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, 2011. The selected historical financial data as of and for the years ended June 30, 2007, 2008, 2009, 2010 and 2011 were derived from our consolidated financial statements that have been audited by Ernst & Young LLP, an independent registered public accounting firm. Dispositions completed during fiscal 2007 and fiscal 2010 have been excluded from all periods presented. See “Executive Overview” included in “
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 in this Report. Our actual results may differ materially from those estimated or projected in any of these forward-looking statements.
In June 2011, we completed our initial public offering (the IPO) of 25,000,000 shares of our common stock. Including the subsequent exercise in July 2011 of the underwriters’ over-allotment option to purchase 3,750,000 shares, a total of 28,750,000 shares were sold by us at a price of $18.00 per share (prior to deducting underwriter discounts and commissions) in connection with the IPO. We used the net proceeds from the IPO to redeem a substantial portion of our 10.375% Senior Discount Notes due 2016 including the 5% redemption premium. Our common stock is now traded on the New York Stock Exchange (symbol “VHS”).
As of June 30, 2011, we owned and operated 26 hospitals with a total of 6,201 licensed beds, and related outpatient service facilities complementary to the hospitals in San Antonio, Texas; metropolitan Detroit, Michigan; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; and Massachusetts, and two surgery centers in Orange County, California. As of June 30, 2011, we also owned three health plans with approximately 245,100 members.
Effective January 1, 2011, we purchased substantially all of the assets of DMC, which assets consist primarily of eight acute care and specialty hospitals in the Detroit, Michigan metropolitan area and related healthcare facilities. These eight hospitals are DMC Children’s Hospital of Michigan, DMC Detroit Receiving Hospital, DMC Harper University Hospital, DMC Huron Valley-Sinai Hospital, DMC Hutzel Women’s Hospital, DMC Rehabilitation Institute of Michigan, DMC Sinai-Grace Hospital and DMC Surgery Hospital, with a combined 1,734 licensed beds. We paid cash of $368.1 million to acquire the DMC assets using cash on hand ($4.8 million of this amount represented acquisition related expenses).
Our ability to attract skilled physicians to our hospitals is critical to our success. Coordination of care and alignment of care strategies between hospitals and physicians will become more critical as reimbursement becomes more episode-based. During fiscal year 2010, we added 70 employed physicians to our physician network (net of physicians who left our network). During fiscal year 2011, we added over 200 additional employed physicians including those from our fiscal year 2011 acquisitions. Our acquisitions of the Arizona Heart Institute and a cardiology group in San Antonio represented important steps in our physician alignment process. We have invested heavily in the infrastructure necessary to coordinate our physician alignment strategies and manage our physician operations. Our hospitalist employment strategy is a key element in coordination of patient-centered care. Because these initiatives require significant upfront investment and may take years to fully implement, our operating results and cash flows could be negatively impacted during the short-term.
The integral component of each of the challenge areas previously discussed is quality of care. We have implemented many of our expanded clinical quality initiatives and are in the process of implementing several others. These initiatives include monthly review of the 46 CMS quality indicators in place for federal fiscal year 2011, rapid response teams, mock Joint Commission surveys, hourly nursing rounds, our nurse leadership professional practice model, alignment of hospital management incentive compensation with quality performance indicators, and the formation of Physician Advisory Councils at our hospitals to align the quality goals of our hospitals with those of the physicians who practice in our hospitals.
Similar to other companies in the hospital industry, we face continued pressures in collecting outstanding accounts receivable primarily due to volatility in the uninsured and underinsured populations in the markets we serve. The following table provides a summary of our accounts receivable payer class mix as of each respective period presented.
Our combined allowances for doubtful accounts, uninsured discounts and charity care covered 83.8% and 88.2% of combined self-pay and self-pay after primary accounts receivable as of June 30, 2010 and 2011, respectively. This ratio was 92.5% on a same hospital basis as of June 30, 2011.
Healthcare spending comprises a significant portion of total spending in the United States and has been growing at annual rates that exceed inflation, wage growth and gross national product. There is considerable pressure on governmental payers, managed Medicare/Medicaid payers and commercial managed care payers to control costs by either reducing or limiting increases in reimbursement to healthcare providers or limiting benefits to enrollees. The current weakness in the U.S. economy has magnified these pressures.
The Governor of Arizona has signed the state’s fiscal 2012 budget legislation, which includes a 5% cut to provider reimbursement effective October 1, 2011, and a reduction of approximately 160,000 eligible Medicaid beneficiaries (including 100,000 childless adults) to be achieved over a twelve month period, beginning July 2011, through enrollment caps, attrition and more stringent eligibility requirements. Arizona had most recently reduced provider reimbursement by 5% in April 2011. These changes require CMS approval under the Health Reform Law. Arizona has received a waiver from CMS which eliminates Medicaid coverage for the estimated 100,000 childless adults and is currently awaiting approval on the remaining 60,000 eligible beneficiaries, which represent families with income levels that fall between 75% and 100% of the federal poverty level. Additionally, AHCCCS has proposed a gain sharing plan, the details of which have not been finalized, which would be implemented through an annual reconciliation process with the managed Medicaid health plans.
If we do not receive increased payer reimbursement rates from governmental or managed care payers that cover the increasing cost of providing healthcare services to our patients or if governmental payers defer payments to our hospitals, our financial position, results of operations and cash flows could be materially adversely impacted.
As previously discussed, in response to the State of Arizona’s budget deficiency during its 2012 fiscal year, AHCCCS has reduced eligibility for coverage and is considering changes to its current contract with PHP that would negatively impact PHP’s current and future revenues. AHCCCS could still take further actions in the near term that could materially adversely impact our operating results and cash flows including further reimbursement rate cuts, enrollment reductions, capitation payment deferrals, covered services reductions or limitations or other steps to reduce program expenditures including cancelling PHP’s contract.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). 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 because they involve highly 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.
We recognize patient service revenues during the period the healthcare services are provided based upon estimated amounts due from payers. We record contractual adjustments to our gross charges to reflect expected reimbursement negotiated with or prescribed by third party 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, we apply contractual adjustments 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 payment is received. If our estimated contractual adjustments as a percentage of gross revenues were 1% higher for all insured accounts, our net revenues would have been reduced by approximately $81.0 million and $117.9 million for the years ended June 30, 2010 and 2011, respectively. We derive most of our patient service revenues from healthcare services provided to patients with Medicare (including managed Medicare plans) or managed care insurance coverage.
Medicare regulations and many of our 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, disproportionate share payments, reimbursable Medicare bad debts and other items that are often subject to interpretation that could result in payments that differ from recorded estimates. We estimate amounts owed to or receivable from the Medicare program using the best information available 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 our consolidated statements of operations in the period in which the revisions are made. Net adjustments for final third party settlements increased patient service revenues and income from continuing operations before income taxes by $8.0 million, $6.6 million and $7.3 million during the years ended June 30, 2009, 2010 and 2011, respectively. Additionally, updated regulations and contract negotiations with payers occur frequently, which necessitates continual review of revenue estimation processes by management. We believe that future adjustments to our current third party settlement estimates will not materially impact our results of operations, cash flows or financial position.
Our presentation of revenues and revenue deductions in our fiscal year 2012 is expected to be significantly modified based upon the reclassification of the allowance for doubtful accounts and provision for doubtful accounts. In July 2011, the Financial Accounting Standards Board (the “FASB”) issued accounting standards update (“ASU”) 2011-07, “Health Care Entities (Topic 954): Presentation of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities,” which will require healthcare entities to present the provision for doubtful accounts related to patient service revenues as a deduction from patient service revenues in the statement of operations rather than as an operating expense. We expect to early adopt this guidance effective July 1, 2011. Additional disclosures relating to our sources of patient revenues and allowance for doubtful accounts related to patient accounts receivable will be required. Upon the retrospective adoption of this ASU, we will reclassify the provision for doubtful accounts related to prior period patient service revenues as a deduction from patient service revenues as required by this ASU.
