These hospitals were constructed, not acquired. Mission Trail Baptist Hospital was a replacement facility for Southeast Baptist Hospital.
These hospitals are operated by a consolidated joint venture limited liability company, in which we own 51% of the equity interests and Valley Baptist Medical Center - Brownsville, a Texas non-profit corporation, owns 49% of the equity interests.
As of June 30, 2012, we leased approximately 53,200 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 the 2010 Credit Facilities are secured by a pledge of substantially all of our assets, including first priority mortgages on each of our hospitals that are owned by subsidiaries that guarantee our obligations under the 2010 Credit Facilities. 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 of operations.
Our mission is to help people in the communities we serve achieve health for life by delivering a patient-centered experience in a high performance environment of integrated care. We plan to grow our business by continually improving quality of care, transforming the delivery of care to a fee for value basis, expanding services and strengthening the financial performance of our existing operations, and selectively developing or acquiring other healthcare businesses where we see an opportunity to improve operating performance and expand our mission. We believe this business strategy is a framework for long-term success in an industry that is undergoing significant change, but we will continue to experience operating challenges in the short term until the general economy improves and our initiatives are fully implemented.
As of June 30, 2012, we owned and operated 28 hospitals with a total of 7,064 licensed beds and related outpatient service facilities complementary to the hospitals in San Antonio, Harlingen and Brownsville Texas; metropolitan Detroit, Michigan; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; and Massachusetts. As of June 30, 2012, we also owned four health plans with approximately 234,500 members.
During the year ended June 30, 2012, we integrated the acquisition of two hospitals and related healthcare services located in Harlingen and Brownsville, Texas. During fiscal 2011, we acquired a total of 11 hospitals and related healthcare services located in metropolitan Detroit; metropolitan Chicago; and metropolitan Phoenix.
On March 30, 2012, we issued an aggregate principal amount of $375.0 million of 7.750% Senior Notes due 2019 (the “New Notes”) in a private placement pursuant to the indenture, dated as of January 26, 2011, governing our existing 7.750% Senior Notes due 2019. The New Notes bear interest at a rate of 7.750% per annum. We pay interest on the notes semi-annually in cash in arrears on February 1 and August 1 of each year. The New Notes mature on February 1, 2019. We used a portion of the net proceeds from the offering of the New Notes to repay all indebtedness outstanding under our revolving credit facility on March 30, 2012.
During the year ended June 30, 2012, we used the net proceeds from our initial public offering in June 2011 and the exercise of the over-allotment option by the underwriters in July 2011 to redeem approximately $450.0 million accreted value of our Senior Discount Notes and to pay $27.6 million of redemption premiums relating thereto. The redemptions resulted in the recognition of debt extinguishment costs of approximately $38.9 million, $25.3 million net of taxes, representing tender premiums and other costs to redeem the Senior Discount Notes and the write-off of net deferred loan costs associated with the redeemed notes. In addition, we redeemed approximately $6.0 million of additional Senior Discount Notes through privately negotiated transactions during the year ended June 30, 2012. The cumulative redemption of the Senior Discount Notes during fiscal 2012 resulted in approximately $9.9 million of remaining unredeemed accreted value of these notes outstanding as of June 30, 2012.
Effective January 1, 2011, we purchased all of the assets of DMC (other than donor-restricted assets and certain other assets), which assets consisted primarily of eight acute care and specialty hospitals and related healthcare facilities in the metropolitan Detroit, Michigan area. 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).
As part of the DMC acquisition, we assumed all of its liabilities (other than its outstanding bonds, certain other debt and certain other liabilities). The assumed liabilities include a pension liability under a “frozen” defined benefit pension plan of DMC. We also committed to spend $350.0 million during the five years subsequent to closing for the routine capital needs of the DMC facilities and an additional $500.0 million in capital expenditures during this same five-year period, which latter amount relates to a specific project list agreed to between the DMC board of representatives and us. To collateralize this $500.0 million specified project capital commitment, we entered into a contingent unsecured subordinated promissory note payable to the legacy DMC entity in the principal amount of $500.0 million. The principal amount of the promissory note is reduced automatically as we expend capital or escrow cash related to this capital commitment.
We believe that the operating environment for hospital operators continues to evolve, which presents both challenges and opportunities for us. In order to remain competitive in the markets we serve, we must transform our operating strategies to not only accommodate changing environmental factors but to make them operating advantages for us relative to our peers. These factors will require continued focus on improving the quality of care, reducing costs and the integration of our ambulatory service lines. The changes to the healthcare landscape that have begun or that we expect to begin in the immediate future are outlined below.
ambulatory surgery centers, home health agencies, cancer centers and imaging centers, in an attempt to create a more comprehensive network of healthcare services. Management believes that the added focus on ambulatory care, together with the addition of new ambulatory competencies, will enable us to take advantage of future opportunities in the ambulatory care sector, especially in an era of health reform.
Further governmental reimbursement will be impacted by 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 reportable CMS quality indicators, rapid response teams, continued focus on work flow efficiency and process improvement, establishing clinical standards of care across key system service lines, improving transition of care to reduce hospital readmissions and aligning hospital management incentive compensation with quality performance indicators.
Our ability to attract skilled physicians to our hospitals is critical to our success. We believe that coordination of care and alignment of care strategies between hospitals and physicians will become more critical as reimbursement becomes more
Budget Control Act. On August 2, 2011, Congress enacted the Budget Control Act of 2011. This law increased the nation's borrowing authority while taking steps to reduce federal spending and the deficit. The deficit reduction component is being implemented in two phases. In the first phase, the law imposes caps that reduce discretionary (non-entitlement) spending by more than $900 billion over ten years, beginning in FFY 2012. Under a second phase, if spending and deficit amounts reach certain thresholds, an enforcement mechanism called “sequestration” will be triggered under which a total of $1.2 trillion in automatic, across-the board spending reductions must be implemented over ten years beginning in February 2013. The spending reductions are to be split evenly between defense and non-defense discretionary spending, although certain programs (including the Medicaid and CHIP programs) are exempt from these automatic spending reductions, and Medicare expenditures cannot be reduced by more than two percent. If sequestration goes into effect and these reductions are implemented, Medicare payments to hospitals and for other services could be reduced. Congress may take additional action in 2012 or 2013 to further reduce federal spending and the deficit to avoid sequestration being triggered. If so, Medicare, Medicaid and CHIP spending could be reduced further, and provider payments under those programs could be substantially reduced. Congress may consider legislation that would seek to further reduce the federal deficit, which could also further substantially reduce Medicare and Medicaid spending, including payments to providers.
We submitted a Pioneer ACO application in Michigan, and were approved to become a Pioneer ACO effective January 1, 2012. We have also been awarded 2013 MSSP ACOs in Massachusetts, Illinois and San Antonio. We expect to continue to explore opportunities to develop or enhance ACOs in our markets.
Medicare and Medicaid EHR Incentive Payments. The American Recovery and Reinvestment Act of 2009 provides for Medicare and Medicaid incentive payments that began in calendar 2011 for eligible hospitals and professionals that adopt and meaningfully use certified electronic health record (“EHR”) technology. During the fiscal years ended June 30, 2011 and 2012, our pre-tax income was positively impacted by $10.1 million and $28.2 million, respectively, related to combined Medicare and Medicaid EHR incentives recognized. We believe that the operational benefits of EHR technology, including improved clinical outcomes and increased operating efficiencies, will contribute to our long-term ability to grow our business.
