A listing of our owned acute hospitals is included in Item 1 of this report under the caption “Business-Our Facilities”. We also own or lease space for outpatient service facilities complementary to our hospitals and own and operate a limited number of medical office buildings (some of which are joint ventures) associated with our hospitals that are occupied primarily by physicians who practice at our hospitals. The most significant of these complementary outpatient healthcare facilities are two surgery centers in Orange County, California, five diagnostic imaging centers in metropolitan Phoenix, Arizona and a 50% interest in five diagnostic imaging centers in San Antonio, Texas. Most of these outpatient facilities are in leased facilities, and the diagnostic imaging centers in San Antonio are owned and operated in joint ventures where we have minority partners.
On September 23, 2004, The Blackstone Group and certain of its affiliates (collectively “Blackstone”) purchased approximately 66% of our equity interests (the “Merger”). Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively “MSCP”) and certain of our senior members of management and other shareholders (collectively the “Rollover Management Investors”) purchased the remaining 34% of our equity interests. The transaction was treated as a leveraged buyout purchase for accounting purposes. In connection with the Merger, we repaid $299.0 million of our outstanding $300.0 million 9.75% senior subordinated notes (we repaid the remaining $1.0 million in October 2005), our outstanding $17.6 million 8.18% subordinated notes and the $300.0 million Term B loans outstanding under our 2004 senior secured credit facility. We financed the Merger by issuing $575.0 million of 9.0% senior subordinated notes (the “9.0% Notes”), by issuing 11.25% senior discount notes (the “11.25% Notes”) having an aggregate principal amount at maturity of $216.0 million, by borrowing $475.0 million of initial Term B loans under new senior secured credit facilities (the “merger credit facilities”) and with equity proceeds totaling approximately $749.0 million (valued at approximately $635.7 million for accounting purposes). Certain members of senior management also purchased $5.7 million of the equity incentive units in VHS Holdings LLC. The merger credit facilities include a $250.0 million revolving credit facility, of which $42.8 million of capacity was utilized for letters of credit (with no outstanding borrowings) as of June 30, 2006. The merger credit facilities also included $325.0 million in delayed draw term loan facilities. We borrowed $60.0 million under the delayed draw term loan facilities to finance the acquisition of three acute-care hospitals and related healthcare businesses in Massachusetts from subsidiaries of Tenet Healthcare Corporation on December 31, 2004, and we borrowed $90.0 million on February 18, 2005 to fund the working capital buildup of the Massachusetts hospitals and to fund capital expenditures. We borrowed the remaining $175.0 million under the delayed draw term loan facilities during September 2005.
We own and operate 19 hospitals with a total of 4,587 licensed beds, and related outpatient service facilities complementary to the hospitals in San Antonio, Texas, metropolitan Phoenix, Arizona, metropolitan Chicago, Illinois, Orange County, California, and Massachusetts. We own three health plans as detailed in the following table.
We have implemented multiple operating strategies to achieve our mission of providing high-quality, cost-effective healthcare services in the communities we serve. We consider the following to be the most important of these strategies: quality of care and patient safety; expansion of services; nurse and physician relations; compliance and ethics; and resource allocation. We believe the successful implementation of these strategies and initiatives will improve our operating results and our competitive position in the communities we serve. However, there are many risks and uncertainties, including those discussed in the “Risk Factors” section of this document, that make it more difficult for us to achieve our objectives and could limit our ability to realize improved operating results.
Specific action steps we are taking to implement our business strategies are set forth below.
Becoming the employer of choice in the markets we serve and attracting quality physicians.
On December 31, 2004, we acquired three acute-care hospitals with a then total of 768 licensed beds and related healthcare businesses located in or around Worcester, Framingham and Natick, Massachusetts (the “Massachusetts hospitals”) from subsidiaries of Tenet Healthcare Corporation for $87.7 million. We funded the purchase price and the subsequent buildup of working capital by borrowing $150.0 million in acquisition delayed draw term loans during December 2004 and February 2005. The acquisition of these hospitals gave us an established presence in the suburban Boston and central Massachusetts areas with an opportunity to grow the hospitals by adding new services. Operating results for the Massachusetts hospitals are included in our consolidated statements of operations for the second half of our fiscal year ended June 30, 2005 and all of our fiscal year ended June 30, 2006.
