manage the impact of these trends play vital roles in our current and future success. In many cases, we are unable to predict what impact these trends, if any, will have on us.
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Accounts Receivable Collection Risks Leading to Increased Bad Debts
Similar to others in the hospital industry, the collectibility of our accounts receivable has deteriorated primarily due to an increase in self-pay accounts receivable. The following table provides a summary of our accounts receivable by age since discharge date by payer type as of June 30, 2004, 2005 and 2006 (in millions).
June 30, 2004 | | 0-90 days | | | 91-180 days | | Over 180 days | | Total |
| |
| | |
| |
| |
|
Medicare | | $ | 71.4 | | | $ | 3.0 | | $ | 2.6 | | $ | 77.0 |
Medicaid | | | 28.0 | | | | 5.9 | | | 4.1 | | | 38.0 |
Managed Care | | | 147.3 | | | | 17.4 | | | 8.4 | | | 173.1 |
Self Pay(1) | | | 42.2 | | | | 35.3 | | | 10.2 | | | 87.7 |
Other | | | 11.8 | | | | 2.7 | | | 1.6 | | | 16.1 |
| | |
| | | |
| | |
| | |
|
Total(3) | | $ | 300.7 | | | $ | 64.3 | | $ | 26.9 | | $ | 391.9 |
| | |
| | | |
| | |
| | |
|
| | | | | | | | | |
June 30, 2005 | | 0-90 days(2) | | | 91-180 days(2) | | Over 180 days | | Total |
| |
| | |
| |
| |
|
Medicare | | $ | 95.9 | | | $ | 5.5 | | $ | 2.3 | | $ | 103.7 |
Medicaid | | | 43.1 | | | | 12.1 | | | 7.3 | | | 62.5 |
Managed Care | | | 204.1 | | | | 21.2 | | | 10.1 | | | 235.4 |
Self Pay(1) | | | 53.8 | | | | 45.4 | | | 10.0 | | | 109.2 |
Other | | | 17.8 | | | | 6.0 | | | 1.8 | | | 25.6 |
| | |
| | | |
| | |
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|
Total(3) | | $ | 414.7 | | | $ | 90.2 | | $ | 31.5 | | $ | 536.4 |
| | |
| | | |
| | |
| | |
|
| | | | | | | | | |
June 30, 2006(2) | | 0-90 days | | | 91-180 days | | Over 180 days | | Total |
| |
| | |
| |
| |
|
Medicare | | $ | 93.7 | | | $ | 5.4 | | $ | 3.5 | | $ | 102.6 |
Medicaid | | | 40.6 | | | | 11.6 | | | 7.2 | | | 59.4 |
Managed Care | | | 208.6 | | | | 24.0 | | | 11.9 | | | 244.5 |
Self Pay(1) | | | 58.8 | | | | 51.7 | | | 11.9 | | | 122.4 |
Other | | | 14.7 | | | | 5.3 | | | 2.3 | | | 22.3 |
| | |
| | | |
| | |
| | |
|
Total(3) | | $ | 416.4 | | | $ | 98.0 | | $ | 36.8 | | $ | 551.2 |
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| | | |
| | |
| | |
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____________________
(1) Includes uninsured patients and those patient co-insurance and deductible amounts for which payment has been received from the
primary payer. If primary payment has not been received for an account, the patient co-insurance and deductible amounts remain
classified in the primary payer category.
(2) Includes accounts receivable balances for the Massachusetts hospitals acquired on December 31, 2004.
(3) The total accounts receivable balances reflected on these tables differ from the net accounts receivable balances as stated on the
consolidated balance sheets for those respective periods because the balance sheet accounts receivable amounts are reduced by manual
contractual allowances for unbilled patient accounts, certain billed patient accounts and for cash payments received but not posted to
patient accounts, whereas those deductions are not reflected on the aging reports. The table below provides a reconciliation of these
amounts.
| | | June 30,
2005 | | | June 30,
2006 |
| | |
| | |
|
| | | (In millions) |
| | | | | | |
Accounts receivable per aging report | | $ | 536.4 | | $ | 551.2 |
Less: Allowance for doubtful accounts | | | (90.1) | | | (103.5) |
Less: Manual contractual allowances for unbilled patient accounts | | | (116.1) | | | (118.4) |
Less: Manual contractual allowances for certain billed patient accounts | | | (36.0) | | | (22.5) |
Less: Unposted cash receipts and other | | | (8.2) | | | (12.7) |
| | |
| | |
|
Net accounts receivable reflected on the consolidated balance sheets | | $ | 286.0 | | $ | 294.1 |
| | |
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|
Our combined allowance for bad debts and allowance for charity care covered 90.5% and 93.4% of self-pay accounts receivable as of June 30, 2005 and 2006, respectively.
The increase in self-pay accounts receivable has led to increased write-offs and older accounts receivable outstanding, resulting in the need for an increased allowance for doubtful accounts. The increase in self-pay accounts receivable results from a combination of factors including increased patient volumes, price increases, higher levels of patient deductibles and co-insurance under managed care programs and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay for escalating healthcare costs. We have implemented policies and procedures designed to expedite upfront cash collections and promote repayment plans from our patients. Our upfront cash collections increased by 3.6% on a same hospital basis during fiscal 2006 compared to fiscal 2005. However, we believe bad debts will remain sensitive to changes in payer mix, pricing and general economic conditions for the hospital industry during the foreseeable future.
Expansion of Charity Care and Self-Pay Discount Programs
We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We exclude charity care accounts from revenues when we determine that the account meets our charity care guidelines. In June 2004, we adopted revised policies that provide expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. CMS has indicated that it is aware of no regulations or guidelines preventing implementation of such policies. During the fiscal years ended 2004, 2005 and 2006, we deducted $37.1 million, $55.6 million and $77.8 million of charity care from revenues, respectively. During fiscal 2006, we began tracking healthcare services provided to undocumented aliens and recording those costs as charity care deductions. Payments received for these services are recorded as a decrease to charity deductions when received. These costs, net of $1.3 million of payments received, accounted for $14.4 million of our charity care deductions during fiscal 2006. Prior to fiscal 2006, these accounts were classified as self-pay and were subject to our allowance for doubtful accounts policy.
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Medicaid Funding Cuts
Many states, including certain states in which we operate, have periodically reported budget deficits as a result of increased costs and lower than expected tax collections. Health and human service programs, including Medicaid and similar programs, represent a significant component of state spending. To address these budgetary concerns, certain states have decreased funding for these programs and other states may make similar funding cuts. These cuts may include tightened participant eligibility standards, reduction of benefits, enrollment caps or payment reductions. Additionally, pressure exists at the federal level to reduce Medicaid matching funds provided to states as evidenced by a budget resolution set forth by Congress in April 2005 calling for $10.0 billion in cuts to federal funding of the Medicaid program over a five-year period. We are unable to assess the financial impact of enacted or proposed state or federal funding cuts at this time.
Volatility of Professional Liability Costs
We maintain professional and general liability insurance coverage through a wholly owned captive insurance subsidiary for individual claims incurred through May 31, 2006 up to $10.0 million. For claims incurred subsequent to May 31, 2006, we self-insure the first $9.0 million per occurrence, and the captive subsidiary insures the next $1.0 million per occurrence. We maintain excess insurance coverage with independent third party carriers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. The total cost of professional and general liability insurance is sensitive to the volume and severity of cases reported. Malpractice premiums have adversely affected the ability of physicians to obtain malpractice insurance at reasonable rates in certain markets, particularly in metropolitan Chicago, Illinois, resulting in physicians relocating to different geographic areas. In the event physicians practicing in our hospitals are unable to obtain adequate malpractice insurance coverage, our hospitals are likely to incur a greater percentage of the amounts paid to claimants. Our professional liability exposures also increase when we employ physicians. Some states, including Texas and Illinois, have recently passed tort reform legislation to place limits on non-economic damages. While we have implemented multiple steps at our facilities to reduce our professional liability exposures, absent significant additional legislation to curb the size of malpractice judgments in other states in which we operate, our insurance costs may increase in the future.
Nursing Shortage and Nursing Ratio Requirements
The hospital industry continues to face a nationwide shortage of nurses. We have experienced particular difficulties in retaining and recruiting nurses in our metropolitan Phoenix, Arizona, and Orange County, California markets. As a result of this shortage, we have utilized more contract labor resources that are typically more costly and less reliable than employed nurses. We expect this shortage to continue for the foreseeable future. We expect to mitigate the effects of the nursing shortage by expanding our comprehensive nurse recruiting and retention program. This program includes the following key components, among others:
• | | Nursing schools in San Antonio and Phoenix |
• | | Foreign nurse recruiting initiatives |
• | | Tuition reimbursement and internal training to promote career advancement opportunities, including specialization qualifications |
• | | Extern programs and campus events to network with students |
• | | Preceptor and other mentoring programs |
• | | Expansion of orientation programs and employee involvement initiatives |
• | | Performance leadership training for managers and directors |
• | | Flexible work hours for nurses |
• | | Quality of care and employee safety initiatives |
• | | Competitive pay and benefits and nursing recognition programs |
We operate the Baptist Health System School of Health Professions (“SHP”) in San Antonio, which offers eight different programs with the greatest enrollment in the professional nursing program. The SHP trains approximately 400 students each year, the majority of which we expect to choose permanent employment with us. SHP expects total enrollment for fall 2006 to increase by 99 students or 32.5% compared to fall 2005 enrollment. Plans are underway to transition SHP’s current diploma program to a degree granting program that will be more
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attractive to potential students. SHP enrollment includes approximately 80 students in our metropolitan Phoenix market that are trained using state of the art distance learning technology maximizing utilization of SHP instructors. Students are provided with company-funded scholarships that cover tuition, books and fees in return for a commitment to work at one of our hospitals for a defined period of time. Should we be unsuccessful in our attempts to maintain adequate nursing staff for our present and future needs, our future operating results could be adversely impacted.
Effective January 1, 2004, minimum nurse to patient ratios for various hospital departments went into effect in the state of California. These requirements apply at all times, including scheduled break and meal periods, and place an additional burden on our already challenging California nurse staffing strategies. Even more stringent ratios for medical/surgical units took effect in California in 2005. We estimate that our additional staffing costs from existing regulations approximate $5.1 million on an annual basis in California. If similar regulations were adopted in other states in which we operate, our future operating results and cash flows could be materially adversely affected.
Increased Cost of Compliance in a Heavily Regulated Industry
We conduct business in a heavily regulated industry. Accordingly, we maintain a comprehensive, company-wide compliance program to address healthcare regulatory and other compliance requirements since if a determination were ever made that we were in material violation of any of the federal or state statutes regulating our healthcare operations, our operations and financial results could be materially adversely affected. This compliance program includes, among other things, initial and periodic ethics and compliance training, a toll-free reporting hotline for employees, annual fraud and abuse audits and annual coding audits. The organizational structure of our compliance program includes oversight by our board of directors and a high-level corporate management compliance committee. Our Senior Vice President of Compliance and Ethics reports jointly to our Chairman and Chief Executive Officer and to our board of directors, serves as Chief Compliance Officer and is charged with direct responsibility for the day-to-day management of our compliance program. During fiscal 2006, we established six regional compliance officers in our markets and staffed the new positions with professionals 100% dedicated to compliance duties. The financial resources necessary for program oversight, enforcement and periodic improvements to our program continue to grow, especially when we add new features to our program or engage external resources to assist with these highly complex matters.
Critical Accounting Policies
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing these financial statements, we make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses included in the financial statements. Management bases its estimates on historical experience and other available information, the results of which form the basis of the estimates and assumptions. We consider the following accounting policies to be critical accounting policies because they involve the most subjective and complex assumptions and assessments, are subject to a great degree of fluctuation period over period and are the most critical to our operating performance.
Revenues and Revenue Deductions
We recognize patient service revenues during the period the healthcare services are provided based upon estimated amounts due from payers. We estimate contractual adjustments and allowances based upon payment terms set forth in managed care health plan contracts and by federal and state regulations. For the majority of our patient service revenues, contractual adjustments are applied to patient accounts at the time of billing using specific payer contract terms entered into the accounts receivable systems, but in some cases we record an estimated allowance until we receive payment. We derive most of our patient service revenues from healthcare services provided to patients with Medicare or managed care insurance (including commercial insurance) coverage. During fiscal 2005 and 2006, combined Medicare and managed care revenues accounted for 77% and 79% of net patient revenues, respectively. For those same periods, Medicaid revenues accounted for 7% of net patient revenues. Services provided to Medicare patients are generally reimbursed at prospectively determined rates per diagnosis (“PPS”), while services provided to managed care patients are generally reimbursed based upon predetermined rates per diagnosis, per diem rates or discounted fee-for-service rates. Medicaid reimbursements vary by state. Other than
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Medicare, no individual payer represents more than 10% of our patient service revenues, either on a gross or net basis.
Medicare regulations and our principal managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in our healthcare facilities. To obtain reimbursement for certain services under the Medicare program, we must submit annual cost reports and record estimates of amounts owed to or receivable from Medicare. These cost reports include complex calculations and estimates related to indirect medical education, reimbursable Medicare bad debts and other items that are often subject to interpretation that could result in payments that differ from our estimates. We make our estimates of amounts owed to or receivable from the Medicare program using the best information available to us and our interpretation of the applicable Medicare regulations. We include differences between original estimates and subsequent revisions to those estimates (including final cost report settlements) in the consolidated statements of operations in the period in which the revisions are made. During the years ended June 30, 2004, 2005 and 2006, we recorded increases to patient service revenues of $10.9 million, $6.1 million and $11.9 million, respectively, related to changes in estimated third party settlements as a result of receipt of notices of provider reimbursement or final audited cost reports. Additionally, updated regulations and contract negotiations occur frequently, which necessitates continual review of estimation processes by management. We believe that future adjustments to our current third party settlement estimates will not significantly impact our results of operations or statement of position.
We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We deduct charity care accounts from revenues when we determine that the account meets our charity care guidelines. In June 2004, we adopted revised policies that provide expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. During the years ended June 30, 2004, 2005 and 2006, we deducted $37.1 million, $55.6 million and $77.8 million of charity care from revenues, respectively.
We had premium revenues of $293.8 million, $333.5 million and $375.0 million during the years ended June 30, 2004, 2005 and 2006, respectively. Our health plans have agreements with AHCCCS, CMS and various health maintenance organizations (“HMOs”) to contract to provide medical services to subscribing participants. Under these agreements, our health plans receive monthly payments based on the number of HMO participants in MHP or the number and coverage level of enrollees in PHP and AAHP. Our health plans recognize the payments as revenues in the month in which members are entitled to healthcare services, with the exception of AAHP reinsurance premiums and low income subsidy cost sharing premiums that are recorded as a liability to fund future healthcare costs.
Allowance for Doubtful Accounts and Provision for Doubtful Accounts
Our ability to collect the self-pay portions of outstanding receivables is critical to our operating performance and cash flows. The allowance for doubtful accounts was approximately 24.0% and 26.0% of accounts receivable, net of contractual discounts, as of June 30, 2005 and 2006, respectively. The primary collection risk relates to uninsured patient accounts and patient accounts for which primary insurance has paid but patient deductibles or co-insurance portions remain outstanding. We estimate the allowance for doubtful accounts using a standard policy that reserves 100% of all accounts aged greater than 180 days subsequent to discharge date plus a pre-determined percentage of accounts receivable due from patients less than 180 days old. We adjust our estimate as necessary on a quarterly basis using a hindsight calculation that utilizes write-off data for all payer classes duringthe previous twelve-month period to estimate the allowance for doubtful accounts at a point in time. We also monitor cash collections and self-pay utilization. We believe that our standard policy is flexible to adapt to changing collection and self-pay utilization trends and our procedures for testing the standard policy provide timely and accurate information. Significant changes in payer mix, business office operations, general economic conditions or healthcare coverage provided by federal or state governments or private insurers may have a significant impact on our estimates and significantly affect our future operations and cash flows.
