• Pressures to contain costs by managed care organizations and other insurers and our ability to negotiate
• The availability of capital to fund our corporate growth strategy
• Our ability to maintain or increase patient membership and control costs of our managed health care
On September 1, 1999, we acquired the West Anaheim Medical Center in Anaheim, California, and the Huntington Beach Hospital in Huntington Beach, California. We financed this acquisition entirely through sales of our common stock to our existing stockholders. The fiscal 2000 results of operations include ten months of operations for these two hospitals.
On June 1, 2000, we acquired Phoenix Baptist Hospital and Medical Center in Phoenix, Arizona, and Arrowhead Community Hospital and Medical Center in Glendale, Arizona. We financed this acquisition through sales of our common stock to our existing stockholders and by borrowing under our 2000 credit facility. The fiscal 2000 results of operations include one month of operations for these two hospitals.
On November 1, 2001, we acquired the assets of Paradise Valley Hospital in Phoenix, Arizona, for approximately $59.8 million comprised of cash of $55.3 million and assumed liabilities of $4.5 million. We financed the acquisition with a portion of our cash proceeds from the July 30, 2001 issuance of our 9.75% Senior Subordinated Notes due 2011 (the “9.75% Notes”). The fiscal 2002 results of operations include eight months of operations for this hospital.
Expanding the spectrum of health care services provided by our facilities. We believe that a key factor in increasing patient volume is to provide the communities we serve a comprehensive medical solution. This strategy requires effective recruiting and retention programs for general practitioners and specialists and maintaining quality nursing support as well as a commitment to capital projects to service the existing facility framework and to provide current technology for expanded services. Also, we believe completing strategic acquisitions to allow for consolidation of specialty practices at certain locations will provide our patients with more effective and efficient care while improving the Company’s operating performance.
Providing continuous training and education to our hospital management teams to identify areas in which operating efficiencies can realistically be achieved. We believe that one of the keys to providing effective and efficient health care services and administrative support lies in effective recruiting and retention programs, including continual training and educational support. Our relationships with the University of Chicago at our MacNeal and Weiss hospitals in metropolitan Chicago, Illinois, demonstrate one of our many commitments to professional development for both health care and administrative staff.
Identifying geographic markets that provide a strategic fit with our goals and objectives. We expect to continue pursuing acquisition activities in markets where we can obtain significant market share and capture additional volume of the aging U.S. population. According to the U.S. Census Bureau, there are approximately 35 million Americans aged 65 or older in the United States today, comprising approximately 13% of the total U.S. population. By the year 2030, the number of these elderly persons is expected to reach 69 million, or 20% of the total population. We believe that our initiatives will position the Company to capitalize on this demographic trend. Obtaining significant market share in key geographic markets provides opportunities to expand services to those communities, provides flexibility in negotiations with managed care and other third party payers and strengthens our base for recruitment of health care professionals.
Although we expect the initiatives above to increase our patient volume, the following risk factors could offset those increases to revenues:
We believe that the professional and general liability insurance market will remain depressed in the near term, and future increases to excess coverage premiums and captive subsidiary retention levels could significantly affect our operating margins. Should we experience significant adverse claims, our future cash flows may not be adequate to fund such liability.
Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined hospital inpatient and outpatient volume. Adjusted discharges-hospitals is computed by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation enables management to assess hospital volume by a combined measure of inpatient and outpatient utilization.
Average length of stay represents the average number of patients in the hospitals each day during our ownership.
Patient days represent the number of days (calculated as overnight stays) our beds were occupied by patients during the period.
Adjusted patient days-hospitals is calculated by multiplying patient days by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation is an indicator of combined inpatient and outpatient volume.
Same hospital revenues are revenues from facilities that were owned for the entire 2001 and 2002 fiscal years.
Same hospital discharges are discharges for hospitals owned for the entire 2001 and 2002 fiscal years.
Same hospital adjusted discharges-hospitals is calculated by multiplying the sum of gross hospital inpatient and outpatient patient revenues and dividing the result by gross hospital inpatient revenues for all hospitals owned for the entire 2001 and 2002 fiscal years.
Year Ended June 30, 2002 Compared to the Year Ended June 30,
Revenues. The $242.8 million increase in revenues during fiscal 2002 was attributable to revenues from acquisitions of $239.9 million and same hospital revenue improvement of $2.9 million. Although same hospital discharges decreased by 1.3% during fiscal 2002, same hospital revenues increased slightly due to our ability to negotiate more favorable payment rates with certain managed care providers in certain markets and improved Medicare reimbursements. We expect net revenues on a same hospital basis to improve as our renegotiation efforts continue and the annual impact of previously negotiated contracts is realized.
