The following table sets forth our selected historical financial and operating data for, or as of the end of, each of the five years ended June 30, 2007 (including the predecessor and successor periods). The selected historical financial data as of and for the predecessor years ended June 30, 2003 and 2004, the combined predecessor and successor year ended June 30, 2005 and the years ended June 30, 2006 and 2007 were derived from our audited consolidated financial statements that have been audited by Ernst & Young LLP, an independent registered public accounting firm. Comparability of the selected historical financial and operating data has been impacted by the timing of acquisitions completed during fiscal 2003 and 2005. Dispositions completed during fiscal 2006 and 2007 have been excluded from all periods presented. See “Executive Overview” included in “
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 $31.6 million of capacity was utilized for letters of credit (with no outstanding borrowings) as of June 30, 2007. The merger credit facilities also included $325.0 million in delayed draw term loan facilities, which were drawn at various times during fiscal 2005 and 2006.
While current payer guidelines are based upon the reporting of quality measures, we believe it is only a matter of time until the quality measures themselves determine reimbursement rates for hospital services. For example, on April 13, 2007, CMS proposed reforms in the hospital inpatient prospective payment system that would implement a provision of the Deficit ReductionAct of 2005 (“DRA”) that takes the first steps towardpreventing Medicare from giving hospitals higher payment for theadditional costs of treating a patient that acquires a condition(including an infection) during a hospital stay. The DRA required CMS to select at least two conditions that are (1) high cost, high volume or both; (2) assigned to a higher payingDRG when present as a secondary diagnosis; and (3) are reasonablypreventable through application of evidence-based guidelines. These rules were adopted in August 2007. Under the rules, beginning in federal fiscal year 2009 (which commences October 1, 2008) cases with these conditions would not be paid at a higher DRG unless they were present on admission. The rules identify eight conditions, including three serious preventable events (sometimes called “never events”) that meet the statutory criteria. Thus, our ability to demonstrate quality of care in our hospitals could significantly impact our future operating results.
In order to demonstrate high quality services, we must hire and retain nurses who share our ideals and beliefs and who have access to the training necessary to implement our quality of care initiatives. Given the nationwide nursing shortage and the particular limited nursing availability in the Phoenix area, we expect continued pressure on nursing salaries and benefits. These pressures include higher than normal base wage increases, flexible working hours and other benefits and higher nurse to patient ratios necessary to improve quality of care. Quality of care initiatives also require additional nurse training programs that increase salaries and benefits costs. We will incur significant training costs as nurses learn to utilize our new information technology tools that allow us to monitor and report quality performance indicators. Becoming the employer of choice for nurses requires upfront human resource investments that could negatively affect operating results in the short-term. We may also be limited in our ability to adjust staffing levels in periods of lower than expected volumes. However, reducing turnover and improving the skill sets of our nurses will reduce our reliance on contract labor and result in improved quality of care and increased revenues in the long-term.
Tuition reimbursement and internal training to promote career advancement opportunities, including specialization qualifications
tuition, books and fees in return for a commitment to work at one of our hospitals for a defined period of time. Should we be unsuccessful in our attempts to maintain adequate nursing staff for our present and future needs, our future operating results could be materially adversely impacted.
The previous paragraphs discuss the industry trends that are integral to our future success and how quality of care is the most important component in achieving success in those areas. While we are in the early stages of implementing our expanded quality of care initiatives, we believe that the following programs currently in place represent key building blocks to a successful strategy.
Monthly review of the 21 quality indicators prescribed by CMS for federal fiscal year 2007 with plans to expand to 27 during our fiscal 2008
We attribute the modest growth in discharges from continuing operations during 2007 to stagnant demand for inpatient healthcare services. Additionally, decreases in certain subacute services as a result of regulatory changes and reduced demand for elective procedures as a result of changes in patient insurance coverage continue to weaken inpatient and outpatient volumes. We expect our volumes to improve more significantly over the long-term as a result of quality initiatives, service expansion initiatives and our market-driven management strategies. We also expect that as we fully implement our significant expansion projects, patient volumes will improve at those facilities where growth was previously constrained by physical plant limitations and patient throughput inefficiencies. However, the success of our growth initiatives is dependent upon maintaining the community’s confidence in our services and staying ahead of the competition in the markets we serve. Continued weakened demand for hospital healthcare services could negate these growth initiatives in the short-term.
During the year ended June 30, 2007, we recorded $11.6 million of revenues for payments received in April 2007 under the Bexar County, Texas upper payment limit (“UPL”) Medicaid payment program that relate to services provided during fiscal years 2005 and 2006. The UPL payment also positively impacted loss from continuing operations before income taxes by $5.9 million during the year ended June 30, 2007 related to services provided in fiscal years 2005 and 2006. The UPL revenues attributable to prior fiscal years represented 0.6% of the 6.4% period over period increase in net patient revenues per adjusted hospital discharge.
Increases in levels of charity care and negotiated self-pay discounts also impact net patient revenues per adjusted hospital discharge by decreasing revenues and decreasing the provision for doubtful accounts. We cannot assure you that future reimbursement rates, even if improved, will sufficiently cover potential increases in the cost of providing healthcare services to our patients.
We recognize premium revenues from our three health plans, PHP, AAHP and MHP. AAHP commenced operations on January 1, 2006 primarily to provide healthcare services (including Medicare Part D) to those individuals eligible for both Medicare and Medicaid benefits based on age and income levels. As of June 30, 2007, approximately 3,400 members were enrolled in this program, most of whom were previously enrolled in PHP. PHP’s membership increased to approximately 98,300 at June 30, 2007 compared to approximately 96,700 at June 30, 2006. Premium revenues from these three plans increased by $26.4 million or 7.0% during the year ended June 30, 2007 compared to the prior year. This increase resulted primarily from the increased per member per month reimbursement from owning AAHP during the full twelve months of fiscal 2007. PHP also experienced period over period increased per member per month reimbursement as a result of a rate increase that went into effect on October 1, 2006. We do not anticipate a significant increase in membership for our health plan reporting segment during our
Many states, including certain states in which we operate, have periodically 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 decreased funding for these programs and other states may make similar funding cuts. These cuts may include tightened participant eligibility standards, reduction of benefits, enrollment caps or payment reductions. Additionally, pressure exists at the federal level to reduce Medicaid matching funds provided to states as evidenced by a budget resolution set forth by Congress in April 2005 calling for $10.0 billion in cuts to federal funding of the Medicaid program over a five-year period. We are unable to assess the financial impact on our business of enacted or proposed state or federal funding cuts at this time.
We maintained 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 our 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 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. On the other hand, some states, including Texas and Illinois, have passed tort reform legislation to place limits on non-economic damages. While we have taken 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.