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We classify accounts pending Medicaid approval as Medicaid accounts in our accounts receivable aging report and record a manual contractual allowance for these accounts equal to the average Medicaid reimbursement rate for that specific state. We have historically been successful in qualifying approximately 60% of submitted accounts for Medicaid coverage. In the event an account is not successfully qualified for Medicaid coverage and does not meet our charity guidelines, the previously recorded Medicaid contractual adjustment remains a revenue deduction (similar to a self-pay discount), and the remaining net account balance is reclassified to the self-pay category to be subjected to our allowance for doubtful accounts policy. If the account does not qualify for Medicaid coverage, but does qualify as charity care, the contractual adjustment is reversed and the gross account balance is recorded as a charity deduction.
Because we require patient verification of coverage at the time of admission, reclassifications of Medicare or managed care accounts to self-pay, other than patient coinsurance or deductible amounts, occur infrequently and are not material to our consolidated financial statements. Additionally, the impact of these classification changes is further limited by our ability to identify any necessary classification changes prior to patient discharge or soon thereafter. Due to information system limitations, we are unable to quantify patient deductible and co-insurance receivables that are included in the primary payer classification in the accounts receivable aging report at any given point in time. When classification changes occur, the account balance remains aged from the patient discharge date.
Insurance Reserves
Given the nature of our operating environment, we are subject to professional and general liability and workers compensation claims and related lawsuits in the ordinary course of business. For claims reported through May 31, 2006, our captive subsidiary insured our professional and general liability risks at a $10.0 million retention level. For claims reported subsequent to May 31, 2006, we self-insure the first $9.0 million per occurrence, and the captive subsidiary insures the next $1.0 million per occurrence. We maintain excess coverage from independent third party insurers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. We self-insure our workers compensations claims up to $1.0 million per claim and purchase excess insurance coverage for claims exceeding $1.0 million. The following tables summarize our professional and general liability and workers compensation reserve balances as of June 30, 2005 and 2006 and our total provision for professional and general liability and workers compensation losses and related claims payments during the years ended June 30, 2004, 2005 and 2006, respectively.
| | | Professional and
General Liability | | Workers
Compensation |
| | |
| |
|
| | | (In millions) |
Reserve balance: | | | | | | |
June 30, 2005 | | | $ 50.5 | | $ | 12.8 | |
June 30, 2006 | | | $ 58.8 | | $ | 15.3 | |
| | | | | | | |
Provision for claims losses: | | | | | | | |
Fiscal Year 2004 | | | $ 22.0 | | $ | 8.3 | |
Fiscal Year 2005 | | | $ 18.8 | | $ | 11.3 | |
Fiscal Year 2006 | | | $ 21.0 | | $ | 8.9 | |
| | | | | | | |
Claims paid: | | | | | | | |
Fiscal Year 2004 | | | $ 7.6 | | $ | 6.4 | |
Fiscal Year 2005 | | | $ 9.2 | | $ | 6.4 | |
Fiscal Year 2006 | | | $ 12.7 | | $ | 6.4 | |
We use an independent actuary to estimate our reserves for professional and general liability and workers compensation claims. Each reserve is comprised of estimated indemnity and expense payments related to: 1) reported events (“case reserves”) and 2) incurred but not reported (“IBNR”) events as of the end of the period. Management uses information from its risk managers and its best judgment to estimate case reserves. Actuarial IBNR estimates are dependent on multiple variables including our loss exposures, our self-insurance limits,
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geographic locations in which we operate, the severity of our historical losses compared to industry averages and the reporting pattern of our historical losses compared to industry averages, among others. Most of these variables require judgment by the independent actuary and changes in these variables could result in significant period over period fluctuations in our estimates. We adjust these reserves from time to time as we receive updated information. During fiscal 2005 and 2006, due to changes in historical loss trends, we decreased our professional and general liability reserve related to prior fiscal years by $3.6 million and $6.9 million, respectively. During fiscal 2005, we increased our workers compensation reserve related to prior fiscal years by $2.0 million. During fiscal 2006, we decreased our workers compensation reserve related to prior fiscal years by $0.7 million. Given the fact that we have operated our hospitals for relatively short periods of time, we expect that additional adjustments to prior year estimates may occur as our reporting history and loss portfolio matures.
The independent actuary provides a best estimate of IBNR using statistical confidence levels deemed adequate by the actuary that are less than 75%. Using a higher statistical confidence level would increase the estimated reserve. The following table illustrates the sensitivity of the reserve estimates at 75% and 90% confidence levels.
| | | Professional and
General Liability | | Workers
Compensation | |
| | |
| |
| |
| | | (In millions) | |
June 30, 2005 reserve: | | | | | | |
As reported | | | $ 50.5 | | $ | 12.8 | |
With 75% Confidence Level | | | $ 54.4 | | $ | 13.1 | |
With 90% Confidence Level | | | $ 60.2 | | $ | 13.6 | |
| | | | | | | |
June 30, 2006 reserve: | | | | | | | |
As reported | | | $ 58.8 | | $ | 15.3 | |
With 75% Confidence Level | | | $ 69.4 | | $ | 16.1 | |
With 90% Confidence Level | | | $ 80.0 | | $ | 16.7 | |
Medical Claims Reserves
During the years ended June 30, 2004, 2005 and 2006, medical claims expense was approximately $211.8 million, $237.2 million and $270.3 million, respectively, primarily representing medical claims of PHP. We estimate our reserve for medical claims using historical claims experience (including severity and payment lag time) and other actuarial data including number of enrollees and the enrollee’s county of residence. The reserve for medical claims, including incurred but not reported claims, for our health plans was approximately $51.2 million and $44.0 million as of June 30, 2005 and 2006, respectively. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from its estimates given changes in the healthcare cost structure or adverse experience. During the years ended June 30, 2004, 2005 and 2006, approximately $29.0 million, $36.6 million and $40.0 million, respectively, of accrued and paid claims for services provided to our health plan enrollees by our hospitals and our other healthcare facilities were eliminated in consolidation. Our operating results and cash flows could be materially affected by increased or decreased utilization of our healthcare facilities by enrollees in our health plans.
Income Taxes
We believe that our tax return provisions are accurate and supportable, but certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. To reflect the possibility that all of our tax positions may not be sustained, we maintain tax reserves that are subject to adjustment as updated information becomes available or as circumstances change. We record the impact of tax reserve changes to our income tax provision in the period in which the additional information, including the progress of tax audits, is obtained. We also estimate a valuation allowance to reduce deferred tax assets to the amount management believes is more likely than not to be realized in future periods. When establishing a valuation allowance, we consider all relative information including ongoing feasible tax planning strategies. We adjust our
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valuation allowance estimate and record the impact of such change to our income tax provision in the period in which management determines that the realization of the deferred tax assets has changed.
Selected Operating Statistics
The following table sets forth certain operating statistics for the periods indicated below.
| | Year Ended June 30, | |
| |
| |
Actual: | | | 2004 | | | 2005 | | | | 2006 | |
| | |
| | |
| | | |
| |
Number of hospitals at end of period | | | 16 | | | 19 | | | | 19 | |
Number of licensed beds at end of period | | | 3,784 | | | 4,557 | | | | 4,587 | |
Discharges (a) | | | 147,600 | | | 171,110 | | | | 182,386 | |
Adjusted discharges - hospitals (b) | | | 215,958 | | | 262,780 | | | | 289,333 | |
Net revenue per adjusted discharge-hospitals (c) | | $ | 6,477 | | $ | 6,899 | | | $ | 7,421 | |
Patient days (d) | | | 619,465 | | | 731,797 | | | | 802,650 | |
Adjusted patient days-hospitals (e) | | | 906,358 | | | 1,123,846 | | | | 1,273,304 | |
Average length of stay (days) (f) | | | 4.2 | | | 4.3 | | | | 4.4 | |
Outpatient surgeries (g) | | | 60,717 | | | 73,921 | | | | 81,240 | |
Emergency room visits (h) | | | 511,066 | | | 591,886 | | | | 645,539 | |
Occupancy rate (i) | | | 45.0 | % | | 48.1 | % | | | 48.3 | % |
Average daily census (j) | | | 1,693.0 | | | 2,005.0 | | | | 2,199.0 | |
Member lives (k) | | | 142,200 | | | 146,700 | | | | 146,200 | |
Medical claims expense percentage (l) | | | 72.1 | % | | 71.1 | % | | | 72.1 | % |
| | | Year ended June 30, | |
| | |
| |
Same hospital: | | | 2005 | | | 2006 | |
| | |
| | |
| |
Number of hospitals at end of period | | | 16 | | | 16 | |
Total revenues (in millions) (m) | | $ | 2,028.7 | | $ | 2,165.1 | |
Patient service revenues (in millions) (n) | | $ | 1,695.2 | | $ | 1,790.1 | |
Discharges (o) | | | 154,089 | | | 150,169 | |
Average length of stay (days) (p) | | | 4.2 | | | 4.4 | |
Patient days (q) | | | 649,708 | | | 653,905 | |
Adjusted discharges-hospitals (r) | | | 229,619 | | | 225,667 | |
Adjusted patient days-hospitals (s) | | | 968,174 | | | 982,658 | |
Net revenue per adjusted discharge-hospitals (t) | | $ | 6,907 | | $ | 7,468 | |
Outpatient surgeries (u) | | | 64,081 | | | 61,567 | |
Emergency room visits (v) | | | 534,971 | | | 533,136 | |
____________________ |
(a) | | Discharges represent the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatient volumes. |
| | |
(b) | | Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined hospital inpatient and outpatient volumes. Adjusted discharges-hospitals is computed by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation enables management to assess hospital volumes by a combined measure of inpatient and outpatient utilization. |
| | |
(c) | | Net revenue per adjusted discharge-hospitals is calculated by dividing net hospital patient revenues by adjusted discharge-hospitals and measures the average net payment expected to be received for a patient’s stay in the hospital. |
| | |
(d) | | Patient days represent the number of days (calculated as overnight stays) our beds were occupied by patients during the periods. |
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(e) | | Adjusted patient days-hospitals is calculated by multiplying patient days by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation is an indicator of combined inpatient and outpatient volumes. |
| | |
(f) | | Average length of stay represents the average number of days an admitted patient stays in our hospitals. |
| | |
(g) | | Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stays not necessary). |
| | |
(h) | | Emergency room visits represent the number of patient visits to a hospital emergency room where treatment is received, regardless of whether an overnight stay is subsequently required. |
| | |
(i) | | Occupancy rate represents the percentage of hospital licensed beds occupied by patients. Occupancy rate provides a measure of the utilization of inpatient rooms. |
| | |
(j) | | Average daily census represents the average number of patients in our hospitals each day during our ownership. |
| | |
(k) | | Member lives represent the total number of enrollees in PHP, AAHP and MHP as of the end of the respective period. |
| | |
(l) | | Medical claims expense percentage is calculated by dividing medical claims expense by premium revenues. |
| | |
(m) | | Same hospital total revenues represent revenues from entities owned (including health plans) for the full 12 months of both years presented. |
| | |
(n) | | Same hospital patient service revenues represent patient service revenues (excluding health plan premium revenues) from entities owned for the full 12 months of both years presented. |
| | |
(o) | | Same hospital discharges represent discharges for hospitals owned for the full 12 months of both years presented. |
| | |
(p) | | Same hospital average length stay represents average length of stay days for hospitals owned for the full 12 months of both years presented. |
| | |
(q) | | Same hospital patient days represent patient days for hospitals owned for the full 12 months of both years presented. |
| | |
(r) | | Same hospital adjusted discharges-hospitals is calculated by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues for all hospitals owned for the full 12 months of both years presented. |
| | |
(s) | | Same hospital adjusted patient days-hospitals is calculated by multiplying patient days by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues for all hospitals owned for the full 12 months of both years presented. |
| | |
(t) | | Same hospital net revenue per adjusted discharge-hospitals is calculated by dividing hospital net patient revenues by adjusted discharges-hospitals for those hospitals owned for the full 12 months of both years presented. This statistic measures the average net payment expected to be received for a patient’s stay in those hospitals owned during both respective periods. |
| | |
(u) | | Same hospital outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers owned for the full 12 months of both years presented, on an outpatient basis (patient overnight stays not necessary). |
| | |
(v) | | Same hospital emergency room visits represent the number of patient visits to receive treatment at a hospital emergency room owned for the full 12 months of both years presented, regardless of whether an overnight stay is subsequently required. |
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Results of Operations
The following tables present a summary of our operating results for the respective periods shown.
| | | Year Ended June 30, | |
| | |
| |
| | | 2004 | | | 2005 | | | | 2006 | |
| | |
| | |
| | | |
| |
| | | Amount | | | % | | | | Amount | | | % | | | | Amount | | | % | |
| | |
| | |
| | | |
| | |
| | | |
| | |
| |
Actual: | | | (Dollars in millions) | |
| | | | |
Patient service revenues | | $ | 1,489.0 | | | 83.5 | % | | $ | 1,935.4 | | | 85.3 | % | | $ | 2,277.7 | | | 85.9 | % |
Premium revenues | | | 293.8 | | | 16.5 | | | | 333.5 | | | 14.7 | | | | 375.0 | | | 14.1 | |
| | |
| | |
| | | |
| | |
| | | |
| | |
| |
Total revenues | | | 1,782.8 | | | 100.0 | | | | 2,268.9 | | | 100.0 | | | | 2,652.7 | | | 100.0 | |
Salaries and benefits (includes stock compensation of
$0.1, $97.4 and $1.7, respectively) | | | 740.9 | | | 41.6 | | | | 1,033.4 | | | 45.6 | | | | 1,118.6 | | | 42.2 | |
Supplies | | | 283.0 | | | 15.9 | | | | 374.2 | | | 16.5 | | | | 428.9 | | | 16.2 | |
Medical claims expense | | | 211.8 | | | 11.9 | | | | 237.2 | | | 10.4 | | | | 270.3 | | | 10.2 | |
Provision for doubtful accounts | | | 118.2 | | | 6.7 | | | | 151.3 | | | 6.7 | | | | 178.1 | | | 6.7 | |
Other operating expenses | | | 256.0 | | | 14.3 | | | | 325.4 | | | 14.4 | | | | 401.9 | | | 15.1 | |
Depreciation and amortization | | | 64.7 | | | 3.6 | | | | 82.0 | | | 3.6 | | | | 107.5 | | | 4.0 | |
Interest, net | | | 43.1 | | | 2.4 | | | | 88.3 | | | 3.9 | | | | 111.0 | | | 4.2 | |
Debt extinguishment costs | | | 4.9 | | | 0.3 | | | | 62.2 | | | 2.7 | | | | 0.1 | | | 0.0 | |
Merger expenses | | | – | | | 0.0 | | | | 23.3 | | | 1.0 | | | | – | | | 0.0 | |
Impairment expense | | | – | | | 0.0 | | | | – | | | 0.0 | | | | 15.0 | | | 0.6 | |
Other expenses | | | (4.8 | ) | | (0.3 | ) | | | 3.3 | | | 0.1 | | | | (2.0 | ) | | (0.1 | ) |
| | |
| | |
| | | |
| | |
| | | |
| | |
| |
Income (loss) before income taxes | | | 65.0 | | | 3.6 | | | | (111.7 | ) | | (4.9 | ) | | | 23.3 | | | 0.9 | |
Provision for income taxes | | | 24.9 | | | 1.4 | | | | (33.6 | ) | | (1.5 | ) | | | 10.4 | | | 0.4 | |
| | |
| | |
| | | |
| | |
| | | |
| | |
| |
Net income (loss) | | $ | 40.1 | | | 2.2 | % | | $ | (78.1 | ) | | (3.4 | )% | | $ | 12.9 | | | 0.5 | % |
| | |
| | |
| | | |
| | |
| | | |
| | |
| |
| | | Year Ended June 30, | |
| | |
| |
| | | 2005 | | | | 2006 | |
| | |
| | | |
| |
| | | Amount | | | % | | | | Amount | | | % | |
| | |
| | |
| | | |
| | |
| |
Same hospital: | | | (Dollars in millions) | |
| | | | |
Patient service revenues | | $ | 1,695.2 | | | 83.6 | % | | $ | 1,790.1 | | | 82.7 | % |
Premium revenues | | | 333.5 | | | 16.4 | | | | 375.0 | | | 17.3 | |
| | |
| | |
| | | |
| | |
| |
Total revenues | | | 2,028.7 | | | 100.0 | | | | 2,165.1 | | | 100.0 | |
Salaries and benefits (includes stock compensation
of $97.4 and $1.7, respectively) | | | 906.9 | | | 44.7 | | | | 859.4 | | | 39.7 | |
Supplies | | | 330.3 | | | 16.3 | | | | 333.2 | | | 15.3 | |
Medical claims expense | | | 237.2 | | | 11.7 | | | | 270.3 | | | 12.5 | |
Provision for doubtful accounts | | | 139.1 | | | 6.8 | | | | 162.2 | | | 7.5 | |
Other operating expenses | | | 286.2 | | | 14.1 | | | | 330.6 | | | 15.2 | |
Depreciation and amortization | | | 76.9 | | | 3.8 | | | | 93.3 | | | 4.3 | |
Interest, net | | | 88.3 | | | 4.4 | | | | 111.0 | | | 5.1 | |
Debt extinguishment costs | | | 62.2 | | | 3.1 | | | | 0.1 | | | 0.0 | |
Merger expenses | | | 23.3 | | | 1.1 | | | | – | | | 0.0 | |
Impairment expense | | | – | | | 0.0 | | | | 15.0 | | | 0.7 | |
Other expenses | | | 3.4 | | | 0.2 | | | | (1.5 | ) | | 0.1 | |
| | |
| | |
| | | |
| | |
| |
Loss before income taxes | | $ | (125.1 | ) | | (6.2 | )% | | $ | (8.5 | ) | | (0.4 | )% |
| | |
| | |
| | | |
| | |
| |
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Year Ended June 30, 2006 Compared to the Year Ended June 30, 2005
Revenues. $247.4 million of the $383.8 million increase in total revenues during fiscal 2006 related to our acquisition of the Massachusetts hospitals, while same hospital revenues improved by $136.4 million. We experienced weakened demand for inpatient and outpatient healthcare services during fiscal 2006. Same hospital adjusted discharges decreased by 1.7% during fiscal 2006. Same hospital emergency room visits and outpatient surgeries decreased by 0.3% and 3.9%, respectively, during fiscal 2006. We attribute this weakened demand to multiple factors including a mild respiratory illness season, decreases in rehabilitation discharges as a result of regulatory changes, greater competition from other hospitals in recruiting and retaining quality physicians and the increase in the number of uninsured patients or those insured patients with higher coinsurance and deductible limits. Although our same hospital volumes declined during fiscal 2006, we realized an 8.1% increase in same hospital net revenue per adjusted discharge compared to fiscal 2005. We implemented successful service mix strategies and realized improved reimbursement from managed care payers and Medicare. We expect revenues growth to continue during fiscal 2007, although factors outside our control including patient demand for healthcare services and increased competition could limit such growth.
