We currently lease approximately 37,150 square feet of office space at 20 Burton Hills Boulevard, Nashville, Tennessee, for our corporate headquarters.
This annual report on Form 10-K contains “forward-looking statements” within the meaning of the federal securities laws that are intended to be covered by safe harbors created thereby. Forward-looking statements are those statements that are based upon management’s current plans and expectations as opposed to historical and current facts and are often identified herein by use of words including but not limited to “may,” “believe,” “will,” “project,” “expect,” “estimate,” “anticipate,” and “plan.” These statements are based upon estimates and assumptions made by the Company’s management that, although believed to be reasonable, are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected. These factors, risks and uncertainties include, among others, the following:
• Our ability to attract and retain qualified management and medical personnel, including physicians and nurses
• Our ability to maintain or increase patient membership and control costs of our managed health care plans
On November 1, 2001, we acquired the assets of Paradise Valley Hospital in Phoenix, Arizona. We paid cash of $55.3 million to satisfy the purchase price for net assets acquired. 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.
On January 3, 2003, but effective January 1, 2003, we acquired, through a majority-owned subsidiary, substantially all of the assets of five acute care hospitals with a total of 1,537 beds and related health care businesses located in San Antonio, Texas, and surrounding areas of south Texas from Baptist Health Services, formerly known as Baptist Health System (“BHS”). The BHS purchase price for net assets acquired was $293.8 million, comprised of cash of $246.2 million, $30.0 million of our Series B payable-in-kind redeemable convertible preferred stock and approximately $17.6 million of our convertible subordinated notes due 2013 bearing interest at 8.18%. We funded the cash portion of the purchase price with $150.0 million of proceeds under the amended 2001 credit facility, $50.0 million from private sales of our common stock and cash on hand of $46.2 million. The BHS acquisition was accounted for using the purchase method of accounting. The fiscal 2003 results of operations include six months of operations for the BHS assets.
In order to increase revenues and enhance operating margins, we have implemented several operating initiatives including the following:
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. Our comprehensive recruiting and retention strategy serves as a cornerstone upon which we build partnering relationships with our employees and physicians to ensure we have the expertise necessary to carry out our mission in all areas of our health care facilities.
Managed care, Medicare and Medicaid revenues are significant to our business and are subject to pricing pressures. For the year ended June 30, 2003, patient days attributable to managed care, Medicare and Medicaid were 45%, 40% and 12% of total patient days, respectively. For the year ended
Intense market competition may limit our ability to enter choice markets or recruit and retain quality health care professionals. We face growing competition in our industry. Consolidation of hospitals into for-profit or not-for-profit systems continues to increase as other hospital companies realize that regional market strength is pivotal in efficiently providing comprehensive health care services, recruiting and retaining qualified health care professionals and effectively managing payer relationships. In addition, the financial resources of some of our competitors exceed our resources. We anticipate consolidation of hospitals and increased competition in the market place to continue in the near future.
Our strategies to achieve in-market growth through facility expansion and medical upgrades require that we have access to capital to sufficiently fund these projects. To the extent our operating results and the availability of third party funds do not sufficiently support these projects, our strategies may not be fully realized.
Many states, including certain states in which we operate, have reported budget deficits as a result of increased costs and lower than expected tax collections. Health and human service programs, including Medicaid and similar programs, represent a significant component of state spending. To address these budgetary concerns, certain states have proposed and others may propose decreased funding for these programs. If these funding decreases are approved by the states in which we operate, our operating results and cash flows could be materially reduced.
Upon renewal of our insurance policies effective June 1, 2002, we experienced a significant increase in premiums paid to insurance carriers, especially for professional and general liability coverage. Prior to June 1, 2002, we maintained third-party insurance coverage on a claims-made basis for individual malpractice claims exceeding $1.0 million and annual aggregate claims exceeding $13.6 million. Effective June 1, 2002, we established a wholly owned captive insurance subsidiary to insure our professional and general liability risks for individual claims up to $10.0 million, which resulted in a significant increase in accrual for claims incurred prior to June 1, 2002, but not reported until after June 1, 2002. The cost of insurance has negatively affected operating results and cash flows throughout the health care industry due to pricing pressures on insurers and fewer carriers willing to underwrite professional and general liability insurance. We recently renewed our insurance coverage for the policy year June 1, 2003 to May 31, 2004. We remain insured during this new policy year for professional and general liability risks for individual claims through our captive insurance subsidiary at a retention level of $10.0 million. Additionally, we have purchased excess coverage from independent insurers for individual claims exceeding $10.0 million per occurrence up to $100.0 million in the aggregate. We expect our professional and general liability costs will increase by 10% to 15% during fiscal 2004 compared to a comparable annualized cost during fiscal 2003. Although we have not experienced a significant increase in the quantity and severity of professional liability claims during the past year, the current industry environment appears to indicate an increase in the quantity and severity of such claims. This environment has led to increased costs in professional liability premiums, which we expect to continue into the foreseeable future.