We had premium revenues of $333.5 million, $375.0 million and $401.4 million during the years ended June 30, 2005, 2006 and 2007, 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 Medicare Part D reinsurance premiums and low income subsidy cost sharing premiums that are recorded as liabilities to fund future healthcare costs or else repaid to the government.
relates to uninsured patient accounts and patient accounts for which primary insurance has paid but patient deductibles or co-insurance portions remain outstanding. As of June 30, 2007, we estimated the allowance for doubtful accounts using a standard policy that reserves 100% of all accounts aged greater than 180 days subsequent to discharge date plus a pre-determined percentage of accounts receivable due from patients less than 180 days old. Effective July 1, 2007, we will transition to a policy that reserves 100% of all accounts greater than 365 days subsequent to discharge date plus 85% of uninsured accounts less than 365 days old plus 40% of self-pay after insurance/Medicare less than 365 days old. We adjust our estimate as necessary on a quarterly basis using a hindsight calculation that utilizes write-off data for all payer classes duringthe previous twelve-month period to estimate the allowance for doubtful accounts at a point in time. We also monitor cash collections and self-pay utilization. Significant changes in payer mix, business office operations, general economic conditions or healthcare coverage provided by federal or state governments or private insurers may have a significant impact on our estimates and significantly affect our future operations and cash flows.
We classify accounts pending Medicaid approval as Medicaid accounts in our accounts receivable aging report and record a manual contractual allowance for these accounts equal to the average Medicaid reimbursement rate for that specific state. We have historically been successful in qualifying approximately 50%-55% of submitted accounts for Medicaid coverage. As of June 30, 2007, we had approximately $12.0 million of Medicaid pending accounts receivable from continuing operations ($3.5 million of which was stated at gross charges with a manual contractual allowance and $8.5 million of which was stated net of contractual discounts). In the event an account is not successfully qualified for Medicaid coverage and does not meet our charity guidelines, the previously recorded Medicaid contractual adjustment remains a revenue deduction (similar to a self-pay discount), and the remaining net account balance is reclassified to uninsured status and subjected to our allowance for doubtful accounts policy. During the year ended June 30, 2007, approximately $13.2 million of net accounts receivable from continuing operations was reclassified from Medicaid pending status to uninsured status. If the account does not qualify for Medicaid coverage but does qualify as charity care, the contractual adjustment is reversed and the gross account balance is recorded as a charity deduction. During the year ended June 30, 2007, we recorded approximately $6.4 million of charity deductions from continuing operations for the net balances of accounts previously classified as Medicaid pending that did not meet Medicaid eligibility requirements.
Because we require patient verification of coverage at the time of admission, reclassifications of Medicare or managed care accounts to self-pay, other than patient coinsurance or deductible amounts, occur infrequently and are not material to our consolidated financial statements. Additionally, the impact of these classification changes is further limited by our ability to identify any necessary classification changes prior to patient discharge or soon thereafter. Due to information system limitations, we are unable to quantify patient deductible and co-insurance receivables that are included in the primary payer classification in the accounts receivable aging report at any given point in time. When classification changes occur, the account balance remains aged from the patient discharge date.
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, 2006 and 2007 and our total provision for professional and general liability and workers compensation losses and related claims payments (including discontinued operations) during the years ended June 30, 2005, 2006 and 2007, respectively.
We use actuarial information to estimate our reserves for professional and general liability and workers compensation claims. Each reserve is comprised of estimated indemnity and expense payments related to: 1) reported events (“case reserves”) and 2) incurred but not reported (“IBNR”) events as of the end of the period. Management uses information from its risk managers and its best judgment to estimate case reserves. Actuarial estimates are dependent on multiple variables including our loss exposures, our self-insurance limits, geographic locations in which we operate, the severity of our historical losses compared to industry averages and the reporting pattern of our historical losses compared to industry averages, among others. Most of these variables require judgment, and changes in these variables could result in significant period over period fluctuations in our estimates. We adjust these reserves from time to time as we receive updated information. During fiscal 2006 and 2007, due to changes in historical loss trends, we decreased our professional and general liability reserve related to prior fiscal years by $6.9 million and $4.5 million, respectively. During fiscal 2005, we increased our workers compensation reserve related to prior fiscal years by $2.0 million. Fiscal 2006 and 2007 adjustments to the workers compensation reserve related to prior years were not significant. 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 actuarial information includes a best estimate of IBNR using statistical confidence levels that we deem adequate. 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.
We believe that our tax return provisions are accurate and supportable, but certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. To reflect the possibility that all of our tax positions may not be sustained, we maintain tax reserves that are subject to adjustment as updated information becomes available or as circumstances change. We record the impact of tax reserve changes to our income tax provision in the period in which the additional information, including the progress of tax audits, is obtained.
Long-lived assets, including property, plant and equipment and amortizable intangible assets, comprise a significant portion of our total assets. We evaluate the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist under the provisions of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. When we believe impairment indicators may exist, we prepare projections of the undiscounted future cash flows associated with the use of and eventual disposition of long-lived assets held for use. If the projections indicate that the carrying values of the long-lived assets are not expected to be recoverable, we reduce the carrying values to fair value. For long-lived assets held for sale, we compare the carrying values to an estimate of fair value less selling costs to determine potential impairment. We test for impairment of long-lived assets at the lowest level for which cash flows are measurable. These impairment tests are heavily influenced by assumptions and estimates that are subject to change as additional information becomes available. Given the relatively few number of hospitals we own and the significant amounts of long-lived assets
Goodwill also represents a significant portion of our total assets. We review goodwill for impairment annually during our fourth fiscal quarter or more frequently if certain impairment indicators arise under the provisions of SFAS 142, Goodwill and Other Intangible Assets. We review goodwill at the reporting level unit, which is one level below an operating segment. We compare the carrying value of the net assets of each reporting unit to the net present value of estimated discounted future cash flows of the reporting unit. If the carrying value exceeds the net present value of estimated discounted future cash flows, an impairment indicator exists and an estimate of the impairment loss is calculated. The fair value calculation includes multiple assumptions and estimates, including the projected cash flows and discount rates applied. Changes in these assumptions and estimates could result in goodwill impairment that could materially adversely impact our results of operations or statement of position.
We completed our annual goodwill impairment test during the fourth quarter of fiscal 2007 noting no impairment. However, two of our reporting units, with combined goodwill of $140.0 million, will require continual monitoring during fiscal year 2008 due to the sensitivity of the projected operating results of these reporting units to the goodwill impairment analysis. If projected future cash flows become less favorable than those projected by management, impairments may become necessary that could have a material adverse impact on our financial position and results of operations.
Net revenue per adjusted discharge-hospitals is calculated by dividing net hospital patient revenues by adjusted discharge-hospitals and measures the average net payment expected to be received for a patient’s stay in the hospital.
Same hospital 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 for all hospitals owned for the full 12 months of both years presented.
The following tables present a summary of our operating results for the respective periods shown.
Year Ended June 30, 2007 Compared to the Year Ended June 30, 2006
Revenues. Patient service revenues increased by 6.6% year over year primarily as a result of a 6.4% increase in patient revenues per adjusted hospital discharge and a 1.5% increase in adjusted hospital discharges. Outpatient volumes increased year over year with outpatient surgeries increasing 0.2% and emergency room visits increasing 3.4%. However, much of the year over year revenues improvement related to low acuity services provided to uninsured and Medicaid patients. Self-pay and Medicaid discharges increased 19.6% and 9.8%, respectively, year over year, while combined Medicare, managed care and commercial discharges were relatively flat year over year. We also continued to generate a lot of our inpatient stays from emergency room activity. We attribute this payer mix shift to the continued rising cost of healthcare insurance that has forced many people to go uninsured or else participate in a plan with higher deductibles and coinsurance. Additionally, we face continued intense competition from other hospitals to recruit and retain the best physicians to practice in their facilities. In order to improve our operating results, we must increase our elective inpatient and outpatient business to counterbalance the shift in payer mix we have experienced during fiscal 2007. We expect that our service mix and physician initiatives and our recently completed hospital expansion projects will positively impact our payer mix and acuity in the short-term. We believe our quality initiatives will be the catalyst for long-term revenue growth especially given the forecasted population growth for most of the markets in which we operate. However, environmental factors outside our control, including patient demand, payer pressures and increased competition could limit our future revenue growth.