In order to demonstrate a highly reliable environment of care, we must hire and retain nurses who share our ideals and beliefs and who have access to the training necessary to implement our clinical quality initiatives. While the national nursing shortage has abated somewhat during the past two years as a result of general economic weakness, the nursing workforce remains volatile. As a result, we expect continuing pressures on nursing salaries and benefits costs. These pressures include higher than normal base wage increases, demands for flexible working hours and other increased benefits, and higher nurse to patient ratios necessary to improve quality of care. We have begun multiple initiatives to stabilize our nursing workforce, including a nurse leadership professional practice model and employee engagement strategies. Inflationary pressures and technological advancements continue to drive supply costs higher. We have implemented multiple supply chain initiatives, including consolidation of low-priced vendors, establishment of value analysis teams, stricter adherence to pharmacy formularies and coordination of care efforts with physicians to reduce physician preference items, but we are uncertain if we can sustain these reductions in future periods.
Our combined allowances for doubtful accounts, uninsured discounts and charity care covered 88.2% and 103.6% of combined self-pay and self-pay after primary accounts receivable as of June 30, 2011 and 2012, respectively. This ratio was 92.5% and 98.4% on a same store basis as of June 30, 2011 and 2012, respectively. See specific discussions that address payment delays and the aging of our accounts receivable at June 30, 2012, within the "Liquidity and Capital Resources - Operating Activities" section of this Annual Report on Form 10-K.
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
The demand for Medicaid coverage has increased during the past two years due to job losses that have left many individuals without health insurance. Medicaid remains the highest individual program cost for most states, including those in which we operate. To balance their budgets, many states, either directly or through their Medicaid or managed Medicaid programs, have enacted and may further enact healthcare spending cuts or defer cash payments to healthcare providers to avoid raising taxes during periods of economic weakness.
The American Recovery and Reinvestment Act enacted in 2009 set aside approximately $87 billion to provide additional Medicaid funding to states in the form of a temporary increase in the federal medical assistance percentage ("FMAP") until December 2010. In August 2010, the additional FMAP assistance was extended until June 30, 2011 with a transitional phase-out to occur from January 1, 2011 to June 30, 2011. Absent significant improvement in economic conditions, we expect that many of the states in which we operate will encounter additional budgetary issues now that the additional FMAP funding has expired and, similar as described below with respect to Arizona and Texas, may choose to reduce Medicaid reimbursements or limit eligibility for Medicaid coverage, which could have a material adverse impact on our results of operations and cash flows. During the fiscal year ended June 30, 2012, Medicaid and managed Medicaid programs accounted for approximately 23.9% of our net patient revenues.
On March 15, 2011, the Governor of Arizona announced the state's plan to reform Medicaid by making changes to eligibility, freezing enrollment, and modifying reimbursement rates, among other proposals. Many of the proposed changes required federal approval. In April 2011, the Governor signed Arizona's fiscal year 2012 budget legislation, which included a 5% reduction to provider reimbursement, effective October 1, 2011, and a reduction in Medicaid beneficiaries through enrollment caps, attrition and more stringent eligibility requirements. Following the passage of the legislation, on October 21, 2011, CMS approved certain modifications to Arizona's waiver, consistent with the legislative plans. The AHH challenged the reimbursement cut, but the U.S. District Court for the District of Arizona declined to issue a preliminary injunction preventing the rate decrease and AHH voluntarily dismissed its claims on April 2, 2012.
During March 2012, CMS issued new Supplemental Security Income ("SSI") ratios used for calculating Medicare DSH reimbursement for FFYs ending September 30, 2006 through September 30, 2009. As a result of these new SSI ratios, hospitals must recalculate their Medicare DSH reimbursement for the affected years and record adjustments for any differences in estimated reimbursement as a part of their annual cost report settlement process. Historically, CMS issued each hospital its SSI ratio annually, several months after the end of each fiscal year. However, CMS delayed issuing final SSI ratios for years after FFY 2005 likely due to a court case challenging the government's computation of SSI ratios. This challenge, which began in 2006, was resolved in the U.S. Circuit Court of Appeals late last year.
Pending CMS's issuance of new SSI ratios for FFY 2006 forward, we had utilized the SSI ratios that were most recently provided by CMS in filing our hospital cost reports. The cumulative impact of this updated Medicare reimbursement estimate was an increase in revenues of approximately $9.1 million for the fiscal year ended June 30, 2012.
We recognize premium revenues from our four health plans, PHP, AAHP, CHS and VBIC. Premium revenues from these plans decreased $112.0 million, or 12.9%, during the fiscal year ended June 30, 2012 compared to the fiscal year ended June 30, 2011. PHP’s average membership decreased to approximately 198,900 for the fiscal year ended June 30, 2012 compared to approximately 203,700 for the fiscal year ended June 30, 2011. PHP’s decrease in revenues resulted from two 5% reimbursement rate reductions by AHCCCS implemented as a 5% reduction in April 2011 and a 5% reduction in November 2011 (retroactive to October 1, 2011) and changes made by AHCCCS effective October 1, 2011 to limit health plan profitability for the remaining enrollee groups not previously subject to settlement.
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 patient service revenues would have been reduced by approximately $117.9 million and $171.8 million for the fiscal years ended June 30, 2011 and 2012, 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.
Services provided to Medicare patients are generally reimbursed at prospectively determined rates per diagnosis, 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 Medicare, no individual payer represented more than 10% of our patient service revenues.
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 HHS). We deduct charity care accounts from revenues when we determine that the account meets our charity care guidelines. We also generally provide 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 fiscal year 2011, a significant percentage of our charity care deductions represented services provided to undocumented aliens under the Section 1011 border funding reimbursement program. Border funding qualification ended in Texas during our 2009 fiscal year and ended in Illinois during our 2010 fiscal year, and qualification will end during our 2013 fiscal year in Arizona.
In the ordinary course of business, we provide services to patients who are financially unable to pay for hospital care. We include charity care as a revenue deduction measured by the value of our services, based on standard charges, to patients who qualify under our charity care policy and do not otherwise qualify for reimbursement under a governmental program. The estimated cost incurred by us to provide these services to patients who are unable to pay was approximately $24.7 million, $34.3 million and $65.8 million for the years ended June 30, 2010, 2011 and 2012, respectively. The estimated cost of charity care services was determined using a ratio of cost to gross charges determined from our most recently filed Medicare cost reports and applying that ratio to the gross charges associated with providing charity care for the period.
Our ability to collect the self-pay portions of our receivables is critical to our operating performance and cash flows. Our allowance for doubtful accounts was approximately 29.7% and 34.3% of accounts receivable, net of contractual discounts, as of June 30, 2011 and 2012, 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 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 12-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. If our uninsured accounts receivable as of June 30, 2011 and 2012 were 1% higher, our provision for doubtful accounts would have increased by $2.1 million and $2.6 million, respectively. Significant changes in payer mix, business office operations, general economic conditions and healthcare coverage provided by federal or state
Many of our hospitals have an uninsured discount policy whereby uninsured accounts (including those pending Medicaid qualification) that do not qualify for charity care receive the standard uninsured discount. The balance of these accounts is subject to our allowance for doubtful accounts policy. For those accounts that subsequently qualify for Medicaid coverage, the uninsured discount is reversed and the account is reclassified to Medicaid accounts receivable with the appropriate contractual discount applied. Thus, the contractual allowance for Medicaid pending accounts is no longer necessary for those accounts subject to the uninsured discount policy. Medicaid pending accounts receivable was $63.7 million and $103.4 million as of June 30, 2011 and 2012, respectively.