We continue to develop and implement strategies to increase volumes at our hospitals including physician recruitment, expansion of specialty services and resource sharing within geographic markets. We are currently in the process of expanding services at many of our hospitals including expansion of cardiac cath labs, emergency rooms, obstetrics units, MRI technology and open heart surgery units. During fiscal 2002, we recruited approximately 600 new physicians to our hospitals, including 430 specialists and 170 internal medicine and general
practitioners. We will continue our physician recruiting and retention strategies to increase hospital volumes and provide the services needed in the markets we serve.
Supplies. Acquisitions accounted for $16.8 million of the $23.2 million increase in supplies during fiscal 2002. Increased volume and acuity of surgeries on a same hospital basis accounted for the remaining increase. Same hospital surgeries increased by 3.0% during fiscal 2002, and same hospital supplies cost per surgical case increased by 3.9% fueled by emerging technologies and increased unit prices of surgical supplies and related sales taxes. Surgeries typically require greater utilization of supplies than do non-surgical admissions, which explains the increase in supplies expense during 2002 when same hospital discharges decreased by 1.3% and same hospital surgeries increased by 3.0%.
Medical claims. The $101.2 million increase in medical claims is almost exclusively due to the acquisition of Phoenix Health Plan on May 1, 2001. Medical claims expense represents the amounts paid by the health plans for health care services provided to their members, including an estimate of incurred but not reported claims that is determined based upon lag data and other actuarial assumptions. Revenues and expenses between the health plans and the Company’s hospitals and related outpatient service providers of approximately $26.2 million, or 16.6% of gross health plan medical claims expense, were eliminated in consolidation during fiscal 2002.
Other operating expenses. Other operating expenses include costs such as rents and leases, professional fees, purchased services, marketing, repairs, utilities, licenses and non-income taxes. Acquisitions accounted for $30.8 million of the $29.9 million increase in other operating expenses during fiscal 2002. Other operating expenses decreased by $0.9 million on a same hospital basis between the two periods.
EBITDA. The $19.7 million increase in EBITDA during fiscal 2002 related to 1) a $29.4 million increase in EBITDA due to acquisitions, 2) a $6.8 million decrease in EBITDA for insurance adjustments related to the increase in our self-insured retention of professional and general liability risks and potential exposure for outstanding PHICO claims as previously discussed and 3) a $2.9 million decrease in same hospital EBITDA net of insurance adjustments.
Same hospital EBITDA was negatively impacted by operations in the metropolitan Los Angeles/Orange County, California market. EBITDA for this market decreased by $4.8 million during fiscal 2002 primarily due to certain payer contracts with unfavorable terms, increased salaries and benefits costs as a result of a nursing shortage in the market and intense competition from other hospitals in the market. EBITDA for one of our hospitals in the market was significantly impacted by high utilization under global capitation plans, including many out-of-network services. We have given these payers notice of our intent to terminate the capitation contracts effective December 31, 2002. While the market experienced a 2.9% increase in discharges and a 3.0% increase in net revenues during 2002, operating expenses during 2002 increased by 7.0% including an 11.6% increase in salaries and benefits. This market has been especially hard hit by the nursing shortage. We incurred significant additional salaries and benefits costs during 2002 to maintain quality core services in this market and have not experienced volume increases necessary to fully absorb the additional costs. During 2002, salaries and benefits per full-time equivalent employee increased from $53,510 to $59,970. As previously discussed, we are developing market-driven comprehensive recruiting and retention programs to help alleviate the nursing shortage and are also developing strategies to increase patient volumes to increase EBITDA for each market we serve.
Depreciation and amortization. The $5.7 million increase in depreciation and amortization during fiscal 2002 related to acquired fixed assets during the year both from acquisitions of hospitals and capital expenditures. On July 1, 2001, we adopted the provisions of SFAS 141 and 142 resulting in re-allocations of the excess purchase price over net assets acquired to goodwill and identifiable intangible assets. Under SFAS 142, goodwill and indefinite-lived intangible assets are no longer amortized but are subject to annual impairment tests. The suspension of goodwill amortization and the changes in classifications of identifiable intangible assets and related remaining useful lives resulted in a net decrease in amortization expense of approximately $2.8 million for the year ended June 30, 2002.