Salaries and benefits. Salaries and benefits as a percentage of total revenues increased to 41.4% during fiscal 2007 from 41.0% during fiscal 2006 primarily as a result of salaries and benefits pressures in our Phoenix market. The national nursing shortage has been particularly challenging in Phoenix during the past few years. Our salaries and benefits at our Phoenix hospitals increased by 2.5% of patient service revenues year over year primarily due to a 6.5% year over year increase in total hospital employed and contract labor full-time equivalents and the limited revenue growth previously discussed. We were successful in building our employed nurse workforce in Phoenix and decreasing our dependence on contract labor in light of the nursing shortage. We believe this transition will allow us to implement our quality initiatives more quickly and efficiently. We also successfully negotiated a new three-year union contract with a significant portion of our nurse workforce in Massachusetts during fiscal 2007.
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 were relatively flat year over year. We continue to incur increasing physician costs for coverage in our emergency rooms and other specialty programs. Our repairs and maintenance costs also increased year over year as we continue to roll out portions of our quality information systems in our hospitals.
Net income. The $145.6 million year over year decrease in net income resulted primarily from the after tax impact of the impairment loss recorded during fiscal 2007 and the significant increases in depreciation and amortization and net interest discussed above.
Costs and Expenses. Total costs and expenses, exclusive of income taxes and discontinued operations, were $2,378.9 million or 98.4% of total revenues during fiscal 2006, an improvement from 105.6% during fiscal 2005. Fiscal 2005 costs and expenses were negatively impacted by costs associated with 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.
The national nursing shortage hindered our ability to fully manage salaries and benefits. We experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix market and were required to utilize more costly and less efficient temporary nurse staffing.
Supplies. Supplies as a percentage of total revenues decreased to 16.3% during fiscal 2006 from 16.5% during fiscal 2005. Supplies as a percentage of patient service revenues decreased to 19.3% during fiscal 2006 compared to 19.8% during fiscal 2005. The year over year improvement in this ratio resulted from our efforts to increase utilization of our group purchasing organization and to implement our materials management strategies in Massachusetts.
Medical claims expense. Medical claims expense as a percentage of premium revenues increased from 71.1% during fiscal 2005 to 72.1% during fiscal 2006 primarily as a result of the start of AAHP operations on January 1, 2006. Medical claims expense represents the amounts paid by the health plans for healthcare 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 $40.0 million, or 12.9% of gross health plan medical claims expense, were eliminated in consolidation during fiscal 2006.
Income taxes. The effective tax rate increased from 30.3% in fiscal 2005 to 40.8% in fiscal 2006. This increase was due to certain Merger-related costs that were non-deductible for tax purposes during fiscal 2005.
Discontinued operations. The significant loss from discontinued operations during fiscal 2006 was primarily attributable to the after tax impact of a $15.0 million impairment charge related to the excess carrying value of our California hospital asset group, which was sold in October 2006, over the asset group's fair value.
At June 30, 2007, we had working capital of $156.4 million, including cash and cash equivalents of $120.1 million. Working capital at June 30, 2006 was $193.0 million. Cash provided by operating activities decreased from $149.3 million during fiscal 2006 to $123.3 million during fiscal 2007. The significant decrease was due to a $23.2 million growth in net accounts receivable from continuing operations, a $7.1 million reduction in cash flows from discontinued operations and a $6.5 million increase in interest payments during fiscal 2007 compared to fiscal 2006. Net days in accounts receivable from continuing operations increased approximately 2 days year over year. Cash provided by discontinued operations decreased year over year primarily due to the deterioration in operations at the California hospitals and PMH during fiscal 2007 that exceeded the net decrease in working capital at those hospitals.
Cash used in investing activities decreased from $245.4 million during fiscal 2006 to $118.5 million during fiscal 2007, primarily as a result of $111.2 million period over period decrease in capital expenditures. During fiscal 2007, capital spending on our six significant expansion projects described below slowed considerably as certain of
these projects were completed in their entirety and portions of others were completed at various times throughout fiscal 2007.
Increased post partum capacity to better utilize labor, delivery and recovery suites.
In addition to increasing the number of licensed beds by 33, the expansion project allows for the utilization of an additional 67 previously licensed beds.
Cash provided by financing activities decreased from $140.5 million during fiscal 2006 to an $8.3 million use of cash during fiscal 2007, due to the $175.0 million term loan borrowing during September 2005 and quarterly term loan principal repayments during fiscal 2007.
The 2005 term loan facility borrowings bear interest at a rate equal to, at our option, a base rate plus 1.25% per annum or LIBOR plus 2.25% per annum. These rates reflect a savings of 1.0% per annum over the interest rate options for our previous initial term loan facility. The borrowings under the revolving credit facility currently bear interest at a rate equal to, at our option, a base rate plus 1.25% per annum or LIBOR plus 2.25% per annum. These rates are subject to increase by up to 0.25% per annum should our leverage ratio exceed certain designated levels.
We are required to pay a commitment fee to the lenders under the revolving credit facility in respect of the unutilized commitments thereunder at a rate equal to 0.50% per annum. We also pay customary letter of credit fees.
The 2005 term loan facility and the revolving credit facility 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 9.0% Notes and 11.25% Notes), pay 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, enter into sale and leaseback transactions, engage in certain transactions with affiliates, amend certain material agreements governing our indebtedness, including the 9.0% Notes and 11.25% Notes, change the business conducted by our subsidiaries and enter into hedging agreements. In addition, the senior credit facilities require us to maintain the following financial covenants: a maximum total leverage ratio, a maximum senior leverage ratio, a minimum interest coverage ratio and a maximum capital expenditures limitation.
We are a party to certain rent shortfall agreements with certain unconsolidated entities, physician income guarantees and service agreement guarantees 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 with their payment dates as of June 30, 2007.
Represents estimated payments to be made in future periods for healthcare costs incurred by enrollees in PHP, AAHP and MHP and is separately stated on our consolidated balance sheet.
Represents our estimate of amounts we are committed to fund in future periods through executed agreements to complete projects included as construction in progress on our consolidated balance sheet.
Represents performance bonds we have purchased related to medical claims liabilities of PHP.
Includes physician guarantee liabilities recognized in our consolidated balance sheet under the provisions of FSP 45-3, Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners, and liabilities for other fixed expenses under physician relocation agreements not yet paid.