Premium revenues increased by 12.4% during fiscal 2006 as a result of the start of AAHP’s operations on January 1, 2006. During fiscal 2006, approximately 3,500 PHP members became AAHP members. Per member per month reimbursement rates are significantly higher under AAHP than under the traditional AHCCCS Medicaid program. Per member per month reimbursement for PHP also increased effective October 1, 2005. Total average membership in PHP and AAHP increased from approximately 99,000 during fiscal 2005 to approximately 100,300 during fiscal 2006.
We continue to focus on implementing the appropriate service line mix that both meets the needs of our patients and improves our operating results. The success of this strategy depends on our physician recruitment and retention initiatives, emergency department and throughput design improvements, surgery unit expansions and primary care development initiatives. We believe that these initiatives and the favorable demographic trends in most of our markets will position us to recapture patient volumes once demand for healthcare services recovers.
Costs and Expenses. Total costs and expenses, exclusive of income taxes, were $2,629.4 million or 99.1% of total revenues during fiscal 2006, an improvement from 104.9% during fiscal 2005. Fiscal 2005 costs and expenses were negatively impacted by the Merger. Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent our most significant individual costs and expenses or those subject to the greatest level of fluctuation period over period.
• | | Salaries and benefits. Salaries and benefits as a percentage of total revenues decreased to 42.2% during fiscal 2006 from 45.6% during fiscal 2005. The decrease resulted primarily from a $95.7 million decrease in stock compensation. Absent the effect of stock compensation, this ratio would have increased to 42.1% during fiscal 2006 compared to 41.3% during fiscal 2005. Our fiscal 2006 salaries and benefits as a percentage of total revenues was adversely impacted by the additional six months of operations of the Massachusetts hospitals which incur higher salaries and benefits costs for approximately 1,550 unionized employees. On a same hospital basis, salaries and benefits excluding stock compensation as a percentage of total revenues decreased to 39.6% during fiscal 2006 compared to 39.9% during fiscal 2005. |
| | |
| | The national nursing shortage hindered our ability to fully manage salaries and benefits. We experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix and Orange County markets and were required to utilize more costly and less efficient temporary nurse staffing. We believe the nursing shortage will persist during the foreseeable future. Additionally, state mandated nurse staffing ratios in California strain our nursing resources even further. We believe our comprehensive nursing recruiting and retention plan will mitigate the impact of the nursing shortage to a certain degree. However, should we be unsuccessful in our attempts to maintain employed nursing coverage adequate for our present and future needs, and especially if additional states in which we operate enact new laws mandating nurse staffing ratios, our salaries and wages costs could be materially adversely impacted. |
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• | | Supplies. Supplies as a percentage of total revenues decreased to 16.2% during fiscal 2006 from 16.5% during fiscal 2005. Supplies as a percentage of patient service revenues decreased to 18.8% during fiscal 2006 compared to 19.3% during fiscal 2005. The year over year improvement in this ratio resulted from our efforts to increase utilization of our group purchasing organization and to implement our materials management strategies in Massachusetts. Because most of our growth strategies include expansion of high acuity services, we do not expect to realize significant future decreases in this ratio. We continue to streamline our materials management process, which should help offset acuity increases. However, price increases for pharmaceuticals and medical supplies, including the impact of increased use of drug-eluting stents, could have a significant adverse impact on future supply costs. |
| | |
• | | Medical claims expense. Medical claims expense as a percentage of premium revenues increased from 71.1% during fiscal 2005 to 72.1% during fiscal 2006 primarily as a result of the start of AAHP operations on January 1, 2006. Medical claims expense represents the amounts paid by the health plans for healthcare services provided to their members, including an estimate of incurred but not reported claims that is determined based upon lag data and other actuarial assumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $40.0 million, or 12.9% of gross health plan medical claims expense, were eliminated in consolidation during fiscal 2006. |
| | |
• | | Provision for doubtful accounts. During fiscal 2006, the provision for doubtful accounts as a percentage of patient service revenues remained consistent with that of fiscal 2005. During fiscal 2006, self-pay revenues as a percentage of net patient revenues decreased from 11.1% to 9.8%. Under our hindsight estimation methodology, our provision for doubtful accounts may be adversely affected by delays in the timing of non self-pay account collections period over period. Collecting outstanding self-pay accounts receivable remains difficult; however, we have experienced improved upfront cash collections and success in qualifying patients for coverage under Medicaid or similar programs. Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy of deducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines. On a combined basis, the provision for doubtful accounts and charity care deductions as a percentage of patient service revenues (prior to charity deductions) increased to 10.9% during fiscal 2006 compared to 10.4% during fiscal 2005. |
Other operating expenses. Other operating expenses include, among others, purchased services, insurance, property taxes, rents and leases, repairs and maintenance and utilities. Other operating expenses as a percentage of total revenues increased to 15.1% during fiscal 2006 compared to 14.4% during fiscal 2005. This increase resulted primarily from increased repairs and maintenance of $11.3 million and a $14.4 million increase in purchased services as a result of a change in policy in accounting for out of network payments under capitated payer contracts. During fiscal 2005, we recorded out of network capitated plan payments as revenue deductions instead of purchased services.
Other. Depreciation and amortization as a percentage of total revenues increased to 4.0% during fiscal 2006 compared to 3.6% during fiscal 2005 as a result of our capital improvement and expansion initiatives. The increase in net interest as a percentage of total revenues to 4.2% during fiscal 2006 compared to 3.9% during fiscal 2005 resulted primarily from our $175.0 million delayed draw term loan borrowing in September 2005. We incurred significant debt extinguishment costs and Merger expenses related to the Merger during fiscal 2005 and recognized an impairment charge of $15.0 million during fiscal 2006 related to the excess carrying value of our California hospital asset group over our estimate of its fair value.
Income taxes. The effective tax rate increased from 30.1% in fiscal 2005 to 44.6% in fiscal 2006. This increase was due to certain Merger-related costs that were non-deductible for tax purposes during fiscal 2005 and nondeductible goodwill associated with the impairment charge in fiscal 2006.
Net income. The $91.0 million year over year increase in net income resulted from the increased revenues as described above in excess of increased expenses. Net income during fiscal 2005 was adversely affected by the significant Merger-related costs.
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Year ended June 30, 2005 compared to Year ended June 30, 2004
Revenues. Revenues increased by $486.1 million during fiscal 2005 compared fiscal 2004 due to the acquisition of the Massachusetts hospitals, same hospital volume increases and improved reimbursement for services provided. Hospital adjusted discharges increased by 21.7% during fiscal 2005. Emergency room visits increased by 15.8%, and outpatient surgery volumes increased by 21.7% during fiscal 2005. Same hospital revenues increased by $245.9 million or 13.8% as a result of increases in same hospital adjusted discharges, emergency room visits and outpatient surgeries of 6.3%, 4.7% and 5.5%, respectively. In addition, same hospital net revenue per adjusted discharge increased 6.6% year over year. Our service expansion initiatives and managed care contracting strategies played significant roles in inpatient and outpatient volume improvements and were responsive to increased demand for such healthcare services created by the high population growth in most of the markets we serve.
Premium revenues increased by 13.5% during fiscal 2005 as a result of a year over year increase in average enrollees at PHP, per member rate increases and increases in reinsurance and supplemental revenues.
Revenues, exclusive of health plan premium and other non-hospital revenues, per adjusted discharge increased 6.5% during fiscal 2005. We successfully negotiated with managed care payers to receive favorable reimbursement for our services. The acuity of care required by our patients also affected this statistic.
We implemented physician recruitment, emergency department expansion, surgery unit expansion, specialty service expansions and intra-market resource sharing strategies during fiscal 2005. We also made considerable progress on our significant expansion projects in San Antonio and Phoenix during fiscal 2005.
Costs and Expenses. Total costs and expenses, exclusive of income taxes, were $2,380.6 million or 104.9% of total revenues during fiscal 2005, compared to 96.4% during fiscal 2004. During fiscal 2005, we incurred approximately $186.2 million of Merger-related costs including stock compensation, debt extinguishment costs, Merger expenses and monitoring fees. Absent these Merger-related costs, total costs and expenses as a percentage of revenues would have been 96.7%. Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent the most significant of our normal costs and expenses or those subject to the greatest level of fluctuation period over period.
• | | Salaries and benefits. Salaries and benefits as a percentage of total revenues increased to 45.6% during fiscal 2005 from 41.6% during fiscal 2004. As a result of the Merger, stock compensation expense increased from $0.1 million during fiscal year 2004 to $97.4 million during fiscal 2005. Absent the effect of stock compensation, salaries and benefits as a percentage of revenues would have been 41.3% during fiscal 2005. On a same hospital basis, absent the effect of stock compensation, salaries and benefits as a percentage of total revenues decreased to 39.9% during fiscal 2005 as a result of our care management, nurse utilization and service expansion strategies. Our improvements in this same hospital ratio were offset by higher salaries and benefits in our newly-acquired Massachusetts hospitals, in which approximately 1,100 of our employees were unionized as of June 30, 2005. |
| | |
| | The national nursing shortage hindered our ability to fully manage salaries and benefits during fiscal 2005. We experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix and Orange County markets. As a result of these factors, we hired additional nurses and utilized more costly outsourced nursing personnel. |
| | |
• | | Supplies. Supplies as a percentage of total revenues increased to 16.5% in total and 16.3% on a same hospital basis during fiscal 2005 compared to 15.9% during fiscal 2004 primarily due to increased acuity of services provided to our patients and increased costs of supplies and pharmaceuticals. Our same hospital orthopedic and cardiac surgical volumes, which typically utilize more costly supplies, increased year over year. |
| | |
• | | Medical claims expense. Medical claims expense as a percentage of premium revenues decreased to 71.1% during fiscal 2005 compared to 72.1% during fiscal 2004. This ratio decreased primarily due to our change from a cash basis to an accrual basis for eliminating in consolidation the impact of healthcare services provided by our hospitals to enrollees in our health plans during fiscal 2005. Medical claims |
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| | expense represents the amounts paid by the health plans for healthcare services provided to their members, including an estimate of incurred but not reported claims that is determined based upon lag data and other actuarial assumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $36.6 million, or 13.4% of gross health plan medical claims expense, were eliminated in consolidation during fiscal 2005. |
| | |
• | | Provision for doubtful accounts. During fiscal 2005, the provision for doubtful accounts as a percentage of patient service revenues decreased to 7.8% from 7.9% during fiscal 2004. During fiscal 2005, our self-pay revenues as a percentage of net patient revenues decreased to 11.1% from 11.7% during fiscal 2004 partly due to lower self pay utilization at our Massachusetts hospitals. On a same hospital basis, the provision for doubtful accounts as a percentage of patient service revenues increased to 8.2% during fiscal 2005. We experienced improved up front cash collections and success in qualifying patients for coverage under Medicaid or similar programs during fiscal 2005. Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy of deducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines. In June 2004, we expanded our charity care guidelines resulting in a decrease in revenues and a reduction in bad debts. During fiscal 2004 and 2005, we recorded $37.1 million and $55.6 million of charity care revenue deductions, respectively. On a combined basis, the provision for doubtful accounts and charity care expense as a percentage of patient service revenues (prior to charity deductions) increased to 10.4% during fiscal 2005 compared to 10.2% during fiscal 2004. |
Other operating expenses. Other operating expenses include, among others, purchased services, insurance, property taxes, rents and leases, repairs and maintenance and utilities. Other operating expenses as a percentage of total revenues remained consistent year over year.
Other. Depreciation and amortization remained consistent year over year at 3.6% of total revenues. We adjusted the values and lives of our property, plant and equipment as of the Merger date based upon an independent appraisal. Net interest as a percentage of total revenues increased to 3.9% during fiscal 2005 compared to 2.4% during fiscal 2004 as a result of the additional debt incurred to finance the Merger and the $150.0 million in delayed draw term loan borrowings subsequent to the Merger. As a result of the Merger, we incurred $62.2 million in debt extinguishment costs during fiscal 2005, an increase of $57.3 million from fiscal 2004, and $23.3 million in Merger expenses.
Income taxes. Our effective tax rate decreased from approximately 38.3% during fiscal 2004 to approximately 30.1% during fiscal 2005 primarily as a result of certain Merger-related costs that were not deductible for tax purposes.
Net income. The $118.2 million year over year decrease in net income resulted primarily from our improved operating results offset by increased interest expense and the Merger-related costs incurred during the current year.
Liquidity and Capital Resources
Operating Activities
At June 30, 2006, we had working capital of $149.7 million, including cash and cash equivalents of $123.6 million. Working capital at June 30, 2005 was $77.7 million. The increase in working capital was primarily due to the borrowing of the $175.0 million in delayed draw term loans in September 2005. Cash provided by operating activities decreased from $201.8 million during fiscal 2005 to $149.3 million during fiscal 2006. The significant decrease was due to positive cash flows of $108.3 million during fiscal 2005 related to the buildup of accounts payable and other liabilities compared to only $3.6 million of positive cash flows for these items in fiscal 2006 and a $21.9 million increase in net interest payments during fiscal 2006 compared to fiscal 2005. These changes were offset by $53.3 million in cash outflows during fiscal 2005 related to the buildup of accounts receivable at our Massachusetts hospitals. Our net revenue days in accounts receivable decreased from 53 days during fiscal 2005 to 51 days during fiscal 2006 as a result of improved upfront cash collections and business office efficiency initiatives.