We record revenues related to the Provider Tax Assessment (“PTA”) programs, such as those in Illinois and Michigan, when the receipt of payment from the state entity is assured. For the Texas Upper Payment Limit (“UPL”) program we recognize revenues that offset the expenses associated with the provision of charity care when the services are provided. We recognize federal match revenues under the Texas UPL program when payments are assured.
We earned premium revenues of $678.0 million, $839.7 million and $869.4 million during the years ended June 30, 2009, 2010, 2011, respectively, from our health plans. Our health plans, PHP, AAHP and MHP, have agreements with AHCCCS, CMS and various health maintenance organizations (“HMOs”), respectively, 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 type of members 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 Medicare Part D reinsurance premiums and low income subsidy cost sharing premiums that are recorded as a liability to fund future healthcare costs or else repaid to CMS.
We estimate our allowance for doubtful accounts using a standard policy that reserves all accounts aged greater than 365 days subsequent to discharge date plus percentages of uninsured accounts and self-pay after insurance accounts less than 365 days old. We test our allowance for doubtful accounts policy quarterly using a hindsight calculation that utilizes write-off data for all payer classes during the previous twelve-month period to estimate the allowance for doubtful accounts at a point in time. We also supplement our analysis by comparing cash collections to net patient revenues and monitoring self-pay utilization. We adjust the standard percentages in our allowance for doubtful accounts reserve policy as necessary given changes in trends from these analyses or policy changes, such as the uninsured discount policy we implemented in Phoenix, San Antonio and Illinois. If our uninsured accounts receivable as of June 30, 2010 and 2011 were 1% higher, our provision for doubtful accounts would have increased by $0.7 million and $2.1 million, respectively. Significant changes in payer mix, business office operations, general economic conditions and healthcare coverage provided by federal or state governments or private insurers may have a significant impact on our estimates and significantly affect our liquidity, results of operations and cash flows.
We have a self-insured medical plan for all of our employees. Claims are accrued under the self-insured plan as the incidents that gave rise to them occur. Unpaid claims accruals are based on the estimated ultimate cost of settlement, including claim settlement expenses, in accordance with an average lag time and historical experience.
Due to 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. We maintain professional and general liability insurance with unrelated commercial insurance carriers to provide for losses up to $65.0 million in excess of our self-insured retention (such self-insured retention maintained through our captive insurance subsidiary and/or other of our subsidiaries) of $10.0 million through June 30, 2010 but increased to $15.0 million for the Illinois hospitals subsequent to June 30, 2010.
In developing our estimates of our reserves for employee health, professional and general liability and workers compensation claims, we utilize actuarial and certain case-specific information. 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 human resource and risk managers and its best judgment to estimate case reserves. Actuarial IBNR estimates are dependent on multiple variables including our risk exposures, our self-insurance limits, 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, and changes in these variables could result in significant period over period fluctuations in our estimates. We discount our workers compensation reserve using actuarial estimates of projected cash payments in future periods (approximately 4.0% for fiscal year 2011). We do not discount our professional and general liability reserve. We adjust these reserves from time to time as we receive updated information.
During the years ended June 30, 2009, 2010 and 2011, health plan claims expense was $525.6 million, $665.8 million and $686.3 million, respectively, primarily representing medical claims of PHP. We estimate PHP’s reserve for medical claims using historical claims experience (including cost per member and payment lag time) and other actuarial data including number of members and certain member demographic information. The following table provides the health plan reserve balances as of June 30, 2010 and 2011 and health plan claims and payment information during the years ended June 30, 2009, 2010 and 2011, respectively (in millions).
Availability, or lack thereof, of taxable income in prior carryback periods that would limit realization of tax benefits;
In addition, financial forecasts used in determining the need for or amount of federal and state valuation allowances are subject to changes in underlying assumptions and fluctuations in market conditions that could significantly alter our recoverability analysis and thus have a material adverse effect on our consolidated financial condition, results of operations or cash flows. Effective July 1, 2007, we adopted the relevant guidance for accounting for uncertainty in income taxes. The following table provides a detailed rollforward of our net liability for uncertain tax positions for the years ended June 30, 2009, 2010 and 2011 (in millions).
The provisions set forth in accounting for uncertain tax positions allow for the classification election of interest on an underpayment of income taxes, when the tax law requires interest to be paid, and penalties, when a tax position does not meet the minimum statutory threshold to avoid payment of penalties, in income taxes, interest expense or another appropriate expense classification based on the accounting policy election of the entity. We elected to continue our historical practice of classifying interest and penalties as a component of income tax expense. Of the $13.2 million total unrecognized tax benefits, $0.3 million of the balance as of June 30, 2011 would impact the effective tax rate if recognized.
Long-lived assets, including property, plant and equipment and amortizable intangible assets comprise a significant portion of our total assets. We evaluate the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist. When management believes impairment indicators may exist, projections of the undiscounted future cash flows associated with the use of and eventual disposition of long-lived assets held for use are prepared. If the projections indicate that the carrying values of the long-lived assets are not recoverable, we reduce the carrying values to fair value. In May 2009, we recorded a $6.2 million ($3.8 million net of taxes) impairment charge to write-down the value of a building that we currently lease to other healthcare service providers to fair value. For long-lived assets held for sale, we compare the carrying values to an estimate of fair value less selling costs to determine potential impairment. We test for impairment of long-lived assets at the lowest level for which cash flows are measurable. These impairment tests are heavily influenced by assumptions and estimates that are subject to change as additional information becomes available. Given the relatively few number of hospitals we own and the significant amounts of long-lived assets attributable to those hospitals, an impairment of the long-lived assets for even a single hospital could materially adversely impact our operating results or financial position.
Goodwill also represents a significant portion of our total assets. We review goodwill for impairment annually during our fourth fiscal quarter or more frequently if certain impairment indicators arise. We review goodwill at the reporting level unit, which is one level below an operating segment. We compare the carrying value of the net assets of each reporting unit to the net present value of estimated discounted future cash flows of the reporting unit. If the carrying value exceeds the net present value of estimated discounted future cash flows, an impairment indicator exists and an estimate of the impairment loss is calculated. The fair value calculation includes multiple assumptions and estimates, including the projected cash flows and discount rates applied. Changes in these assumptions and estimates could result in goodwill impairment that could materially adversely impact our financial position or results of operations.
During the first half of fiscal 2010 we re-assessed the operating results of our then existing Illinois facilities and concluded that it was unlikely that previously projected cash flows for these hospitals would be achieved. We performed an interim goodwill impairment test during the quarter ended December 31, 2009 and, based upon revised projected cash flows, market participant data and appraisal information, we determined that the $43.1 million remaining goodwill related to this reporting unit was impaired. The $43.1 million ($31.8 million, net of taxes) non-cash impairment loss is included in our consolidated statement of operations for the year ended June 30, 2010.
The following table sets forth certain operating statistics on a consolidated and same hospital basis for each of the periods presented. We have excluded eleven of our hospitals from the same hospital statistics for the year ended June 30, 2011. The eleven hospitals excluded from the same hospital statistics were all acquired in our fiscal year ended June 30, 2011.
Inpatient surgeries represent the number of surgeries performed in our hospitals where overnight stays are necessary.
Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stay not necessary).
Discharges, adjusted discharges and emergency room visits increased 32.9%, 36.7% and 47.7%, respectively, during the current year compared to the prior year, while total surgeries increased by 31.2% during the current year. On a same hospital basis, adjusted discharges and emergency room visits increased 2.4% and 6.0%, respectively, during the current year compared to the prior year, while discharges and total surgeries decreased by 0.3% and 4.3%, respectively. General economic weakness in the United States economy continues to impact demand for elective surgical procedures. Patient revenue per adjusted discharge on a same hospital basis increased 2.5% during the current year. The low growth rate during 2011 was primarily attributable to a shift from higher-paying managed care volumes to lower-paying Medicaid and Managed Medicaid volumes. We continue to face volume and pricing pressures as a result of continuing economic weakness in the communities our hospitals serve, state efforts to reduce Medicaid program expenditures and intense competition for limited physician and nursing resources, among other factors. We expect the average population growth in the markets we serve to remain generally high in the long-term. As these populations increase and grow older, we believe that our clinical quality initiatives will improve our competitive position in those markets. However, these growth opportunities may not overcome the current industry and market challenges in the short-term.