Consolidated Statements of Operations for the years ended June 30, 2005 (combined basis),
Consolidated Statements of Stockholders’ Equity for the predecessor period July 1, 2004 through
22, 2004, the successor period September 23, 2004 through June 30, 2005
We have audited the accompanying consolidated balance sheets of Vanguard Health Systems, Inc. as of June 30, 2007 and 2006 and the related consolidated statements of operations, stockholders’ equity and cash flows for the years ended June 30, 2007 and 2006 and for the period from September 23, 2004 to June 30, 2005 and the related consolidated statements of operations, stockholders’ equity and cash flows of Vanguard Health Systems, Inc. (Predecessor) for the period from July 1, 2004 to September 22, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Vanguard Health Systems, Inc. (“Vanguard”) is an investor-owned healthcare company whose affiliates own and operate hospitals and related healthcare businesses in urban and suburban areas. As of June 30, 2007, Vanguard’s affiliates owned and managed 15 acute care hospitals with 4,143 licensed beds and related outpatient service locations complementary to the hospitals providing healthcare services in San Antonio, Texas; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; and Massachusetts. Vanguard also owns managed health plans in Chicago and Phoenix and two surgery centers in Orange County, California.
Vanguard considers the following accounting policies to be most critical to its operating performance and to involve the most subjective and complex assumptions and estimates.
Vanguard participates in the Bexar County, Texas upper payment limit (“UPL”) Medicaid payment program. Vanguard recognizes revenues from the UPL program when Vanguard becomes entitled to the expected reimbursements, including a federal match portion, and such reimbursements are reasonably assured. During the year ended June 30, 2007, Vanguard recorded $11.6 million of revenues for UPL payments received in April 2007 that relate to services provided during fiscal years 2005 and 2006. The UPL payment also positively impacted loss from continuing operations before income taxes by $5.9 million during the year ended June 30, 2007 related to services provided in fiscal years 2005 and 2006. While revenue fluctuations between periods are possible given the timing of the federal match funding, Vanguard does not expect these fluctuations to significantly impact its results of operations or cash flows in future periods.
Vanguard had premium revenues of $333.5 million, $375.0 million and $401.4 million during the years ended June 30, 2005 (combined basis), 2006 and 2007, respectively. Vanguard’s health plans, Phoenix Health Plan (“PHP”), Abrazo Advantage Health Plan (“AAHP”) and MacNeal Health Providers (“MHP”), have agreements with the Arizona Health Care Cost Containment System (“AHCCCS”), Centers for Medicare and Medicaid Services (“CMS”) and various health maintenance organizations (“HMOs”), respectively, to contract to provide medical services to subscribing participants. Under these agreements, Vanguard’s 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. Vanguard’s health plans recognize the payments as revenues in the month in which members are entitled to healthcare services with the exception of AAHP Medicare Part D reinsurance premiums and low income subsidy cost sharing premiums that are recorded as a liability to fund future healthcare costs or else repaid to the government.
Vanguard’s ability to collect the self-pay portions of outstanding receivables is critical to its operating performance and cash flows. The allowance for doubtful accounts was approximately 26.0% and 28.3% of accounts
Vanguard classifies accounts pending Medicaid approval as Medicaid accounts in its accounts receivable aging report and records a manual contractual allowance for these accounts equal to the average Medicaid reimbursement rate for that specific state. Vanguard has historically been successful in qualifying approximately 50%-55% of submitted accounts for Medicaid coverage. As of June 30, 2007, Vanguard had approximately $12.0 million of Medicaid pending accounts receivable from continuing operations ($3.5 million of which was stated at gross charges with a manual contractual allowance and $8.5 million of which was stated net of contractual discounts). In the event an account is not successfully qualified for Medicaid coverage and does not meet Vanguard’s charity guidelines, the previously recorded Medicaid contractual adjustment remains a revenue deduction (similar to a self-pay discount), and the remaining net account balance is reclassified to uninsured status and subjected to Vanguard’s allowance for doubtful accounts policy. During the year ended June 30, 2007, approximately $13.2 million of net accounts receivable from continuing operations was reclassified from Medicaid pending status to uninsured status. If the account does not qualify for Medicaid coverage but does qualify as charity care, the contractual adjustment is reversed and the gross account balance is recorded as a charity deduction. During the year ended June 30, 2007, Vanguard recorded approximately $6.4 million of charity deductions from continuing operations for the net balances of accounts previously classified as Medicaid pending that did not meet Medicaid eligibility requirements.
Because Vanguard requires patient verification of coverage at the time of admission, reclassifications of Medicare or managed care accounts to self-pay, other than patient coinsurance or deductible amounts, occur infrequently and are not material to its financial statements. Additionally, the impact of these classification changes is further limited by Vanguard’s ability to identify any necessary classification changes prior to patient discharge or soon thereafter. Due to information system limitations, Vanguard is unable to quantify patient deductible and co-insurance receivables that are included in the primary payer classification in the accounts receivable aging report at any given point in time. When classification changes occur, the account balance remains aged from the patient discharge date.
A summary of Vanguard’s allowance for doubtful accounts activity, including those for discontinued operations, during the three most recent fiscal years follows (in millions).
Vanguard utilizes actuarial information to estimate its reserves for professional and general liability and workers compensation claims. Each reserve is comprised of estimated indemnity and expense payments related to: 1) reported events (“case reserves”) and 2) incurred but not reported (“IBNR”) events as of the end of the period. Management uses information from its risk managers and its best judgment to estimate case reserves. Actuarial IBNR estimates are dependent on multiple variables including Vanguard’s loss exposures, its self-insurance limits, geographic locations in which it operates, the severity of its historical losses compared to industry averages and the reporting pattern of its historical losses compared to industry averages, among others. Most of these variables require judgment, and changes in these variables could result in significant period over period fluctuations in Vanguard’s estimates. Vanguard discounts its workers compensation reserve using actuarial estimates of projected cash payments in future periods. Vanguard adjusts these reserves from time to time as it receives updated information. During fiscal 2006 and 2007, due to changes in historical loss trends, Vanguard decreased its professional and general liability reserve related to prior fiscal years by $6.9 million and $4.5 million, respectively. During fiscal 2005, Vanguard increased its workers compensation reserve related to prior fiscal years by $2.0 million. Adjustments to the workers compensation reserve related to prior years during fiscal 2006 and 2007 were not significant. Given the fact that Vanguard has operated its hospitals for relatively short periods of time, management expects that additional adjustments to prior year estimates may occur as Vanguard’s reporting history and loss portfolio matures.
During the years ended June 30, 2005 (combined basis), 2006 and 2007, medical claims expense was approximately $237.2 million, $270.3 million and $297.0 million, respectively, primarily representing medical claims of PHP. Vanguard estimates PHP’s reserve for medical claims using historical claims experience (including severity and payment lag time) and other actuarial data including number of enrollees and the county in which the enrollee resides. The reserve for medical claims, including incurred but not reported claims, for PHP and AAHP was approximately $44.0 million and $57.2 million as of June 30, 2006 and 2007, 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, 2005 (combined basis), 2006 and 2007, approximately $36.6 million, $40.0 million and $34.2 million, respectively, of accrued and paid claims for services provided to Vanguard’s health plan enrollees by its hospitals and its other healthcare facilities were eliminated in consolidation. Vanguard’s operating results and cash flows could be materially affected by increased or decreased utilization of its healthcare facilities by enrollees in its health plans.