Income taxes. The provision for income taxes increased from $0.5 million for 2001 to $2.9 million for 2002 resulting in an increase in the effective tax rate from 4.7% in 2001 to 29.8% in 2002. The valuation allowance that offsets our deferred tax assets decreased by $4.1 million and $1.4 million for the years ended June 30, 2001 and 2002, respectively, resulting in a decrease in our effective tax rates.
Year Ended June 30, 2001 Compared to the Year Ended June 30,
Revenues. The $363.1 million increase in revenues during fiscal 2001 was attributable to revenues from acquired hospitals of $366.7 million offset by a decrease in same hospital revenues of $3.6 million. The same hospital decrease was primarily related to a decrease in revenues at Maryvale Hospital Medical Center that resulted from the loss of several key physicians who relocated their practices outside the Maryvale service area. Maryvale has subsequently recruited several new physicians to the market. Premium revenues from our health plans increased by $39.3 million during fiscal 2001 due to the acquisition of Phoenix Health Plan in May 2001 and the full year of operations of MacNeal Health Providers during fiscal 2001.
Salaries and benefits. The $177.1 million increase in salaries and benefits during fiscal 2001 was primarily attributable to our acquisitions during fiscal 2001 and the effect of a full year of operations for our fiscal 2000 acquisitions during fiscal 2001. Salaries and benefits as a percentage of revenues increased to 48.5% for fiscal 2001 compared to 48.1% for fiscal 2000. This increase is attributable to a 1.6% increase due to the higher level of patient acuity at the hospitals acquired during fiscal 2000, which had a full year of operations during fiscal 2001, offset by a 1.4% decrease due to the acquisition of Phoenix Health Plan, which requires a much lower human resource cost for its revenue base.
Supplies. The $52.4 million increase in supplies expense during fiscal 2001 was primarily attributable to our acquisitions during fiscal 2001 and the effect of a full year of operations for our fiscal 2000 acquisitions during fiscal 2001. Supplies expense as a percentage of revenues increased to 13.9% for fiscal 2001 compared to 13.3% for fiscal 2000. Approximately 1.0% of this increase relates to the higher level of patient acuity at the facilities we acquired. For example, MacNeal Hospital and Phoenix Baptist Hospital both provide open-heart surgical procedures and significant orthopedic procedures that require more expensive surgical supplies. The increase in supplies expense as a percentage of revenues was offset by a 0.4% decrease due to the acquisition of Phoenix Health Plan, which utilizes no medical supplies in its operations.
Insurance. Insurance expense increased by $2.4 million or 41.4% from fiscal 2000 to fiscal 2001 due to the acquisitions during fiscal 2000 and 2001. On a same hospital basis, insurance expense decreased by $1.1 million from fiscal 2000 to fiscal 2001.
Provision for doubtful accounts. The $23.7 million increase in the provision for doubtful accounts was primarily attributable to the fiscal 2001 and 2000 acquisitions. The provision for doubtful accounts as a percentage of revenue decreased from 10.9% in fiscal 2000 to 8.5% in fiscal 2001. This decrease is due to a lower bad debt experience rate at hospitals acquired during fiscal 2000 and 2001 than that of Maryvale Hospital. Maryvale Hospital has an unusually high bad debt expense rate due to the demographics of the market it serves. We believe that the recent expansion of eligibility for the Arizona Medicaid program will help reduce Maryvale’s bad debt expense.
Depreciation and amortization. The $12.0 million increase in depreciation and amortization was attributable to our fiscal 2001 and 2000 acquisitions. All of the acquisitions were accounted for using the purchase method of accounting, and we recorded approximately $74.5 million of goodwill and other intangible assets for the fiscal 2001 and 2000 acquisitions. Amortization of these intangible assets was $5.3 million and $3.0 million during fiscal 2001 and 2000, respectively.
Debt extinguishment costs. During fiscal 2000, we incurred $1.1 million in debt extinguishment costs related to the refinancing of the 1998 credit facility. On April 1, 2002, we adopted the provisions of SFAS 145 resulting in the treatment of these debt extinguishment costs as operating costs as opposed to extraordinary items.
Income taxes. The provision for income taxes increased from $0.1 million for 2000 to $0.5 million for 2001. These provisions reflect effective tax rates of 8.9% and 4.8% for the years ended June 30, 2000 and 2001, respectively. The valuation allowance that offsets our deferred tax assets decreased by $4.1 million in 2001, resulting in a decrease in our effective tax rates.