Provision for doubtful accounts. The provision for doubtful accounts as a percentage of patient service revenues increased to 7.5% during the current year from 6.0% during the prior year. This ratio was negatively impacted in the current year by the increase in self-pay volumes, as measured on a same hospital basis, and by the continued challenges we face to collect the patient co-pays and deductibles. On a combined basis, the provision for doubtful accounts, charity care deductions and uninsured discounts as a percentage of acute care services segment revenues (prior to these revenue deductions) was 15.8% and 15.7% on a consolidated basis and 15.8% and 17.5% on a same hospital basis for the years ended June 30, 2010 and 2011, respectively.
Income taxes. Our effective tax rate was approximately 118.1% during the year ended June 30, 2011 compared to 23.6% during the prior year. The effective rate was higher in the current year due to the non-deductibility of certain components of monitoring fees and expenses and an increase in the valuation allowance associated with state net operating loss carryforwards. The effective rate was lower during the prior year due to the fact that a considerable portion of the goodwill impairment loss related to our Illinois hospitals reporting unit, as previously discussed, was non-deductible for tax purposes.
Net income (loss) attributable to Vanguard Health Systems, Inc. stockholders. Net loss attributable to Vanguard stockholders was $10.9 million and $49.2 million for the years ended June 30, 2011 and 2010, respectively. In addition to changes to our core business due to acquisitions in the current year, this change resulted from the goodwill impairment loss and the debt extinguishment costs recognized during the prior year.
Discharges, adjusted discharges and emergency room visits increased 0.3%, 2.4% and 3.4%, respectively, during the year ended June 30, 2010 compared to the prior year, while total surgeries decreased by 0.9% during the year ended June 30, 2010. Two new competitor hospitals in San Antonio opened in March 2009 and July 2009, which negatively impacted volumes in certain of our San Antonio hospitals during the year ended June 30, 2010.
Costs and expenses. Total costs and expenses from continuing operations, exclusive of income taxes, were $3,435.3 million, or 101.7% of total revenues, during the year ended June 30, 2010, compared to 98.5% during the prior year. The current year measure was negatively impacted by the goodwill impairment loss related to our Illinois hospitals recognized in December 2009 and by debt extinguishment costs incurred to complete our refinancing finalized in January 2010 as further discussed in “Liquidity and Capital Resources” and presented elsewhere in this report. Many year over year comparisons of individual cost and expense items as a percentage of total revenues, particularly for health plan claims expense and the provision for doubtful accounts, were impacted by the significant growth in health plan premium revenues and the uninsured discount and Medicaid pending policy changes previously discussed. Salaries and benefits, health plan claims, supplies and provision for doubtful accounts represent the most significant of our normal costs and expenses and those typically subject to the greatest level of fluctuation year over year.
Health plan claims. Health plan claims expense as a percentage of premium revenues increased to 79.3% during the year ended June 30, 2010, compared to 77.5% during the prior year. As enrollment increases, this ratio becomes especially sensitive to the mix of members, including covered groups based upon age and gender and county of residence. AHCCCS also implemented limits on profitability for certain member groups during the current contract year, which negatively impacted this ratio. In addition, the increased PHP revenues diluted the impact of the third party administrator revenues at MHP that have no corresponding health plan claims expense. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $42.8 million, or 6.0% of gross health plan claims expense, were eliminated in consolidation during the year ended June 30, 2010.
Provision for doubtful accounts. The provision for doubtful accounts as a percentage of patient service revenues decreased to 6.0% during the year ended June 30, 2010 from 8.4% during the prior year. Most of this decrease related to the uninsured discount policy and Medicaid pending policy changes previously discussed. The net impact of these policy changes resulted in the recognition of a significant amount of uninsured revenue deductions that would have otherwise been reflected in the provision for doubtful accounts absent these changes.
Other. Depreciation and amortization increased by $10.7 million year over year as a result of our capital improvement and expansion initiatives. Net interest increased slightly year over year. We recorded a goodwill impairment loss of $43.1 million ($31.8 million, net of taxes) related to our Illinois hospitals during the year ended June 30, 2011, based upon an interim goodwill impairment test completed in December 2009. In connection with the Refinancing, we recorded debt extinguishment costs of $73.5 million ($45.6 million, net of taxes) during the year ended June 30, 2010.
Income taxes. Our effective tax rate was approximately 23.6% during the year ended June 30, 2010, compared to 34.4% during the prior year. The effective rate was lower during the current year due to the fact that a considerable portion of the goodwill impairment loss related to our Illinois hospitals reporting unit, as previously discussed, was non-deductible for tax purposes.
Net income (loss) attributable to Vanguard Health Systems, Inc. stockholders. Net loss attributable to Vanguard stockholders was $49.2 million during the year ended June 30, 2010, compared to net income attributable to Vanguard Health Systems, Inc. stockholders of $28.6 million during the prior year. This change resulted primarily from the goodwill impairment loss and the debt extinguishment costs recognized during the current year.
On January 26, 2011, we issued an aggregate principal amount of $350.0 million of senior notes due 2019 (the “2011 Senior Notes”) and senior discount notes due 2016 with a stated principal amount at maturity of approximately $747.2 million generating approximately $444.7 million of gross proceeds (the “2011 Discount Notes”), each in a private placement. The 2011 Senior Notes bear interest at a rate of 7.750% per annum. We will pay cash interest on the 2011 Senior Notes semi-annually in arrears on February 1 and August 1 of each year, beginning on August 1, 2011. The 2011 Senior Notes mature on February 1, 2019. We used the proceeds from the 2011 Senior Notes for general corporate purposes, including acquisitions, and to pay the related transaction fees and expenses of both notes offerings. The 2011 Discount Notes have an initial accreted value of $602.23 per $1,000 stated principal amount at maturity and were issued at a price of $595.08 per $1,000 stated principal amount at maturity. No cash interest will accrue on the 2011 Discount Notes, but the 2011 Discount Notes will accrete at a rate of 10.375% per annum, compounded semi-annually on February 1 and August 1 of each year, such that the accreted value will equal the stated principal amount at maturity on February 1, 2016. We used the proceeds from the offering of the 2011 Discount Notes to pay a dividend to our equity holders.
Our 2010 Credit Facilities 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 8.0% Notes and the 2011 Senior Notes); pay certain 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; create a healthcare joint venture; engage in certain transactions with affiliates; amend certain material agreements governing our indebtedness, including the 8.0% Notes and the 2011 Senior Notes; change the business conducted by our subsidiaries; enter into certain hedging agreements; and make capital expenditures above specified levels. In addition, the 2010 credit facilities include a maximum consolidated leverage ratio and a minimum consolidated interest coverage ratio. The following table sets forth the leverage and interest coverage covenant tests as of June 30, 2011.
We anticipate spending a total of $400.0 million to $450.0 million in capital expenditures during fiscal 2012. We expect that cash on hand, cash generated from our operations and cash available to us under our 2010 Credit Facilities will be sufficient to meet our working capital needs, debt service requirements and planned capital expenditure programs during the next twelve months and into the foreseeable future, including those required by the DMC purchase agreement. As previously mentioned, the DMC purchase agreement requires that we expend $350.0 million for routine capital needs and $500.0 million for a specified project list related to the DMC facilities during the five year period subsequent to the acquisition. The $500.0 million commitment for specified construction projects and the $350.0 million for routine capital expenditures include the following annual aggregate spending as of June 30, 2011: $126.0 million committed within one year; $300.0 million committed within two to three years and $400.0 million within four to five years. We cannot assure you that our operations will generate sufficient cash or that cash on hand, additional future borrowings under our 2010 Credit Facilities or additional equity offerings will be available to enable us to meet these requirements, especially given the current general economic weakness.