Income taxes are computed on the liability method of accounting whereby deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are increased using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Management believes that Vanguard’s tax return provisions are accurate and supportable, but certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. To reflect the possibility that all of its tax positions may not be sustained, Vanguard maintains tax reserves that are subject to adjustment as updated information becomes available or as circumstances change. Vanguard records the impact of tax reserve changes to its income tax provision in the period in which the additional information, including the progress of tax audits, is obtained.
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 Vanguard’s recoverability analysis and thus have a material adverse impact on its consolidated financial condition, results of operations or cash flows.
Long-lived assets, including property, plant and equipment and amortizable intangible assets, comprise a significant portion of our total assets. Vanguard evaluates the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist under the provisions of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. When management believes impairment indicators may exist, projections of the undiscounted future cash flows associated with the use of and eventual disposition of long-lived assets held for use are prepared. If the projections indicate that the carrying values of the long-lived assets are not expected to be recoverable, Vanguard reduces the carrying values to fair value. For long-lived assets held for sale, Vanguard compares the carrying values to an estimate of fair value less selling costs to determine potential impairment. Vanguard tests for impairment of long-lived assets at the lowest level for which cash flows are measurable. These impairment tests are heavily influenced by assumptions and estimates that are subject to change as additional information becomes available. Given the relatively few number of hospitals Vanguard owns and the significant amounts of long-lived assets attributable to those hospitals, an impairment of the long-lived assets for even a single hospital could materially adversely impact its operating results or financial position.
In December 2006, Vanguard recorded at impairment charge related to its Chicago hospitals. See Note 7 for further discussion of this impairment charge.
Vanguard’s primary concentration of credit risk is patient accounts receivable, which consists of amounts owed by various governmental agencies, insurance companies and private patients. Vanguard manages the receivables by regularly reviewing its accounts and contracts and by providing appropriate allowances for contractual discounts and uncollectible amounts. Medicare program receivables comprised approximately 21% and 18% of net patient receivables as of June 30, 2006 and 2007, respectively. Medicare revenues are included in the acute care services operating segment. Medicaid programs comprised approximately 16% and 13% of net patient receivables as of June 30, 2006 and 2007, respectively. Remaining receivables relate primarily to various HMO and Preferred Provider Organization (“PPO”) payers, managed Medicare and Medicaid payers, commercial insurers and private patients. Concentration of credit risk for these payers is limited by the number of patients and payers.
During fiscal 2005, Vanguard adjusted the stated values of property, plant and equipment that existed as of the date of the Merger based upon guidance set forth in Emerging Issues Task Force No. 88-16, Basis in Leveraged Buyout Transactions (“EITF 88-16”) using appraisals received from an independent third party. Purchases of property, plant and equipment subsequent to the Merger are stated at cost. Routine maintenance and repairs are charged to expense as incurred. Expenditures that increase values, change capacities or extend useful lives are capitalized. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which approximate 18 months to 44 years. Depreciation expense was approximately $15.5 million, $57.1 million, $72.6 million, $97.1 million and $115.4 million for the predecessor period July 1, 2004 through September 22, 2004, the successor period September 23, 2004 through June 30, 2005, the combined year ended June 30, 2005, the year ended June 30, 2006 and the year ended June 30, 2007, respectively. Vanguard tests its property, plant and equipment and other long-lived assets for impairment as management becomes aware of impairment indicators.
During fiscal 2005 (combined basis), 2006 and 2007, Vanguard capitalized $4.3 million, $8.3 million and $3.0 million of interest, respectively, associated with certain of its hospital construction and expansion projects. Vanguard estimates that it is contractually obligated to expend approximately $50.5 million related to projects classified as construction in progress as of June 30, 2007. Vanguard also capitalizes costs associated with
developing computer software for internal use under the provisions of AICPA Statement of Position 98-1 (“SOP 98-1”). Under SOP 98-1, Vanguard capitalizes both internal and external direct costs, excluding training, during the application development stage primarily for the purpose of customizing vendor software to integrate with our hospitals’ information systems. The following table provides the gross asset balances for each major class of asset and total accumulated depreciation as of June 30, 2006 and 2007 (in millions).
Vanguard operates primarily in four geographic markets. Should economic or other factors limit its ability to provide healthcare services in one or more of these markets, Vanguard’s cash flows and results of operations could be materially adversely impacted. Approximately 1,600 full-time employees in Vanguard’s Massachusetts hospitals are subject to collective organizing agreements. This group represents approximately 9% of Vanguard’s workforce. During fiscal 2007, Vanguard entered into a new three-year contract with the union representing the majority of this group that ends on December 31, 2009. Should Vanguard experience significant future labor disruptions related to these unionized employees, its cash flows and results of operations could be materially adversely impacted.
under the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (“SFAS 123(R)”). Vanguard also adopted SFAS 123(R) on a prospective basis and such adoption did not significantly impact any indicator of Vanguard’s results of operations or cash flows.
For purposes of pro forma disclosures, the estimated fair value of options is amortized to expense on a straight-line basis over the options’ vesting period. The following table reflects the pro forma impact on net income (loss) assuming Vanguard had adopted SFAS 123 since the inception of its stock option grants as opposed to adopting SFAS 123 on July 1, 2003 using the prospective method set forth in SFAS 148 (in millions).
The fair values of Vanguard’s 9.0% Notes and 11.25% Notes as of June 30, 2007 were approximately $567.8 million and $178.2 million, respectively, based upon stated market prices. The fair values are subject to change as market conditions change.
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 gives entities the option to voluntarily choose, at certain election dates, to measure many financial assets and liabilities at fair value. Elections are made on an instrument by instrument basis and are irrevocable once made. Subsequent changes to the fair value of any instrument for which an election is made are reflected through earnings. SFAS 159 is effective for Vanguard as of July 1, 2008 with early adoption permitted. Vanguard does not expect SFAS 159 to have a significant impact on its future financial position, results of operations or cash flows.
On September 15, 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurement (“SFAS 157”). SFAS 157 sets forth comprehensive guidance for measuring fair value of assets and liabilities. Under the provisions of SFAS 157, fair value should be based on the assumptions market participants would use to complete the sale of an asset or transfer of a liability. SFAS 157 provides a hierarchy of information to be used to determine the applicable market assumptions, and fair value measurements would be separately disclosed under each applicable layer of the hierarchy. SFAS 157 does not expand or restrict the use of fair value for measuring assets and liabilities but provides a single methodology to be used when fair value accounting is applied. SFAS 157 is effective for Vanguard’s fiscal year beginning July 1, 2008 with early adoption permitted. Vanguard does not expect the adoption of SFAS 157 to significantly impact its future financial position, results of operations or cash flows.
On September 23, 2004, affiliates of The Blackstone Group (“Blackstone”), a private equity firm, purchased a majority equity interest in VHS Holdings LLC (“Holdings”), which became the principal stockholder of
As of June 30, 2007, Blackstone beneficially owns approximately 66% of the equity interests in Vanguard through its subscription and purchase of approximately $494.9 million aggregate amount of Class A membership units in Holdings and common stock of Vanguard in connection with the Merger.
Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively, “MSCP”), Vanguard’s previous private equity sponsor, contributed $130.0 million and management (along with certain other investors) contributed approximately $124.1 million by contributing shares of Vanguard common stock and/or utilizing cash proceeds from the Merger to purchase Class A membership units in Holdings. These stockholders, on a combined basis, beneficially own as of June 30, 2007, approximately 34% of the equity interests in Vanguard. Certain members of management also purchased $5.7 million of the equity incentive units in Holdings in connection with the Merger.
Vanguard accounted for the transaction as a purchase under the guidance set forth in EITF 88-16. Under EITF 88-16, the transaction was deemed to be a purchase by new controlling investors for which Holdings’ interests in Vanguard were valued using a partial change in accounting basis. In effect, the membership units of Holdings owned by the management investors were valued using predecessor basis, while the membership units of Holdings owned by Blackstone, MSCP and other certain investors were recorded at fair value.
The following table summarizes the sources and uses of funds to finance the Merger (in millions):
The new senior credit agreement governed senior secured term loan facilities of $800.0 million, of which $475.0 million was drawn at closing, and a new revolving loan facility of $250.0 million, none of which was utilized at closing with the exception of $27.7 million of outstanding letters of credit.
Vanguard issued and sold $216.0 million aggregate principal amount at maturity ($124.7 million in gross proceeds) of 11.25% senior discount notes due 2015 (the “11.25% Notes”).
The table below provides a detail of the Merger-related costs (in millions).
On October 1, 2006, certain of Vanguard’s subsidiaries completed the sale of their three hospitals in Orange County, California (West Anaheim Medical Center, Huntington Beach Hospital and La Palma Intercommunity Hospital) to subsidiaries of Prime Healthcare, Inc. for net proceeds of $40.0 million, comprised of cash proceeds of $37.0 million and $3.0 million of proceeds placed in escrow which was distributed to a subsidiary of Vanguard on July 2, 2007. Approximately $12.8 million of retained working capital, including $25.3 million of patient accounts receivable, was excluded from the sale. See Note 5 for discussion of discontinued operations treatment related to the sale of these hospitals.
On March 8, 2006, certain subsidiaries of Vanguard sold medical office buildings in California to an independent third party for net sales proceeds of approximately $28.7 million. The net book value of the property, plant and equipment sold was approximately $14.8 million, and Vanguard allocated approximately $2.8 million of existing goodwill to the disposed assets. Vanguard recognized a gain on the sale of approximately $11.1 million ($8.3 million net of taxes) during fiscal 2006 that is included in discontinued operations, net of taxes in the accompanying consolidated statement of operations for the year ended June 30, 2006. See Note 5 for discussion of discontinued operations treatment related to the sale of these assets.
On December 31, 2004, certain of Vanguard’s subsidiaries acquired the property, plant and equipment, investments and certain current assets and assumed certain current liabilities of 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. Vanguard paid $87.7 million at closing, including the base purchase price of $103.5 million for the property, plant and equipment and investments of the Massachusetts Hospitals less $15.8 million for the excess of the current liabilities assumed and closing costs incurred over the current assets acquired. Vanguard funded the purchase price by borrowing $60.0 million from the $150.0 million acquisition delayed draw term facility under its senior secured credit facilities, entered into in connection with the Merger, and using $27.4 million of cash on hand. Vanguard invested an estimated additional $37.4 million during the third quarter of fiscal 2005 related to the build-up of working capital at the Massachusetts Hospitals. On February 18, 2005, Vanguard borrowed the remaining $90.0 million available to it under the acquisition delayed draw term facility to fund the working capital build-up at the Massachusetts Hospitals and to fund capital expenditures projects. The acquisition of these hospitals gave Vanguard an established presence in the suburban Boston area and central Massachusetts area with an opportunity to grow the hospitals by adding new services. The results of operations of the Massachusetts Hospitals are included in the accompanying consolidated statements of operations for the period January 1, 2005 to June 30, 2005 and for all of fiscal 2006 and 2007.
The purchase price for the fiscal 2005 acquisition was allocated as follows (in millions).
During fiscal 2006, prior to the sale of the California hospitals, Vanguard recorded an impairment charge of $15.0 million ($9.4 million net of taxes) to write down its basis in the net property, plant and equipment of these hospitals to estimated fair value using a discounted cash flows model. The California hospitals assets were not originally classified as assets held for sale at June 30, 2006, because the Board of Directors had not yet approved the sale. However, the accompanying balance sheet as of June 30, 2006, now includes these assets as assets held for sale, and the previously recorded impairment charge is included in discontinued operations, net of taxes in the accompanying consolidated statement of operations for the year ended June 30, 2006.
The following table sets forth the components of discontinued operations, net of taxes for the years ended June 30, 2005 (combined basis), 2006 and 2007, respectively (in millions).
Amortization expense for the predecessor period July 1, 2004 through September 22, 2004, the successor period September 23, 2004 through June 30, 2005, the combined year ended June 30, 2005 and the years ended June 30, 2006 and 2007 was approximately $0.5 million, $2.5 million, $3.0 million, $3.2 million and $3.2 million, respectively. Vanguard expects amortization expense for these intangible assets, excluding deferred loan costs that are amortized to interest expense and physician income and service agreement guarantees that are amortized to other operating expenses, to approximate $3.2 million during the fiscal years ending June 30, 2008 through June 30, 2012. The lives over which intangible assets are amortized range from two years to eleven years.
The following table presents the changes in the carrying amount of goodwill from June 30, 2005 through June 30, 2007 (in millions).
A summary of Vanguard’s long-term debt at June 30, 2006 and 2007 follows (in millions).
On July 30, 2001, Vanguard received gross proceeds of $300.0 million through the issuance of the 9.75% Notes due August 2011. Interest on the 9.75% Notes was payable semi-annually on February 1 and August 1. Payment of the principal and interest of the 9.75% Notes was subordinate to amounts owed for Vanguard’s existing and future senior indebtedness and was guaranteed, jointly and severally, on an unsecured senior subordinated basis by most of Vanguard’s subsidiaries. Vanguard was subject to certain restrictive covenants under the Indenture governing the 9.75% Notes. In connection with the Merger, Vanguard completed a tender offer to repurchase the 9.75% Notes and a consent solicitation adopting amendments to the indenture that amended or eliminated substantially all of the restrictive covenants contained in the indenture. Holders of $299.0 million of the 9.75% Notes tendered their notes for repurchase by Vanguard and consented to the proposed amendments to the indenture. Vanguard paid tender premiums and consent fees of $50.2 million related to the repurchase on the Merger date. Vanguard repurchased the remaining $1.0 million of 9.75% Notes in October 2005 and paid additional tender premiums and consent fees of $0.1 million.
On January 26, 2005, Vanguard exchanged all of its outstanding 9.0% senior subordinated notes due 2014 for new 9.0% senior subordinated notes due 2014 with identical terms and conditions, except that they were registered under the Securities Act of 1933. Terms and conditions of the exchange offer were set forth in the registration statement on Form S-4 filed with the Securities and Exchange Commission that became effective on December 23, 2004.