The hospital industry continues to face a nationwide shortage of nurses. We have experienced particular difficulty in retaining and recruiting nurses in our Phoenix, Arizona, San Antonio, Texas and Los Angeles/Orange County, California markets. Recent reports forecast this shortage to continue into the near future. During fiscal 2003 we implemented comprehensive recruiting and retention plans for nurses that focuses on competitive salaries and benefits as well as employee satisfaction, best practices, tuition assistance, effective training programs and workplace environment. However, should we be unsuccessful in our attempts to maintain nursing coverage adequate for our present and future needs, our future operating results could be adversely impacted.
Discharges represent the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatient volume.
Net revenue per adjusted discharge-hospitals is calculated by dividing net hospital patient revenues by adjusted discharges-hospitals and measures the average net payment expected to be received for a patient’s stay in the hospital.
Same hospital patient service revenues represent patient service revenues (excluding health plan premium revenues) from entities owned for the full twelve months of both years presented.
Same hospital average length stay represents average length of stay for hospitals owned for the full twelve months of both years presented.
Same hospital patient days represent patient days for hospitals owned for the full twelve months of both years presented.
Revenues. The $429.9 million increase in revenues during fiscal 2003 was attributable to revenues from acquisitions of $371.1 million and same hospital revenue improvement of $58.8 million. On a same hospital basis, discharges increased by 0.8% during fiscal 2003, while adjusted discharges-hospitals (which includes a factor for outpatient volume) increased by 2.3% during fiscal 2003. Revenues, exclusive of health plan premium and other non-hospital revenues, per adjusted discharge increased 2.8% on a same-hospital basis during fiscal 2003 as a result of our successful negotiations of managed care contracts with improved reimbursement rates in certain markets and also improved Medicare reimbursement rates. However, with certain of our managed care payers, higher negotiated reimbursement rates resulted in volume declines. We expect net revenues on a same hospital basis to improve as we continue renegotiation efforts and recover volumes from certain managed care payers.
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. Current capital projects underway, or initiatives expected to begin during the next 12 months, include expansions and upgraded technology for obstetrics, emergency room, psychiatric, rehabilitation, cardiac, radiology, and surgery units as well as real estate projects to support hospital buildouts and construction of medical office buildings. During fiscal 2003, we added a significant number of credentialed specialists and general practitioners to our hospitals. We will continue our physician recruiting and retention strategies to increase hospital volumes and provide the services needed in the communities we serve.
extended period of time to fully implement our staffing mix model at acquired hospitals, especially significant acquisitions such as the BHS assets. On a same hospital basis, salaries and benefits as a percentage of revenues decreased from 41.9% to 41.6% during fiscal 2003.
We successfully managed staffing levels at our hospitals and improved labor productivity during fiscal 2003. However, our productivity efficiencies were partially offset by increased nursing compensation and utilization of contract labor. The hospital industry continues to face a nationwide shortage of nurses. We have experienced particular difficulty in retaining and recruiting nurses in our Phoenix, Arizona, San Antonio, Texas, and Los Angeles/Orange County, California markets. Recent reports forecast this shortage to continue into the near future, especially in California where state mandated increased nurse-staffing ratios begin to go into effect on January 1, 2004. Our comprehensive recruiting and retention plans for nurses that focuses on competitive salaries and benefits as well as employee satisfaction, best practices, tuition assistance, effective training programs and workplace environment has mitigated some of the effects of the nursing shortage. However, should we be unsuccessful in our attempts to maintain nursing coverage adequate for our present and future needs, and especially if additional states in which we operate enact new laws regarding nurse-staffing ratios, our future operating results could be adversely impacted by increased salaries and benefits expense.