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Investing Activities
Cash used in investing activities decreased from $324.3 million during fiscal 2005 to $245.4 million during fiscal 2006, primarily as a result of the $50.9 million of direct acquisition costs we paid during fiscal 2005 related to the Merger, the $87.7 million purchase price paid for the Massachusetts hospitals offset by a $46.3 million period over period increase in capital expenditures.
We spent $284.5 million for capital expenditures during fiscal 2006. In May 2004 and July 2005, our board of directors approved major expansion projects at six of our existing hospitals in San Antonio and metropolitan Phoenix. We estimate that these projects will cost a total of approximately $333.5 million, including capitalized interest costs. Through June 30, 2006, we have spent approximately $235.8 million related to these projects and expect to incur the remaining $97.7 million during our next two fiscal years. All of these projects will result in additional capacity at each of the six hospitals. In addition, most of the projects will facilitate an expansion of clinical service capabilities. The following table summarizes these major expansion projects as of September 1, 2006.
Hospital | | Estimated
Construction Period | | Approximate
Additional
Licensed Bed
Capacity | | Additional
Emergency
Room
Positions | | Additional
Operating
Rooms | | Additional
Labor &
Delivery
Rooms |
Begin | | Completed |
| |
| |
| |
| |
| |
| |
|
Phoenix | | | | | | | | | | | | |
Arrowhead Hospital | | Q4 FY 04 | | Q1 FY 07 | | 100(5) | | P | | P | | P |
Paradise Valley Hospital | | Q1 FY 07 | | Q3 FY 08 | | 22(4) | | (2) | | P | | P |
West Valley Hospital | | Q1 FY 06 | | Q4 FY 07 | | 39 | | P | | P | | (1) |
| | | | | | | | | | | | |
San Antonio | | | | | | | | | | | | |
North Central Baptist Hospital | | Q4 FY 04 | | Q1 FY 07 | | 140 | | P | | P | | P |
Northeast Baptist Hospital | | Q4 FY 04 | | Q1 FY 07 | | 33(3) | | P | | P | | P |
St. Luke’s Baptist Hospital | | Q2 FY 06 | | Q3 FY 07 | | 27 | | | | | | |
____________________ |
(1) | | Will increase post partum capacity to better utilize labor, delivery and recovery suites. |
(2) | | An expanded emergency room was opened in July 2004, expanding capacity from 16 to 28 bays. |
(3) | | In addition to increasing the number of licensed beds by 33, the expansion project will allow for the utilization of an additional 67 previously licensed beds. |
(4) | | In addition to increasing the number of licensed beds by 22, the expansion will allow for the utilization of an additional 18 previously licensed beds. |
(5) | | 40 of these beds were added during the fourth quarter of fiscal 2005. |
We anticipate spending a total of $230.0 million to $250.0 million in capital expenditures during fiscal 2007. This estimate includes the expansion projects mentioned above and all other renovation projects and technology upgrades at our facilities. These capital expenditures will be funded by cash flows from operations and availability under our revolving credit facility. We believe our capital expenditure program is sufficient to service, expand and improve our existing facilities to meet our quality objectives.
Financing Activities
Cash provided by financing activities decreased from $151.6 million during fiscal 2005 to $140.5 million during fiscal 2006, due to the significant financing activities associated with the Merger on September 23, 2004.
We have outstanding $1,519.2 million in aggregate indebtedness and $207.2 million of available borrowing capacity under our revolving credit facility ($250.0 million net of outstanding letters of credit of $42.8 million). Our liquidity requirements are significant, primarily due to debt service requirements. The 9.0% Notes require semi-annual interest payments. However, prior to October 1, 2009, the interest expense on the 11.25% Notes will consist solely of non-cash accretions of principal.
Our previous senior secured credit facilities executed in September 2004 consisted of a revolving credit facility and the initial term loan facility. Our revolving credit facility provides for loans in a total principal amount of up to $250.0 million, and matures in September 2010. The initial term loan facility, which was scheduled to
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mature in September 2011, provided for loans in a total principal amount of up to $800.0 million as follows: (1) $475.0 million borrowed on September 23, 2004 to finance the Merger, to refinance our then existing indebtedness and to pay fees and expenses relating thereto; (2) $150.0 million borrowed on December 31, 2004 and February 18, 2005 to finance the acquisition of the Massachusetts hospitals and for other general corporate purposes and (3) $175.0 million borrowed in September 2005 to fund capital expenditures and for other general corporate purposes.
On September 26, 2005, we refinanced and repriced all $795.7 million of the outstanding term loans under the initial term loan facility by borrowing $795.7 million of replacement term loans (the “2005 term loan facility”).
The 2005 term loan facility borrowings bear interest at a rate equal to, at our option, a base rate plus 1.25% per annum or LIBOR plus 2.25% per annum. These rates reflect a savings of 1.0% per annum over the interest rate options for our previous initial term loan facility. The borrowings under the revolving credit facility currently bear interest at a rate equal to, at our option, a base rate plus 1.00% per annum or LIBOR plus 2.00% per annum. These rates are subject to increase by up to 0.50% per annum should our leverage ratio exceed certain designated levels.
We are required to pay a commitment fee to the lenders under the revolving credit facility in respect of the unutilized commitments thereunder at a rate equal to 0.50% per annum. We also pay customary letter of credit fees.
The 2005 term loan facility and the revolving credit facility contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability, and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, repay other indebtedness (including the 9.0% Notes and 11.25% Notes), pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, loans or advances, make certain acquisitions, engage in mergers or consolidations, enter into sale and leaseback transactions, engage in certain transactions with affiliates, amend certain material agreements governing our indebtedness, including the 9.0% Notes and 11.25% Notes, change the business conducted by our subsidiaries and enter into hedging agreements. In addition, the senior credit facilities require us to maintain the following financial covenants: a maximum total leverage ratio, a maximum senior leverage ratio, a minimum interest coverage ratio and a maximum capital expenditures limitation.
As of June 30, 2006, we were in compliance with the debt covenant ratios as defined in our senior secured credit agreement, as follows.
| | Debt Covenant
Ratio | | Actual Ratio |
| |
| |
|
Interest coverage ratio requirement | | 1.90x | | 2.78x |
Total leverage ratio limit | | 6.15x | | 4.14x |
Senior leverage ratio limit | | 3.75x | | 1.87x |
The senior credit facilities and the indentures governing the 9.0% Notes and the 11.25% Notes limit our ability to:
• incur additional indebtedness or issue preferred stock;
• pay dividends on or make other distributions or repurchase our capital stock or make other restricted
payments;
• make investments;
• enter into certain transactions with affiliates;
• pay dividends or other similar payments by our subsidiaries;
• create liens on pari passu or subordinated indebtedness without securing the notes;
• designate the issuers’ subsidiaries as unrestricted subsidiaries; and
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• sell certain assets or merge with or into other companies or otherwise dispose of all or substantially all of
their assets.
The table below summarizes our credit ratings as of the date of this filing.
| | Standard & Poor’s | | Moody’s |
| |
| |
|
Corporate credit rating | | B | | N/A |
9.0% Senior Subordinated Notes | | CCC+ | | Caal |
11.25% Senior Discount Notes | | CCC+ | | Caa2 |
Senior credit facilities | | B | | B2 |
We expect that cash generated from our operations and cash available to us under our revolving credit facility will be sufficient to meet our working capital needs, debt service requirements and planned capital expenditure programs that we consider necessary to continue our growth. However, we cannot assure you that our operations will generate sufficient cash or that future borrowings under our refinanced senior credit facilities will be available to enable us to meet these requirements and needs.
We also intend to continue to pursue acquisitions or partnering arrangements, either in existing markets or new markets, which fit our growth strategies. To finance such transactions, we might have to draw upon amounts available under our revolving credit facility or seek additional funding sources. We continually assess our capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions, fund capital projects or for other corporate purposes. However, should our operating results and borrowing capacities not sufficiently support these capital projects or acquisition opportunities, our growth strategies may not be fully realized. Our future operating performance, ability to service or refinance our new debt and ability to draw upon other sources of capital will be subject to future economic conditions and other business factors, many of which are beyond our control.
Guarantees and Off Balance Sheet Arrangements
We are a party to certain rent shortfall agreements with certain unconsolidated entities and other guarantee arrangements, including parent-subsidiary guarantees, in the ordinary course of business. We have not engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to materially affect liquidity.
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Obligations and Commitments
The following table reflects a summary of obligations and commitments outstanding, including both the principal and interest portions of long-term debt and capital leases, with their payment dates as of June 30, 2006.
| | Payments due by period | | | |
| |
| | | |
| | Within
1 year | | During
Years 2-3 | | During
Years 4-5 | | After
5 years | | Total | |
| |
| |
Contractual Cash Obligations: | | (In millions) | |
Long-term debt | | $ | 121.6 | | | $ | 241.4 | | | $ | 242.5 | | | $ | 1,848.9 | | $ | | 2,454.4 | |
Capital lease obligations | | | 0.4 | | | | – | | | | – | | | | – | | | | 0.4 | |
Operating leases | | | 28.3 | | | | 44.8 | | | | 27.5 | | | | 47.4 | | | | 148.0 | |
Purchase obligations | | | 33.1 | | | | – | | | | – | | | | – | | | | 33.1 | |
Health claims payable | | | 44.0 | | | | – | | | | – | | | | – | | | | 44.0 | |
Estimated self-insurance liabilities | | | 21.1 | | | | 32.7 | | | | 16.4 | | | | 5.5 | | | | 75.7 | |
| | |
| | | |
| | | |
| | | |
| | | |
| |
Subtotal | | $ | 248.5 | | | $ | 318.9 | | | $ | 286.4 | | | $ | 1,901.8 | | | $ | 2,755.6 | |
| | |
| | | |
| | | |
| | | |
| | | |
| |
| | Payments due by period | | | |
| |
| | | |
| | Within
1 year | | During
Years 2-3 | | During
Years 4-5 | | After
5 years | | Total | |
| |
| |
Other Commitments: | | (In millions) | |
Construction and capital improvements | | $ | 89.2 | | | $ | 22.1 | | | $ | 4.0 | | | $ | 14.2 | | $ | | 129.5 | |
Guarantees of surety bonds | | | 18.0 | | | | – | | | | – | | | | – | | | | 18.0 | |
Letters of credit | | | – | | | | – | | | | – | | | | 42.8 | | | | 42.8 | |
Physician commitments | | | 7.0 | | | | – | | | | – | | | | – | | | | 7.0 | |
Minimum rent revenue commitments | | | 0.2 | | | | – | | | | – | | | | – | | | | 0.2 | |
| | |
| | | |
| | | |
| | | |
| | | |
| |
Subtotal | | $ | 114.4 | | | $ | 22.1 | | | $ | 4.0 | | | $ | 57.0 | | | $ | 197.5 | |
| | |
| | | |
| | | |
| | | |
| | | |
| |
Total obligations and commitments | | $ | 362.9 | | | $ | 341.0 | | | $ | 290.4 | | | $ | 1,958.8 | | | $ | 2,953.1 | |
| | |
| | | |
| | | |
| | | |
| | | |
| |
California has a statute and regulations that require hospitals to meet certain seismic performance standards. Hospitals that do not meet the standards may be required to retrofit their facilities. We have filed our required compliance plans with the State of California. Assuming we continue to own our California hospitals, we expect to comply with the initial seismic requirements at all of our California facilities by 2013 and to incur approximately $14.8 million in costs to meet our compliance plan. Upon completion of the $14.8 million in improvements, our California facilities will be compliant with the seismic regulations and standards through 2029. We estimate that the majority of the square footage in our California facilities will be compliant with the seismic regulations and standards that come into effect during 2030 once we have completed our $14.8 million in improvements, but we are unable at this time to estimate our costs for full compliance with the 2030 requirements.
Healthcare Reform
In recent years, an increasing number of legislative proposals have been introduced or proposed to Congress and in some state legislatures that would significantly affect the services provided by and reimbursement to healthcare providers in our markets. The cost of certain proposals would be funded in significant part by reduction
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in payments by government programs, including Medicare and Medicaid, to healthcare providers or by taxes levied on hospitals or other providers. While we are unable to predict which, if any, proposals for healthcare reform will be adopted, we cannot assure you that proposals adverse to our business will not be adopted.
Federal and State Regulation and Investigations
The healthcare industry is subject to extensive federal, state and local laws and regulations relating to licensing, conduct of operations, ownership of facilities, addition of facilities and services, confidentiality and security issues associated with medical records, financial arrangements with physicians and other referral sources, and billing for services and prices for services. These laws and regulations are extremely complex and the penalties for violations are severe. In many instances, the industry does not have the benefit of significant regulatory or judicial interpretation of these laws and regulations. As a result of these laws and regulations, some of our activities could become the subject of governmental investigations or inquiries. Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies. Several hospital companies have settled allegations raised during such investigations for substantial sums out of concern for the possible exclusion from the Medicare and Medicaid programs. In the event of a determination that we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed.
Effects of Inflation and Changing Prices
Various federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices. Revenues for acute hospital services rendered to Medicare patients are established under the federal government’s prospective payment system. We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of changes in payer mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. In addition, as a result of increasing regulatory and competitive pressures, our ability to maintain operating margins through price increases to non-Medicare patients is limited.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We are subject to market risk from exposure to changes in interest rates based on our financing, investing, and cash management activities. As of June 30, 2006, we had in place $1,039.7 million of senior credit facilities bearing interest at variable rates at specified margins above either the agent bank’s alternate base rate or its LIBOR rate. The senior credit facilities consist of $789.7 million in term loans maturing in September 2011 and a $250.0 million revolving credit facility maturing in September 2010 (of which $42.8 million of capacity was utilized by outstanding letters of credit as of June 30, 2006). Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates would not be material to our results of operations or cash flows. Holding other variables constant, including levels of indebtedness, a 0.125% increase in interest rates would have an annual estimated impact on pre-tax income and cash flows of approximately $1.0 million.
The $250.0 million revolving credit facility bears interest at the alternate base rate plus a margin ranging from 1.00%-1.50% per annum or the LIBOR rate plus a margin ranging from 2.00%-2.50% per annum, in each case dependent upon our leverage ratio. The revolving credit facility matures in September 2010. The $789.7 million in outstanding term loans bear interest at the alternate base rate plus a margin of 1.25% per annum or the LIBOR rate plus a margin of 2.25% per annum and mature in September 2011.
From time to time, we use derivatives such as interest rate swaps to manage our market risk associated with variable rate debt or similar derivatives for fixed rate debt. We do not hold or issue derivative instruments for trading purposes and are not a party to any instruments with leverage features.
Item 8. Financial Statements and Supplementary Data.
Information with respect to this Item is contained in our consolidated financial statements indicated in the Index on Page F-1 of this Annual Report on Form 10-K.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Control and Procedures
As of the end of the period covered by this report, our management conducted an evaluation, with the participation of our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting during our fiscal quarter ended June 30, 2006 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B. Other Information.
None.
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PART III
Item 10. Directors and Executive Officers of the Registrant.
The table below presents information with respect to the members of our board of directors and our executive officers and their ages as of September 1, 2006.