In connection with the Merger on September 23, 2004, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding Company I, LLC and Vanguard Holding Company I, Inc. (collectively the “Discount Issuers”), completed a private placement of $216.0 million aggregate principal amount at maturity ($124.7 million in gross proceeds) of 11.25% Notes. The 11.25% Notes accrete at the stated rate compounded semi-annually on April 1 and October 1 of each year to, but not including, October 1, 2009. From and after October 1, 2009, cash interest on the 11.25% Notes will accrue at 11.25% per annum, and will be payable on April 1 and October 1 of each year, commencing on April 1, 2010 until maturity. The 11.25% Notes are general senior unsecured obligations and rank junior in right of payment to all existing and future senior indebtedness of the Discount Issuers but senior to any of the Discount Issuers’ future senior subordinated indebtedness. All payments on the 11.25% Notes are guaranteed by Vanguard as a holding company guarantee.
At any time prior to October 1, 2007, the Discount Issuers may redeem up to 35% of the aggregate principal amount at maturity of the 11.25% Notes with the net proceeds of certain equity offerings at 111.25% of the accreted value of the 11.25% Notes plus accrued and unpaid interest. Prior to October 1, 2009, the issuers may redeem the 11.25% Notes, in whole or in part, at a price equal to 100% of the accreted value thereof, plus accrued and unpaid interest, plus a make-whole premium. On or after October 1, 2009, the Discount Issuers may redeem all or a part of the 11.25% Notes at various redemption prices given the date of redemption as set forth in the indenture governing the 11.25% Notes. The initial redemption price for the 11.25% Notes on October 1, 2009 is equal to 105.625% of their principal amount, plus accrued and unpaid interest. The redemption price declines each year after 2009. The redemption price will be 100% of the principal amount, plus accrued and unpaid interest, beginning on October 1, 2012.
Future maturities of Vanguard’s debt as of June 30, 2007 follow (in millions).
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 Vanguard’s deferred tax assets and liabilities as of June 30, 2006 and 2007, were approximately as follows (in millions):
Excess book basis over tax basis of prepaid assets and other
During fiscal 2007, Vanguard increased the valuation allowance by $10.6 million, of which $4.7 million related to discontinued operations. $5.0 million of the valuation allowance attributable to operations existed as of the Merger date described in Note 3. Any subsequent recognition of tax benefits associated with the pre-Merger valuation allowances will be accounted for as a reduction of goodwill attributable to the Merger in accordance with applicable accounting standards. During fiscal 2006, Vanguard increased goodwill by a total of $4.5 million to adjust the tax accounts that existed as of the Merger date given the final Merger purchase price allocation and the IRS examination discussed below.
Immediately prior to the Merger, Vanguard had authorized 600,000 shares of common stock, of which 232,784 shares were outstanding. A portion of the proceeds of the Merger were used to pay the holders of the common stock for their stock and the holders of outstanding options under the 1998 Stock Option Plan, the 2000 Stock Option Plan, the Initial Option Plan and the Carry Option Plan for the excess of the Merger consideration over the exercise prices of such options. In connection with the Merger, Blackstone, MSCP, management and other investors purchased $624.0 million of Class A Membership Units of Holdings. Holdings then invested the $624.0 million in the common stock of Vanguard, and in addition Blackstone invested $125.0 million directly in the common stock of Vanguard. In February 2005, other investors purchased approximately $0.6 million of Class A membership units of Holdings. Holdings then invested the $0.6 million in the common stock of Vanguard.
As previously discussed, Vanguard used the minimum value pricing model permitted under SFAS 123 to determine stock compensation costs related to stock option grants prior to July 1, 2006. On July 1, 2006, Vanguard adopted the provisions of SFAS 123(R), to account for stock option grants subsequent to July 1, 2006. Vanguard adopted SFAS 123(R) on a prospective basis as required for companies that chose to adopt SFAS 123 using the transition guidance set forth in SFAS 148. During the combined fiscal year 2005, Vanguard incurred stock compensation of $97.4 million primarily as a result of $96.7 million incurred during the predecessor period July 1, 2004 through September 22, 2004 related to Merger payments to stock option holders under Vanguard’s former stock option plans as calculated under the provisions of APB 25 for option grants prior to July 1, 2003, and under SFAS 123 for option grants on or after July 1, 2003. During fiscal years 2006 and 2007, Vanguard incurred stock compensation of $1.7 million and $1.2 million, respectively, related to grants under its 2004 Stock Incentive Plan.
On June 1, 1998, the Vanguard board of directors (the “Board”) approved the first grant of options, each exercisable for one share of common stock at an exercise price of $170.12, under the Vanguard Health Systems, Inc. Carry Option Plan (the “Carry Option Plan”). In November 2001, the Board approved a second grant of options under the Carry Option Plan, bringing the total number of outstanding options to 29,822, the maximum allowed pursuant to the Amended and Restated Shareholders Agreement dated as of June 1, 2000 and the Carry Option Plan. On the Merger date, the number of exercisable options under the Carry Option Plan was determined to be 10,625 based upon calculations set forth in the plan document. Pursuant to the merger agreement, on September 23, 2004, Vanguard cancelled all options under the Carry Option Plan, terminated the plan and paid the option holders promptly thereafter the excess of the Merger consideration over the exercise price of exercisable options.
The purpose of the Vanguard Health Systems, Inc. Nonqualified Initial Option Plan (the “Initial Option Plan”) was primarily to grant option awards to those employees who agreed to work for Vanguard for no cash salaries or cash salaries below fair market value during the eleven months ended May 31, 1998. On June 1, 1998, the Board approved the grant of 3,595 options, each exercisable for one share of common stock, at an exercise price of $170.12 per share. The maximum number of shares of common stock reserved for grant of awards under the Initial Option Plan was 3,595. Each of the 3,595 granted options vested on June 1, 1999 (one-year vesting period). 3,396 of the options became exercisable on June 1, 1999, and the other 199 options became exercisable on the Merger date. Pursuant to the merger agreement, on September 23, 2004, Vanguard cancelled all options under the Initial Option Plan, terminated the plan and paid the option holders promptly thereafter the excess of the Merger consideration over the exercise price of the options.
The following table provides information relating to the 2004 Option Plan as of June 30, 2007.
The following table sets forth certain information regarding those options vested at June 30, 2007, those expected to vest subsequent to June 30, 2007 and the total expected to vest over the life of all options granted.
Effective June 1, 1998, Vanguard adopted the Vanguard 401(k) Retirement Savings Plan (the “401(k) Plan”). The 401(k) Plan is a multiple employer defined contribution plan whereby employees who are age 21 or older are eligible to participate.
For the predecessor period July 1, 2004 through September 22, 2004, the successor period September 23, 2004 through June 30, 2005, the combined year ended June 30, 2005 and the years ended June 30, 2006 and 2007, rent expense was approximately $5.1 million, $22.0 million, $27.1 million, $33.9 million and $37.4 million, respectively.
Laws and regulations governing the Medicare and Medicaid and other federal healthcare programs are complex and subject to interpretation. Vanguard’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. While no such regulatory inquiries have been made, Vanguard’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.