We receive premiums from private, state and federal agencies for members that are assigned to, or have selected, us to provide healthcare services under applicable contracts. The premiums we receive for each member vary according to the specific contract and are generally determined at the beginning of each contract period. The premiums are subject to adjustment throughout the terms of the respective contracts, although such adjustments are typically made at the commencement of each new contract renewal period.
We have self-insured medical plans that cover all of our employees. Claims are accrued under the self-insured plans 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 one of our captive insurance subsidiaries 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. Effective with the acquisition of DMC on January 1, 2011, we also provide professional and general liability coverage to certain non-employed physicians in Michigan through another of our captive insurance subsidiaries.
Management uses information from our risk management incident reporting system, which contains claim-specific information obtained from our risk managers and external attorneys who review the claims, to estimate the appropriate case reserves based upon case-specific facts and circumstances. Case reserves are reduced as claim payments are made and are increased or decreased as management's estimates regarding the expected amounts of future losses are revised based upon new information received about the incidents or developments in the cases. Once case reserves are finalized for a particular assessment period, incurred and paid loss information is stratified by coverage layers, accident years, reported years and the states in which our hospitals operate. Due to the significant variation in types of medical situations underlying the claims, the geographic jurisdiction of the claims and other claim-specific circumstances, we do not stratify claims data into any further homogenous groups. Our historical loss information, which includes actual claims payments and estimated remaining case reserves for all claims since the our inception in 1997, is utilized to help develop IBNR estimates on a semi-annual basis along with industry data.
During the fiscal years ended June 30, 2010, 2011 and 2012, health plan claims expense was $665.8 million, $686.3 million and $578.9 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, 2011 and 2012 and health plan claims and payment information during the fiscal years ended June 30, 2010, 2011 and 2012 (in millions).
The increases in reserves, claims losses and claims payments from 2010 to 2011 was primarily due to the increase in PHP members during the period. The decrease in these amounts from 2011 to 2012 primarily related to decreases in PHP members as a result of AHCCCS eligibility restrictions put in place beginning October 1, 2011. Health plan claims expense is recognized in the period in which services are provided and includes an estimate of costs incurred but not yet paid. Accrued health plans claims and settlements on our consolidated balance sheet includes (1) an estimate of claims incurred but not yet received or adjudicated and claims adjudicated but not yet paid; (2) estimated unallocated loss adjustment expenses representing an estimate of the administrative costs necessary to resolve outstanding claims; and (3) certain amounts receivable from or payable to AHCCCS or CMS for the settlement of actual claims incurred compared to interim payments received related to member groups for which profitability or the risk of loss is limited. Accrued health plan claims and settlements do not include a reserve for adverse deviation. As of June 30, 2011 and 2012, net settlements payable to AHCCCS or CMS were $27.7 million and $2.4 million, respectively.
We estimate accrued health claims by analyzing claims payment information from a claims triangle model that compares the incurred date for claims to the payment date for those claims. We then calculate per member per month health plan claims costs based upon claims payments for historical periods divided by the number of members during that period. Completion factors are then applied to this estimate to determine the total accrual estimate. We assess the appropriateness of this methodology by comparing our estimates to those of an independent external actuary and also by reviewing ultimate claims payments for certain prior year periods and analyzing utilization trends to determine if adjustments need to be made to the estimation methodology. Any change in the amount of incurred claims related to prior years included in the health plan claims reserve does not directly correspond to a change in our statement of operations due to the reconciliation and settlement provisions included in certain reconciled member groups.
The provisions set forth in accounting for uncertain tax positions allow for the classification 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 $9.7 million total unrecognized tax benefits, as of June 30, 2012, $0.3 million of this balance would impact the effective tax rate if recognized.
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 store basis for each of the periods presented. We have excluded certain of our hospitals from the same store statistics that were not owned for the entirety of the fiscal year presented. The hospitals excluded from the same store statistics were acquired in our fiscal years ended June 30, 2011 and 2012.
Acute care services on a same store basis. Net patient service revenues increased $145.3 million, or 5.9%, during the current year compared to the prior year. We define same store as those facilities that we owned for the entirety of both 12-month comparative periods. We excluded 13 hospitals and related healthcare facilities from our same store analysis. After excluding the impact for updates to Medicare reimbursement estimates related to rural floor and SSI updates during the current year, net patient service revenues increased $114.9 million, or 4.7%, during the current year compared to the prior year.
Our percentage of uncompensated care as a percentage of net patient revenues, as previously defined, increased to 21.4% during the current year compared to 17.9% during the prior year. This increase primarily resulted from an increase in same store self-pay discharges as a percentage of total discharges during the current year and price increases implemented since the prior year.
Discharges decreased 2.1%, while adjusted discharges and emergency room visits increased 1.4% and 3.6%, respectively, during the current year compared to the prior year. Both inpatient and outpatient surgeries decreased 1.7% and 1.6%, respectively, during the current year compared to the prior year. General economic weakness in the markets we serve continues to impact demand for elective surgical procedures.
Health plan premium revenue. Health plan premium revenues decreased $112.0 million, or 12.9%, during the current year compared to the prior year. Effective October 1, 2011, AHCCCS reduced Medicaid eligibility and coverage for certain member categories. PHP’s average membership decreased by 2.4% during the current year compared to the prior year. Additionally, revenues were lower during the current year as a result of two 5% reimbursement rate reductions implemented by AHCCCS in April 2011 and November 2011 (retroactive to October 1, 2011), and limitations to health plan profitability for member groups not previously subject to settlement.
Income taxes. Our effective tax rate was approximately 28.2% during the current year. This rate was lower than expected due to a combination of changes to state tax laws in Michigan and adjustments to state deferred tax asset valuation allowances on loss carryforwards in other states during the fourth quarter of fiscal 2012 combined with a reduction in the reserve for uncertain tax positions related to success-based transaction costs during the third quarter of fiscal 2012. The 141.0% effective income tax rate during the prior year resulted from 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.
Acute care services on a consolidated basis. Net patient service revenues increased $1,327.6 million, or 55.7%, during fiscal 2011 compared to the prior year. The significant increase in net patient service revenues is primarily the result of recent acquisitions, including the Resurrection Facilities on August 1, 2010 and DMC on January 1, 2011.
Our percentage of uncompensated care (defined as the sum of uninsured discounts, charity care adjustments and the provision for doubtful accounts) as a percentage of net patient revenues (prior to these uncompensated care deductions) was 16.4% during fiscal 2011 compared to 16.3% during the prior year.
Discharges, adjusted discharges and emergency room visits increased 32.9%, 36.7% and 47.7%, respectively, during fiscal 2011 compared to the prior year. Inpatient and outpatient surgeries increased 33.5% and 30.2%, respectively, during fiscal 2011 compared to the prior year.
Health plan premium revenue. Health plan premium revenues increased $29.7 million, or 3.5%, during fiscal 2011 as a result of increased PHP enrollment. Average enrollment at PHP was approximately 203,700 during the year ended June 30, 2011, an increase of 4.1% compared to the prior year, due to more individuals becoming eligible for AHCCCS coverage during fiscal 2011. Enrollment in our other two health plans was substantially unchanged as of June 30, 2011 compared to June 30, 2010.
Salaries and benefits. Salaries and benefits as a percentage of total revenues increased to 44.1% during fiscal 2011 compared to 40.2% for the prior year. On a same store basis, salaries and benefits as a percentage of total revenues was 40.0% during fiscal 2011. For the acute care services operating segment, salaries and benefits as a percentage of net patient service revenues was 52.8% during fiscal 2011 compared to 51.8% during the prior year. As of June 30, 2011, we had approximately 38,600 full-time and part-time employees compared to approximately 20,100 as of June 30, 2010. On a same store basis, including corporate and regional employees, the number of full-time and part-time employees increased approximately 1.3% when compared to the prior year. On a same store basis, our contract labor expense as a percentage of net patient service revenues continued its downward trend to 0.9% for the year ended June 30, 2011 compared to 1.3% for the prior year.