Name | | Age | Position |
Charles N. Martin, Jr. | | 63 | Chairman of the Board & Chief Executive Officer; Director |
Kent H. Wallace | | 51 | President & Chief Operating Officer |
Keith B. Pitts | | 49 | Vice Chairman |
Joseph D. Moore | | 59 | Executive Vice President, Chief Financial Officer & Treasurer |
Ronald P. Soltman | | 60 | Executive Vice President, General Counsel & Secretary |
Dan F. Ausman | | 51 | Senior Vice President-Operations |
Reginald M. Ballantyne III | | 62 | Senior Vice President-Market Strategy & Government Affairs |
James Bonnette, M.D. | | 55 | Senior Vice President & Chief Medical Officer |
Bruce F. Chafin | | 50 | Senior Vice President-Compliance & Ethics |
J. Michael Cowling | | 55 | Senior Vice President-Operations |
Alan N. Cranford | | 48 | Senior Vice President & Chief Information Officer |
James Johnston | | 62 | Senior Vice President-Human Resources |
Joseph J. Mullany | | 42 | Senior Vice President-Operations |
Harold H. Pilgrim III | | 45 | Senior Vice President-Operations |
Phillip W. Roe | | 45 | Senior Vice President, Controller & Chief Accounting Officer |
James H. Spalding | | 47 | Senior Vice President, Assistant General Counsel & Assistant Secretary |
Alan G. Thomas | | 52 | Senior Vice President-Operations Finance |
Thomas M. Ways | | 56 | Senior Vice President-Managed Care & Physician Integration |
Michael A. Dal Bello | | 35 | Director |
Eric T. Fry | | 39 | Director |
Benjamin J. Jenkins | | 35 | Director |
Neil P. Simpkins | | 40 | Director |
Charles N. Martin, Jr. has served as Chairman of the board of directors and Chief Executive Officer of Vanguard since July 1997. Until May 31, 2001, he was also Vanguard’s President. From January 1992 until January 1997, Mr. Martin was Chairman, President and Chief Executive Officer of OrNda HealthCorp (“OrNda”), a hospital management company. Prior thereto Mr. Martin was President and Chief Operating Officer of HealthTrust, Inc., a hospital management company, from September 1987 until October 1991. Mr. Martin is also a director of several privately held companies.
Kent H. Wallace has served as Vanguard’s President & Chief Operating Officer since September 2005. Prior thereto he was a Senior Vice President - Operations of Vanguard from February 2003 until September 2005. Prior thereto from July 2001 to December 2002 he was Regional Vice President of Province Healthcare Company of Brentwood, Tennessee, an owner and operator of 20 non-urban, acute care hospitals in 13 states of the United States. During this time Mr. Wallace had managerial responsibility for seven of these hospitals. From June 1999 until June 2001 Mr. Wallace was President and Chief Executive Officer of Custom Curb, Inc. of Chattanooga, Tennessee, a family owned company which manufactured roof accessories. Prior thereto from January 1997 until May 1999 Mr. Wallace was a Vice President - Acquisitions and Development of Tenet Healthcare Corporation of Dallas, Texas, a hospital management company (“Tenet”).
Keith B. Pitts has been Vanguard’s Vice Chairman since May 2001, was a director of Vanguard from August 1999 until September 2004, and was an Executive Vice President of Vanguard from August 1999 until May 2001. Prior thereto, from November 1997 until June 1999, he was the Chairman and Chief Executive Officer of Mariner Post-Acute Network, Inc. and its predecessor, Paragon Health Network, Inc., which is a nursing home management company. Prior thereto from August 1992 until January 1997, Mr. Pitts served as Executive Vice President and Chief Financial Officer of OrNda.
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Joseph D. Moore has served as Vanguard’s Executive Vice President, Chief Financial Officer and Treasurer since July 1997 and was a director of Vanguard from July 1997 until September 2004. From February 1994 to April 1997, he was Senior Vice President - Development of Columbia/HCA Healthcare Corporation (“Columbia”), a hospital management company. Mr. Moore first joined Hospital Corporation of America (a predecessor of Columbia) in April 1970, rising to Senior Vice President - Finance and Development in January 1993.
Ronald P. Soltman has been Vanguard’s Executive Vice President, General Counsel and Secretary since July 1997 and was a director of Vanguard from July 1997 until September 2004. From April 1994 until January 1997, he was Senior Vice President, General Counsel and Secretary of OrNda. From February 1994 until March 1994, he was Vice President and Assistant General Counsel of Columbia. From 1984 until February 1994, he was Vice President and Assistant General Counsel of Hospital Corporation of America.
Dan F. Ausman has served as a Senior Vice President - Operations of Vanguard since February 2006. Prior thereto from May 2005 to February 2006 he was Vice President - Operations of Vanguard. From 1998 to April 2005 Mr. Ausman was the President & Chief Executive Officer of Irvine Regional Hospital and Medical Center, a 176-bed acute care hospital in Irvine, CA which is owned by an affiliate of Tenet.
Reginald M. Ballantyne III, joined Vanguard in May 2001 and has served as Senior Vice President - Market Strategy & Government Affairs of Vanguard since January 2002. From 1984 to 2001, he served as President of PMH Health Resources, Inc., an Arizona based multi-unit healthcare system. Prior to 1984, Mr. Ballantyne served as President of Phoenix Memorial Hospital in Phoenix, Arizona. Mr. Ballantyne served as Chairman of the American Hospital Association (“AHA”) in 1997 and as Speaker of the AHA House of Delegates in 1998. He is a Fellow of the American College of Healthcare Executives (“ACHE”) and a recipient of the ACHE Gold Medal Award for Management Excellence. Mr. Ballantyne also served as a member of the national Board of Commissioners for the Joint Commission on Accreditation of Healthcare Organizations and as Chairman of the AHA Committee of Commissioners from 1992 until 1995. Mr. Ballantyne previously served as a director of Superior Consultant Holdings Corporation and is currently a director of several privately held companies.
James Bonnette, M.D., has served as Senior Vice President and Chief Medical Officer of Vanguard since November 2004. Prior thereto he was Vice President & Chief Medical Officer of Vanguard from November 2002 to November 2004. Prior thereto from November 2001 to November 2002 he was Vice President - Clinical Operations of Vanguard. Prior thereto he was Vice President - Materials Management of Vanguard from November 2000 to November 2001. Prior thereto from October 1999 to November 2000 he was Vice President and Chief Medical Officer of CoActive Systems (formerly, Health Connections, Inc.) of Nashville, TN, a company engaged in the business of staffing nurse triage call centers for hospitals and HMO’s and disease management services.
Bruce F. Chafin has served as Senior Vice President - Compliance & Ethics of Vanguard since July 1997. Prior thereto, from April 1995 to January 1997, he served as Vice President - Compliance & Ethics of OrNda.
J. Michael Cowling has served as a Senior Vice President - Operations of Vanguard since August 1, 2005. Prior thereto from August 2004 to July 2005 he was President of Baptist Montclair Hospital, a 534-bed acute care hospital located in Birmingham, Alabama. Prior thereto from May 1998 to August 2004 Mr. Cowling was a Regional Vice President Operations of MedCath Corporation of Charlotte, NC, a hospital management company that owns acute care hospitals in a number of states which focus primarily on the diagnosis and treatment of cardiovascular disease.
Alan N. Cranford has served as Senior Vice President and Chief Information Officer of Vanguard since September 2003. Prior thereto from June 2000 to August 2003 and from May 1995 to May 2000 he was Senior Vice President - Operations, and Vice President - Operations, respectively, of Tenet.
James Johnston has served as Senior Vice President - Human Resources of Vanguard since July 1997. Prior thereto from November 1995 to January 1997, he served as Senior Vice President - Human Resources of OrNda.
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Joseph J. Mullany has served as a Senior Vice President - Operations of Vanguard since September 2005. Prior thereto from October 2002 to August 2005 he was a Regional Vice President of Essent Healthcare, Inc. of Nashville, TN, an investor-owned hospital management company, responsible for its New England Division. Prior thereto from October 1998 to October 2002 Mr. Mullany was a Division Vice President of Health Management Associates, Inc. of Naples, Florida, an investor-owned hospital management company, responsible for its Mississippi Division.
Harold H. Pilgrim III has served as a Senior Vice President - Operations of Vanguard since September 2005. Prior thereto from February 2003 to September 2005 he was Vice President - Business Development of Vanguard, responsible for development for Vanguard’s Texas operations. Prior thereto from November 2001 to January 2003 Mr. Pilgrim was Vanguard’s Vice President - Investor Relations, and during that period he was also involved in Vanguard’s acquisitions and development activities. From January 1, 2001 to October 2001 Mr. Pilgrim was Chief Development Officer for Velocity Health Capital, Inc., a Nashville, TN - based investment banking firm focused on the health care and bio-sciences industries.
Phillip W. Roe has been Senior Vice President, Controller and Chief Accounting Officer of Vanguard since July 1997. Prior thereto he was Senior Vice President, Controller and Chief Accounting Officer of OrNda from September 1996 until January 1997. Prior thereto, from October 1994 until September 1996, Mr. Roe was Vice President, Controller and Chief Accounting Officer of OrNda.
James H. Spalding has served as Senior Vice President, Assistant General Counsel and Assistant Secretary of Vanguard since November 1998. Prior thereto he was Vice President, Assistant General Counsel and Assistant Secretary of Vanguard from July 1997 until November 1998. Prior thereto from April 1994 until January 1997, he served as Vice President, Assistant General Counsel and Assistant Secretary of OrNda.
Alan G. Thomas has been Senior Vice President - Operations Finance of Vanguard since July 1997. Prior thereto, Mr. Thomas was Senior Vice President - Hospital Financial Operations of OrNda from April 1995 until January 1997. Prior thereto he was Vice President - Reimbursement and Revenue Enhancement of OrNda from June 1994 until April 1995.
Thomas M. Ways has served as Senior Vice President - Managed Care & Physician Integration of Vanguard since March 1998. Prior thereto from February 1997 to February 1998, he was Chief Executive Officer of MSO/Physician Practice Development for the Southern California Region of Tenet. Prior thereto from August 1994 to January 1997, he was Vice President - Physician Integration of OrNda.
Michael A. Dal Bello became a member of Vanguard’s board of directors on September 23, 2004. Mr. Dal Bello has been a Principal in the Private Equity Group of Blackstone since December 2005 and from 2002 until December 2005, he was an Associate in this Group. While at Blackstone, Mr. Dal Bello has been actively involved in Blackstone’s healthcare investment activities. Prior to joining Blackstone, Mr. Dal Bello received an M.B.A. from Harvard Business School in 2002. Mr. Dal Bello worked at Hellman & Friedman LLC from 1998 to 2000 and prior thereto at Bain & Company. He currently serves on the board of representatives of Team Finance LLC and Global Tower Partners.
Eric T. Fry has served as a director of Vanguard since May 1998. Since September 2004, he has been a Managing Director of Metalmark Capital LLC, a new independent private equity firm established by the former principals of Morgan Stanley Capital Partners, including Mr. Fry, which began managing the existing Morgan Stanley Capital Partners funds in September 2004. Prior thereto, Mr. Fry was employed by Morgan Stanley & Co. Incorporated initially in 1989 and was a Managing Director of both Morgan Stanley & Co. Incorporated and Morgan Stanley Capital Partners from December 2001 until September 2004. He is also a director of ACG Holdings, Inc., American Color Graphics, Inc., EnerSys and several privately held companies.
Benjamin J. Jenkins became a member of Vanguard’s board of directors on September 23, 2004. Mr. Jenkins has been a Principal in the Private Equity group of Blackstone since 1999. Previously, Mr. Jenkins was an Associate at Saunders Karp & Megrue. Prior to that, Mr. Jenkins worked in the Mergers & Acquisitions Department at Morgan Stanley & Co. Mr. Jenkins holds a B.A. in Economics from Stanford University and an M.B.A. from
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Harvard Business School. He currently serves on the supervisory board of Celanese AG, the board of representatives of Team Finance LLC and is a director of Celanese Corporation and Global Tower Partners.
Neil P. Simpkins became a member of Vanguard’s board of directors on September 23, 2004. Mr. Simpkins has served as a Senior Managing Director of Blackstone since December 1999. From 1993 until the time he joined Blackstone, Mr. Simpkins was a Principal at Bain Capital. Prior to joining Bain Capital, Mr. Simpkins was a consultant at Bain & Company in London and the Asia Pacific region. He currently serves as Chairman of the board of directors of TRW Automotive Holdings Corp. and is a member of the board of representatives of Team Finance LLC.
Composition of the Board of Directors
General
The board of directors of Vanguard consists of five members, three of whom were nominated by Blackstone, one of whom was nominated by MSCP and one of whom is our chief executive officer (and, if our chief executive officer is not Charles N. Martin, Jr., such other person designated by senior management (the “Manager Representative”)). Blackstone has the right to increase the size of this board to nine members, with two additional directors to be designated by Blackstone and two additional directors to be independent persons identified by our chief executive officer and acceptable to Blackstone. MSCP and, subject to the conditions above, senior management, will each continue to be entitled to nominate and elect one director unless and until the respective group ceases to own at least 50.0% of the Class A membership units in VHS Holdings LLC (“Holdings”) owned on September 23, 2004. Holdings acquired Vanguard pursuant to a merger (the “Merger”) on September 23, 2004. See “Item 1. Business – The Merger”.
Committees
Our board of directors currently does not have any standing committees, including an audit committee. Our entire board of directors is acting as our audit committee to oversee our accounting and financial reporting processes and the audits of our financial statements, as allowed under the Securities Exchange Act of 1934 for issuers without securities listed on a national securities exchange or on an automated national quotation system. Additionally, because our securities are not so listed, our board of directors is not required to have on it a person who qualifies under the rules of the Securities and Exchange Commission as an “audit committee financial expert” or as having accounting or financial management expertise under the similar rules of the national securities exchanges. While our board of directors has not designated any of its members as an audit committee financial expert, we believe that each of the current board members is fully qualified to address any accounting, financial reporting or audit issues that may come before it.
Code of Ethics
We have adopted a Code of Business Conduct and Ethics for all of our employees, a copy of which has been posted on our Internet website at www.vanguardhealth.com/CodeofBusinessConductandEthics.pdf. Our Code of Business Conduct and Ethics is a “code of ethics”, as defined in Item 406(b) of Regulation S-K of the Securities and Exchange Commission. Please note that our Internet website address is provided as an inactive textual reference only. We will make any legally required disclosures regarding amendments to, or waivers of, provisions of our code of ethics on our Internet website.
Item 11. Executive Compensation.
As an independent company, we have established executive compensation practices that link compensation with our performance as a company. We will continually review our executive compensation programs to ensure that they are competitive.
The following table sets forth, for the fiscal year ended June 30, 2006, the compensation earned by the Chief Executive Officer and the four other most highly compensated executive officers of the registrant, Vanguard. We refer to these persons as our named executive officers.