In addition, our liquidity and ability to fund our capital requirements are dependent on our future financial performance, which is subject to general economic, financial and other factors that are beyond our control. If those factors significantly change or other unexpected factors adversely affect us, our business may not generate sufficient cash flows from operations or we may not be able to obtain future financings to meet our liquidity needs. We anticipate that to the extent additional liquidity is necessary to fund our operations, it would be funded through borrowings under our 2010 Revolving Facility, the incurrence of other indebtedness, additional equity issuances or a combination of these potential sources of liquidity. We may not be able to obtain additional liquidity when needed on terms acceptable to us.
The following table reflects a summary of obligations and commitments outstanding, including both the principal and interest portions of long-term debt, with payment dates as of June 30, 2011.
Includes both principal and interest payments. The interest portion of our debt outstanding at June 30, 2011 assumes an average interest rate of 8.0%.
This obligation represents our estimated minimum required funding to the DMC Pension Plan trust beginning in our first quarter of fiscal year 2012. Because the future cash outflows are uncertain and subject to change, the timing and amounts of payments to the trust beyond twelve months are not included as of June 30, 2011. For additional information about the DMC Pension Plan and expected future benefit payments from the trust see Item 8 - Note 10 to the Consolidated Financial Statements.
Consolidated Statements of Operations for the years ended June 30, 2009, 2010 and 2011
Consolidated Statements of Equity for the years ended June 30, 2009, 2010 and 2011
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, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2011, in conformity with U.S. generally accepted accounting principles.
The Sponsors have provided management and advisory services to Vanguard pursuant to the transaction and monitoring fee agreement among Vanguard and the Sponsors executed in connection with Holdings’ acquisition of Vanguard in September 2004. The transaction and monitoring fee agreement was terminated pursuant to its terms upon completion of the initial public offering of Vanguard’s common stock, and Vanguard recorded a liability payable quarterly through July 1, 2014 of $14.9 million. The accrued liability is included in other accrued expenses and current liabilities on the accompanying consolidated balance sheet.
The accompanying consolidated financial statements include the accounts of subsidiaries and affiliates controlled by Vanguard. Vanguard generally defines control as the ownership of the majority of an entity’s voting interests. Vanguard also consolidates any entities for which it receives the majority of the entity’s expected returns or is at risk for the majority of the entity’s expected losses based upon its investment or financial interest in the entity. All material intercompany accounts and transactions have been eliminated. The share and earnings per share information included in the accompanying consolidated financial statements and included in Note 12 reflect the impact of the stock split that Vanguard effectuated in connection with the initial public offering of its common stock. The majority of Vanguard’s expenses are “cost of revenue” items. Costs that could be classified as general and administrative include certain Vanguard corporate office costs, which approximated $44.3 million, $65.8 million and $71.9 million for the years ended June 30, 2009, 2010 and 2011, respectively.
In preparing Vanguard’s financial statements in conformity with accounting principles generally accepted in the United States, management makes estimates and assumptions that affect the amounts recorded or classification of items in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
During the third quarter of fiscal 2009, the federal government approved federal matching funds for the Illinois Provider Tax Assessment (“PTA”) program. The PTA program enables the State of Illinois to increase funding for its state Medicaid plan. Hospitals providing services to Medicaid enrollees receive funds directly from the state. Hospital providers, with certain exceptions, are then assessed a provider tax, which is payable to the state, and may or may not exceed funds received from the state. Vanguard participates in a similar program with the state of Michigan through its DMC hospitals. Vanguard recognizes revenues equal to the gross PTA payments to be received when such payments are assured. Vanguard recognizes expenses for the taxes due back to the states under these PTA programs when the related revenues are recognized.
As of June 30, 2010 and 2011, approximately $16.4 million and $17.5 million, respectively, of total cash and cash equivalents in the accompanying consolidated balance sheets were identified for the operations of Vanguard’s captive insurance subsidiaries.
As of both June 30, 2010 and 2011, Vanguard had restricted cash balances of $2.3 million. These balances primarily represent restricted cash accounts related to liquidity requirements of AAHP and certain other arrangements.
Effective July 1, 2007, Vanguard began estimating the allowance for doubtful accounts using a standard policy that reserves 100% of all accounts aged greater than 365 days subsequent to discharge date plus a standard percentage of uninsured accounts less than 365 days old plus a standard percentage of self-pay after insurance/Medicare accounts less than 365 days old. Vanguard has periodically adjusted its policy to increase the standard percentages applied to uninsured accounts and self-pay after insurance/Medicare accounts to account for pricing changes and for the impact of its new uninsured discount policy, as previously described. Vanguard tests its allowance for doubtful accounts policy quarterly using a hindsight calculation that utilizes write-off data for all payer classes during the previous twelve-month period to estimate the allowance for doubtful accounts at a point in time. Vanguard also supplements its analysis by comparing cash collections to net patient revenues and monitoring self-pay utilization. Significant changes in payer mix, business office operations, general economic conditions and healthcare coverage provided by federal or state governments or private insurers may have a significant impact on Vanguard’s estimates and significantly affect its results of operations and cash flows.
Long-lived assets, including property, plant and equipment and amortizable intangible assets, comprise a significant portion of Vanguard’s total assets. Vanguard evaluates the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist. When management believes impairment indicators may exist, projections of the undiscounted future cash flows associated with the use of and eventual disposition of long-lived assets held for use are prepared. Vanguard uses Level 3 inputs, generally defined as unobservable inputs representing Vanguard’s own assumptions, when impairment indicators may exist. If the projections indicate that the carrying values of the long-lived assets are not expected to be recoverable, Vanguard reduces the carrying values to fair value. For long-lived assets held for sale, Vanguard compares the carrying values to an estimate of fair value less selling costs to determine potential impairment. Vanguard tests for impairment of long-lived assets at the lowest level for which cash flows are measurable. These impairment tests are heavily influenced by assumptions and estimates that are subject to change as additional information becomes available. Given the relatively few number of hospitals Vanguard owns and the significant amounts of long-lived assets attributable to those hospitals, an impairment of the long-lived assets for even a single hospital could have a material adverse impact on its operating results or financial position.
Goodwill also represents a significant portion of Vanguard’s total assets. Vanguard reviews goodwill for impairment annually during its fourth fiscal quarter or more frequently if certain impairment indicators arise. Vanguard reviews goodwill at the reporting unit level, which is one level below an operating segment. Vanguard compares the carrying value of the net assets of each reporting unit to the net present value of estimated discounted future cash flows of the reporting unit. If the carrying value exceeds the net present value of estimated discounted future cash flows, an impairment indicator exists and an estimate of the impairment loss is calculated. The fair value calculation includes multiple assumptions and estimates, including the projected cash flows and discount rates applied. Changes in these assumptions and estimates could result in goodwill impairment that could have a material adverse impact on Vanguard’s results of operations or financial position.
Amounts allocated to contract-based intangible assets, which primarily represent PHP’s contract with AHCCCS and PHP’s various contracts with network providers, are amortized over their useful lives, which equal 10 years. The expected future cash flows supporting the value of contract-based intangible assets are affected by Vanguard’s ability and intent to renew or extend the related PHP contracts. No amortization is recorded for indefinite-lived intangible assets. Deferred loan costs and syndication costs are amortized over the life of the applicable credit facility or notes using the effective interest method. Physician income and service agreement guarantee intangible assets are recorded based upon the estimated future payments under the contracts and are amortized over the applicable contract service periods. The useful lives over which intangible assets are amortized range from two years to ten years.
The DMC Pension Plan is measured using actuarial techniques that reflect management’s assumptions for discount rate, expected long-term investment returns on plan assets, expected retirement and mortality. Management determines the discount rate with the assistance of actuaries.
The accounting guidance related to employers’ accounting for defined benefit pension plans requires recognition in the balance sheet of the funded status of defined benefit pension plans, and the recognition in other comprehensive income of unrecognized gains or losses and prior service costs or credits. Additionally, the guidance requires the measurement date for plan assets and liabilities to coincide with the plan sponsor’s year end.