Other operating expenses. Other operating expenses as a percentage of total revenues increased to 17.4% during fiscal 2011 compared to 15.0% during the prior year primarily as a result of increased purchased services related to our fiscal 2011 acquisitions.
Other. Depreciation and amortization increased by $54.2 million, or 38.8%, year over year as a result of our capital improvement and expansion initiatives and the acquisition of the Resurrection Facilities and DMC. Net interest increased by $55.7 million year over year as a result of our note offerings in July 2010 and in January 2011. We incurred $12.5 million of acquisition-related expenses during fiscal 2011. We also incurred $5.1 million of restructuring charges during fiscal 2011 related to the elimination of approximately 40 positions for the realignment of certain corporate services.
Income taxes. Our effective tax rate was approximately 141.0% during the year ended June 30, 2011 compared to 23.6% during the prior year. The effective rate was higher during fiscal 2011 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.
As of June 30, 2012 we had working capital of $594.3 million, including cash and cash equivalents of $455.5 million. Working capital at June 30, 2011 was $333.1 million. Cash flows from operating activities were $113.6 million during the fiscal year ended June 30, 2012. Net operating assets and liabilities, excluding the impact of acquisitions, negatively impacted operating cash flows by $292.8 million during the year ended June 30, 2012 compared to a positive impact of $42.0 million during year ended June 30, 2011. We made $166.9 million of interest and income tax payments during the year ended June 30, 2012, which was $34.4 million higher than these payments during the fiscal year ended June 30, 2011. The increase to net operating assets and liabilities primarily resulted from higher than normal net accounts receivable days, from approximately 39 days at June 30, 2011 to approximately 50 days at June 30, 2012, due to significant payment delays from the Illinois Medicaid program and certain third party billing and coding delays; higher supplemental program and settlement receivables with governmental entities; reductions to health plan claims payables as a result of lower enrollment and payments for prior year settlements due to AHCCCS; and increased contributions to the DMC defined benefit pension plan.
Cash flows from financing activities decreased by $1,028.8 million during the fiscal year ended June 30, 2012 compared to the fiscal year ended June 30, 2011 primarily due to the redemption of Senior Discount Notes during the current year with proceeds from our initial public offering received during the prior year. We also issued additional notes during the prior year and recorded net proceeds from our initial public offering in June 2011 of $417.6 million.
In July and August 2011, we redeemed approximately $450.0 million of the Senior Discount Notes using proceeds from our initial public offering, including the exercise of the underwriters’ over-allotment option. We recorded debt extinguishment costs of $38.9 million, $25.3 million net of taxes, representing tender premiums and other costs to redeem the Senior Discount Notes and the write-off of net deferred loan costs associated with the redeemed Senior Discount Notes. During the fiscal year ended June 30, 2012, we redeemed approximately $6.0 million of the remaining Senior Discount Notes through privately negotiated transactions. The accreted value of the remaining outstanding Senior Discount Notes was approximately $9.9 million as of June 30, 2012.
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, the 7.750% Senior Notes and Senior Discount 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, the 7.750% Senior Notes and the Senior Discount 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 minimum consolidated interest coverage ratio and a maximum consolidated leverage ratio. The following table sets forth the interest coverage and leverage covenant tests as of June 30, 2012.
Factors outside our control may make it difficult for us to comply with these covenants during future periods. These factors include, among others, a prolonged economic recession, a higher number of uninsured or underinsured patients and decreased governmental or managed care payer reimbursement, any or all of which could negatively impact our results of operations and cash flows and cause us to violate one or more of these covenants. Violation of one or more of the covenants could result in an immediate call of the outstanding principal amount under our 2010 Term Loan Facility or the necessity of lender waivers with more onerous terms, including adverse pricing or repayment provisions or more restrictive covenants. A default under our 2010 Credit Facilities would also result in a default under the indenture governing our 8.0% Notes and the indentures governing the 7.750% Senior Notes and Senior Discount Notes.
(including the $80.0 million required to have been spent by December 31, 2011) on capital expenditures related to the specific project list by December 31, 2012, and we will need to escrow any shortfall from this amount prior to mid-February 2013.
As part of the Valley Baptist acquisition, we issued a redeemable non-controlling interest to the seller that enables the seller to require us to redeem all or a portion of its 49% equity interest in the partnership on the third or fifth anniversary of the acquisition date at a stated redemption value. If the seller exercises this option, we may purchase the non-controlling interest with cash or by issuing stock. It is our intent to settle in cash, if the option is exercised. These potential cash outflows could limit our ability to fund our other operating needs, including acquisitions or other growth opportunities.
As of June 30, 2012, we held $51.8 million in total available-for-sale investments in securities held by one of our wholly-owned captive insurance subsidiaries acquired in the DMC acquisition. We may not be able to utilize these investments to fund our operating or capital expenditure funding needs due to statutory limitations placed on this captive insurance subsidiary.
Due primarily to the DMC capital commitment escrow funding requirement and continued reimbursement delays from certain governmental payers, at various times subsequent to December 31, 2011, we made borrowings under our revolving credit facility to fund our working capital needs. In April 2012, we received commitments, which became effective in May 2012, to increase the amount available under our 2010 Revolving Facility from $260.0 million to $365.0 million. We expect that cash on hand, the expanded capacity under our 2010 Revolving Facility, and cash generated from our operations to be sufficient to fund our operating and capital needs during the next 12 months and into the foreseeable future. However, we cannot be certain that cash on hand, cash flows from operations and the capacity under our 2010 Revolving Facility will be sufficient to fund our operating and capital needs and debt service requirements during the long-term.
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, 2012.
Represents our estimate of amounts we are committed to fund in future periods through executed agreements to complete projects included as property, plant and equipment on our consolidated balance sheets. The construction and capital improvements obligations, include the following capital commitments under the executed DMC purchase
Includes amounts outstanding as of July 2012 primarily for letters of credit with the third party administrator of our self-insured workers’ compensation program.
Consolidated Statements of Comprehensive Income (Loss) for the years ended June 30, 2010, 2011 and 2012
Consolidated Statements of Equity for the years ended June 30, 2010, 2011 and 2012
Consolidated Statements of Cash Flows for the years ended June 30, 2010, 2011 and 2012
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, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2012, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company changed its presentation of revenues and provision for doubtful accounts as a result of the adoption of the amendments to the FASB Accounting Standards Codification resulting from Accounting Standards Update No. 2011-07, Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Healthcare Entities.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Vanguard Health Systems, Inc.'s internal control over financial reporting as of June 30, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 23, 2012 expressed an unqualified opinion thereon.
The Company is an investor-owned healthcare company whose subsidiaries and affiliates own and operate hospitals and related healthcare businesses in urban and suburban areas. As of June 30, 2012, the Company’s subsidiaries and affiliates owned and operated 28 acute care hospitals with 7,064 licensed beds and related outpatient service locations complementary to the hospitals providing healthcare services in San Antonio, Harlingen and Brownsville, Texas; metropolitan Detroit, Michigan; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; and Massachusetts. The Company also owns managed health plans in Chicago, Illinois, Harlingen, Texas, and Phoenix, Arizona, and two surgery centers in Orange County, California.