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Summary Compensation Table
| | Annual Compensation | | | Long-Term Compensation | | | |
| |
| | |
| | | |
Name and Principal Position | | Fiscal
Year | | Salary
($) | | Bonus
($) (c) | | Other Annual
Compensation
($) (a) | | | Restricted
Stock
Awards ($) | | Securities
Underlying
Options (#) | | All Other
Compensation
($) (b) | |
| |
| |
| |
| |
| | |
| |
| |
| |
Charles N. Martin, Jr. | | 2006 | | 1,036,942 | | 525,146 | | 0 | | | 0 | | 0 | | 9,864 | |
Chairman of the Board & Chief Executive | | 2005 | | 1,014,998 | | 2,145,230 | | 0 | | | (d) | | 0 | | 9.714 | |
Officer | | 2004 | | 945,000 | | 810,000 | | 0 | | | 0 | | 0 | | 9,564 | |
| | | | | | | | | | | | | | | |
Kent H. Wallace | | 2006 | | 560,383 | | 273,978 | | 71,240 | | | 0 | | 7,000 | | 7,291 | |
President & Chief Operating Officer | | 2005 | | 402,525 | | 745,039 | | 0 | | | (d) | | 200 | | 625 | |
| | 2004 | | 390,775 | | 377,300 | | 187,647 | | | 0 | | 0 | | 810 | |
| | | | | | | | | | | | | | | |
Keith B. Pitts | | 2006 | | 632,497 | | 288,831 | | 0 | | | 0 | | 0 | | 7,110 | |
Vice Chairman | | 2005 | | 614,075 | | 3,075,483 | | 0 | | | (d) | | 0 | | 6,960 | |
| | 2004 | | 577,500 | | 440,000 | | 0 | | | 0 | | 0 | | 6,810 | |
| | | | | | | | | | | | | | | |
Joseph D. Moore | | 2006 | | 574,998 | | 204,223 | | 0 | | | 0 | | 0 | | 2,322 | |
Executive Vice President, Chief Financial | | 2005 | | 558,250 | | 773,200 | | 0 | | | (d) | | 0 | | 2,322 | |
Officer & Treasurer | | 2004 | | 525,000 | | 300,000 | | 0 | | | 0 | | 0 | | 2,322 |
| | | | | | | | | | | | | | | |
Ronald P. Soltman | | 2006 | | 517,498 | | 170,672 | | 0 | | | 0 | | 0 | | 2,322 |
Executive Vice President, General Counsel | | 2005 | | 502,425 | | 641,518 | | 0 | | | (d) | | 0 | | 2,296 |
& Secretary | | 2004 | | 472,500 | | 247,500 | | 0 | | | 0 | | 0 | | 2,064 |
____________________ |
(a) | | An “0” in this column means that no such compensation was paid other than perquisites and other personal benefits which have not been included because their aggregate value provided to any of the named executive officers was below the reporting threshold established by the Securities and Exchange Commission. Other Annual Compensation of $71,240 for Mr. Wallace in fiscal 2006 represents our payment to him of $69,280 to reimburse him for certain relocation expenses in his move to our Nashville, Tennessee headquarters from San Antonio, Texas after his election in September 2005 as our President & Chief Operating Officer and $1,960 to reimburse him for club dues. Other Annual Compensation of $187,647 for Mr. Wallace in fiscal 2004 represents our payment to him of $185,287 to reimburse him for certain relocation expenses in his move to San Antonio, Texas, to commence employment with Vanguard and $2,360 to reimburse him for club dues. |
| | |
(b) | | The amounts disclosed under All Other Compensation in the Summary Compensation Table represent for the named executive officers in fiscal 2006 (i) the following amounts of our matching contributions made under our 401(k) Plan: Mr. Martin: $6,300; Mr. Wallace: $6,300; Mr. Pitts: $6,300; Mr. Moore: $0; and Mr. Soltman: $0; and (ii) the following amounts of insurance premiums paid by Vanguard with respect to group term life insurance: Mr. Martin: $3,564; Mr. Wallace: $991; Mr. Pitts: $810; Mr. Moore: $2,322; and Mr. Soltman: $2,322. The amounts disclosed under All Other Compensation in the Summary Compensation Table represent for the named executive officers in fiscal 2005 (i) the following amounts of our matching contributions made under our 401(k) Plan: Mr. Martin: $6,150; Mr. Wallace: $0; Mr. Pitts: $6,150; Mr. Moore: $0; and Mr. Soltman: $0; and (ii) the following amounts of insurance premiums paid by Vanguard with respect to group term life insurance: Mr. Martin: $3,564; Mr. Wallace: $625; Mr. Pitts: $810; Mr. Moore: $2,322; and Mr. Soltman: $2,296. The amounts disclosed under All Other Compensation in the Summary Compensation Table represent for the named executive officers in fiscal 2004 (i) the following amounts of our matching contributions made under our 401(k) Plan: Mr. Martin: $6,000; Mr. Wallace: $0; Mr. Pitts: $6,000; Mr. Moore: $0; and Mr. Soltman: $0; and (ii) the following amounts of insurance premiums paid by Vanguard with respect to group term life insurance: Mr. Martin: $3,564; Mr. Wallace: $810; Mr. Pitts: $810; Mr. Moore: $2,322; and Mr. Soltman: $2,064. |
| | |
(c) | | In respect of the bonus amounts shown for fiscal year 2005, $917,730, $383,939; $498,520, $339,900 and $280,418 of these aggregate amounts for Messrs. Martin, Wallace, Pitts, Moore and Soltman, respectively, were paid to these executives in September 2005 under the Company’s 2001 Annual Incentive Plan for reaching performance targets in fiscal year 2005 and $1,227,500, $361,100, $722,100, $433,300 and $361,100 of these aggregate amounts for Messrs. Martin, Wallace, Pitts, Moore and Soltman, respectively, were paid to these officers as one-time Merger completion bonuses on or about September 23, 2004. $1,854,863 of this aggregate amount for Mr. Pitts for fiscal year 2005 reflects a one-time bonus payment to him on September 23, 2004, in connection with the cancellation just prior to the Merger of 5,275 stock options granted to him in August 2000 under Vanguard’s former 1998 Stock Option Plan as part of his recruitment package to Vanguard. |
| | |
(d) | | On September 23, 2004, in connection with completion of the Merger, these executive officers purchased for cash unvested class B, C and D units in Holdings at a purchase price equal to the estimated fair market value of these units. See the discussion below in “Holdings LLC Units Plan – Holdings LLC Units Held by Certain of our Managers” below in this Item 11. The vesting of these units are subject to the passing of time, continued employment to the period of complete vesting and certain other conditions, as discussed below. Since there is no market in the Holdings units or Vanguard shares of common stock, the Company cannot estimate the value of these units if they were completely to vest. Unvested B, C and D units have no rights to dividend payments or rights upon liquidation or dissolution of Holdings (other than a return of their purchase price). |
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Stock Option Grants During Fiscal 2006
During the fiscal year ended June 30, 2006, the grants of stock options under our stock-based employee benefit plans to the named executive officers were as follows.
| | Number of
Securities
Underlying
Options
Granted (#) | | Percent of
Total Options
Granted to
Employees in
Fiscal Year (%) | | Exercise
Price
($/Sh) | | Market Price
on Date of
Grant ($/Sh) | | Expiration
Date | | Potential Realizable Values at
Assumed Annual Rates of Stock
Price Appreciation for
Option Term ($)(a) |
| |
|
| | | | | | | | | | | | 0% | | 5% | | 10% |
Charles N. Martin, Jr. | | – | | – | | – | | – | | – | | – | | – | | – |
Kent H. Wallace | | 858(b) | | 2.3 | | 1,150.37 | | 1,150.37 | | 11/3/15 | | 0 | | 620,730 | | 1,573,052 |
| | 858(c) | | 2.3 | | 1,150.37 | | 1,150.37 | | 11/3/15 | | 0 | | 620,730 | | 1,573,052 |
| | 736(b) | | 2.0 | | 3,000.00 | | 1,150.37 | | 11/3/15 | | 0 | | 0 | | 0 |
| | 1,592(d) | | 4.3 | | 1,150.37 | | 1,150.37 | | 11/28/15 | | 0 | | 1,151,751 | | 2,918,762 |
| | 1,592(e) | | 4.3 | | 1,150.37 | | 1,150.37 | | 11/28/15 | | 0 | | 1,151,751 | | 2,918,762 |
| | 1,364(d) | | 3.7 | | 3,000.00 | | 1,150.37 | | 11/28/15 | | 0 | | 0 | | 0 |
Keith B. Pitts | | – | | – | | – | | – | | – | | – | | – | | – |
Joseph D. Moore | | – | | – | | – | | – | | – | | – | | – | | – |
Ronald P. Soltman | | – | | – | | – | | – | | – | | – | | – | | – |
____________________ |
(a) | | In accordance with the rules of the Securities and Exchange Commission (the “SEC”), shown are the gains or “option spreads” that would exist for the respective options granted. These gains are based on the assumed rates of annual compound stock price appreciation of 5% and 10% from the date the option was granted over the full option term. These assumed annual compound rates of stock price appreciation are mandated by the rules of the SEC and do not represent our estimate or projection of our future common stock prices. |
| | |
(b) | | 20% of the stock options vest and become exercisable on each of the first five anniversaries of the November 3, 2005, grant date of these options. |
| | |
(c) | | 100% of the stock options vest and become exercisable on the eighth anniversary of the November 3, 2005, grant date of these options. |
| | |
(d) | | 20% of the stock options vest and become exercisable on each of the first five anniversaries of the November 28, 2005, grant date of these options. |
| | |
(e) | | 100% of the stock options vest and become exercisable on the eighth anniversary of the November 28, 2005, grant date of these options. |
Aggregate Option Exercises During Fiscal 2006 and Fiscal Year-End Option Values
The following table sets forth information with respect to the named executive officers concerning their exercise of stock options during the fiscal year ended June 30, 2006 and in respect of the number and value of unexercised options held by each of them as of June 30, 2006.
| | Shares Acquired
on Exercise (#)(a) | | Value
Realized ($) | | Number of Securities Underlying
Unexercised Options At
Fiscal Year-End(#) | | Value of Unexercised
In-the-Money Options At
Fiscal Year-End($)(a) |
| | | |
| |
|
Name | | | | Exercisable | | Unexercisable | | Exercisable | | Unexercisable |
| |
| |
| |
|
Charles N. Martin, Jr. | | 0 | | 0 | | 0 | | 0 | | 0 | | 0 |
Kent H. Wallace | | 0 | | 0 | | 0 | | 7,000 | | 0 | | 0 |
Keith B. Pitts | | 0 | | 0 | | 0 | | 0 | | 0 | | 0 |
Joseph D. Moore | | 0 | | 0 | | 0 | | 0 | | 0 | | 0 |
Ronald P. Soltman | | 0 | | 0 | | 0 | | 0 | | 0 | | 0 |
____________________ |
(a) | | There was no public market for our common stock at June 30, 2006. The dollar values of unexercised in-the-money options represent the difference between the assumed fair market value of $1,150.37 per share at June 30, 2006 pursuant to the most recent share appraisal obtained by the Company and the exercise prices of the options. |
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Compensation Committee Interlocks and Insider Participation
During fiscal 2006, we had no compensation committee of our board of directors. Charles N. Martin, Jr., one of the named executive officers, participated in deliberations of our board of directors concerning executive officer compensation during fiscal 2006.
Director Compensation
Historically, we have paid no compensation to members of our board of directors for their service. We do, however, reimburse them for travel expenses and other out-of-pocket costs incurred in connection with attendance at meetings of the boards. Members of these boards are not eligible to receive options pursuant to our option plans, as described in Item 11 under the caption “Our 2004 Stock Incentive Plan.” As an independent company, we expect at some time in the future to establish directors’ compensation practices that will be aligned with creating and sustaining stockholder value. No additional remuneration will be paid to officers or employees of ours who also serve as directors.
Annual Incentive Plan (Bonus) Awards
The Board of Directors annually approves awards to be made under the Company's 2001 Annual Incentive Plan ("AIP"). Each year, the Board establishes earnings-related AIP goals for all of its executive officers, including the named executive officers, for the fiscal year. The executive officers are eligible to receive a cash award or awards based primarily on the extent to which the Company meets its pre-established earnings and/or cash flow goals. The Board determines one or more target awards for each executive officer, designates a Company performance level or levels required to earn each target bonus, determines a threshold performance level at which minimum awards are earned and determines a performance level that results in a maximum award to be paid. Target awards may vary among executives based on competitive market practices for comparable positions, their decision-making authority and their ability to affect financial performance. Awards for executives may be increased or decreased by the Board of Directors on a discretionary basis.
For fiscal year 2006, AIP awards for most executive officers were 50% based on the Company achieving certain consolidated EBITDA targets and 50% upon achieving certain consolidated free cash flow targets. Award maximum levels for these officers ranged from 30% to 50% of their base salaries for meeting the EBITDA maximum target and 30% to 50% of their base salaries for meeting the free cash flow maximum target. For officers responsible only for the operations of the various regions of the Company, their AIP awards were solely based upon regional EBITDA targets and their award targets ranged from 70% to 108% of their base salaries depending on the EBITDA levels actually obtained.
Holdings LLC Units Plan
Holdings acquired Vanguard in the Merger on September 23, 2004. The following contains a summary of the material terms of the Holdings LLC Units Plan, which we refer to as the 2004 Units Plan, pursuant to which Holdings may grant the right to purchase units to members of our management. Charles N. Martin, Jr., Kent H. Wallace, Keith B. Pitts, Joseph D. Moore, Ronald P. Soltman and certain other members of our management have been granted the right to purchase units under the 2004 Units Plan.
General
The 2004 Unit Plan permits the grant of the right to purchase Class A Units, Class B Units, Class C Units and Class D Units to employees of Holdings or its affiliates. A maximum of 117,067 Class A Units, 41,945 Class B Units, 41,945 Class C Units and 35,952 Class D Units may be subject to awards under the 2004 Unit Plan. Units covered by awards that expire, terminate or lapse will again be available for option or grant under the 2004 Unit Plan. On September 23, 2004, certain members of management purchased all 117,067 Class A Units for an aggregate purchase price of $117,067,000 and all 41,945 Class B units, all 41,945 Class C Units and all 35,952 of the Class D Units for an aggregate purchase price of $5.8 million.
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Administration
The 2004 Unit Plan is administered by a committee of Holdings’ board of representatives or, in the board of representatives’ discretion, the board of representatives. The committee has the sole discretion to determine the employees to whom awards may be granted under the 2004 Unit Plan, the number and/or class of Units to be covered by an award, the purchase price, if any, of such awards, determine the terms and conditions of any award and determine under what circumstances awards may be settled or cancelled. The committee is authorized to interpret the 2004 Unit Plan, to establish, amend and rescind any rules and regulations relating to the 2004 Unit Plan, and to make any other determinations that it deems necessary or desirable for the administration of the plan. The committee may correct any defect or supply any omission or reconcile any inconsistency in the 2004 Unit Plan in the manner and to the extent the committee deems necessary or desirable.
Adjustments Upon Certain Events
In the event of any changes in the Units by reason of any reorganization, recapitalization, merger, unit exchange or any other similar transaction, the board of representatives, in its sole discretion, may adjust (1) the number or kind of Units or other securities that may be issued or reserved for issuance pursuant to the 2004 Unit Plan or pursuant to any outstanding awards or (2) any other affected terms of such awards.
Amendment and Termination
The Holdings board of representatives may amend or terminate the 2004 Unit Plan at any time, provided that no amendment or termination is permitted that would diminish any rights of a management member pursuant to a previously granted award without his or her consent, subject to the committee’s authority to adjust awards upon certain events as described in the previous paragraph. No awards may be made under the 2004 Unit Plan after the tenth anniversary of the effective date of the plan.
Holdings LLC Units Held by Certain of our Managers
The units of Holdings consist of Class A units, Class B units, Class C units and Class D units. As of September 1, 2006, approximately 59.2% of Holdings’ Class A Units were held by Blackstone, approximately 20.8% were held by MSCP, approximately 15.6% were held by certain members of our management and approximately 4.4% were held by other investors. The Class B units, Class C units and Class D units are held exclusively by members of our senior management and all such units were purchased on September 23, 2004.
Of our named executive officers, Charles N. Martin, Jr. owns 40,000 class A units, 8,913 class B units, 8,913 class C units and 7,640 class D units; Kent H. Wallace owns 850 class A units, 2,622 class B units, 2,622 class C units and 2,247 class D units; Keith B. Pitts owns 11,000 class A units, 5,243 class B units, 5,243 class C units and 4,494 class D units; Joseph D. Moore owns 10,450 class A units, 3,146 class B units, 3,146 class C units and 2,696 class D units; and Ronald P. Soltman owns 8,196 class A units, 2,622 class B units, 2,622 class C units and 2,247 class D units. As of September 1, 2006, none of the class C units are vested, but 20% of the Class B and D units are vested; and an additional 20% of such class B and D units will vest on September 23, 2006. See the vesting provisions in respect of the class A, B, C and D units in the discussion immediately below.
Terms of the Holdings’ Class A Units, Class B Units, Class C Units and Class D Units
The following is a summary of certain terms of the Holdings’ Class A units, Class B units, Class C units and Class D units and certain rights and restrictions applicable to those units.
Class A units have economic characteristics that are similar to those of shares of common stock in a private corporation. Subject to applicable law, only the holders of Class A units are entitled to vote on any matter. Class A units are fully vested. The Class B units, Class C units and Class D units are subject to the vesting provisions described below.