Unsettled circumstances that, if favorably resolved, would adversely affect future operations
Vanguard’s reserves for professional and general liability as of June 30, 2010 and 2011 were $91.8 million and $326.8 million, respectively. As of June 30, 2010 and 2011 the reserves for workers’ compensation were $15.7 million and $32.1 million, respectively. Vanguard utilizes actuarial information to estimate its 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 Vanguard’s risk exposures, its self-insurance limits, geographic locations in which it operates, the severity of its historical losses compared to industry averages and the reporting pattern of its historical losses compared to industry averages, among others. Most of these variables require judgment, and changes in these variables could result in significant period over period fluctuations in Vanguard’s estimates. Vanguard discounts its workers compensation reserve using a 4% factor, an actuarial estimate of projected cash payments in future periods. Vanguard does not discount the reserve for estimated professional and general liability claims.
In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income” (Topic 220): Presentation of Comprehensive Income. ASU 2011-5 eliminates Vanguard’s currently elected option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. Instead, ASU 2011-5 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-5 is required to be applied retrospectively and is effective for public companies for fiscal years beginning after December 15, 2011, and interim periods within those fiscal years. Early adoption is permitted. Vanguard anticipates applying the provisions of ASU 2011-5 for its interim period ending March 31, 2012. As of June 30, 2011, Vanguard recognized comprehensive income related to changes in the fair value of investments in securities and pension plan (see Note 14). Accordingly, the adoption of ASU 2011-5 will impact the presentation of Vanguard’s other comprehensive income.
Effective August 1, 2010, Vanguard acquired substantially all of the assets used in the operations of Westlake Hospital in Melrose Park, Illinois and West Suburban Medical Center in Oak Park, Illinois, (collectively, “the Resurrection Facilities”) from certain affiliates of Resurrection Health Care. These assets included the two general acute care hospital facilities with a combined 458 licensed beds, the real property on which each facility is located, their respective current assets (except cash and certain other current assets) and outpatient facilities and other healthcare assets related to each such hospital, such as outpatient facilities located in River Forest, Illinois and three physician clinics located in Oak Park and Melrose Park, Illinois. The cash purchase price for the acquired assets was approximately $45.3 million, which was funded with cash on hand.
Under the acquisition method of accounting, the purchase price of the Resurrection Facilities was allocated to the identifiable assets acquired and liabilities assumed based upon their estimated fair values as of August 1, 2010. Vanguard has completed the purchase price allocation based upon its estimates of fair value of assets acquired based upon appraisal information and liabilities assumed at the acquisition date and has determined that no goodwill should be recorded related to this acquisition.
In October 2010, Vanguard completed the purchase of substantially all of the assets and assumed certain liabilities used in the operation of the 59-bed Arizona Heart Hospital and of the Arizona Heart Institute (collectively “Arizona Heart”), both located in Phoenix, Arizona, for an aggregate purchase price of approximately $39.0 million, which was funded with cash on hand.
Under the acquisition method of accounting, the purchase price of Arizona Heart was allocated to the identifiable assets acquired and liabilities assumed based upon their estimated fair values as of the acquisition dates. Vanguard has completed the purchase price allocation based upon its estimates of fair value of assets acquired and liabilities assumed at the acquisition date. The excess of the purchase price over the estimated fair value of the identifiable assets acquired and liabilities assumed was recorded as goodwill. Goodwill recorded for this acquisition represents the business value of the entity not specifically related to net assets acquired. The $0.9 million of goodwill was assigned to Vanguard’s acute care services segment and is expected to be deductible for tax purposes.
Effective January 1, 2011, Vanguard purchased substantially all of the assets of The Detroit Medical Center, a Michigan non-profit corporation, and certain of its affiliates (collectively, “DMC”), which assets consist primarily of eight acute care and specialty hospitals in the Detroit, Michigan metropolitan area and related healthcare facilities. The eight hospitals are DMC Children’s Hospital of Michigan, DMC Detroit Receiving Hospital, DMC Harper University Hospital, DMC Huron Valley-Sinai Hospital, DMC Hutzel Women’s Hospital, DMC Rehabilitation Institute of Michigan, DMC Sinai-Grace Hospital and DMC Surgery Hospital, with a combined 1,734 licensed beds. The cash purchase price for the acquired DMC assets paid at closing was $363.3 million and was funded with cash on hand. Vanguard has substantially completed its purchase price allocation based upon its estimates of fair value of assets acquired and liabilities assumed at the acquisition date. The goodwill acquired in connection with the DMC acquisition was assigned to Vanguard’s acute care services segment and is not expected to be deductible for tax purposes.
The pro forma results for the Arizona Heart acquisition are not included, as Vanguard deems those results to be insignificant for disclosure.
Vanguard’s financial assets recorded at fair value on a recurring basis primarily relate to investments in available-for-sale securities held by two of its captive insurance subsidiaries. The following tables present information about the assets that are measured at fair value on a recurring basis as of June 30, 2011 and June 30, 2010 (in millions). The following tables also indicate the fair value hierarchy of the valuation techniques Vanguard utilized to determine such fair values. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets. Vanguard considers a security that trades at least weekly to have an active market. Fair values determined by Level 2 inputs utilize data points that are observable, such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset, and include situations where there is little, if any, market activity for the asset. Vanguard’s policy is to recognize transfers between levels as of the actual date of the event or change in circumstances that caused the transfer.
The following table provides a reconciliation of the beginning and ending balances for the year ended June 30, 2011 and the year ended June 30, 2010 for those fair value measurements using significant Level 3 unobservable inputs (in millions).
As of June 30, 2011, Vanguard held $63.3 million in total available for sale investments in debt and equity securities, which are included in investments in securities on the consolidated balance sheets. Investments in corporate bonds, valued at approximately $14.1 million at June 30, 2011, consist of corporate bonds and other fixed income investments with average maturities of approximately 11.4 years as of June 30, 2011.
As of June 30, 2011, approximately $54.5 million of the acquired DMC investments were reflected on the accompanying consolidated balance sheet in investments in securities. Vanguard calculates the realized gain or loss on sales of investments using the amortized cost basis, as determined by specific identification. The amortized cost basis of these investments was approximately $52.8 million as of June 30, 2011.
As of June 30, 2011, Vanguard held $8.8 million in total available for sale investments in auction rate securities (“ARS”) backed by student loans, which are included in investments in securities on the accompanying consolidated balance sheets. These ARS are accounted for as long-term available for sale securities. The par value of the remaining interest in ARS was $10.0 million at June 30, 2011. The ARS have a maturity date of 2040 and are guaranteed by the U.S. government at approximately 96%-98% of the principal and accrued interest under the Federal Family Education Loan Program or other similar programs. Due to the lack of market liquidity and other observable market inputs for these ARS, Vanguard utilized Level 3 inputs to estimate the $8.8 million fair value of these ARS. Valuations from forced liquidations or distressed sales are inconsistent with the definition of fair value set forth in the pertinent accounting guidance, which assumes an orderly market. For its valuation estimate, management utilized a discounted cash flow analysis that included estimates of the timing of liquidation of these ARS and the impact of market risks on exit value. Vanguard does not currently intend to sell and does not believe it is more likely than not it will be required to sell these ARS prior to liquidity returning to the market and their fair value substantially recovering to par value. During the year ended June 30, 2011, approximately $14.3 million of the ARS were redeemed for cash.
The fair values of the 8.0% Notes and the 2010 term loan facility (both as defined in Note 9) as of June 30, 2011 were approximately $1,222.0 million and $806.9 million, respectively, based upon stated market prices. The fair values of the 7.750% Senior Notes and the 10.375% Senior Discount Notes (both as defined in Note 9) were approximately $355.3 million and $493.2 million, respectively, based upon significant unobservable inputs including interest rates, maturity and credit ratings as of June 30, 2011. The fair values are subject to change as market conditions change.
Prepaid expenses and other current assets in the accompanying consolidated balance sheets consist of the following as of June 30, 2010 and 2011 (in millions).