Medical claims. The $28.8 million increase in medical claims is due to the significant increase in enrollees and revenues for Phoenix Health Plan. Medical claims expense as a percentage of premium revenues increased from 71.4% to 73.5% during fiscal 2003 due to slight increases in member inpatient utilization and severity during fiscal 2003. 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 our hospitals and related outpatient service providers of approximately $24.9 million, or 13.4% of gross health plan medical claims expense, were eliminated in consolidation during fiscal 2003.
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 $54.3 million of the $55.1 increase in other operating expenses during fiscal 2003. Other operating expenses remained flat on a same hospital basis between the two periods. Other operating expenses as a percentage of
Depreciation and amortization. During fiscal 2003, depreciation and amortization related to acquisitions was $12.3 million, while same hospital depreciation and amortization increased by $5.1 million. As part of our commitment to expand and improve our capital infrastructure, we spent approximately $98.5 million for capital improvements in fiscal 2003, including $26.6 million related to our construction of a new hospital in the Phoenix market. These capital purchases resulted in increased depreciation and amortization during fiscal 2003. 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 is fully reflected in both the fiscal 2003 and 2002 amounts.
Net income. Net income increased from $6.8 million in fiscal 2002 to $16.9 million in fiscal 2003. The increase relates to increased revenues as described above in excess of increases expenses. Net income in fiscal 2003 was adversely affected by increases in depreciation and amortization, net interest and income taxes of $17.4 million, $8.2 million and $8.0 million, respectively. We view these costs as products of our strategic growth initiative.
negotiate more favorable payment rates with certain managed care providers in certain markets and improved Medicare reimbursements.
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. 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%.
Minority interests and other. Minority interests and other expenses decreased $1.7 million in fiscal 2002 compared to fiscal 2001. Minority interests represent the third party portion of earnings of certain of our non-wholly owned affiliates included in our consolidated statements of operations. Minority interests for fiscal 2002 remained comparable to fiscal 2001 at $0.8 million. The $1.7 million decrease in minority interests and other expenses during fiscal 2002 primarily relates to gains on sales of land and other assets of $0.8 million during fiscal 2002 as compared to losses on sales of assets of $0.5 million during fiscal 2001.
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 29.9% 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.
The following table presents summarized unaudited quarterly results of operations for the fiscal years ended June 30, 2002 and 2003. 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, 2002 and 2003. 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.
Cash used in investing activities increased from $135.4 million for the year ended June 30, 2002 to $344.0 million for the year ended June 30, 2003. Cash used to fund hospital acquisitions, net of cash received, increased from $100.3 million for the year ended June 30, 2002 to $249.4 million for the year ended June 30, 2003, primarily as a result of the BHS acquisition. Cash used for capital expenditures also increased by approximately $63.4 million to $98.5 million for the year ended June 30, 2003, $26.6 million of which related to construction of West Valley Hospital Medical Center (“West Valley”), our new hospital recently opened in Goodyear, Arizona. The funding of capital expenditures is in part subject to the timing of certain capital projects at the BHS hospitals, Arrowhead Community Hospital and Phoenix Baptist Hospital that are required under the respective purchase agreements for these hospitals as well as the construction of West Valley. As of June 30, 2003, we have funded or committed to fund approximately $30.8 million of our $200.0 million commitment in respect of the BHS hospitals and $26.8 million of our $50.0 million contractual commitment in respect of Arrowhead and Phoenix Baptist hospitals. We anticipate spending during fiscal year 2004 an additional $24.0 million of the estimated project cost of $55.0 million for the construction of West Valley. We expect to complete all of these capital projects and commitments during the next one to six years.
Our amended 2001 credit facility contains provisions that limit annual capital expenditures. For the year ended June 30, 2003, we are in compliance with these capital expenditure provisions. We believe our capital expenditure program is sufficient to service, expand and improve our existing facilities to meet our quality objectives.
capacity remains at $125.0 million under the amended 2001 credit facility, subject to reduction for outstanding letters of credit. Additionally, as part of the BHS purchase price, we issued approximately $17.6 million of our convertible subordinated notes which provide for annual interest payments at 8.18% until their maturity on January 3, 2013. The notes are convertible at any time into our Common Stock at a $3,500 per share conversion price. We may not redeem the notes prior to January 1, 2008, and must pay premiums of 102% and 101% for redemptions during the two years subsequent to January 1, 2008, respectively, with redemptions thereafter being available at par.