The following table provides details of discharges by payer for the years ended June 30, 2004, 2005 and 2006.
We recognize premium revenues from our three health plans, PHP, AAHP and MHP. AAHP commenced operations on January 1, 2006 to provide healthcare services for Medicare Part D recipients and for those individuals eligible for Medicare who also receive full Medicaid benefits. As of June 30, 2006, approximately 3,500 members were enrolled in this program, most of whom were previously enrolled in PHP. PHP’s membership decreased to approximately 96,700 at June 30, 2006 compared to approximately 100,200 at June 30, 2005. Premium revenues from these three plans increased by $41.5 million or 12.4% during the year ended June 30, 2006 compared to the prior year period. This increase resulted primarily from the increased per member per month reimbursement from AAHP during our third and fourth fiscal quarters. PHP’s per member per month reimbursement rate also increased effective October 1, 2005. We do not anticipate a significant increase in membership for our health plan reporting segment during our fiscal year ending June 30, 2007 but could realize significant membership increases during future fiscal years. PHP’s contract with the Arizona Health Care Cost Containment System (“AHCCCS”) commenced on October 1, 2003 and ends of September 30, 2007 with an option for AHCCCS to renew the contract for an additional one-year period. AAHP’s contract with the Centers for Medicare and Medicaid Services (“CMS”) went into effect on January 1, 2006 for a term of one year with a provision for successive year renewals. Should the PHP contract terminate, our future operating results and cash flows could be materially reduced.
Similar to others in the hospital industry, the collectibility of our accounts receivable has deteriorated primarily due to an increase in self-pay accounts receivable. The following table provides a summary of our accounts receivable by age since discharge date by payer type as of June 30, 2004, 2005 and 2006 (in millions).
(1) Includes uninsured patients and those patient co-insurance and deductible amounts for which payment has been received from the
We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We exclude charity care accounts from revenues when we determine that the account meets our charity care guidelines. In June 2004, we adopted revised policies that provide expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. CMS has indicated that it is aware of no regulations or guidelines preventing implementation of such policies. During the fiscal years ended 2004, 2005 and 2006, we deducted $37.1 million, $55.6 million and $77.8 million of charity care from revenues, respectively. During fiscal 2006, we began tracking healthcare services provided to undocumented aliens and recording those costs as charity care deductions. Payments received for these services are recorded as a decrease to charity deductions when received. These costs, net of $1.3 million of payments received, accounted for $14.4 million of our charity care deductions during fiscal 2006. Prior to fiscal 2006, these accounts were classified as self-pay and were subject to our allowance for doubtful accounts policy.
We maintain professional and general liability insurance coverage through a wholly owned captive insurance subsidiary for individual claims incurred through May 31, 2006 up to $10.0 million. For claims incurred subsequent to May 31, 2006, we self-insure the first $9.0 million per occurrence, and the captive subsidiary insures the next $1.0 million per occurrence. We maintain excess insurance coverage with independent third party carriers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. The total cost of professional and general liability insurance is sensitive to the volume and severity of cases reported. Malpractice premiums have adversely affected the ability of physicians to obtain malpractice insurance at reasonable rates in certain markets, particularly in metropolitan Chicago, Illinois, resulting in physicians relocating to different geographic areas. In the event physicians practicing in our hospitals are unable to obtain adequate malpractice insurance coverage, our hospitals are likely to incur a greater percentage of the amounts paid to claimants. Our professional liability exposures also increase when we employ physicians. Some states, including Texas and Illinois, have recently passed tort reform legislation to place limits on non-economic damages. While we have implemented multiple steps at our facilities to reduce our professional liability exposures, absent significant additional legislation to curb the size of malpractice judgments in other states in which we operate, our insurance costs may increase in the future.