During the year ended June 30, 2011, Vanguard determined that a $0.9 million ($0.6 million net of taxes or $0.01 per diluted share) impairment charge was necessary to write-down the book value of real property associated with a hospital that was being replaced in the Texas market to estimated fair value based on significant unobservable inputs (level 3). The remaining net impairment and restructuring charges for the year ended June 30, 2011 include approximately $5.1 million of restructuring charges related to employee severance and related costs negotiated during Vanguard’s third quarter of fiscal 2011.
Vanguard’s restructuring charges during the year ended June 30, 2011 represent the elimination of approximately forty positions for the realignment of certain corporate services within the acute care services segment. As of June 30, 2011 accrued expenses on the accompanying consolidated balance sheet included approximately $3.0 million of severance and related expenses that Vanguard expects to fund over the next fourteen months.
The following table provides information regarding the intangible assets, including deferred loan costs, included on the accompanying consolidated balance sheets as of June 30, 2010 and 2011 (in millions).
Amortization of deferred loan costs of $5.4 million, $5.2 million and $6.3 million during the years ended 2009, 2010 and 2011, respectively, is included in net interest. Vanguard capitalized approximately $25.9 million of additional deferred loan costs during fiscal 2011 associated with the additional debt offerings in July 2010 and January 2011 (see Note 9). Amortization of physician income and other guarantees of $6.2 million, $6.7 million and $4.8 million during the years ended 2009, 2010 and 2011, respectively, is included in purchased services or other operating expenses.
During the year ended 2011, goodwill increased by $90.6 million related to acute care services segment acquisitions. During 2010, goodwill increased by $0.1 million related to acute care services segment acquisitions and decreased by $43.1 million related to the Illinois market impairment recognized. As of June 30, 2011, Vanguard has recognized goodwill impairments of $166.9 million in the aggregate, all of which relate to Vanguard’s acute care services segment.
A summary of Vanguard’s long-term debt as of June 30, 2010 and 2011 follows (in millions).
On January 29, 2010, Vanguard completed a comprehensive refinancing plan (the “Refinancing”). In connection with the Refinancing on January 29, 2010, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding Company II, LLC and Vanguard Holding Company II, Inc. (collectively, the “Issuers”), completed a private placement of $950.0 million ($936.3 million cash proceeds) 8% Senior Unsecured Notes due February 1, 2018 (“8.0% Notes”). Interest on the 8.0% Notes is payable semi-annually in August and February of each year. The 8.0% Notes are unsecured general obligations of the Issuers and rank pari passu in right of payment to all existing and future senior unsecured indebtedness of the Issuers. The $13.7 million discount is accreted to par over the term of the 8.0% Notes. All payments on the 8.0% Notes are guaranteed jointly and severally on a senior unsecured basis by Vanguard and its domestic subsidiaries, other than those subsidiaries that do not guarantee the obligations of the borrowers under the 2010 credit facilities (as defined below).
On June 14, 2011, the Issuers exchanged substantially all of their outstanding Add-on Notes for new 8.0% senior unsecured notes with identical terms and conditions, except that the exchange notes were registered under the Securities Act of 1933. Terms and conditions of the exchange offer were set forth in the registration statement on Form S-4 filed with the Securities and Exchange Commission on April 8, 2011, that became effective on May 4, 2011.
The Senior Notes bear interest at a rate of 7.750% per annum. Vanguard will pay cash interest semi-annually in arrears on February 1 and August 1 of each year, beginning on August 1, 2011. The Senior Notes are unsecured general obligations of the Issuers and rank pari passu in right of payment to all existing and future unsecured indebtedness of the Issuers. The Senior Notes mature on February 1, 2019. Vanguard used the proceeds from the Senior Notes for general corporate purposes, including acquisitions, and to pay the related transaction fees and expenses of the offering and the offering of the Senior Discount Notes, defined below.
On January 26, 2011, Vanguard issued senior discount notes due 2016 with a stated principal amount at maturity of approximately $747.2 million generating approximately $444.7 million of gross proceeds (the “Senior Discount Notes”), in a private placement. The Senior Discount Notes are not guaranteed by any of Vanguard’s subsidiaries.
The Senior Discount Notes had an initial accreted value of $602.23 per $1,000 stated principal amount at maturity and were issued at a price of $595.08 per $1,000 stated principal amount at maturity. No cash interest will accrue on the Senior Discount Notes, but the Senior Discount Notes will accrete at a rate of 10.375% per annum, compounded semi-annually on February 1 and August 1 of each year, such that the accreted value will equal the stated principal amount at maturity on February 1, 2016. Vanguard used the proceeds from the offering of the Senior Discount Notes to pay a dividend of approximately $447.2 million ($593.58 per common share) to its equity holders.
Vanguard used the net proceeds from its initial public offering in June 2011 and the exercise of the over-allotment option by the offering underwriters in July 2011 to redeem $453.6 million accreted value of the Senior Discount Notes and to pay $27.6 million of redemption premiums thereof in July and August 2011. Approximately $450.2 million of the Senior Discount Notes, representing the accreted value as of June 30, 2011, has been reclassified to current maturities of long-term debt on the accompanying consolidated balance sheet as of June 30, 2011 in anticipation of these redemptions. See Note 22 for additional details.
In connection with the Refinancing on January 29, 2010, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding Company II, LLC and Vanguard Holding Company II, Inc. (collectively, the “Co-borrowers”), entered into new senior secured credit facilities (the “2010 credit facilities”) with various lenders and Bank of America, N.A. as administrative agent, and repaid all amounts outstanding under the previous credit facility. The 2010 credit facilities include a six-year term loan facility (the “2010 term loan facility”) in the aggregate principal amount of $815.0 million and a five-year $260.0 million revolving credit facility (the “2010 revolving facility”).
In addition, subject to the receipt of commitments by existing lenders or other financial institutions and the satisfaction of certain other conditions, the Co-borrowers may request an incremental term loan facility to be added to the 2010 term loan facility. The Co-borrowers may also seek to increase the borrowing availability under the 2010 revolving facility to an amount larger than $260.0 million, subject to the receipt of commitments by existing lenders or other financial institutions for such increased revolving capacity and the satisfaction of other conditions. Vanguard’s remaining borrowing capacity under the 2010 revolving facility, net of letters of credit outstanding, was $222.8 million as of June 30, 2011.
The 2010 term loan facility bears interest at a rate equal to, at Vanguard’s option, LIBOR (subject to a 1.50% floor) plus 3.50% per annum or a base rate plus 2.50% per annum. The interest rate applicable to the 2010 term loan facility was approximately 5.0% as of June 30, 2011. Vanguard also makes quarterly principal payments equal to one-fourth of one percent of the outstanding principal balance of the 2010 term loan facility and will continue to make such payments until maturity of the term debt.
The 2010 credit facilities contain numerous covenants that restrict Vanguard or its subsidiaries from completing certain transactions and also include limitations on capital expenditures, a minimum interest coverage ratio requirement and a maximum leverage ratio requirement. Vanguard was in compliance with each of these debt covenants as of June 30, 2011. Obligations under the credit agreement are unconditionally guaranteed by Vanguard and Vanguard Health Holding Company I, LLC (“VHS Holdco I”) and, subject to certain exceptions, each of VHS Holdco I’s wholly-owned domestic subsidiaries (the “U.S. Guarantors”). Obligations under the credit agreement are also secured by substantially all of the assets of Vanguard Health Holding Company II, LLC (“VHS Holdco II”) and the U.S. Guarantors including a pledge of 100% of the membership interests of VHS Holdco II, 100% of the capital stock of substantially all U.S. Guarantors (other than VHS Holdco I) and 65% of the capital stock of each of VHS Holdco II’s non-U.S. subsidiaries that are directly owned by VHS Holdco II or one of the U.S. Guarantors and a security interest in substantially all tangible and intangible assets of VHS Holdco II and each U.S. Guarantor.