As of June 30, 2003, we had 55,194 shares of two series of Payable-In-Kind Convertible Redeemable Preferred Stock (“PIK Preferred Stock”) outstanding with a liquidation value of $1,000 per share. We issued 20,000 shares of our first series of PIK Preferred Stock on February 1, 2000 in connection with the acquisition of MacNeal Hospital. We currently intend to issue and record paid-in-kind dividends annually at 8% of the liquidation value of our first series of PIK Preferred Stock until January 31, 2008 and to pay cash dividends thereafter until the January 31, 2015 redemption date for the stock. As of June 30, 2003, 25,194 shares of this series were outstanding. Our first series of 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. In connection with our purchase of the health care assets of BHS on January 3, 2003, we issued 30,000 shares of our Series B PIK Preferred Stock with a liquidation value of $1,000 per share. We currently intend to issue and record paid-in-kind dividends annually at 6.25% of the liquidation value of the Series B PIK Preferred Stock until January 1, 2010 and to pay cash dividends annually thereafter until the January 31, 2015 redemption date applicable to such shares. The Series B PIK Preferred Stock is convertible to our Common Stock at any time at a $3,500 per share conversion price.
On January 9, 2003, subsequent to our purchase of the health care assets of BHS and expansion of the 2001 credit facility, Standard and Poor’s 1) lowered our corporate credit rating from “B+” to “B”; 2) lowered the credit rating on the 9.75% Notes from “B-” to “CCC+”; and 3) affirmed the “B+” credit rating on our amended 2001 credit facility. Standard and Poor’s stated that it made the downgrades due to its concerns about the size of the BHS acquisition and our ability to generate sufficient returns in relation to our indebtedness. On December 2, 2002, Moody’s affirmed its existing rating of “Ba3” for the $125.0 million revolving loan facility under the existing 2001 credit facility, affirmed its existing rating of “B3” for the 9.75% Notes and assigned a “Ba3” rating to the $150.0 million term loans under the amended 2001 credit facility.
We also intend to acquire additional hospitals and will continue to seek acquisitions that fit our corporate growth strategy. These acquisitions would require financing in addition to the working capital on hand, availability of funds under our revolving loan 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. However, should our operating results and borrowing capacities not sufficiently support these capital projects or acquisition opportunities, our in-market growth strategies may not be fully realized.
We are subject to certain restrictive and financial covenants under the amended 2001 credit facility including a total leverage ratio, a senior leverage ratio, an interest coverage ratio and capital expenditure restrictions. As of June 30, 2003, we were in compliance with each of these covenants. As of June 30, 2003, the only amounts drawn against the revolving facility under amended 2001 credit facility were letters of credit totaling approximately $25.8 million.
We are a party to certain rent shortfall or master lease 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.
required compliance plans with the State of California. We recently filed a request to extend the deadline for seismic compliance from the current state-imposed deadline of 2008 to 2013 and expect to comply with the seismic requirements at all of our California facilities by the final deadline required. We expect to incur approximately $11.2 million in costs to meet our compliance plan. Upon completion of the $11.2 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 $11.2 million in improvements, but we are unable at this time to estimate our costs for full compliance with the 2030 requirements.
For the year ended June 30, 2003, medical claims expense was approximately $160.8 million, primarily representing medical claims 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 $33.5 million as of June 30, 2003. 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, 2003, approximately $24.9 million of health plan payments to hospitals and other health care facilities owned by us for services provided to health plan enrollees were eliminated in consolidation. Our operating results and cash flows could be materially affected by increased or decreased utilization of our owned health care facilities by enrollees of our health plans.
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 annual increases we obtain in prospective payments under the Medicare program.
Health Care Reform. In recent years, an increasing number of legislative proposals have been introduced or proposed to Congress and in some state legislatures that would significantly affect the services provided by and reimbursement to health care providers in our markets. The cost of certain proposals would be funded in significant part by reduction in payments by government programs, including Medicare and Medicaid, to health care providers or by taxes levied on hospitals or other providers. While we are unable to predict which, if any, proposals for health care reform will be adopted, we can not assure you that proposals adverse to our business will not be adopted.