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Class B units vest in five equal annual installments on the first five anniversaries of the date of purchase, subject to an employee’s continued service with Holdings and its affiliates. However, the Class B units will vest earlier upon a change of control of Holdings. In the event of an employee’s termination of employment with Vanguard, other than due to termination by Vanguard for “cause” or by the employee without “good reason”, the employee shall be deemed vested in any Class B unit that would otherwise have vested in the calendar year in which such termination of employment occurs. No employee who holds Class B units will receive any distributions until the holders of the Class A units receive the aggregate amount invested for their Class A units. Following return of the aggregate amount invested for the Class A units, the holders of Class B units will be entitled to receive the amount of their investment in the Class B units and, once all the aggregate investment amount invested for all of the units has been returned to their holders, the vested Class B units will share in any distributions pro rata with the Class A units and vested Class C units.
Class C units vest on the eighth anniversary of the date of purchase, subject to the employee’s continued service with Holdings and its affiliates. However, the Class C units will vest earlier upon the occurrence of a sale by Blackstone of at least 25.0% of its Class A Units at a price per Class A unit exceeding two and one-half times the price per Class A Unit invested by Blackstone in connection with the Merger. No employee who holds Class C units will receive any distributions until the holders of the Class A units receive the aggregate amount invested for their Class A units. Following return of the aggregate amount invested for the Class A units, the holders of Class C units will be entitled to receive the amount of their investment in the Class C units and, once all the aggregate investment amount invested for all of the units has been returned to their holders, the vested Class C units will share in any distributions pro rata with the Class A units and vested Class B units.
Class D units vest in five equal annual installments on the fifth anniversary of the date of purchase, subject to an employee’s continued service with Holdings and its affiliates. However, the Class D units will vest earlier upon a change of control of Holdings. In the event of an employee’s termination of employment with Vanguard, other than due to termination by Vanguard for “cause” or by the employee without “good reason”, the employee shall be deemed vested in any Class D unit that would otherwise have vested in the calendar year in which such termination of employment occurs. No employee who holds Class D units will receive any distributions until the holders of the Class A units receive the aggregate amount invested for their Class A units. Following return of the aggregate amount invested for the Class A units, the holders of Class D units will be entitled to receive the amount of their investment in the Class D units and, once all the aggregate investment amount invested for all of the units has been returned to their holders and the holders of the Class A units have received an amount representing a 300% return on their aggregate investment along with pro rata distributions to the vested Class B and Class C units, the vested Class D units will share in any distributions pro rata with the Class A units, the vested Class B units and the vested Class C units.
Certain Rights and Restrictions Applicable to the Units Held by Our Managers
The units held by members of our management are not transferable for a limited period of time except in certain circumstances. In addition, the units (other then Class A units) may be repurchased by Holdings, and in certain cases, Blackstone, in the event that the employees cease to be employed by us. Blackstone has the ability to force the employees to sell their units along with Blackstone if Blackstone decides to sell its units.
The employees that hold units are entitled to participate in certain sales by Blackstone. In addition, in the event that Holdings were to make a public offering of its equity securities, the employees would have limited rights to participate in subsequent registered public offerings.
Our Employment Agreements
On June 1, 1998, we entered into written employment agreements with our Chief Executive Officer, Chief Financial Officer and our General Counsel (Messrs. Martin, Moore and Soltman, respectively), which were amended and restated on September 23, 2004, to extend the term of the employment agreements for five years, and to provide that the Merger did not constitute a change in control under the agreements. On September 1, 1999, we entered into a written employment agreement with Keith B. Pitts to be our Executive Vice President for a term expiring on September 1, 2004. Effective May 31, 2001, Mr. Pitts was promoted to the position of Vice Chairman, and on September 23, 2004, his employment agreement was amended and restated to extend the term of the
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employment agreement for five years, and to provide that the Merger did not constitute a change in control under the agreement.
The term of each employment agreement will renew automatically for additional one-year periods, unless any such agreement is terminated by us or by the officer by delivering notice of termination no later than 90 days before the end of any such renewal term. The base salaries of Messrs. Martin, Moore, Pitts and Soltman under such written employment agreements are, during calendar year 2006, $1,050,291, $583,495, $641,845 and $525,146, respectively. Pursuant to these agreements the officers are eligible to participate in an annual bonus plan giving each of them an opportunity to earn an annual bonus in such amount as our board of directors should determine, as well as pension, medical and other customary employee benefits. The terms of these agreements state that if the officer terminates his employment for Good Reason (as defined in the agreements) or if we terminate the officer’s employment without Cause (as defined in the agreements), he will receive within a specified time after the termination a payment of up to three times the sum of (i) his annual salary plus (ii) the average of the bonuses given to him in the two years immediately preceding his termination.
Our Severance Protection Agreements
We provide our executives at the Vice President level and above (other than Messrs. Martin, Moore, Pitts and Soltman, who each have a written employment agreement containing severance provisions) with severance protection agreements granting them severance payments in amounts of 200% to 300% of annual salary and bonus. Generally, severance payments are due under these agreements if a change in control (as defined in the agreements) should occur and employment of the officer is terminated during the term of the agreement by us (or our successor) without Cause (as defined in the agreements) or by the executive for Good Reason (as defined in the agreement). In addition, these agreements state that in the event of a Potential Change in Control (defined as the time at which an agreement which would result in a change in control is signed, an acquisition attempt relating to us is publicly announced or there is an increase in the number of shares owned by one of our 10% shareholders by 5% or more), the executives have an obligation to remain in our employ until the earliest of (1) six months after the Potential Change in Control; (2) a change in control; (3) a termination of employment by us; or (4) a termination of employment by the employee for Good Reason (treating Potential Change in Control as a change in control for the purposes of determining whether the executive had a Good Reason) or due to death, disability or retirement. On September 23, 2004, all the outstanding severance protection agreements were amended and restated to provide that the Merger did not constitute a change in control under the agreements, and that we would not terminate the agreements prior to the third anniversary of the closing of the Merger.
Our 2004 Stock Incentive Plan
General
The Company adopted the 2004 Stock Incentive Plan upon consummation of the Merger which permits the grant of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock and other stock-based awards with respect to the Company to employees of the Company or its affiliates. The awards available under the 2004 Stock Incentive Plan, together with Holdings’ equity incentive units, represent 20.0% of the fully-diluted equity of the Company at the closing of the Merger. Shares covered by awards that expire, terminate or lapse are again available for option or grant under the 2004 Stock Incentive Plan. The total number of shares of the Company’s common stock which may be issued under the 2004 Stock Incentive Plan is 98,120. All of our previous option plans were terminated upon consummation of the Merger on September 23, 2004.
Administration
The 2004 Stock Incentive Plan is administered by a committee of the board of directors or, in the sole discretion of the board of directors, the board of directors. The committee has the sole discretion to determine the employees, representatives and consultants to whom awards may be granted under the 2004 Stock Incentive Plan and the manner in which such awards will vest. Options, stock appreciation rights, restricted stock and other stock-based awards will be granted by the committee to employees, representatives and consultants in such numbers and at such times during the term of the 2004 Stock Incentive Plan as the committee shall determine. The committee is authorized to interpret the 2004 Stock Incentive Plan, to establish, amend and rescind any rules and regulations
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relating to the 2004 Stock Incentive Plan, and to make any other determinations that it deems necessary or desirable for the administration of the plan. The committee may correct any defect or supply any omission or reconcile any inconsistency in the 2004 Stock Incentive Plan in the manner and to the extent the committee deems necessary or desirable.
Stock Options and Stock Appreciation Rights
Options granted under the 2004 Stock Incentive Plan are vested and exercisable at such times and upon such terms and conditions as may be determined by the committee, but in no event will an option be exercisable more than 10 years after it is granted. The exercise price per share for any option awarded is determined by the committee, but may not be less than 100% of the fair market value of a share on the day the option is granted with respect to incentive stock options.
An option may be exercised by paying the exercise price in cash or its equivalent, and/or, to the extent permitted by the committee, shares, a combination of cash and shares or, if there is a public market for the shares, through the delivery of irrevocable instruments to a broker to sell the shares obtained upon the exercise of the option and to deliver to the Company an amount equal to the exercise price.
The committee may grant stock appreciation rights independent of or in conjunction with an option. The exercise price of a stock appreciation right is an amount determined by the committee. Generally, each stock appreciation right entitles a participant upon exercise to an amount equal to (i) the excess of (1) the fair market value on the exercise date of one share over (2) the exercise price, times (ii) the number of shares covered by the stock appreciation right. Payment will be made in shares or in cash or partly in shares and partly in cash (any shares valued at fair market value), as determined by the committee.
As of June 30, 2006, options to purchase 70,657 shares of the Company’s common stock (the “New Options”) were outstanding under the 2004 Stock Incentive Plan. The New Options were granted in part as “time options,” and in part as “performance options” which vest and become exercisable ratably on a yearly basis on each of the first five anniversaries following the date of grant (or earlier upon a change of control of the Company), with 35% of the shares subject to the time options having been granted with an exercise price equal to the fair market price per share at the time of grant (a range of $1,000 to $1,150.37 per share), with 30% of the shares subject to the performance options having been granted with an exercise price of $3,000 per share, and with the 35% remainder of the shares subject to the “liquidity options” having been granted with an exercise price equal to the fair market price per share at the time of grant (a range of $1,000 to $1,150.37 per share) and which shall become fully vested and exercisable upon the completion of any of certain designated business events, and in any event by the eighth anniversary of the date of grant. Any common stock for which such options are exercised are governed by a stockholders agreement, which is described below under “Item 13. Certain Relationships and Related Transactions - Stockholders Agreement.”
Other Stock-Based Awards
The committee, in its sole discretion, may grant restricted stock, stock awards, stock appreciation rights, unrestricted stock and other awards that are valued in whole or in part by reference to, or are otherwise based on the fair market value of, the shares of the Company. Such other stock-based awards shall be in such form, and dependent on such conditions, as the committee shall determine, including, without limitation, the right to receive, or vest with respect to, one or more shares (or the equivalent cash value of such shares) upon the completion of a specified period of service, the occurrence of an event and/or the attainment of performance objectives.
Adjustments Upon Certain Events
In the event of any stock dividend or split, reorganization, recapitalization, merger, share exchange or any other similar transaction, the committee, in its sole discretion, may adjust (i) the number or kind of shares or other securities that may be issued or reserved for issuance pursuant to the 2004 Stock Incentive Plan or pursuant to any outstanding awards, (ii) the option price or exercise price and/or (iii) any other affected terms of such awards. In the event of a change of control, the committee may, in its sole discretion, provide for the (i) termination of an award upon the consummation of the change of control, but only if such award has vested and been paid out or the
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participant has been permitted to exercise the option in full for a period of not less than 30 days prior to the change of control, (ii) acceleration of all or any portion of an award, (iii) payment of a cash amount in exchange for the cancellation of an award, which, in the case of options and stock appreciation rights, may equal the excess, if any, of the fair market value of the shares subject to such options or stock appreciation rights over the aggregate option price or grant price of such option or stock appreciation rights, and/or (iv) issuance of substitute awards that will substantially preserve the otherwise applicable terms of any affected awards previously granted hereunder.
Amendment and Termination
The committee may amend or terminate the 2004 Stock Incentive Plan at any time, provided that no amendment or termination shall diminish any rights of a participant pursuant to a previously granted award without his or her consent, subject to the committee’s authority to adjust awards upon certain events (described under “Adjustments Upon Certain Events” above). No awards may be made under the 2004 Stock Incentive Plan after the tenth anniversary of the effective date of the plan.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
As of September 1, 2006, VHS Holdings LLC (“Holdings”) directly owned 624,550 of the outstanding shares of the common stock of Vanguard (representing a 83.3% ownership interest), certain investment funds affiliated with Blackstone directly owned 125,000 of the outstanding shares of the common stock of Vanguard (representing a 16.7% ownership interest) and no other person or entity had a direct beneficial ownership interest in the common stock of Vanguard, except for certain key employees who held an aggregate of 4,030 exercisable options into 4,030 shares of the common stock of Vanguard as of such date. However, ignoring only the direct ownership of Holdings in the common stock of Vanguard, the following table sets forth information with respect to the direct or indirect beneficial ownership of the common stock of Vanguard as of September 1, 2006 by (1) each person (other than Holdings) known to own beneficially more than 5.0% of the common stock of Vanguard, (2) each named executive officer, (3) each of our directors and (4) all executive officers and directors as a group. The indirect beneficial ownership of the common stock of Vanguard reflects the direct beneficial ownership of all Class A units and all vested Class B and D units of Holdings.
Notwithstanding the beneficial ownership of the common stock of Vanguard presented below, the limited liability company agreement of Holdings governs the holders’ exercise of their voting rights with respect to election of Vanguard’s directors and certain other material events. See “Item 13. Certain Relationships and Related Transactions - Holdings Limited Liability Company Agreement.”
Name of Beneficial Owner | | Beneficial
Ownership | | Ownership
Percentage | |
| |
| |
| |
Blackstone Funds(1) | | 494,930 | | 66.0% | |
MSCP Funds(2) | | 130,000 | | 17.3% | |
Charles N. Martin Jr.(3) | | 46,622 | | 6.2% | |
Joseph D. Moore(4) | | 12,788 | | 1.7% | |
Keith B. Pitts(5) | | 14,896 | | 2.0% | |
Ronald P. Soltman(6) | | 10,144 | | 1.3% | |
Kent H. Wallace(7) | | 2,798 | | * | |
Neil P. Simpkins (1) | | 494,930 | | 66.0% | |
Benjamin J. Jenkins | | —(8) | | —(8) | |
Michael A. Dal Bello | | —(8) | | —(8) | |
Eric T. Fry (9) | | 130,000 | | 17.3% | |
All directors and executive officers as a group (22 persons) (10) | | 739,013 | | 95.4% | |
____________________ |
* | | Less than 1% of shares of common stock outstanding (excluding, in the case of all directors and executive officers as a group, shares beneficially owned by Blackstone and by the MSCP Funds). |
| | |
(1) | | Includes common stock interests directly and indirectly owned by each of Blackstone FCH Capital Partners IV L.P., Blackstone FCH Capital Partners IV-A L.P., Blackstone FCH Capital Partners IV-B L.P., Blackstone Capital Partners IV-A L.P., Blackstone Family Investment Partnership IV-A L.P., Blackstone Health Commitment Partners L.P. and Blackstone Health Commitment Partners-A L.P. (the “Blackstone Funds”), for which Blackstone Management Associates IV L.L.C. (“BMA”) is the general partner having voting and |
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| | investment power over the membership interests in Holdings and the shares in Vanguard held or controlled by each of the Blackstone Funds. Mr. Simpkins is a member of BMA and disclaims any beneficial ownership of the membership interests or the shares beneficially owned by BMA. Messrs. Peter G. Peterson and Stephen A. Schwarzman are the founding members of BMA and as such may be deemed to share beneficial ownership of the membership interests or shares held or controlled by the Blackstone Funds. Each of BMA and Messrs. Peterson and Schwarzman disclaims beneficial ownership of such membership interests and shares. The address of BMA and the Blackstone Funds is c/o The Blackstone Group L.P., 345 Park Avenue, New York, New York 10154. |
| | |
(2) | | The MSCP Funds consist of Morgan Stanley Capital Partners III, L.P., MSCP III 892 Investors, L.P., Morgan Stanley Capital Investors, L.P., Morgan Stanley Dean Witter Capital Partners IV, L.P., MSDW IV 892 Investors, L.P., and Morgan Stanley Dean Witter Capital Investors IV, L.P. The address of each such entity is c/o Metalmark Capital LLC, 1177 Avenue of the Americas, New York, New York 10036. |
| | |
(3) | | Includes 3,566 B units and 3,056 D units in Holdings which are vested or vest within 60 days of September 1, 2006. |
| | |
(4) | | Includes 1,259 B units and 1,079 D units in Holdings which are vested or vest within 60 days of September 1, 2006. |
| | |
(5) | | Includes 2,098 B units and 1,798 D units in Holdings which are vested or vest within 60 days of September 1, 2006. |
| | |
(6) | | Includes 1,049 B units and 899 D units in Holdings which are vested or vest within 60 days of September 1, 2006. |
| | |
(7) | | Includes 1,049 B units and 899 D units in Holdings which are vested or vest within 60 days of September 1, 2006. |
| | |
(8) | | Messrs. Jenkins and Dal Bello are employees of Blackstone, but do not have investment or voting control over the shares beneficially owned by Blackstone. |
| | |
(9) | | Mr. Fry is a Managing Director of Metalmark Capital LLC and exercises shared voting or investment power over the membership interests in Holdings owned by the MSCP Funds and, as a result, may be deemed to be the beneficial owner of such membership interests and the shares of Vanguard common stock indirectly owned. Mr. Fry disclaims beneficial ownership of such membership interests and shares of common stock as a result of his employment arrangements with Metalmark, except to the extent of his pecuniary interest therein ultimately realized. |
| | |
(10) | | Includes 1,796 options in Vanguard and 12,484 B units and 10,701 D units in Holdings which have vested or vest within 60 days of September 1, 2006. |
Equity Compensation Plan Information
The following table gives information about our common stock that may be issued upon the exercise of options, warrants and rights under all of Vanguard’s existing equity compensation plans as of June 30, 2006.
| | Equity Compensation Plan Information |
| |
|
Plan Category | | Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
(a) | | Weighted-average
exercise price of
outstanding options,
warrants and rights
(b) | | Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a))
(c) |
| |
|
Equity compensation plans approved by
security holders | | 70,657 (1) | | $1,644.12 | 27,322 (1) |
| | | | | |
Equity compensation plans not approved
by security holders | | 0 | | $ 0 | 0 |
| |
| |
|
|
Total | | 70,657 | | $1,644.12 | 27,322 |
____________________ | | | | | |
(1) The material features of the equity compensation plan under which these options were issued are set forth in this report under “Item
11. Executive Compensation – Our 2004 Stock Incentive Plan.” |
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Item 13. Certain Relationships and Related Transactions.
Holdings Limited Liability Company Agreement
In the Merger, Blackstone invested, and MSCP, Baptist and the Rollover Management Investors re-invested, in our company by subscribing for and purchasing Class A membership units in Holdings. In addition, at the closing of the Merger, the board of representatives of Holdings issued to certain Rollover Management Investors Class B, C and D membership units in Holdings as part of a new equity incentive program.
Under the limited liability company agreement of Holdings, the board of representatives of Holdings consists of the same five individuals who constitute the sole members of our board of directors. At Blackstone’s election, the size of the board of representatives may be increased to nine members, with two additional representatives to be designated by Blackstone and two additional representatives to be independent representatives identified by our chief executive officer and acceptable to Blackstone. If at any time our chief executive officer is not Charles N. Martin, Jr., the Rollover Management Investors shall have the right to designate one representative to the board (the “Manager Representative”) so long as the Rollover Management Investors continue to own not less than 50% of the Class A units held by them immediately after the completion of the Merger. MSCP will continue to be entitled to nominate and elect one representative so long as MSCP continues to own not less than 50% of the Class A units it held immediately after the completion of the Merger.
The limited liability company agreement of Holdings also has provisions relating to restrictions on transfer of securities, rights of first refusal, tag-along, drag-along, preemptive rights and affiliate transactions. At the completion of the Merger, the Company issued Class B, C and D warrants to Holdings, exercisable for the proportional percentage of equity represented by the related classes of membership units in Holdings. With respect to the Class B, C and D units only, the limited liability company agreement also has call provisions applicable in the event of certain termination events relating to a Rollover Management Investor’s employment.
Stockholders Agreement
Recipients of options to purchase the Company’s common stock are required to enter into a stockholders agreement governing such grantees’ rights and obligations with respect to the common stock underlying such options. The provisions of the stockholders agreement are, with limited exceptions, similar to those set forth in the limited liability company agreement of Holdings, including certain restrictions on transfer of shares of common stock, rights of first refusal, call rights, tag-along rights and drag-along rights. The transfer restrictions apply until the earlier of the fifth anniversary of the date the stockholder becomes a party to the stockholders agreement, or a change in control of the Company. The right of first refusal provision gives the Company a right of first refusal at any time after the fifth anniversary of the date the stockholder became a party to the stockholders agreement and prior to the earlier of a change in control of the Company or a registered public offering of our common stock meeting certain specified criteria. The call provisions provide rights with respect to the shares of our common stock held by the stockholder, whether or not such shares were acquired upon the exercise of a New Option, except for shares received upon conversion of or in redemption for Class A membership units in Holdings pursuant to the limited liability company agreement of Holdings. Such call rights are applicable in the event of certain termination events relating to the grantee’s employment with the Company.
Transaction and Monitoring Fee Agreement
In connection with the Merger, Vanguard entered into a transaction and monitoring fee agreement with affiliates of Blackstone and Metalmark pursuant to which these affiliates provide certain structuring, advisory and management services to us. Under this agreement, Vanguard paid to Blackstone Management Partners IV L.L.C. (“BMP”) upon the closing of the Merger a transaction fee of $20.0 million. In consideration for ongoing consulting and management advisory services, Vanguard is required to pay to BMP an annual fee of $4.0 million. In consideration for on-going consulting and management services Vanguard is required to pay to Metalmark Subadvisor LLC (“Metalmark SA”), an affiliate of Metalmark, an annual fee of $1.2 million for the first five years and thereafter an annual fee of $600,000. In the event or in anticipation of a change of control or initial public offering, BMP may elect at any time to have Vanguard pay to BMP and Metalmark SA lump sum cash payments
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equal to the present value (using a discount rate equal to the yield to maturity on the date of notice of such event of the class of outstanding U.S. government bonds having a final maturity closest to the tenth anniversary of such written notice) of all then-current and future fees payable to each of BMP and Metalmark SA under the agreement (assuming that the agreement terminates on the tenth anniversary of the closing of the Merger). In the event that BMP receives any additional fees in connection with an acquisition or disposition involving Vanguard, Metalmark SA will receive an additional fee equal to 15.0% of such fees paid to BMP or, if both parties provide equity financing in connection with the transaction, Metalmark SA will receive a portion of the aggregate fees payable by Vanguard, if any, based upon the amount of equity financing provided by Metalmark SA. The transaction and monitoring fee agreement also requires Vanguard to pay or reimburse BMP and Metalmark SA for reasonable out-of-pocket expenses in connection with, and indemnify them for liabilities arising from, the engagement of BMP and Metalmark SA of independent professionals pursuant to and the performance by BMP and Metalmark SA of the services contemplated by the transaction and monitoring fee agreement. The transaction and monitoring fee agreement will remain in effect with respect to each of BMP and Metalmark SA until the earliest of (1) BMP and Metalmark SA, as the case may be, beneficially owning less than 5.0% of Vanguard’s common equity on a fully diluted basis, (2) the completion of a lump-sum payout as described above or (3) termination of the agreement upon the mutual consent of BMP and/or Metalmark SA, as the case may be, and Vanguard. Upon termination of Metalmark SA as a party to the agreement, Metalmark SA will be entitled to the excess, if any, of 15.0% of the aggregate amount of fees paid to date to BMP under the agreement minus any monitoring fees already paid to Metalmark SA.
Under the transaction and monitoring fee agreement during fiscal year 2006, Vanguard paid to BMP the annual $4.0 million fee referred to above. BMP is an affiliate of the Blackstone Funds which own 66.0% of the equity of Vanguard. Three of our five directors, Messrs. Dal Bello, Jenkins and Simpkins, are employed by affiliates of BMP.
Under the transaction and monitoring fee agreement during fiscal year 2006, Vanguard paid to Metalmark SA the annual $1.2 million fee referred to above. Vanguard also incurred $2,569 of the out-of-pocket expenses of Metalmark SA in connection with performing services for us under the agreement, which Vanguard paid to Metalmark in July 2006. Metalmark SA is an affiliate of Metalmark Capital LLC which manages the MSCP Funds and the MSCP Funds own 17.3% of the equity of Vanguard. One of our five directors, Eric T. Fry, is employed by an affiliate of Metalmark SA.
Registration Rights Agreement
In connection with the Merger, the Company entered into a registration rights agreement with Blackstone, MSCP and other investors and the Rollover Management Investors, pursuant to which Blackstone and MSCP are entitled to certain demand registration rights and pursuant to which Blackstone, MSCP and other investors and the Rollover Management Investors are entitled to certain piggyback registration rights.
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Item 14. Principal Accounting Fees and Services.
Fees Paid to the Independent Auditor
The following table presents fees for professional services rendered by Ernst & Young LLP for the audit of Vanguard’s annual financial statements for 2005 and 2006, and fees billed for audit-related services, tax services and all other services rendered by Ernst & Young LLP for 2005 and 2006.
| | 2005 | | | | 2006 | |
| |
| | | |
| |
Audit fees(1) | $ | 1,230,549 | | | $ | 771,187 | |
Audit-related fees(2) | | 42,442 | | | | – | |
| |
| | | |
| |
Audit and audit-related fees | | 1,272,991 | | | | 771,187 | |
Tax fees(3) | | 45,698 | | | | 78,954 | |
All other fees(4) | | 590,104 | | | | 1,128,488 | |
| |
| | | |
| |
Total fees(5) | $ | 1,908,793 | | | $ | 1,978,629 | |
| |
| | | |
| |
____________________ |
(1) | | Audit fees for 2005 and 2006 include fees for the audit of the annual consolidated financial statements, reviews of the condensed consolidated financial statements included Vanguard’s quarterly reports and statutory audits. Additionally, audit fees for 2005 include fees for services provided in connection with a Rule 144A offering memorandum and Registration statement and issuances of related letters to the initial purchasers and consents. |
| | |
(2) | | Audit-related fees for 2005 consisted principally of fees for advice and consultation related to the potential acquisition of the Company. |
| | |
(3) | | Tax fees for 2005 and 2006 consisted principally of fees for tax advisory services. |
| | |
(4) | | All other fees for 2005 and 2006 consisted of assistance in filing Medicare and Medicaid appeals and reopening requests for cost reports that had been settled by the fiscal intermediary; assistance in identification of Medicaid eligible days for inclusion in the Medicare cost reports for Medicare disproportionate share reimbursement and assistance on accounting issues in the ownership of medical office buildings. |
| | |
(5) | | Ernst & Young LLP full time, permanent employees performed all of the professional services described in this chart. |
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Pre-Approval Policies and Procedures
In February 2004, our board of directors first adopted an audit and non-audit services pre-approval policy and in November 2004 and May 2006 the board amended and restated this policy. This policy sets forth the Board’s procedures and conditions pursuant to which services proposed to be performed by the Company’s regular independent auditor (and those other independent auditors for whom pre-approvals are legally necessary) are presented to the Board for pre-approval. Normally, the policy would have been approved by the audit committee and ratified by the board of directors, but in February 2004, November 2004 and May 2006 we had no audit committee and, as a result, the full board of directors has the responsibility for all matters that are usually the responsibility of the audit committee.
The policy provides that the board of directors shall pre-approve audit services, audit-related services, tax services and those other services that it believes to be routine and recurring services that do not impair the independence of the auditor. Under the policy, our Chief Accounting Officer is responsible for determining whether services provided by the independent auditor are included as part of those services already pre-approved or whether separate approval from the board of directors is required. All services performed for us by Ernst & Young LLP, our independent registered public accounting firm, subsequent to the adoption of the policy have been pre-approved by the board of directors. The board of directors has concluded that the audit-related services, tax services and other non-audit services provided by Ernst & Young LLP in fiscal year 2006 were compatible with the maintenance of the firm’s independence in the conduct of its auditing functions. In addition, to safeguard the continued independence of the independent auditors, the policy prevents our independent auditors from providing services to us that are prohibited under Section 10A(g) of the Securities Exchange Act of 1934, as amended.
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PART IV
Item 15. Exhibits and Financial Statement Schedules.
(a) List of documents filed as part of this report.
(1) Financial Statements. The accompanying index to financial statements on page F-1 of this
report is provided in response to this item.
(2) Financial Statement Schedules. All schedules are omitted because the required information
is either not present, not present in material amounts or presented within the consolidated
financial statements.
(3) Exhibits. The exhibits filed as part of this report are listed in the Exhibit Index which is
located at the end of this report.
(b) Exhibits.
See Item 15(a)(3) of this report.
(c) Financial Statement Schedules.
See Item 15(a)(2) of this report.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
VANGUARD HEALTH SYSTEMS, INC. Date
By: /s/ Charles N. Martin, Jr. September 20, 2006
Charles N. Martin, Jr.
Chairman of the Board & Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature | | Title | | Date |
/s/ Charles N. Martin, Jr. | | Chairman of the Board & Chief Executive Officer;
Director
(Principal Executive Officer) | | September 20, 2006 |
Charles N. Martin, Jr. |
| | | | |
/s/ Joseph D. Moore | | Executive Vice President, Chief Financial Officer &
Treasurer
(Principal Financial Officer) | | September 20, 2006 |
Joseph D. Moore |
| | | | |
/s/ Phillip W. Roe | | Senior Vice President, Controller & Chief Accounting
Officer
(Principal Accounting Officer) | | September 20, 2006 |
Phillip W. Roe |
| | | | |
/s/ Michael A. Dal Bello | | Director | | September 20, 2006 |
Michael A. Dal Bello |
| | | | |
/s/ Eric T. Fry | | Director | | September 20, 2006 |
Eric T. Fry |
| | | | |
/s/ Benjamin J. Jenkins | | Director | | September 20, 2006 |
Benjamin J. Jenkins |
| | | | |
/s/ Neil P. Simpkins | | Director | | September 20, 2006 |
Neil P. Simpkins |
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Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) of the Act by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Act.
No annual report or proxy material has been sent to security holders.
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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
| | Page |
| |
|
VANGUARD HEALTH SYSTEMS, INC. | | |
Consolidated Financial Statements: | | |
Report of Independent Registered Public Accounting Firm | | F-2 |
Consolidated Balance Sheets as of June 30, 2005 and 2006 | | F-3 |
Consolidated Statements of Operations for the years ended June 30, 2004, 2005 and 2006 | | F-4 |
Consolidated Statements of Operations for the predecessor period July 1, 2004 through September
22, 2004, the successor period September 23, 2004 through June 30, 2005
and the combined year ended June 30, 2005 | | F-5 |
Consolidated Statements of Stockholders’ Equity for the years ended June 30, 2004, 2005 and 2006 | | F-6 |
Consolidated Statements of Cash Flows for the years ended June 30, 2004, 2005 and 2006 | | F-7 |
Consolidated Statements of Cash Flows for the predecessor period July 1, 2004 through September
22, 2004, the successor period September 23, 2004 through June 30, 2005
and the combined year ended June 30, 2005 | | F-9 |
Notes to Consolidated Financial Statements | | F-10 |
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
Vanguard Health Systems, Inc.
We have audited the accompanying consolidated balance sheets of Vanguard Health Systems, Inc. as of June 30, 2006 and 2005 and the related consolidated statements of operations, stockholders’ equity and cash flows for the year ended June 30, 2006 and for the period from September 23, 2004 to June 30, 2005 and the related consolidated statements of operations, stockholders’ equity and cash flows of Vanguard Health Systems, Inc. (Predecessor) for the period from July 1, 2004 to September 22, 2004 and the year ended June 30, 2004 (Predecessor). 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vanguard Health Systems, Inc. at June 30, 2006 and 2005 and the consolidated results of its operations and its cash flows for the year ended June 30, 2006 and the period from September 23, 2004 to June 30, 2005 and the consolidated results of its operations and its cash flows for the period from July 1, 2004 to September 22, 2004 and for the year ended June 30, 2004 (Predecessor) in conformity with U.S. generally accepted accounting principles.
/s/ Ernst & Young LLP
Nashville, Tennessee
August 31, 2006
F-2