Effective June 1, 1998, Vanguard executed employment agreements with three of its current senior executive officers. Vanguard executed an employment agreement with a fourth current senior executive officer on September 1, 1999. The employment agreements were amended on September 23, 2004 to extend the term of each employment agreement another 5 years and to provide that the Merger did not constitute a change of control, as defined in the agreements. The employment agreements will renew automatically for additional one-year periods, unless terminated by Vanguard or the executive officer. The employment agreements provide, among other things, for minimum salary levels, for participation in bonus plans, and for amounts to be paid as liquidated damages in the event of a change in control or termination by Vanguard without cause.
Vanguard entered into physician relocation agreements and service agreements under which it guarantees minimum monthly income, revenues or collections to physicians during a specified period of time (typically 12 months to 24 months). In return for the minimum guarantee payment, the physicians are required to practice in the community or to provide emergency room or specialty program coverage at Vanguard’s hospitals for a stated period of time (typically 3 to 5 years) or else return the payments to Vanguard. In January 2006, Vanguard adopted Financial Accounting Standards Board Staff Position No. FIN 45-3, Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners (“FSP 45-3”). FSP 45-3 requires that a liability
As part of its contract with AHCCCS, PHP is required to maintain a performance guarantee in the amount of $19.0 million, an amount determined based upon PHP’s membership and capitation premiums received. As of June 30, 2007, Vanguard maintained this performance guarantee entirely in the form of surety bonds with independent third party insurers that expire on September 30, 2007. Vanguard is required to arrange for $2.9 million in letters of credit to collateralize its $19.0 million in surety bonds with the third party insurers. As of June 30, 2007, Vanguard provided a $0.6 million guarantee of the debt of a joint venture accounted for as an equity method investment and also from time to time enters into parent-subsidiary guarantee arrangements in the ordinary course of operating its business.
Vanguard is a party to three contractual agreements whereby it may be required to make monthly payments to the developers and managers of three medical office buildings located on its hospital campuses through minimum rent revenue guarantees. Vanguard entered into these agreements to provide an incentive to the developers to fund the construction of the medical office buildings and manage the buildings upon their completion in order to make physician office space available near its hospital campuses. One of the contracts commenced prior to the effective date of Financial Interpretation Number 46, Variable Interest Entities, (as amended by FIN 46R) and is scheduled to terminate in March 2016. Due to the significance of Vanguard’s minimum rent revenue payments to the operations of the medical office building, Vanguard consolidated this entity for financial reporting purposes as of June 30, 2006 and 2007. The variable interest entity’s debt is collateralized by the medical office building asset (cost value of $2.4 million) and not by any Vanguard assets. The second contract commenced in April 2005 for a period of 12 years. Vanguard deemed this contract a VIE in which Vanguard is not the primary beneficiary. The maximum annual amount Vanguard would pay under the contract assuming zero occupancy would be approximately $1.5 million. Vanguard expects to achieve the permanent burnoff provisions under the third contract during fiscal 2008 and deems the developer landlord to be the primary beneficiary. Vanguard currently expects to make no rental shortfall payments during fiscal 2008 under the second and third contracts given current and expected future occupancy levels.
During fiscal 2005 (combined basis), Vanguard paid approximately $6,000 of the out-of-pocket expenses of MSCP related to their review of Vanguard’s proposed transactions and reimbursement for travel and related expenses. MSCP maintained an equity interest in Vanguard of 17.3% as of June 30, 2007. Also, one of Vanguard’s directors as of June 30, 2007, Eric T. Fry, and two previous directors, Howard I. Hoffen and Karen H. Bechtel, were managing directors of Morgan Stanley & Co. Incorporated during a portion of fiscal 2005. Until September 2004, Eric T. Fry was a managing director of Morgan Stanley Private Equity, while Howard I. Hoffen was Chairman and Chief Executive Officer of Morgan Stanley Private Equity. Morgan Stanley & Co. Incorporated, Morgan Stanley Private Equity and Morgan Stanley Senior Funding, Inc. are affiliates of MSCP.
Pursuant to the merger agreement, Vanguard entered into a transaction and monitoring fee agreement with Blackstone and Metalmark Subadvisor LLC (“Metalmark”). Under the terms of the agreement, Vanguard paid Blackstone a transaction and advisory fee on the Merger date equal to $20.0 million plus approximately $350,000 of out of pocket expenses for Blackstone’s expertise in undertaking financial and structural analysis, due diligence investigations and other advice and negotiation assistance necessary to complete the Merger. This fee is included in goodwill as a direct acquisition cost. Funds affiliated with Blackstone held an equity interest in Vanguard of 66.0% as of June 30, 2007. Vanguard also agreed to pay Blackstone and Metalmark an annual monitoring fee of $4.0
Vanguard’s acute care hospitals and related healthcare businesses are similar in their activities and economic environments in which they operate (i.e. urban markets). Accordingly, Vanguard’s reportable operating segments consist of 1) acute care hospitals and related healthcare businesses, collectively, and 2) health plans consisting of MacNeal Health Providers, a contracting entity for MacNeal Hospital and Weiss Memorial Hospital in the metropolitan Chicago area, Phoenix Health Plan, a Medicaid managed health plan operating in Arizona and Abrazo Advantage Health Plan, a Medicare and Medicaid dual eligible managed health plan operating in Arizona. The following tables provide financial information by business segment for the year ended June 30, 2005 (combined basis), the year ended June 30, 2006, the year ended June 30, 2007, the predecessor period July 1, 2004 through September 22, 2004 and the successor period September 23, 2004 through June 30, 2005. The measure of operating profit or loss presented in the following tables, income or loss from continuing operations before income taxes, is different than the measure used in previous years as a result of the discontinued operations as discussed in Note 5.
Segment EBITDA is defined as income before interest expense (net of interest income), income taxes, depreciation and amortization, minority interests, equity method income or loss, stock compensation, debt extinguishment costs, merger expenses, gain or loss on sale of assets, monitoring fees, impairment loss and discontinued operations. Management uses Segment EBITDA to measure performance for Vanguard’s segments and to develop strategic objectives and operating plans for those segments. Segment EBITDA eliminates the uneven effect of non-cash depreciation of tangible assets and amortization of intangible assets, much of which results from acquisitions accounted for under the purchase method of accounting. Segment EBITDA also eliminates the effects of changes in interest rates which management believes relate to general trends in global capital markets, but are not necessarily indicative of the operating performance of Vanguard’s segments. Management believes that Segment EBITDA provides useful information about the financial performance of Vanguard’s segments to investors, lenders, financial analysts and rating agencies. Additionally, management believes that investors and lenders view Segment EBITDA as an important factor in making investment decisions and assessing the value of Vanguard. Segment EBITDA is not a substitute for net income, operating cash flows or other cash flow statement data determined in accordance with accounting principles generally accepted in the United States. Segment EBITDA, as presented, may not be comparable to similarly titled measures of other companies.
The following table presents summarized unaudited quarterly results of operations for the fiscal years ended June 30, 2006 and 2007. Management believes 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 Vanguard’s consolidated financial statements for the fiscal years ended June 30, 2006 and 2007. 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 (in millions).
Total revenues disclosed above differ from the amounts disclosed in our previously filed fiscal 2007 Quarterly Reports on Form 10-Q due to the reclassification of PMH total revenues to discontinued operations as presented below (in millions).