The following table presents summarized unaudited quarterly results of operations for the fiscal years ended June 30, 2001 and 2002. We believe that all necessary adjustments have been included in the amounts stated below for a fair presentation of the results of operations for the periods presented when read in conjunction with the consolidated financial statements for the fiscal years ended June 30, 2001 and 2002. Results of operations for a
particular quarter are not necessarily indicative of results of operations for an annual period and are not predictive of future periods.
EBITDA is defined as income before interest expense (net of interest income), income taxes, depreciation, amortization, minority interests, gain or loss on the sale of assets, equity method income and debt extinguishment costs. While you should not consider EBITDA in isolation or as a substitute for net income, operating cash flows or other cash flow statement data determined in accordance with accounting principles generally accepted in the United States, management understands that EBITDA is a commonly used analytical indicator within the health care industry and serves as a measure of leverage capacity and debt service ability. EBITDA, as presented, may not be comparable to similarly titled measures of other companies.
Cash used in investing activities increased from $38.1 million for the year ended June 30, 2001 to $135.4 million for the year ended June 30, 2002. Cash used to fund hospital acquisitions, net of cash received, increased from $10.6 million for the year ended June 30, 2001 to $100.3 million for the year ended June 30, 2002, as a result of the acquisitions of Paradise Valley Hospital and Louis A. Weiss Memorial Hospital. Cash used for capital expenditures also increased by approximately $8.5 million to $35.1 million for the year ended June 30, 2002. The funding of capital expenditures is in part subject to the timing of certain capital projects at Maryvale Hospital Medical Center, Arrowhead Community Hospital and Phoenix Baptist Hospital and the construction of West Valley Hospital in Goodyear, Arizona. As of June 30, 2002, the Company has funded approximately $30.0 million of its $65.0 million contractual commitment for these capital projects at Maryvale, Arrowhead and Phoenix Baptist. As of June 30, 2002, we have expended approximately $2.5 million of the estimated project cost of $50.0 million for the construction of West Valley Hospital. We expect to complete these capital projects and commitments during the next two to five years.
Cash provided by financing activities increased from $26.7 million for the year ended June 30, 2001 to $134.0 million for the year ended June 30, 2002. The increase was primarily attributable to the issuance of the 9.75% Notes, offset by (1) the repayment of the 2000 credit facility, (2) early buyouts of certain capital leases and (3) payments of deferred loan costs incurred in conjunction with the issuance of the 9.75% Notes and the 2001 credit facility.
As of June 30, 2002, we had 23,328 shares of Payable-In-Kind Preferred Stock (“PIK Preferred Stock”) outstanding with a liquidation value of $1,000 per share. The Company originally issued 20,000 shares of PIK Preferred Stock on February 1, 2000 in connection with the acquisition of MacNeal Hospital. The Company currently intends to issue and record paid-in-kind dividends annually at 8% of the liquidation value of the PIK Preferred Stock until January 31, 2008 and to pay cash dividends thereafter until the January 31, 2015 mandatory redemption date of the PIK Preferred Stock. The PIK Preferred Stock will automatically convert to common stock upon an initial public offering of our common stock with gross proceeds to us of at least $50.0 million at a conversion price equal to the initial public offering price.
We believe that the working capital on hand and the $119.4 million available as of June 30, 2002, under our 2001 credit facility are sufficient to meet our operating and capital needs for the foreseeable future. Additionally, certain funds controlled by Morgan Stanley Capital Partners (the “MSCP Funds”) have entered into a subscription agreement with us to purchase an additional $322.3 million of our common stock to fund future acquisitions and cash flow needs. Common stock purchases by the MSCP Funds are subject to several conditions outside the control of the Company, including the approval of the Investment Committee of Morgan Stanley Capital Partners. No assurance can be given that any or all of such conditions to additional common stock purchases will be met. We intend to acquire additional hospitals and are actively seeking acquisitions that fit our corporate growth strategy. These acquisitions may, however, require financing in addition to the working capital on hand, availability of funds under the 2001 credit facility and our future operating cash flows. We continually assess our capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions or for other corporate purposes.