The aggregate annual principal payments and scheduled redemptions of long-term debt, including capital leases and other long term debt, for each of the next five years and thereafter are as follows: Year 1 - $461.8 million; Year 2 - $11.2 million; Year 3 - $11.5 million; Year 4- $8.2 million; Year 5 - $797.4 million and $1,525.0 million thereafter.
The following table reflects the amounts included in Vanguard’s accompanying consolidated balance sheet as of June 30, 2011 related to the DMC Pension Plan (in millions):
Vanguard recognizes changes in the funded status of the pension plan as a direct increase or decrease to stockholders’ equity through accumulated other comprehensive income (loss). As of June 30, 2011, Vanguard recognized a change in the funded status of the DMC Pension Plan as an increase in equity through accumulated other comprehensive income of $31.8 million ($19.7 million, net of tax) based primarily on year-end adjustments related to a decrease in its projected benefit obligation due to an increase in the discount rate used to measure the liability. The discount rate was increased from 5.35% at January 1, 2011 to 5.57% at June 30, 2011.
To develop the expected long-term rate of return on assets assumption, the DMC Pension Plan considers the current level of expected returns on risk-free investments (primarily government bonds), the historical level of risk premium associated with the other asset classes in which the portfolio is invested and the expectations for future returns on each asset class. The expected return for each asset class was then weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio. The DMC Pension Plan’s weighted-average asset allocations by asset category as of June 30, 2011, were as follows:
The DMC Pension Plan assets are invested in separately managed portfolios using investment management firms. The DMC Pension Plan’s objective for all asset categories is to maximize total return without assuming undue risk exposure. The DMC Pension Plan maintains a well-diversified asset allocation that best meets these objectives. The DMC Pension Plan assets are largely comprised of equity securities, which include companies with all market capitalization sizes in addition to international and convertible securities. Cash and cash equivalents are comprised of money market funds. Debt securities include domestic and foreign government obligations, corporate bonds, and mortgage backed securities. Alternative investments include investments in limited partnerships. Under the investment policy of the DMC Pension Plan, investments in derivative securities are not permitted for the sole purpose of speculating on the direction of market interest rates. Included in this prohibition are leveraging, shorting, swaps, futures, options, forwards, and similar strategies.
The following table summarizes the pension plan assets measured at fair value on a recurring basis as of June 30, 2011, the most recent measurement date, aggregated by the level in the fair value hierarchy within which those measurements are determined as disclosed in Note 5. Fair value methodologies for Level 1 and Level 2 are consistent with the inputs described in Note 5. Fair value for Level 3 represents Vanguard’s ownership interest in the net asset value of the respective partnership, which approximates fair value.
The expected future employer contributions, which represent amounts required to be paid by regulators and law to the pension plan trust, are approximately $27.2 million for Vanguard’s fiscal year ending June 30, 2012. There is no expected amortization from the amounts included in other comprehensive income into net pension plan expense (credit) over the next fiscal year. Additionally, no plan assets are expected to be returned to Vanguard during the next fiscal year. The expected benefits payments from the DMC Pension Plan, which represent the total benefits expected to be paid from the plan assets held by the pension plan trust, for the next five years and the five years thereafter are as follows (in millions):
Of the $13.2 million total unrecognized tax benefits, $0.3 million of the balance as of June 30, 2011 of unrecognized tax benefits would impact the effective tax rate if recognized.
Income tax expense for the year ended June 30, 2011 includes the impact of establishing a $5.3 million valuation allowance for unitary state net operating loss carryforwards during the year. Given the magnitude of Vanguard’s valuation allowance, its future income/losses could result in a significant adjustment to this valuation allowance.
Vanguard computes basic earnings (loss) per share using the weighted average number of common shares outstanding. Vanguard computes diluted earnings (loss) per share using the weighted average number of common shares outstanding, plus the dilutive effect of outstanding stock options, restricted shares, warrants for equity incentive units and restricted stock units, computed using the treasury stock method.
The following table sets forth the computation of basic and diluted earnings (loss) per share for the years ended June 30, 2009, 2010 and 2011 (in millions except share and per share amounts):
In connection with the Blackstone merger in 2004, Blackstone, Morgan Stanley Capital Partners and its affiliates (collectively, “MSCP”), management and other investors purchased $624.0 million of Class A Membership Units of Holdings. Holdings then invested the $624.0 million in the common stock of Vanguard, and in addition Blackstone invested $125.0 million directly in the common stock of Vanguard. In February 2005, other investors purchased approximately $0.6 million of Class A membership units of Holdings. Holdings then invested the $0.6 million in the common stock of Vanguard.
In connection with the Blackstone merger, certain members of senior management purchased Class B, Class C and Class D membership units in Holdings (collectively the “equity incentive units”) for approximately $5.7 million pursuant to the Amended and Restated Limited Liability Company Operating Agreement of Holdings dated September 23, 2004 (“LLC Agreement”). Vanguard determined the value of the equity incentive units by utilizing appraisal information. The Class B and D units vest 20% on each of the first five anniversaries of the purchase date, while the Class C units vest on the eighth anniversary of the purchase date subject to accelerated vesting upon the occurrence of a sale by Blackstone of at least 25% of its Class A units at a price per unit exceeding 2.5 times the per unit price paid on September 23, 2004. Upon a change of control (as defined in the LLC Agreement), all Class B and D units fully vest, and Class C units fully vest if the change in control constitutes a liquidity event (as defined in the LLC Agreement). During previous fiscal years, Vanguard and Holdings repurchased certain outstanding equity incentive units from former executive officers for approximately $0.4 million. The purchase price for unvested units was based upon the lower of cost or fair market value (determined by an independent appraisal) or the lower of cost or fair market value less a 25% discount, as set forth in the LLC Agreement. The purchase price for vested units was fair market value or fair market value less a 25% discount.
Immediately prior to Vanguard’s initial public offering, Holdings was merged with and into Vanguard so that Vanguard survived the merger (the “Holdings Merger”). As a result of the Holdings Merger, (1) each holder of Class A units of Holdings received a number of shares of Vanguard’s common stock, (2) each holder of Class B units of Holdings received a number of shares of Vanguard’s common stock, (3) each holder of Class C units of Holdings received a number of shares of Vanguard’s restricted stock and Vanguard’s unrestricted common stock and (4) each holder of Class D units of Holdings received a number of shares of Vanguard’s common stock and stock options to acquire shares of Vanguard’s common stock. In each of these cases, the holders of the outstanding units of Holdings received the same financial values of ownership interests from the equity issued by Vanguard as that surrendered in Holdings calculated based on the deemed equity value of Vanguard from the initial public offering. The net impact from the Holdings Merger resulted in Vanguard issuing to the former unit holders in Holdings an additional 1,720,379 shares of common stock, an additional 1,684,733 shares of restricted stock but with full voting rights and an additional 1,245,086 options to purchase common stock. The restricted stock issued in the Holdings Merger will vest in September 2012.
Comprehensive income (loss) consists of two components: net income (loss) attributable to Vanguard Health Systems, Inc. stockholders and other comprehensive income (loss). Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under the guidance related to accounting for comprehensive income are recorded as elements of equity but are excluded from net income (loss) attributable to Vanguard Health Systems, Inc. stockholders. The following table presents the components of comprehensive income (loss), net of taxes, for the years ended June 30, 2009, 2010 and 2011 (in millions).
The components of accumulated other comprehensive income (loss), net of taxes, as of June 30, 2010 and 2011 are as follows (in millions).
As previously discussed, Vanguard used the minimum value pricing model to determine stock compensation costs related to stock option grants prior to July 1, 2006. On July 1, 2006, Vanguard recorded stock compensation using the Black-Scholes-Merton model. During fiscal years 2009, 2010 and 2011, Vanguard incurred stock compensation of $4.4 million and $4.2 million and $4.8 million, respectively, related to grants under its 2004 Stock Incentive Plan.
As of June 30, 2011, 5,939,267 options and 577,962 restricted stock units were outstanding under the 2004 Stock Incentive Plan. Subsequent to June 20, 2011, no more equity rights will be granted under the 2004 Stock Incentive Plan.
During the years ended June 30, 2010 and 2011, Vanguard’s Board of Directors approved one distribution and declared one dividend to stockholders. Pursuant to the terms of the 2004 Stock Incentive Plan, the holders of nonvested stock options received $994.05 per share ($16.68 on a post-split basis) reductions (subject to certain tax related limitations that resulted in deferred distributions for a portion of the declared dividend, which will be paid upon the vesting of the applicable stock options) to the exercise price of the share-based awards as a result of the distribution and the dividend.
All common share and per common share amounts in these consolidated financial statements and notes to the consolidated financial statements reflect the 59.584218-to-1 split that occurred in June 2011 (see Note 1).
The following tables summarize options transactions during the year ended June 30, 2011.
The following table sets forth certain information regarding vested options at June 30, 2011, options expected to vest subsequent to June 30, 2011 and total options expected to vest over the life of all options granted.
The following table summarizes restricted stock unit activity during the year ended June 30, 2011.
The 401(k) Plan allows eligible employees to make contributions of 2% to 20% of their annual compensation. Employer matching contributions, which vary by employer, vest 20% after two years of service and continue vesting at 20% per year until fully vested. For purposes of determining vesting percentages in the 401(k) Plan, many employees received credit for years of service with their respective predecessor companies. Vanguard’s matching accrual, included in accrued salaries and benefits on the accompanying consolidated balance sheets, as of June 30, 2010 and 2011 was approximately $9.1 million and $3.2 million, respectively. Vanguard’s matching expense, including matching expense for discontinued operations, for the years ended 2009, 2010 and 2011 was approximately $15.7 million, $17.7 million and $21.7 million, respectively.
Given the nature of its operating environment, Vanguard is subject to professional and general liability claims and related lawsuits in the ordinary course of business. Vanguard maintains professional and general liability insurance with unrelated commercial insurance carriers to provide for losses up to $65.0 million in excess of its self-insured retention (such self-insured retention maintained through Vanguard’s captive insurance subsidiary and/or another of its subsidiaries) of $10.0 million through June 30, 2010 but increased to $15.0 million for its Illinois hospitals subsequent to June 30, 2010.
Vanguard has acquired and expects to continue to acquire businesses with prior operating histories. Acquired companies may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-referral laws. Although Vanguard institutes policies designed to conform practices to its standards following the completion of its acquisitions, there can be no assurance that it will not become liable for past activities of prior owners that may later be asserted to be improper by private plaintiffs or government agencies. Although Vanguard generally seeks to obtain indemnification from prospective sellers covering such matters, there can be no assurance that any such matter will be covered by indemnification, or if covered, that such indemnification will be adequate to cover potential losses and fines.
In the normal course of its business, Vanguard enters into physician relocation agreements under which it guarantees minimum monthly income, revenues or collections or guarantees reimbursement of expenses up to maximum limits to physicians during a specified period of time (typically, 12 months to 24 months). In return for the guarantee payments, the physicians are required to practice in the community for a stated period of time (typically, 3 to 4 years) or else return the guarantee payments to Vanguard. Vanguard records a liability at fair value for all guarantees entered into on or after January 1, 2006. Vanguard determines this liability and an offsetting intangible asset by calculating an estimate of expected payments to be made over the guarantee period. Vanguard reduces the liability as it makes guarantee payments and amortizes the intangible asset over the term of the physicians’ relocation agreements. Vanguard also estimates the fair value of liabilities and offsetting intangible assets related to payment guarantees for physician service agreements for which no repayment provisions exist. As of June 30, 2011, Vanguard had a net intangible asset of $5.0 million and a remaining liability of $2.7 million related to these physician income and service guarantees. The maximum amount of Vanguard’s unpaid physician income and service guarantees as of June 30, 2011 was approximately $4.0 million.
As part of its contract with the Arizona Health Care Cost Containment System, one of Vanguard’s health plans, PHP, is required to maintain a performance guarantee, the amount of which is based upon PHP’s membership and capitation premiums received. As of June 30, 2011, Vanguard maintained this performance guarantee in the form of $55.0 million of surety bonds with independent third party insurers collateralized by letters of credit of approximately $5.0 million. These surety bonds expire on September 30, 2011.
In connection with the initial public offering, Blackstone and Vanguard agreed to amend and terminate the existing transaction and monitoring fee agreement. As a result, Vanguard recorded approximately $14.9 of monitoring fees during the fourth quarter of fiscal year 2011, $13.0 million payable to Blackstone and $1.9 million payable to Metalmark SA, which is included in other accrued expenses and current liabilities on the accompanying consolidated balance sheet at June 30, 2011. The quarterly payments are due beginning July 1, 2011 and ending July 1, 2014 unless Blackstone elects at any time to accelerate the aforementioned quarterly payments to it and Metalmark SA to a lump sum payable due immediately. During fiscal 2009, Vanguard paid approximately $4.0 million and $1.2 million in monitoring fees and expenses to Blackstone and Metalmark SA, respectively. During fiscal 2010, Vanguard paid $4.4 million and $0.7 million in monitoring fees and expenses to Blackstone and Metalmark SA, respectively. During fiscal 2011, Vanguard paid $4.3 million and $0.6 million in monitoring fees and expenses to Blackstone and Metalmark SA, respectively.
A summary of the monitoring fees and expenses incurred by Vanguard for the year ended June 30, 2011 is as follows:
Effective July 1, 2008, Vanguard entered into an Employer Health Program Agreement with Equity Healthcare LLC (“Equity Healthcare”), which is an affiliate of Blackstone. Equity Healthcare negotiates with providers of standard administrative services for health benefit plans as well as other related services for cost discounts and quality of service monitoring capability by Equity Healthcare. Equity Healthcare receives from Vanguard a fee of $2 per employee per month (“PEPM Fee”). As of June 30, 2011, Vanguard has approximately 14,100 employees enrolled in these health and welfare benefit plans.
Segment EBITDA is defined as income (loss) from continuing operations before income taxes less interest expense (net of interest income), depreciation and amortization, equity method income, stock compensation, gain or loss on disposal of assets, realized gains or losses on investments, monitoring fees and expenses, acquisition related expenses, debt extinguishment costs, impairment and restructuring charges, and pension expense (credits). Management uses Segment EBITDA to measure performance for Vanguard’s segments and to develop strategic objectives and operating plans for those segments. Segment EBITDA eliminates the uneven effect of non-cash depreciation of tangible assets and amortization of intangible assets, much of which results from acquisitions accounted for under the purchase method of accounting. Segment EBITDA also eliminates the effects of changes in interest rates which management believes relate to general trends in global capital markets, but are not necessarily indicative of the operating performance of Vanguard’s segments. Management believes that Segment EBITDA provides useful information about the financial performance of Vanguard’s segments to investors, lenders, financial analysts and rating agencies. Additionally, management believes that investors and lenders view Segment EBITDA as an important factor in making investment decisions and assessing the value of Vanguard. Segment EBITDA is not a substitute for net income (loss), operating cash flows or other cash flow statement data determined in accordance with accounting principles generally accepted in the United States. Segment EBITDA, as presented, may not be comparable to similar measures of other companies.
Vanguard used the net proceeds from its initial public offering in June 2011 and the exercise of the over-allotment option by the offering underwriters in July 2011 to redeem $453.6 million estimated accreted value of the Senior Discount Notes and to pay $27.6 million of redemption premiums thereof in July and August 2011. Approximately $450.2 million of the Senior Discount Notes, representing the accreted value as of June 30, 2011, has been reclassified to current maturities of long-term debt on the accompanying consolidated balance sheet as of June 30, 2011 in anticipation of these redemptions. The redemptions resulted in approximately $14.7 million of remaining unredeemed accreted value of these notes outstanding on August 11, 2011 immediately after the redemptions were completed and are expected to result in the recognition of debt extinguishment costs of approximately $38.8 million in Vanguard’s first quarter of fiscal year 2012.