Pending CMS's issuance of new SSI ratios for FFY 2006 forward, the Company had utilized the SSI ratios that were most recently provided by CMS in filing its hospital cost reports. The cumulative impact of this updated Medicare reimbursement estimate was an increase in revenues of approximately $9.1 million and an increase to net income attributable to Vanguard Health Systems, Inc. stockholders of $5.3 million ($0.07 per diluted share) for the year ended June 30, 2012.
Medicaid program for private hospitals. The Company recognizes revenues from the UPL program when the Company becomes entitled to the expected reimbursements, including a federal match portion, and such reimbursements are assured.
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. The Company participates in a similar program with the state of Michigan through its DMC hospitals. The Company recognizes revenues equal to the gross PTA payments to be received when such payments are assured. The Company recognizes expenses for the taxes due back to the states under these PTA programs when the related revenues are recognized.
Effective for service dates on or after April 1, 2009, as a result of a state mandate, the Company implemented an uninsured discount policy for those patients receiving services in its Illinois hospitals who had no insurance coverage and who did not otherwise qualify for charity care under its guidelines. The Company implemented this same policy in its Phoenix and San Antonio hospitals effective for service dates on or after July 1, 2009 and in its Harlingen and Brownsville, Texas hospitals upon acquisition of those facilities. Under this policy, the Company applies an uninsured discount (calculated as a standard percentage of gross charges) at the time of patient billing and includes this discount as a reduction to patient service revenues. These discounts were approximately $277.2 million and $451.4 million for the fiscal years ended June 30, 2011 and 2012, respectively.
during its fiscal year ended June 30, 2011, comprised of $6.1 million of Medicaid revenues and $5.8 million of Medicare revenues. During the quarter ended September 30, 2011, the Company recognized approximately $7.2 million of EHR revenues, comprised of $5.1 million of Medicaid revenues and $2.1 million of Medicare revenues.
The Company has concluded that it should have applied the contingency model to account for Medicare and Medicaid EHR incentive payments beginning in its year ended June 30, 2011. If the Company had utilized the contingency model from the time that EHR incentive payments commenced, previously reported net income attributable to the Company's stockholders would have been reduced by $1.1 million, reduced by $2.5 million and increased by $3.6 million for the year ended June 30, 2011, the quarter ended September 30, 2011 and the quarter ended December 31, 2011, respectively, which amounts the Company deems not material. To correct these errors, the Company has retroactively applied the contingency model for the fiscal year ended June 30, 2011, the quarter ended September 30, 2011 and the quarter ended December 31, 2011. To reflect this correction in the Company's June 30, 2012 consolidated financial statements, the Company increased its June 30, 2011 current deferred tax assets by $0.7 million, increased other accrued expenses and current liabilities by $1.8 million and decreased retained earnings by $1.1 million on the accompanying consolidated balance sheets. In addition, the Company increased net income attributable to Vanguard Health Systems, Inc. stockholders by $1.1 million during the fiscal year ended June 30, 2012 on the accompanying consolidated statements of operations to retroactively apply this correction to its current year results of operations. The $1.1 million net impact of this correction reflected in the Company's results of operations for the year ended June 30, 2012 was comprised of a $2.5 million decrease for the three months ended September 30, 2011 ($4.1 million decrease to Medicare and Medicaid EHR incentives, net of a $1.6 million income tax benefit) and a $3.6 million increase for the three months ended December 31, 2011 ($5.9 million increase to Medicare and Medicaid EHR incentives, net of a $2.3 million income tax expense).
The Company recognized approximately $28.2 million of other income related to Medicare and Medicaid EHR incentives during the year ended June 30, 2012 under the contingency model. The Company incurs both capital expenditures and operating expenses in connection with the implementation of its various EHR initiatives. The amount and timing of these expenditures do not directly correlate with the timing of the Company's cash receipts or recognition of the EHR incentives as other income. As of June 30, 2011 and 2012, the Company had recognized approximately $6.1 million and $2.7 million in Medicaid EHR receivables, respectively, on its consolidated balance sheet. In addition, as of June 30, 2011 and 2012, the Company had recognized $3.8 million and $4.3 million in Medicare EHR deferred revenues, respectively, on its consolidated balance sheet.
The Company considers all highly liquid investments with maturity of 90 days or less when purchased to be cash equivalents. The Company manages its credit exposure by placing its investments in high quality securities and by periodically evaluating the relative credit standing of the financial institutions holding its cash and investments.
A summary of the Company’s allowance for doubtful accounts activity, including those for discontinued operations, during the three most recent fiscal years follows (in millions).
Depreciation and amortization expense was approximately $139.6 million, $193.8 million and $258.3 million for the fiscal years ended June 30, 2010, 2011 and 2012, respectively. The Company tests its property, plant and equipment and other long-lived assets for impairment as management becomes aware of impairment indicators.
In 2012, the Company elected not to perform a qualitative impairment assessment for goodwill but instead to complete the quantitative analysis. The first step of the quantitative two-step process involves a comparison of the estimated fair value of a reporting unit to its carrying amount, including goodwill. In performing the first step, the Company determines the fair value of a reporting unit using a discounted cash flow (“DCF”) analysis. Determining fair value requires the exercise of significant judgment, including judgments about appropriate discount rates, perpetual growth rates and the amount and timing of expected future cash flows. The significant judgments are typically based upon Level 3 inputs, generally defined as unobservable inputs representing the Company's own assumptions. The cash flows employed in the DCF analysis are based on the Company's most recent budgets and business plans and, when applicable, various growth rates are assumed for years beyond the current business plan period. Discount rate assumptions are based on an assessment of the risks inherent in the future cash flows of the respective reporting units. If the estimated fair value of a reporting unit exceeds its carrying amount, the goodwill of the reporting unit is not impaired and the second step of the impairment test is not necessary.
If the carrying amount of a reporting unit exceeds its estimated fair value, then the second step of the goodwill impairment test must be performed. The second step of the goodwill impairment test compares the implied fair value of the reporting unit's goodwill with its carrying amount to measure the amount of impairment loss, if any. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination (i.e., the estimated
fair value of the reporting unit is allocated to all of the assets and liabilities of that reporting unit including any unrecognized intangible assets as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid). If the carrying amount of the reporting unit's goodwill exceeds the implied fair value of the reporting unit's goodwill, an impairment loss is recognized in an amount equal to that excess.
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 ten years. The expected future cash flows supporting the value of contract-based intangible assets are affected by the Company’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.
During the fiscal years ended June 30, 2010, 2011 and 2012, health plan claims expense was $665.8 million, $686.3 million and $578.9 million, respectively, primarily representing health claims incurred by members in PHP. Vanguard estimates PHP’s reserve for health 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. Accrued health plan claims and settlements, including incurred but not reported claims and net amounts payable to AHCCCS and CMS for certain programs for which profitability is limited, for all the Company's health plans combined was approximately $114.9 million and $67.8 million as of June 30, 2011 and 2012, 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. Due to changes in historical claims trends during its fiscal years ended June 30, 2010, 2011 and 2012, the Company decreased its health plan claims and settlements reserve related to prior fiscal year health claims by $4.9
The Company covers substantially all of its employees under self-insured medical plans. Claims are accrued under the self-insured medical plans as the incidents that give 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. The reserve for self-insured medical plans was approximately $30.6 million and $28.9 million as of June 30, 2011 and 2012, respectively, and is included in accrued salaries and benefits in the accompanying consolidated balance sheets. The Company mitigated its self-insured risk by purchasing stop-loss coverage for catastrophic claims for a portion of its covered employees at a $500,000 per enrollee annual limit. During the fiscal years ended June 30, 2011 and 2012, approximately $58.7 million and $75.8 million, respectively, of medical claims expense was eliminated in consolidation related to self-insured medical claims expense incurred and revenues earned due to employee utilization of the Company’s healthcare facilities.
Given the nature of its operating environment, the Company is subject to professional and general liability and workers compensation claims and related lawsuits in the ordinary course of business. The Company 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 the Company’s wholly-owned captive insurance subsidiary and/or another of its wholly-owned subsidiaries) of $10.0 million through June 30, 2010 but increased to $15.0 million for its Illinois hospitals subsequent to June 30, 2010.
The Company adjusts these reserves from time to time as it receives updated information. Due to changes in historical loss trends, during its fiscal year ended June 30, 2010, the Company increased its professional and general liability reserve related to prior fiscal years by $8.4 million ($5.2 million net of taxes or $0.12 per diluted share). During its fiscal year ended June 30, 2011, the Company decreased its professional liability and general reserve related to prior fiscal years by $5.4 million ($3.3 million net of taxes or $0.07 per diluted share). During its fiscal year ended June 30, 2012, the Company increased its professional liability and general reserve related to prior fiscal years by $0.5 million ($0.3 million net of taxes or $0.01 per diluted share).
Similarly, the Company decreased its workers compensation reserve related to prior fiscal years by $5.1 million ($3.1 million net of taxes or $0.07 per diluted share), $4.3 million ($2.6 million net of taxes or $0.06 per diluted share) and $0.3 million ($0.2 million net of taxes), respectively, during its fiscal years ended June 30, 2010, 2011 and 2012. Additional adjustments to prior year estimates may be necessary in future periods as the Company’s reporting history and loss portfolio matures.
The DMC Pension Plan is measured using actuarial techniques that reflect management’s assumptions for discount rates relative to the projected benefit obligation and the interest cost component of net periodic pension cost, expected long-term investment returns on plan assets, expected retirement and mortality. Management utilizes an independent actuary in determining these estimates.
In September 2011, the Company obtained a 51% controlling interest in a partnership that held the assets acquired and liabilities assumed in the purchase of Valley Baptist Health Systems as more fully discussed in Note 3. The remaining 49% non-controlling interest was granted to the former owner of Valley Baptist (the “seller”) as purchase consideration. The partnership operating agreement includes an option by which the seller may put its 49% non-controlling interest back to the Company upon either the third or fifth anniversary of the transaction date. The redemption value is calculated based upon the operating results and the debt of the partnership, but is subject to a floor value. The Company also has the option to call a stated percentage of the seller's non-controlling interest in the event the seller does not exercise its put option on either of the anniversary dates.
The Company accounts for income taxes using the asset and liability method. This guidance requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities.
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 the Company’s recoverability analysis and thus have a material adverse impact on the Company’s consolidated financial condition, results of operations or cash flows.
In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ("ASU") No. 2012-02, Intangibles--Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU states that an entity has the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. This allows for the same evaluation as described in ASU 2011-08 for Intangibles-Goodwill and Other. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity's financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. ASU 2012-02 is not expected to significantly impact the Company’s financial position, results of operations or cash flows.
In September 2011, the FASB issued ASU No. 2011-08, “Intangibles-Goodwill and Other” (Topic 350): Testing Goodwill for Impairment (“ASU 2011-08”). ASU 2011-08 is intended to simplify how entities, both public and nonpublic, test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50%. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. ASU 2011-08 is not expected to significantly impact the Company’s financial position, results of operations or cash flows.
In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive
Effective January 1, 2011, the Company purchased substantially all of the assets of DMC, a Michigan non-profit corporation, and certain of its affiliates, which assets consisted of eight acute care and specialty hospitals and related healthcare facilities in the Detroit, Michigan metropolitan area. The table below summarizes the DMC purchase price allocation.
Effective September 1, 2011, the Company acquired substantially all of the assets of Valley Baptist Medical Center, a 586-bed acute care hospital in Harlingen, Texas, and Valley Baptist Medical Center-Brownsville, a 280-bed acute care hospital in Brownsville, Texas, as well as the assets of certain other incidental healthcare businesses, partnerships, physician practices and medical office buildings operated as part of such hospital businesses (collectively “Valley Baptist”). The Company paid approximately $200.5 million in cash at closing to acquire the net assets of Valley Baptist. In addition to the cash investment, the Company also assumed certain of the seller’s debt and issued a 49% non-controlling interest in the partnership to the seller. The Company funded the cash investment with cash on hand. The Valley Baptist partnership is consolidated by the Company. In connection with this acquisition, the Company entered into a management agreement, pursuant to which the Company is responsible for the management of Valley Baptist’s operations.
Revenues of approximately $358.3 million for the Valley Baptist acquisition (effective September 1, 2011) are included in the Company's consolidated statement of operations for the fiscal year ended June 30, 2012. The following table provides certain pro forma financial information for the Company as if the Valley Baptist acquisition, the DMC acquisition, and the Company's acquisition of two hospitals from Resurrection Health Care (effective August 1, 2010) occurred at the beginning of fiscal year 2011 (in millions).
The investments acquired from DMC are classified as “available-for-sale” and recorded at fair value. The investment securities are held for the purpose of providing a funding source to pay professional liability claims covered by the captive insurance subsidiary. The Company adjusts the book value of these investments to fair value on a quarterly basis.
Supplemental information regarding the Company's available-for-sale investment securities held as of June 30, 2012 is set forth in the table below (in millions).
During fiscal year 2010, the Company recognized realized losses related to its investments in ARS for approximately $0.1 million in connection with a $6.2 million redemption of ARS at 98% of par value. During the fiscal year ended June 30, 2011, the Company recognized a realized gain of $0.6 million related to the redemption, at par, of the ARS that had previously been impaired due to the failed tender during the quarter ended September 30, 2008. As of June 30, 2011, the Company had recognized temporary impairments of $1.2 million ($0.7 million, net of taxes) related to the ARS that was included in accumulated other comprehensive income (loss) (“AOCL”) on the accompanying consolidated balance sheet. During the fiscal year ended June 30, 2012, the Company's previously recognized temporary impairments of $1.2 million ($0.7 million, net of taxes) were reversed from AOCL and a corresponding gain was recognized due to the redemption, at par, of the remaining ARS. As of June 30, 2012, the Company had no remaining ARS.
Prepaid expenses and other current assets in the accompanying consolidated balance sheets consist of the following as of June 30, 2011 and 2012 (in millions).
Amortization expense for contract-based intangibles and other intangible assets during the fiscal years ended 2010, 2011 and 2012 was approximately $4.8 million, $4.0 million and $4.1 million, respectively. Total estimated amortization expense for these intangible assets during the next five years and thereafter is as follows: 2013 - $4.2 million; 2014 - $4.2 million; 2015 - $1.7 million; 2016 - $0.6 million; 2017 - $0.1 million and $0.7 million thereafter.
Amortization of deferred loan costs of $5.2 million, $6.3 million and $6.9 million during the years ended 2010, 2011 and 2012, respectively, is included in net interest. Net deferred loan costs of $11.2 million were written off as part of the debt extinguishment costs associated with the redemption of the 10.375% Senior Discount Notes (see Note 7). The Company capitalized approximately $10.6 million of additional deferred loan costs during fiscal 2012 associated with the additional debt offerings in March 2012 (see Note 7).
Amortization of physician income and other guarantees of $6.7 million, $4.8 million and $5.1 million during the fiscal years ended June 30, 2010, 2011 and 2012, respectively, is included in purchased services or other operating expenses.
A summary of the Company’s long-term debt as of June 30, 2011 and 2012 follows (in millions).
Securities and Exchange Commission on April 8, 2011, that became effective on May 4, 2011.
On January 26, 2011, the Issuers issued an aggregate principal amount of $350.0 million of 7.750% senior notes due 2019 (the “Senior Notes”), in a private placement. The Issuers’ obligations under the Senior Notes were fully and unconditionally guaranteed on a senior basis by the Company, Vanguard Health Holding Company I, LLC and certain subsidiaries of VHS Holdco II (as defined below).
The Senior Notes bear interest at a rate of 7.750% per annum. The Company 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. The Company 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.
The New Notes are expected to be treated as a single series with the Existing Notes, except that (i) the New Notes are subject to a separate registration rights agreement and (ii) unless and until the New Notes are registered, the New Notes will have a different CUSIP number from that of the Existing Notes and will not be fungible with the Existing Notes. The Company used a portion of the net proceeds from the offering of the New Notes to repay all indebtedness outstanding under the Company's revolving credit facility on March 30, 2012.
During the fiscal year ended June 30, 2012, the Company used the net proceeds from its initial public offering in June 2011 and the exercise of the over-allotment option by the underwriters in July 2011 to redeem approximately $450.0 million accreted value of the Senior Discount Notes and to pay $27.6 million of redemption premiums related thereto. The redemptions
resulted in approximately $14.7 million of remaining unredeemed accreted value of these notes outstanding immediately after the redemptions were completed and resulted in the recognition of debt extinguishment costs of approximately $38.9 million ($25.3 million net of taxes or $0.32 per diluted share), representing tender premiums and other costs to redeem the Senior Discount Notes and the write-off of net deferred loan costs associated with the redeemed notes. During the fiscal year ended June 30, 2012, the Company redeemed an additional $6.0 million of Senior Discount Notes through privately negotiated transactions. The remaining outstanding Senior Discount Notes are not callable until February 1, 2013.
The Company's senior secured credit facilities include a six-year term loan facility (“2010 term loan facility”) in the amount of $815.0 million and a five-year revolving credit facility (the “2010 revolving facility” and together with the 2010
The 2010 term loan facility bears interest at a rate equal to, at the Company’s option, LIBOR (subject to a 1.50% floor) plus 3.50% per annum or an alternate base rate plus 2.50% per annum. The interest rate applicable to the 2010 term loan facility was approximately 5.00% as of June 30, 2012. The Company 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 the maturity of the term debt.
The 2010 credit facilities contain numerous covenants that restrict the Company 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. The Company was in compliance with each of these debt covenants as of June 30, 2012. Obligations under the credit agreement are unconditionally guaranteed by the Company 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 - $11.6 million; Year 2 - $13.1 million; Year 3 - $13.1 million; Year 4 - $11.4 million; Year 5 - $780.5 million and $1,897.2 million thereafter.
The Company conducts substantially all of its business through its subsidiaries. Most of the Company’s subsidiaries jointly and severally guarantee the 8.0% Notes, the Senior Notes and the New Notes. Certain of the Company’s other consolidated wholly-owned and non-wholly-owned entities do not guarantee these notes or the Senior Discount Notes in conformity with the provisions of the indentures governing those notes, and do not guarantee the 2010 credit facilities in
conformity with the provisions thereof. The accompanying consolidating financial information for the parent company, the issuers of the senior notes and term debt, the issuers of the Senior Discount Notes, the subsidiary guarantors, the non-guarantor subsidiaries, certain eliminations and consolidated Company as of June 30, 2011 and 2012 and for the fiscal years ended June 30, 2010, 2011 and 2012 follows.
The following table summarizes the funded status of the DMC Pension Plan based upon actuarial valuations prepared as of the most recent valuation dates of June 30, 2011 and 2012, respectively (in millions).
A summary of the components of net pension plan expense (credits) for the fiscal years ended June 30, 2011 and 2012, respectively, is as follows (in millions):
of $80.6 million ($49.2 million, net of tax) based primarily on year-end adjustments related to an increase in its unfunded pension liability due to a decrease in the discount rate used to measure the projected benefit obligation partially off-set by an increase in the fair value of plan assets. The discount rate was decreased from 5.57% at June 30, 2011 to 4.40% at June 30, 2012.
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 various 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.
In each investment account, investment managers are responsible to monitor and react to economic indicators, such as GDP, CPI and the Federal Monetary Policy, that may affect the performance of their account. The performance of all managers and the aggregate asset allocation are formally reviewed on a quarterly basis, with a rebalancing of the asset allocation occurring at least once a year. The current asset allocation objective is to maintain a certain percentage with each class allowing for a 10% deviation from the target.
The following table summarizes the plan assets measured at fair value on a recurring basis as of June 30, 2012, the most recent measurement date, aggregated by the level in the fair value hierarchy within which those measurements are determined as disclosed in Note 4. Fair value methodologies for Level 1 and Level 2 are consistent with the inputs described in Note 4. Fair value for Level 3 inputs are unobservable data points for the asset, and include situations where there is little, if any, market activity for the asset.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of June 30, 2011 and 2012, were as follows (in millions):
In the quarter ended June 30, 2012, the Company recorded a $4.9 million deferred tax benefit from the application of the recently enacted Michigan Corporate Income Tax to future taxable and deductible temporary differences. The Michigan Corporate Income Tax was enacted on May 25, 2011 and was effective January 1, 2012 for companies that elected to be subject to the new corporate income as opposed to continuing to be taxed under the Michigan Business Tax. The Company elected, during the fourth fiscal quarter, to be subject to the Michigan Corporate Income Tax on its Michigan tax return for the fiscal year ended June 30, 2012.
The following table sets forth the computation of basic and diluted earnings (loss) per share for the fiscal years ended June 30, 2010, 2011 and 2012 (dollars in millions, except share and per share amounts):
For the fiscal year ended June 30, 2012, the Company excluded 4,377,280 potentially dilutive stock option and other stock-based awards from the calculation of diluted earnings per share because their inclusion would be anti-dilutive.
The Company has the authority to issue 500,000,000 shares of common stock, par value $.01 per share. As discussed in Note 1, in June and July 2011, the Company completed an initial public offering of 28,750,000 shares, inclusive of the exercise of the over-allotment option exercised in July 2011, of its common stock at $18.00 per share, prior to underwriting discounts, commissions and other related offering expenses of approximately $33.8 million.
In January 2011, the Company paid dividends of approximately $444.7 million ($9.81 per common share on a post-split basis) to its equity holders. The dividend was funded by the proceeds from the Senior Discount Notes previously described.
As previously discussed, the Company uses the Black-Scholes-Merton model to record stock-based compensation expense for options granted. During the 2010, 2011 and 2012 fiscal years, the Company incurred stock-based compensation expense of $4.2 million, $4.8 million and $9.2 million, respectively, under its stock incentive plans. Compensation cost related to stock-based awards will be adjusted for future changes in estimated forfeitures and actual results of performance measures.
In June 2011, the Company adopted the 2011 Stock Incentive Plan (the “2011 Plan”), which effectively replaced the 2004 Stock Incentive Plan (the "2004 Plan"), from which stock-based awards were granted prior to the initial public offering. No further equity awards will be made under the 2004 Plan. The 2011 Plan allows for the issuance of 14,000,000 shares of common stock, all of which may be granted as incentive stock awards. As of June 30, 2012, there were 1,392,904 options, 799,753 restricted stock units, 740,409 performance-based restricted stock units and 1,530,139 restricted shares outstanding under the 2011 Plan. The options issued during fiscal year 2012 vest and become exercisable ratably over three years, while the time-based restricted stock units vest ratably over four years. The performance-based restricted stock units granted in September 2011 vest ratably on September 1, 2012, 2013, 2014 and 2015, respectively. The restricted shares vest in the Company's first quarter of fiscal 2013.
As of June 30, 2012, the performance-based restricted stock units earned were 740,409 based upon the Company’s fiscal 2012 financial performance. The Company recognized estimated expense for the year ended June 30, 2012 for the performance-based awards based upon the Company achieving its maximum targets related to financial performance metrics for fiscal 2012.
During the fiscal year ended June 30, 2011, the Company’s Board of Directors declared a dividend to stockholders. Pursuant to the terms of the 2004 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 dividend.
The following table summarizes information about the Company’s outstanding stock options as of June 30, 2012:
The following table summarizes restricted stock unit activity during the fiscal year ended June 30, 2012.
As of June 30, 2012, all performance-based restricted stock awards were unvested and had an aggregate intrinsic value of approximately $6.6 million. As of June 30, 2012, there was approximately $6.5 million of estimated unrecognized compensation cost related to performance awards. These costs are expected to be recognized over a weighted average remaining period of approximately 2.1 years.
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. The Company’s matching accrual, included in accrued salaries and benefits on the accompanying consolidated balance sheets, was approximately $3.2 million for both June 30, 2011 and 2012. The Company’s matching expense, including matching expense for discontinued operations, for the years ended 2010, 2011 and 2012 fiscal years was approximately $17.7 million, $21.7 million and $26.7 million, respectively.
During the fiscal years ended June 30, 2010, 2011 and 2012, rent expense was approximately $43.8 million, $54.1 million and $75.0 million, respectively.
As part of its acquisition of DMC, the Company committed to spend a total of $850.0 million over a five-year period, $500.0 million of which related to a specific list of expansion projects. As of June 30, 2012, the Company had spent approximately $160.3 million related to this commitment, including approximately $74.2 million related to the specific project list. Under the terms of the DMC acquisition agreement, the Company was required to spend at least $80.0 million related to the specific list of expansion projects through December 31, 2011. Since this commitment was not met, the Company deposited $41.8 million of cash into an escrow account restricted for the purpose of funding capital expenditures related to the specific project list until the escrow is depleted. The cash escrow funds will be utilized to fund DMC capital expenditures on the specific project list incurred subsequent to January 1, 2012. Since funding the escrow, the Company had drawn approximately $21.5 million from the account for reimbursement of capital expenditures related to the specific project list through June 30, 2012. As of June 30, 2012, the Company estimated its remaining commitments, excluding those for DMC, to complete all capital projects in process to be approximately $112.1 million.
The Company has entered into tolling agreements with the DOJ. In addition, the DOJ has advised us that the investigation covers implantations after October 1, 2003, has identified the cases that are the subject of the DOJ’s investigation, and has requested that the Company review the identified cases. The Company understands that the DOJ has made similar requests for self-reviews of the other health systems and hospitals under investigation. The Company understands that the DOJ is finalizing a set of auditing instructions that it will be issuing to all the hospitals, nationally, that are being investigated. The Company further understands that the DOJ will request that hospitals audit the cases previously identified by the DOJ in accordance with those instructions, and that the DOJ intends to pursue settlement negotiations based on the results of the audit.
The Company intends to cooperate fully with the investigation of this matter. To date, the DOJ has not asserted any specific claim of damages against the Company or its hospitals. Because the Company still is in the early stages of this investigation, the Company is unable to predict its timing or outcome at this time. However, as the Company understands that this investigation is being conducted under the federal False Claims Act ("FCA"), the Company is at risk for significant damages under the FCA’s treble damages and civil monetary penalty provisions if the DOJ concludes a large percentage of claims for the identified patients are false claims and, as a result, such damages could materially affect the Company's business, financial condition or results of operations.
The Company believes that this OIG investigation may have been related to a pending civil action that was filed under seal on December 15, 2011 with the U.S. District Court for the District of Arizona. On June 21, 2012 the U.S. Government filed a Notice of Election to Decline Intervention in that matter, as described below. The Company believes that all of the allegations described are without merit and intend to vigorously defend ourselves in this action, if pursued. Management does not believe that the final outcome of this matter will be material.
United States of America ex rel. Brad Graber v. VHS Outpatient Clinics, Inc. d/b/a Abrazo Medical Group and Vanguard Health Systems, Inc.
The Company believes that all of the allegations described above are without merit and intend to vigorously defend ourselves in these actions, if pursued. Management does not believe that the final outcome of this matter will be material.
2012, the judge issued an opinion and order granting in part and denying in part the defendants' motions for summary judgment. The defendants' motions were granted as to the count of the complaint alleging wage fixing by defendants, but were denied as to the count alleging that the defendants' sharing of wage information allegedly resulted in the suppression of nurse wages. The opinion, however, did not address plaintiffs' motion for class certification and did not address defendants' challenge to the opinion of plaintiffs' expert, but specifically reserved ruling on those matters for a later date.
Laws and regulations governing the Medicare and Medicaid and other federal healthcare programs are complex and subject to interpretation. The Company’s management believes that it is in compliance with all applicable laws and regulations in all material respects and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing related to Medicare and Medicaid programs. While no such regulatory inquiries have been made, the Company’s compliance with such laws and regulations is subject to future government review and interpretation. Non-compliance with
such laws and regulations could result in significant regulatory action including fines, penalties, and exclusion from the Medicare, Medicaid and other federal healthcare programs.
As part of its contract with the Arizona Health Care Cost Containment System, one of the Company’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, 2012, the Company maintained this performance guarantee in the form of $45.0 million of surety bonds with independent third party insurers collateralized by letters of credit of approximately $5.0 million. The Company also has a surety bond for its Michigan Pioneer ACO in the amount of $3.0 million as part of the requirements set forth by CMS. The Company also holds other miscellaneous surety bonds for various corporate needs.
Under the transaction and monitoring fee agreement, Blackstone and Metalmark SA are entitled to receive additional compensation for providing investment banking or other financial advisory services to the Company by mutual agreement among Blackstone, Metalmark SA and the Company. In this regard, in May 2011, the Company agreed to pay financial advisory fees to Blackstone and Metalmark SA of $10.0 million and $1.5 million, respectively, to reflect their contributions to the Company’s accomplishments during fiscal year 2011.
A summary of the monitoring fees and expenses incurred by the Company for the year ended June 30, 2011 is as follows:
Effective July 1, 2008, the Company 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, 2012, the Company has approximately 13,400 employees enrolled in these health and welfare benefit plans.
The Company’s acute care hospitals and related healthcare businesses are similar in their activities and the economic environments in which they operate (i.e. urban markets). Accordingly, the Company’s reportable operating segments consist of 1) acute care hospitals and related healthcare businesses, collectively, and 2) health plans consisting of CHS, a contracting entity for outpatient services provided by MacNeal Hospital and Weiss Memorial Hospital and participating physicians in the Chicago area, PHP, a Medicaid managed health plan operating in Arizona, AAHP, a Medicare and Medicaid dual eligible managed health plan operating in Arizona and VBIC, which offers health maintenance organization, preferred provider organization, and self-funded products to its members in the form of large group, small group, and individual product offerings in south Texas.
The Company eliminates in consolidation those patient service revenues earned by its healthcare facilities attributable to services provided to members in its owned health plans and eliminates the corresponding medical claims expenses incurred by the health plans for those services. Amount is net of the provision for doubtful accounts consistent with the presentation in ASU 2011-07.