Effective January 1, 2004, minimum nurse to patient ratios for various hospital departments went into effect in the state of California. These requirements apply at all times, including scheduled break and meal periods, and place an additional burden on our already challenging California nurse staffing strategies. Even more stringent ratios for medical/surgical units took effect in California in 2005. We estimate that our additional staffing costs from existing regulations approximate $5.1 million on an annual basis in California. If similar regulations were adopted in other states in which we operate, our future operating results and cash flows could be materially adversely affected.
Medicare, no individual payer represents more than 10% of our patient service revenues, either on a gross or net basis.
We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We deduct charity care accounts from revenues when we determine that the account meets our charity care guidelines. In June 2004, we adopted revised policies that provide expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. During the years ended June 30, 2004, 2005 and 2006, we deducted $37.1 million, $55.6 million and $77.8 million of charity care from revenues, respectively.
We had premium revenues of $293.8 million, $333.5 million and $375.0 million during the years ended June 30, 2004, 2005 and 2006, respectively. Our health plans have agreements with AHCCCS, CMS and various health maintenance organizations (“HMOs”) to contract to provide medical services to subscribing participants. Under these agreements, our health plans receive monthly payments based on the number of HMO participants in MHP or the number and coverage level of enrollees in PHP and AAHP. Our health plans recognize the payments as revenues in the month in which members are entitled to healthcare services, with the exception of AAHP reinsurance premiums and low income subsidy cost sharing premiums that are recorded as a liability to fund future healthcare costs.
Given the nature of our operating environment, we are subject to professional and general liability and workers compensation claims and related lawsuits in the ordinary course of business. For claims reported through May 31, 2006, our captive subsidiary insured our professional and general liability risks at a $10.0 million retention level. For claims reported subsequent to May 31, 2006, we self-insure the first $9.0 million per occurrence, and the captive subsidiary insures the next $1.0 million per occurrence. We maintain excess coverage from independent third party insurers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. We self-insure our workers compensations claims up to $1.0 million per claim and purchase excess insurance coverage for claims exceeding $1.0 million. The following tables summarize our professional and general liability and workers compensation reserve balances as of June 30, 2005 and 2006 and our total provision for professional and general liability and workers compensation losses and related claims payments during the years ended June 30, 2004, 2005 and 2006, respectively.
geographic locations in which we operate, the severity of our historical losses compared to industry averages and the reporting pattern of our historical losses compared to industry averages, among others. Most of these variables require judgment by the independent actuary and changes in these variables could result in significant period over period fluctuations in our estimates. We adjust these reserves from time to time as we receive updated information. During fiscal 2005 and 2006, due to changes in historical loss trends, we decreased our professional and general liability reserve related to prior fiscal years by $3.6 million and $6.9 million, respectively. During fiscal 2005, we increased our workers compensation reserve related to prior fiscal years by $2.0 million. During fiscal 2006, we decreased our workers compensation reserve related to prior fiscal years by $0.7 million. Given the fact that we have operated our hospitals for relatively short periods of time, we expect that additional adjustments to prior year estimates may occur as our reporting history and loss portfolio matures.
The independent actuary provides a best estimate of IBNR using statistical confidence levels deemed adequate by the actuary that are less than 75%. Using a higher statistical confidence level would increase the estimated reserve. The following table illustrates the sensitivity of the reserve estimates at 75% and 90% confidence levels.
During the years ended June 30, 2004, 2005 and 2006, medical claims expense was approximately $211.8 million, $237.2 million and $270.3 million, respectively, primarily representing medical claims of PHP. We estimate our reserve for medical claims using historical claims experience (including severity and payment lag time) and other actuarial data including number of enrollees and the enrollee’s county of residence. The reserve for medical claims, including incurred but not reported claims, for our health plans was approximately $51.2 million and $44.0 million as of June 30, 2005 and 2006, respectively. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from its estimates given changes in the healthcare cost structure or adverse experience. During the years ended June 30, 2004, 2005 and 2006, approximately $29.0 million, $36.6 million and $40.0 million, respectively, of accrued and paid claims for services provided to our health plan enrollees by our hospitals and our other healthcare facilities were eliminated in consolidation. Our operating results and cash flows could be materially affected by increased or decreased utilization of our healthcare facilities by enrollees in our health plans.
Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stays not necessary).
Same hospital adjusted discharges-hospitals is calculated by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues for all hospitals owned for the full 12 months of both years presented.
Same hospital emergency room visits represent the number of patient visits to receive treatment at a hospital emergency room owned for the full 12 months of both years presented, regardless of whether an overnight stay is subsequently required.
Premium revenues increased by 12.4% during fiscal 2006 as a result of the start of AAHP’s operations on January 1, 2006. During fiscal 2006, approximately 3,500 PHP members became AAHP members. Per member per month reimbursement rates are significantly higher under AAHP than under the traditional AHCCCS Medicaid program. Per member per month reimbursement for PHP also increased effective October 1, 2005. Total average membership in PHP and AAHP increased from approximately 99,000 during fiscal 2005 to approximately 100,300 during fiscal 2006.
We continue to focus on implementing the appropriate service line mix that both meets the needs of our patients and improves our operating results. The success of this strategy depends on our physician recruitment and retention initiatives, emergency department and throughput design improvements, surgery unit expansions and primary care development initiatives. We believe that these initiatives and the favorable demographic trends in most of our markets will position us to recapture patient volumes once demand for healthcare services recovers.
Costs and Expenses. Total costs and expenses, exclusive of income taxes, were $2,629.4 million or 99.1% of total revenues during fiscal 2006, an improvement from 104.9% during fiscal 2005. Fiscal 2005 costs and expenses were negatively impacted by the Merger. Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent our most significant individual costs and expenses or those subject to the greatest level of fluctuation period over period.
Other operating expenses. Other operating expenses include, among others, purchased services, insurance, property taxes, rents and leases, repairs and maintenance and utilities. Other operating expenses as a percentage of total revenues increased to 15.1% during fiscal 2006 compared to 14.4% during fiscal 2005. This increase resulted primarily from increased repairs and maintenance of $11.3 million and a $14.4 million increase in purchased services as a result of a change in policy in accounting for out of network payments under capitated payer contracts. During fiscal 2005, we recorded out of network capitated plan payments as revenue deductions instead of purchased services.
Year ended June 30, 2005 compared to Year ended June 30, 2004
Premium revenues increased by 13.5% during fiscal 2005 as a result of a year over year increase in average enrollees at PHP, per member rate increases and increases in reinsurance and supplemental revenues.
We implemented physician recruitment, emergency department expansion, surgery unit expansion, specialty service expansions and intra-market resource sharing strategies during fiscal 2005. We also made considerable progress on our significant expansion projects in San Antonio and Phoenix during fiscal 2005.
Costs and Expenses. Total costs and expenses, exclusive of income taxes, were $2,380.6 million or 104.9% of total revenues during fiscal 2005, compared to 96.4% during fiscal 2004. During fiscal 2005, we incurred approximately $186.2 million of Merger-related costs including stock compensation, debt extinguishment costs, Merger expenses and monitoring fees. Absent these Merger-related costs, total costs and expenses as a percentage of revenues would have been 96.7%. Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent the most significant of our normal costs and expenses or those subject to the greatest level of fluctuation period over period.
The national nursing shortage hindered our ability to fully manage salaries and benefits during fiscal 2005. We experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix and Orange County markets. As a result of these factors, we hired additional nurses and utilized more costly outsourced nursing personnel.