California has a statute and regulations that require hospitals to meet certain seismic performance standards. Hospitals that do not meet the standards may be required to retrofit their facilities. We have filed our required compliance plan with the State of California and expect to comply with the seismic requirements at all of our California facilities by the state-imposed deadline of 2008. We expect to incur approximately $10.1 million in costs to meet our compliance plan. Upon completion of the $10.1 million in improvements, our California facilities will be compliant with the seismic regulations and standards through 2029. We estimate that the majority of the square footage in our California facilities will be compliant with the seismic regulations and standards that come into effect during 2030 once we have completed our $10.1 million in improvements, but we are unable at this time to estimate our costs for full compliance with the 2030 requirements.
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing the consolidated financial statements, we make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses included in the financial statements. Management bases its estimates on historical experience and other available information, the results of which form the basis of the estimates and assumptions. We consider the following accounting policies to be most critical to our operating performance and involve the most subjective and complex assumptions and assessments.
We typically receive payments from third party payers, including Medicare, Medicaid and managed care payers, that are less than billed charges requiring the estimation of contractual discount allowances. The Medicare and Medicaid regulations and various managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in our health care facilities and cost settlement provisions requiring complex calculations and assumptions subject to interpretation. We estimate the allowance for contractual discounts on a payer-specific basis given our interpretation of the applicable regulations or contract terms. We have made significant investments in human resources and information systems to improve the estimation process. However, the services authorized and provided and related reimbursement are often subject to interpretation that may result in payments that differ from our estimates. Additionally, updated regulations and contract renegotiations occur frequently necessitating management’s continual review and assessment of the estimation process.
Given the nature of our operating environment, we may become subject to medical malpractice or workers compensation claims or lawsuits. Through May 31, 2002, we maintained third-party insurance coverage for individual malpractice claims exceeding $1.0 million and workers compensation claims exceeding $250,000 to mitigate a portion of this risk. Effective June 1, 2002, we established a wholly owned captive subsidiary to insure our professional and general liability risks at a $10.0 million retention level. We maintain excess coverage for individual claims exceeding $10.0 million per occurrence up to $100.0 million in the aggregate. We estimate our reserve for self-insured professional and general liability and workers compensation risks using historical claims data, demographic factors, severity factors, current incident logs and other actuarial data. As of June 30, 2002, our professional and general liability accrual for asserted and unasserted claims was approximately $16.3 million. The estimated accrual for malpractice and workers compensation claims could be significantly affected should current and future occurrences differ from historical claims trends. The estimation process is also complicated by the relatively short period of time in which we have owned our health care facilities as occurrence data under previous ownership may not necessarily reflect occurrence data under our ownership. While management monitors current claims closely and considers outcomes when estimating its reserve, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in the estimates.
For the year ended June 30, 2002, medical claims expense was approximately $132.0 million, primarily representing medical claims on behalf of enrollees in our Medicaid managed health plan in Phoenix, Arizona, Phoenix Health Plan. We estimate our reserve for medical claims incurred but not reported using historical claims experience (including severity and payment lag time) and other actuarial data including number of enrollees, age of enrollees and certain enrollee health indicators. The reserve for medical claims incurred but not reported for our health plans was approximately $24.4 million as of June 30, 2002. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from our estimates given changes in the health care cost structure or adverse experience. For the year ended June 30, 2002, approximately $26.2 million of health care plan payments to hospitals and other health care facilities owned by us for services provided to enrollees were eliminated in consolidation. Our operating results and cash flows could be
Effects of Inflation and Changing Prices. The health care industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. Various Federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices. Revenues for acute care hospital services rendered to Medicare patients are established under the Federal government’s prospective payment system. We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of deterioration in inpatient volumes, changes in payer mix and growth in operating expenses in excess of the increase in prospective payment under the Medicare program.
Unfiled Medicare Cost Reports. Hospitals participating in the Medicare program, whether paid on a reasonable cost basis or by the prospective payment system (“PPS”), are required to meet certain financial reporting requirements, including submission of annual cost reports identifying medical costs and expenses associated with hospital services to Medicare recipients. Since implementation of outpatient PPS in August 2000, the due dates of all Medicare cost reports have been extended due to delays in receiving necessary reports from the Medicare fiscal intermediaries. We currently have 10 unfiled Medicare cost reports relating to Medicare fiscal year-ends 2000 and 2001 and anticipate filing these 10 cost reports and up to 4 additional cost reports relating to Medicare fiscal year-end 2002 during fiscal 2003 that could result in significant changes to our estimates of amounts payable to or receivable from Medicare.