Provision for doubtful accounts. During fiscal 2005, the provision for doubtful accounts as a percentage of patient service revenues decreased to 7.8% from 7.9% during fiscal 2004. During fiscal 2005, our self-pay revenues as a percentage of net patient revenues decreased to 11.1% from 11.7% during fiscal 2004 partly due to lower self pay utilization at our Massachusetts hospitals. On a same hospital basis, the provision for doubtful accounts as a percentage of patient service revenues increased to 8.2% during fiscal 2005. We experienced improved up front cash collections and success in qualifying patients for coverage under Medicaid or similar programs during fiscal 2005. Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy of deducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines. In June 2004, we expanded our charity care guidelines resulting in a decrease in revenues and a reduction in bad debts. During fiscal 2004 and 2005, we recorded $37.1 million and $55.6 million of charity care revenue deductions, respectively. On a combined basis, the provision for doubtful accounts and charity care expense as a percentage of patient service revenues (prior to charity deductions) increased to 10.4% during fiscal 2005 compared to 10.2% during fiscal 2004.
Other. Depreciation and amortization remained consistent year over year at 3.6% of total revenues. We adjusted the values and lives of our property, plant and equipment as of the Merger date based upon an independent appraisal. Net interest as a percentage of total revenues increased to 3.9% during fiscal 2005 compared to 2.4% during fiscal 2004 as a result of the additional debt incurred to finance the Merger and the $150.0 million in delayed draw term loan borrowings subsequent to the Merger. As a result of the Merger, we incurred $62.2 million in debt extinguishment costs during fiscal 2005, an increase of $57.3 million from fiscal 2004, and $23.3 million in Merger expenses.
We spent $284.5 million for capital expenditures during fiscal 2006. In May 2004 and July 2005, our board of directors approved major expansion projects at six of our existing hospitals in San Antonio and metropolitan Phoenix. We estimate that these projects will cost a total of approximately $333.5 million, including capitalized interest costs. Through June 30, 2006, we have spent approximately $235.8 million related to these projects and expect to incur the remaining $97.7 million during our next two fiscal years. All of these projects will result in additional capacity at each of the six hospitals. In addition, most of the projects will facilitate an expansion of clinical service capabilities. The following table summarizes these major expansion projects as of September 1, 2006.
On September 26, 2005, we refinanced and repriced all $795.7 million of the outstanding term loans under the initial term loan facility by borrowing $795.7 million of replacement term loans (the “2005 term loan facility”).
We also intend to continue to pursue acquisitions or partnering arrangements, either in existing markets or new markets, which fit our growth strategies. To finance such transactions, we might have to draw upon amounts available under our revolving credit facility or seek additional funding sources. We continually assess our capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions, fund capital projects or for other corporate purposes. However, should our operating results and borrowing capacities not sufficiently support these capital projects or acquisition opportunities, our growth strategies may not be fully realized. Our future operating performance, ability to service or refinance our new debt and ability to draw upon other sources of capital will be subject to future economic conditions and other business factors, many of which are beyond our control.
We are a party to certain rent shortfall agreements with certain unconsolidated entities and other guarantee arrangements, including parent-subsidiary guarantees, in the ordinary course of business. We have not engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to materially affect liquidity.
The following table reflects a summary of obligations and commitments outstanding, including both the principal and interest portions of long-term debt and capital leases, with their payment dates as of June 30, 2006.
in payments by government programs, including Medicare and Medicaid, to healthcare providers or by taxes levied on hospitals or other providers. While we are unable to predict which, if any, proposals for healthcare reform will be adopted, we cannot assure you that proposals adverse to our business will not be adopted.
The healthcare industry is subject to extensive federal, state and local laws and regulations relating to licensing, conduct of operations, ownership of facilities, addition of facilities and services, confidentiality and security issues associated with medical records, financial arrangements with physicians and other referral sources, and billing for services and prices for services. These laws and regulations are extremely complex and the penalties for violations are severe. In many instances, the industry does not have the benefit of significant regulatory or judicial interpretation of these laws and regulations. As a result of these laws and regulations, some of our activities could become the subject of governmental investigations or inquiries. Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies. Several hospital companies have settled allegations raised during such investigations for substantial sums out of concern for the possible exclusion from the Medicare and Medicaid programs. In the event of a determination that we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed.