Item 1. BUSINESS
Company Overview
We began operations in 1993 and have grown our business through developing and acquiring hospitals to become a leading operator of long-term acute care (“LTAC”) hospitals in the United States. As of December 31, 2011, we operated 27 hospitals located in ten states, consisting of eight “hospital within a hospital” facilities (20% of beds) and 19 freestanding facilities (80% of beds). Through these 27 hospitals, we operate 1,390 licensed LTAC beds and 40 transitional care beds, and employ approximately 4,500 people, the majority of whom are registered or licensed nurses and respiratory therapists. Additionally, we hold a 50% investment in a joint venture for a 51-bed LTAC hospital located in Muskegon, Michigan.
We believe we have developed a reputation for excellence in providing treatment for patients with complex medical needs requiring extended treatment. Our patients have serious medical conditions such as respiratory failure, chronic pulmonary disease, nervous system disorders, infectious diseases and severe wounds. They generally require a high level of monitoring and specialized care, yet may not require the continued services of an intensive care unit. Due to their serious medical conditions, our patients are generally not clinically appropriate for admission to a skilled nursing facility or inpatient rehabilitation facility. By combining general acute care services with a focus on long-term treatment, we believe that our hospitals provide medically complex patients with better and more cost-effective outcomes.
On August 11, 2005, we consummated an acquisition pursuant to which Rainier Acquisition Corp., a Delaware corporation formed by investment funds associated with The Carlyle Group, merged with and into our company, with our company continuing as the surviving corporation. The funds necessary to consummate the acquisition were approximately $552.0 million, including approximately $512.2 million to pay the then current stockholders and option holders, approximately $10.7 million to repay existing indebtedness and approximately $29.1 million to pay related fees and expenses. The effective date of the merger was August 11, 2005. We refer to this acquisition and related financings as the “Transactions.”
In connection with the Transactions, we borrowed $255.0 million under a senior credit facility and issued $150.0 million principal amount of outstanding senior subordinated notes. We also entered into a revolving credit facility that provided up to $75.0 million (amended to $60.0 million in 2007) of borrowing capacity. As discussed further in the “Liquidity and Capital Resources” section contained herein, the $255.0 million senior secured credit facility and the $60.0 million revolving credit facility were refinanced with a new $257.5 million senior secured credit facility and a $30.0 million revolving credit facility on February 1, 2011. On May 17, 2011, we entered into an amendment to our senior credit facility, as discussed below.
On August 1, 2011, we purchased five long-term acute care hospitals (the “Facilities”), which operate at seven locations, from HealthSouth Corporation and certain affiliates of HealthSouth Corporation (collectively, the “Sellers”), pursuant to an Asset Purchase Agreement (the “Purchase Agreement”). According to the Purchase Agreement, we acquired substantially all of the non-real estate assets (excluding accounts receivable and certain other components of working capital) in exchange for a cash purchase price of approximately $42.5 million less the value of working capital associated with the Facilities. We financed the acquisition with a combination of an incremental term loan from our existing senior secured credit facility and cash on hand. In connection with this acquisition, we paid a $750,000 transaction fee to Heath Care REIT, Inc. and our indirect parent granted a warrant to Health Care REIT, Inc. to purchase 6.25% of such parent’s common stock. In addition, Health Care REIT, Inc. purchased the real estate assets associated with four of these Facilities from the Sellers for $75.0 million. We simultaneously entered into a lease with Health Care REIT, Inc. for these properties.
On May 17, 2011, we entered into an amendment, (the “Incremental Amendment”), to our current credit agreement (the “Credit Agreement”), with JPMorgan Chase Bank, N.A., the lenders party thereto, and the other agents named therein. The Incremental Amendment provided for an additional $47.2 million in new senior secured term loans. Proceeds were restricted to (i) payment of consideration for the acquisition of the Facilities, (ii) payment of fees and expenses in connection with the acquisition of the Facilities and (iii) working capital purposes of the Company and its subsidiaries. The new senior secured term loans have the same terms as the outstanding senior secured term loans, including with respect to interest rate, amortization, maturity date and optional and mandatory prepayments. On August 1, 2011, in connection with the completion of the acquisition and the funding of the additional term loan proceeds, we paid a consent fee of $1.4 million to the lenders under the Credit Agreement for consenting to the Incremental Amendment.
On December 1, 2011, we purchased selected assets of the long-term acute care hospital operation of Vibra Specialty Hospital (“Vibra”) located in Dallas, Texas. We relocated 60 beds from our existing Dallas location into the Vibra Dallas facility and ceased operations at our exiting Dallas facility. We acquired the assets in exchange for a purchase price of approximately $10.9 million, less adjustments for certain equipment items and liabilities assumed. We paid $5.6 million at closing and the remaining $5.0 million will be paid in six equal quarterly installments beginning on March 1, 2012. The note is noninterest bearing; therefore we have discounted the note using a rate based on our estimated incremental borrowing rate for a similarly structured debt.
Liquidity and Uncertainties Related to Going Concern
As of December 31, 2011, we had $437.0 million of long-term debt outstanding consisting of our $30.0 million senior secured revolving credit facility, which matures on February 1, 2015, of which there is no outstanding balance, our senior secured term loan credit facility in an outstanding principal amount of $313.2 million, which matures on February 1, 2016, our senior subordinated notes in an outstanding principal amount of $119.3 million, which mature on August 11, 2013, and our note payable to Vibra in an outstanding principal amount of $4.5 million, which matures on June 1, 2013. Although we are highly leveraged, we believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under our senior secured revolving credit facility will be sufficient to finance our operations and meet our scheduled debt service requirements for at least the next twelve months, absent certain actions of lenders in the case of an event of default under our senior secured credit facility as discussed below.
We are required to comply on a quarterly basis with certain financial and other covenants under our senior secured credit facility, including a minimum consolidated cash interest expense coverage ratio test and a maximum senior secured leverage ratio test which are tested quarterly. We are required to meet a leverage ratio of 6.00x at December 31, 2011, which reduces to 5.75x at June 30, 2012. Our leverage ratio at December 31, 2011 is 5.49x. We are required to meet an interest coverage ratio of 1.25x at December 31, 2011 and throughout 2012, which increases to 1.30x on March 31, 2013. Our interest coverage ratio is 1.65x at December 31, 2011. We are currently in compliance with the covenants under our senior secured credit facility for the quarterly period ended December 31, 2011. We expect to maintain compliance under the covenants of our senior secured credit facility for the next twelve months. See more discussion in the “Liquidity and Capital Resources” section contained herein.
We may not be able to continue to satisfy the covenant requirements in subsequent periods. In the event we are unable to comply with the covenants under our senior secured credit facility, an event of default may occur. If we are unable to obtain waivers or amendments to cure such event of default, the lenders would be entitled to take various actions, including the acceleration of amounts due under our senior secured credit facility, terminating our access to our revolving credit facility and all actions permitted to be taken by a secured creditor. Acceleration under our senior secured credit facility would further create a cross-default under our senior subordinated notes indenture. Such acceleration would have a material adverse effect on our financial position, results of operations and cash flow.
We are continuing to pursue operational and strategic objectives that may result in profitability and lower total indebtedness in order to remain in compliance with the financial covenants under our senior secured credit facility. These objectives include, among other items, increasing the occupancy levels of our hospitals, reducing administrative and operating expenses, and reducing days of net patient service revenue in accounts receivable. We also continue to seek opportunities to refinance our senior subordinated notes and explore various strategic transactions, such as an acquisition, as a means to reduce our leverage and strengthen our operating and financial conditions.
There can be no assurance, however, that we will be able to refinance our senior subordinated notes on commercially reasonable terms or at all, achieve profitability or be able to successfully execute strategic transactions. In that case, we may be required to consider all of our alternatives in restructuring our business and our capital structure.
Industry Overview
A LTAC hospital serves patients with serious and complicated illnesses or injuries requiring extended hospitalization. LTAC hospitals are specifically designed to accommodate such patients and provide them with a higher level of care than a skilled nursing facility or an inpatient rehabilitation facility, each of which is often incapable of treating the same conditions and delivering the same outcome as a LTAC hospital. Patients are typically referred to a LTAC hospital from a general acute care hospital.
To qualify as a LTAC hospital under Medicare, the Centers for Medicare & Medicaid Services (“CMS”) requires that a hospital meet certain criteria, including:
1. primarily providing inpatient services to Medicare beneficiaries with medically complex conditions that require a long hospital stay;
2. monitoring each individual patient’s criteria for appropriateness of admission (to be completed within 48 hours of an admission) and continuation of care;
3. having daily, active physician involvement with patient care;
4. having an interdisciplinary team of healthcare professionals prepare and carry out individualized treatment plans for each patient; and,
5. maintaining an inpatient average length of stay greater than 25 days for Medicare patients, measured annually over a cost report period.
CMS estimates that there are approximately 426 LTAC hospitals in the United States and that Medicare reimbursement to LTAC hospitals will be approximately $5.3 billion in the year beginning October 1, 2011. There are two general business models for operating LTAC hospitals-“hospital within a hospital” (“HIH”) facilities and freestanding facilities. The HIH model refers to facilities that lease space from a general acute care, or host, hospital but are independently licensed and operated, while freestanding LTAC facilities are not located in or on the campus of a general acute care hospital. In general, HIH facilities are much less expensive to develop than freestanding facilities, but they are typically smaller and subject to increased regulatory scrutiny by CMS to ensure their independence from their host hospitals.
Recent Regulatory Developments
Proposed Legislation
Legislation entitled the “Long-Term Care Hospital Improvement Act of 2011” was introduced into the United States Senate on August 2, 2011, and was subsequently referred to the Committee on Finance. This legislation, if signed into law, would implement certain patient and facility level criteria for LTAC hospitals, including core services that a LTAC hospital must offer, a standardized preadmission screening process, criteria specifically set forth for admission and continued stay in a LTAC hospital, and would require a LTAC hospital to meet additional classification criteria to continue to be paid under LTAC hospital payment methodologies. The legislation also sets forth four criteria for which 70% of the LTAC hospital’s Medicare fee-for-service discharges would be required to comply with at least one of the four. These four criteria include: (a) a length of stay of 25 days or greater, (b) a LTAC stay that includes ventilator services, (c) a LTAC hospital stay with three or more complications or comorbidities, or (d) a high cost outlier in the prior general acute hospital stay. These criteria would be phased in over a three year period. In addition to the facility and patient level criteria, the proposed legislation would repeal and prohibit CMS from the application of the enacted 25 Percent Rule regulations. These regulations provide for reduced reimbursement for Medicare patients discharged from LTAC hospitals who were admitted from a co-located hospital or a non-co-located hospital above certain thresholds. This legislation would also prohibit CMS from implementing a budget neutrality adjustment and a so-called very short stay outlier policy, both as proposed by CMS previously. It is not certain whether or not this legislation will be subsequently enacted into law or, if enacted, would be similar to the currently drafted legislation.
Middle Class Tax Relief and Job Creation Act of 2012
On February 22, 2012, the Middle Class Tax Relief and Job Creation Act of 2012 was enacted. As a result, Medicare’s reimbursement of bad debts will be reduced from 70% to 65% for cost reporting periods on or after October 1, 2012.
2011 Final Rule
On August 1, 2011, CMS published their annual payment update for LTAC hospitals for the 2012 rate year, which became effective for all discharges on or after October 1, 2011 (the “2011 Final Rule”). The 2011 Final Rule included a net increase in the standard federal rate of $623 to $40,222, or 1.6%, which was based on a market basket update of 2.9% less a 0.22% area wage level budget neutrality factor and the two adjustments required by the Patient Protection and Affordable Care Act (“PPACA”): the multifactor productivity adjustment of 1.0% and statutory payment rate reduction of 0.1%. The 2011 Final Rule also included a decrease in the high-cost outlier fixed-loss amount to $17,931 from $18,785. Additionally, the 2011 Final Rule included updates to the weighting of Medicare-Severity Diagnosis Related Groups (“MS-LTC-DRG”). CMS estimated that the changes outlined above for the 2012 rate year, taken as a whole, would result in an increase of 2.5% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of the 2011 Final Rule depending upon their Medicare patient population and their specific base rate changes due to geographical location. The 2011 Final Rule also established a new quality reporting program for LTAC hospitals in accordance with provisions of the Affordable Care Act and clarified CMS’ position that Medicare Advantage days, along with traditional Medicare fee-for-service program days, were to be included in the determination of whether a LTAC hospital meets the greater than 25 day average length of stay requirement. Furthermore, the 2011 Final Rule extended the application of the LTAC bed moratorium to LTAC hospitals developed under exceptions to the LTAC facility moratorium and proposed a rebasing of the market basket used by LTCH hospitals.
Our Competitive Strengths
We believe the following strengths serve as a foundation for our strategy:
Leading market position supported by strong clinical reputation. We were founded in 1993 by a clinician who recognized an opportunity to provide patients requiring acute care with better sustained treatment than they were receiving in general acute care hospitals. As a result, from the outset we have had a strict commitment to providing quality medical care to patients with complex medical conditions. With this strong clinical focus, we have grown to become a leading operator of LTAC hospitals in the United States. We believe this approach and our strong market position help us to attract patients, quality doctors and staff, aid us in our marketing efforts to payors and referral sources and facilitate our efforts in negotiating favorable payor contracts.
Expertise in treating patients with the highest acuity levels. We believe we have developed an expertise and a reputation for excellence in providing treatment for patients with the most severe and complex acute care needs. Generally, the treatment of patients with more complex diagnoses also generates higher reimbursement rates and higher margins for the treatment provider. Additionally, we believe that these strengths better position us to take advantage of the potential changes in regulations that are presently contemplated by CMS.
Equity investment by experienced private equity firm. We are controlled by investment funds associated with The Carlyle Group, which have invested approximately $176.7 million of equity into our company. The Carlyle Group is a leading, global private equity firm with approximately $147.0 billion under management and with extensive experience investing in a collection of portfolio companies across various sectors of the healthcare industry including services, payors, medical devices and products and pharmaceuticals. The Carlyle Healthcare Group includes 20 investment professionals worldwide with experience investing in highly regulated healthcare businesses at stages of development from early-stage venture investments to leveraged acquisitions.
Our Strategy
The primary components of our business strategy include the following:
Continued focus on the treatment of higher acuity patients. We are continuing to execute our strategy of focusing on admissions of higher acuity patients, especially ventilator dependent patients and patients who require significant wound care treatment protocols. This strategy has included identifying opportunities to increase in certain of our hospitals the capacity to treat these higher acuity patients through the addition of intensive care or high observation rooms, special procedure rooms, and certain diagnostic equipment.
Growth through selective acquisitions. We may selectively develop or acquire other specialized hospitals where we see opportunities for attractive returns on our investments, subject to our ability to do so in our current regulatory environment
and our ability to finance development and acquisitions. We plan to adhere to selective criteria in our acquisition analysis and seek to acquire facilities for attractive valuations. We plan to increase margins at acquired facilities by adding clinical programs that attract commercial payors, centralizing administrative functions and implementing our standardized staffing models and resource management programs.
Provide high quality care and service. We believe that our focus on quality care and service has established brand loyalty, which allows us to maintain and strengthen our relationships with physicians and payors. To effectively address the high acuity of our patients’ medical conditions, we have developed three primary areas of focus and expertise: ventilator management and weaning, wound management and multi-system diagnosis management. We have implemented specific staffing models that are designed to provide patients access to the necessary level of clinical attention. The quality of the patient care we provide is continually monitored using several measures, including patient, payor and physician satisfaction, as well as clinical outcomes.
Increase higher-margin commercial volume. We typically receive higher reimbursement rates from commercial payors than we do from the federal Medicare program. As a result, we work to expand relationships with payors to increase the volume of patients covered by commercial insurers. We believe that commercial payors seek to contract with our hospitals because we offer patients high quality and cost-effective care.
Enhancement of operating efficiency and effectiveness. We are continually seeking to improve the cost effectiveness of our hospital and corporate operating environment while assuring we maintain the highest quality of patient care and establish an infrastructure that will be capable of executing our strategic plans. The initiatives we focus on are:
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The standardization of our various facility and corporate processes.
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Enhancement of our information technology applications.
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Standardization of our facility staffing to assure we can adjust staffing levels based upon changes in patient acuity and our patient census levels.
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Development of formal hiring and training programs to assure we attract and retain a highly qualified workforce.
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Continuing to identify opportunities to consolidate certain administrative functions. We currently have centralized functions such as financial reporting, payroll, legal, reimbursement, compliance and human resources.
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Entering into corporate wide contracts to purchase hospital supplies pursuant to group purchasing contracts.
Attracting and retaining quality physicians to practice in our hospitals. Our ability to maintain a high quality clinical setting is in part dependent on the recruitment and retention of physicians with excellent credentials. The confidence our referral sources have in our ability to deliver quality patient care is often dependent on the quality of the medical staff that practices in our hospitals. We attempt to identify physicians who have excellent credentials and are respected within the medical community in each of our existing markets. This core group of physicians then assists our hospital staff in recruiting other physicians.
Maintaining strong relationships with referral sources. Our patients are transferred from other healthcare settings once they are medically stable and have been determined to be appropriate for receiving clinical care in a LTAC hospital setting. We receive most of our patient referrals from discharge planners at other healthcare facilities, physicians and managed care organization case managers. As a result, we have clinical liaisons and case managers who focus on maintaining strong relationships with these various referral sources. Specifically our liaisons and case managers utilize face-to-face interaction and case studies to educate these referral sources on the clinical benefits of our programs as well as to encourage early interventions and the transfer of medically complex patients to our hospitals. We also utilize our corporate managed care resources to interact with managed care professionals on the clinical and cost effective benefits of our treatment protocols.
Hospital Operations
Our hospitals provide long-term acute care services to patients with serious and often complex medical conditions. Our hospitals have the capability to treat patients who suffer from conditions such as respiratory failure, chronic pulmonary disease, nervous system disorders, infectious diseases and non-healing wounds. These conditions require a high level of monitoring and specialized care yet may not necessitate the continued services of an intensive care unit. Due to their serious medical conditions, these patients are not clinically appropriate for admission to a skilled nursing facility or inpatient rehabilitation facility.
Referral Process
Our patients are admitted to our facilities primarily from general acute care hospitals. Patients are typically referred to us by physicians, payor case managers and hospital discharge planners. Our facility administrators and marketing staff execute marketing and strategic plans directed at these referral sources. At each of our facilities, these efforts are under the direction of the facility administrator with significant support from our regional and corporate staff. Our hospital marketing staff works with specific doctors, hospital discharge planners and payor case managers to educate these referral sources on the clinical benefits of our programs and to encourage appropriate early intervention and transfer of medically complex patients.
Hospital Patient Admission
When a patient is referred to one of our facilities, a clinical evaluation is performed to determine the care required and whether the patient meets our medical necessity criteria. Based on the determinations reached in this clinical evaluation, an admission decision is made by the attending physician.
Upon admission, a transdisciplinary team reviews a new patient’s condition. The transdisciplinary team is comprised of a number of clinicians and may include any or all of the following: an attending physician; a specialty nurse; a respiratory therapist; a dietician; a pharmacist; and a case manager. Upon completion of an initial evaluation by each member of the treatment team, an individualized treatment plan is established and implemented. A case manager, the vast majority of whom are registered nurses, coordinates all aspects of the patient’s hospital stay and serves as a liaison with the patient’s insurance carrier’s staff when appropriate. The case manager communicates progress, resource utilization and treatment goals between the patient, the treatment team and the payor. The transdisciplinary team works with the attending physician throughout the patient’s hospital stay to make any necessary modification to the patient’s care plan during the stay, with the goal of achieving the optimal clinical outcome.
Quality Assessment and Improvement
We maintain an outcomes program that includes a pre-admission evaluation program and concurrent review of all of our patient population against utilization and quality screenings, as well as quality of outcomes data collection and patient and family satisfaction surveys. In addition, each of our hospitals has an integrated quality assessment and improvement program administered by a quality review manager that encompasses quality improvement, infection control and risk management. Our objective in these programs is to ensure that patients are appropriately admitted to our hospitals and that we render to our patients quality healthcare in a cost-effective manner.
We have an on-going program whereby our hospitals are reviewed annually by internal quality auditors for compliance with standards of The Joint Commission, a non-profit organization that evaluates and accredits healthcare organizations in the United States. The purposes of this internal review process are to (i) ensure ongoing compliance with industry recognized standards for our hospitals, (ii) assist management in analyzing each hospital’s operations and (iii) provide consulting and educational opportunities for each hospital to identify opportunities to improve patient care.
Facilities
As of December 31, 2011, we had eight HIH facilities and 19 freestanding facilities. We own two freestanding LTAC hospitals and lease the remaining LTAC hospitals. We generally seek ten to 15-year leases for our LTAC hospitals, with one or more five-year renewal options.
The following table lists our hospital facilities as of December 31, 2011:
(1) Included in this location is the transitional care unit that includes 40 of the 72 licensed beds for the facility.
We lease our non-hospital facilities, including our corporate headquarters, which is located in Plano, Texas, and several other spaces related to administrative and operational support functions. We believe that our existing facilities are suitable to conduct our operations.
Employees
As of December 31, 2011, we employed approximately 4,500 people throughout the United States in the locations noted above.
Professional Staff
Each of our hospitals is staffed with a transdisciplinary team of healthcare professionals. A professional nursing staff trained to care for long-term acute patients is on duty 24 hours each day in our hospitals. Other professional staff include respiratory therapists, physical therapists, occupational therapists, speech therapists, pharmacists and case managers.
Each of our hospitals has a fully credentialed, multi-specialty medical staff to meet the needs of the patients, and provides for 24 hour physician coverage for patients through direct on-site physicians or through on-call contractual arrangements with individual physicians or physician groups. Each patient is visited at least once a day by a physician. Our credentialed physicians typically practice in specialties such as critical care, internal medicine, pulmonary medicine, cardiology, hematology, nephrology, infectious diseases, oncology, endocrinology, psychiatry, surgery and wound care.
The physicians at our hospitals generally are not our employees and may also be members of the medical staff at other hospitals. Generally, we do not enter into exclusive contracts with these physicians to provide services for our patients. We enter into administrative agreements with physicians to provide administrative support and clinical oversight of our clinical programs.
Centralized Management and Operational Oversight
A hospital administrator supervises and is responsible for the day-to-day operations at each of our hospitals. In addition, our hospitals employ a director of nursing to oversee the clinical operations of the hospital and a quality assurance manager to direct an integrated quality assurance program. Our corporate support center provides services in the areas of
system design and development, training, human resource management, payroll, reimbursement expertise, legal advice, accounting support, centralized billing, insurance/risk management services, managed care expertise, purchasing and facilities management. Financial control is maintained through fiscal and accounting policies that are established at the corporate level for use at each of our hospitals. We have standardized operating procedures, and we monitor our hospitals to assure consistency of operations.
We also employ a series of checks and balances designed to ensure that management and operational decisions at our facilities are made while considering our patients’ best interests. We have developed a system to monitor operating metrics, such as nursing hours per patient day and non-clinical staff metrics, at each of our facilities. This monitoring includes a review of clinical staffing levels and measures time devoted to our patients against goals set by management. Our aim is to ensure that we are providing the right staffing and other resources to match our patients’ acuity levels.
Payor Relationship Management
It is important to our business to be able to establish relationships with commercial healthcare payors and to maintain our reputation with those payors as a provider of acute care. Our staff includes persons with expertise in the field of payor contracting and rate modeling. These professionals negotiate contracts with purchasers of group healthcare services, including private employers, managed care companies, preferred provider organizations and health maintenance organizations. Some payor organizations attempt to obtain discounts from established hospital charges. We focus on demonstrating to these payors how our services can provide them and their customers with the most viable pricing arrangements in circumstances where they may otherwise be faced with funding treatment at expensive rates at other types of facilities. The importance of obtaining contracts with preferred provider organizations, health maintenance organizations and other organizations varies among markets, depending on such factors as the number of commercial payors and their relative market strength.
Competition
We compete on the basis of the quality of services we provide, pricing, location and the clinical outcomes we achieve. The primary competitive factors in the LTAC hospital industry include location, quality of services, charges for services and responsiveness to the needs of patients, families, payors and physicians. Other companies operate LTAC hospitals that compete with our hospitals, including large operators of similar facilities, such as Kindred Healthcare, Inc. and Select Medical Corporation. Some of these operations have greater financial resources and longer operating histories than we do. In addition, in each of our markets there are general acute care hospitals that provide services similar to those we provide.
Government Regulations
General
The healthcare industry is required to comply with many laws and regulations at the federal, state and local levels. These laws and regulations require that hospitals meet various requirements, including those relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse. These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or judicial interpretation. If we fail to comply with applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate and our ability to participate in the Medicare, Medicaid and other federal and state healthcare programs.
As a result of our hospital’s state licensures and certifications under the Medicare and various Medicaid programs, we are subject to regular reviews, surveys, audits and investigations conducted by, or on the behalf of, the federal and state agencies, including CMS, that are responsible for the oversight of these programs. These agency’s reviews may include reviews or surveys of our compliance with required conditions of participation regulations. The purpose of these surveys is to ensure that healthcare providers are in compliance with governmental requirements, including requirements such as adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse. These surveys may identify deficiencies with conditions of participation which require corrective actions to be made by the hospital within a given timeline. If a hospital is not successful in addressing the deficiencies and conditions in a timely manner, then CMS reserves the right to deem the hospital to be out of compliance with Medicare conditions of participation and may terminate the hospital from participation in the Medicare program. Termination of a hospital from the Medicare program would have a material adverse effect on our results of operations and cash flows.
Additionally, these agencies may review our compliance with various payment regulations, including enhanced medical necessity reviews of LTAC hospital cases pursuant to the Medicare, Medicaid and SCHIP Extension Act of 2007 (the “SCHIP Extension Act”), and conduct audits under CMS’s Recovery Audit Contractor (“RAC”) program. The RAC
program has been made permanent and was expanded broadly to cover healthcare providers pursuant to the Tax Relief and Health Care Act of 2006. The results of the enhanced medical necessity reviews and the RAC program audits could have an adverse effect on our business, financial position, result of operations and liquidity. To the extent these reviews result in an adverse finding, we may contest the adverse finding vigorously; however, these matters can result in significant legal expense and consume our resources.
Licensure
Facility Licensure. Our healthcare facilities are subject to state and local licensing regulations ranging from the adequacy of medical care to compliance with building codes and environmental protection laws. In order to assure continued compliance with these various regulations, governmental and other authorities periodically inspect our facilities.
Some states still require us to get approval under certificate of need regulations when we create, acquire or expand our facilities or services. If we fail to show public need and obtain approval in these states for our facilities, we may be subject to civil or even criminal penalties, lose our facility license or become ineligible for reimbursement if we proceed with our development or acquisition of the new facility or service.
Professional Licensure and Corporate Practice. Healthcare professionals at our hospitals are required to be individually licensed or certified under applicable state law. We take steps to ensure that our employees and agents possess all necessary licenses and certifications.
Certification. In order to participate in the Medicare program and receive Medicare reimbursement, each facility must comply with the applicable regulations of the United States Department of Health and Human Services relating to, among other things, the type of facility, its equipment, its personnel and its standards of medical care, as well as compliance with all applicable state and local laws and regulations. All of our hospitals participate in the Medicare program.
Accreditation. Our hospitals receive accreditation from The Joint Commission, a nationwide commission which establishes standards relating to the physical plant, administration, quality of patient care and operation of medical staffs of hospitals. The Joint Commission has accredited all of our hospitals.
Overview of U.S. and State Government Reimbursements
Medicare. The Medicare program reimburses healthcare providers for services furnished to Medicare beneficiaries, who are persons generally age 65 and older, those who are chronically disabled, and those suffering from end stage renal disease. The program is governed by the Social Security Act and is administered primarily by the Department of Health and Human Services through its CMS. The Medicare program reimburses various types of providers, including LTAC hospitals, using different payment methodologies. We received from Medicare approximately 60.5% of our net patient service revenue in 2011.
The Medicare payment system for LTAC hospitals is currently based upon a Prospective Payment System (“PPS”) specifically designed for LTAC hospitals. LTAC hospital PPS is based upon discharged-based MS-LTC-DRGs. The basic form of payment under the LTAC hospital PPS provides for three potential payment amounts: (a) a short stay outlier payment, which applies to patients whose length of stay is less than 5/6 th of the geometric mean length of stay for that MS-LTC-DRG; (b) a full DRG payment which applies to patients whose length of stay is greater than 5/6th of the geometric mean length of stay and whose cost has not exceeded the amount of MS-LTC-DRG reimbursement plus a fixed cost outlier threshold established each year by CMS; and (c) a high cost outlier payment that will provide a partial coverage of costs for patients whose cost of care exceeds the MS-LTC-DRG reimbursement plus a fixed cost outlier threshold per discharge. For patients in the high cost outlier category, Medicare will reimburse 80% of the costs incurred above the sum of the MS-LTC-DRG payment amount plus a fixed cost outlier threshold per discharge.
Reimbursement for patients whose length of stay is less than 5/6th of the geometric mean length of stay is the lesser of (1) a per diem based upon the average payment for that MS-LTC-DRG, (2) the estimated costs of the patient’s stay, (3) the full MS-LTC-DRG payment, or (4) a blend of an amount comparable to what would otherwise be paid under the short-term acute care in-patient payment system (“IPPS”) computed as a per diem, capped at the full IPPS MS-DRG comparable payment amount and per diem based upon the average payment for MS-LTC-DRG under LTAC PPS.
LTAC hospital PPS provides for an adjustment for differences in geographic area wages resulting from salary and benefit variations. There are additional rules for payment for patients who are transferred from a LTAC hospital to another healthcare setting and are subsequently re-admitted to the LTAC hospital. The LTAC hospital PPS payment rates also are subject to annual adjustments.
Only providers qualified as LTAC hospitals may be paid under this system. To maintain qualification under LTAC hospital PPS, the hospital’s average length of stay of Medicare patients must be more than 25 days measured annually at the end of a cost report period, among other things.
Prior to qualifying under the payment system applicable to LTAC hospitals, a new LTAC hospital initially receives payments under the short-term acute care reimbursement system. The LTAC hospital must continue to be paid under this system for a minimum of six months while meeting certain Medicare LTAC hospital requirements, the most significant requirement being an average length of stay of more than 25 days.
LTAC Hospital Medicaid Reimbursement. The Medicaid program is designed to provide medical assistance to individuals unable to afford care. The program is governed by the Social Security Act and administered and funded jointly by each individual state government and CMS. Medicaid payments are made under a number of different systems, which include cost based reimbursement, prospective payment systems or programs that negotiate payment levels with individual hospitals. In addition, Medicaid programs are subject to statutory and regulatory changes, administrative rulings, interpretations of policy by the state agencies and certain government funding limitations, all of which may increase or decrease the level of program payments to our hospitals. Less than 2% of our net patient service revenue for the year ended December 31, 2011 was derived from Medicaid programs.
Annual Payment Updates
2011 Final Rule
On August 1, 2011, CMS published their annual payment update for LTAC hospitals for the 2012 rate year, which became effective for all discharges on or after October 1, 2011 (the “2011 Final Rule”). The 2011 Final Rule included a net increase in the standard federal rate of $623 to $40,222, or 1.6%, which was based on a market basket update of 2.9% less a 0.22% area wage level budget neutrality factor and the two adjustments required by the PPACA: the multifactor productivity adjustment of 1.0% and statutory payment rate reduction of 0.1%. The 2011 Final Rule also included a decrease in the high-cost outlier fixed-loss amount to $17,931 from $18,785. Additionally, the 2011 Final Rule included updates to the weighting of MS-LTC-DRG. CMS estimated that the changes outlined above for the 2012 rate year, taken as a whole, would result in an increase of 2.5% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of the 2011 Final Rule depending upon their Medicare patient population and their specific base rate changes due to geographical location. The 2011 Final Rule also established a new quality reporting program for LTAC hospitals in accordance with provisions of the Affordable Care Act and clarified CMS’ position that Medicare Advantage days, along with traditional Medicare fee-for-service program days, were to be included in the determination of whether a LTAC hospital meets the greater than 25 day average length of stay requirement. Furthermore, the 2011 Final Rule extended the application of the LTAC bed moratorium to LTAC hospitals developed under exceptions to the LTAC facility moratorium and proposed a rebasing of the market basket used by LTCH hospitals.
2010 Final Rule
On July 30, 2010, CMS published their annual payment update for LTAC hospitals for the 2011 rate year, which became effective for all discharges on or after October 1, 2010 (the “2010 Final Rule”). The 2010 Final Rule included a net decrease in the standard federal rate of $195, or 0.5%, to $39,600, which was based on a market basket update of 2.5% less an adjustment of 0.5% as required by the PPACA of 2010 and less an adjustment of 2.5% to account for changes in documentation and coding practices. The 2010 Final Rule also included an increase in the high-cost outlier fixed-loss amount to $18,785 from $18,615. Additionally, the 2010 Final Rule included updates to the weighting of MS-LTC-DRGs, which CMS indicated will be budget neutral for aggregate LTAC hospital payments. CMS also estimated that the changes for the 2011 rate year, taken as a whole, including changes to the area wage adjustments for the 2011 rate year, an increase in high-cost outlier payments and an increase in short-stay outlier payments, would result in an increase of 0.5% in Medicare reimbursement to LTAC hospitals.
The 2009 Final Rule
On July 31, 2009, CMS issued its final annual payment update for LTAC hospitals for the 2010 rate year, which became effective for all discharges on or after October 1, 2009 (the “2009 Final Rule”). The 2009 Final Rule included a net increase in the standard federal rate of $783 to $39,897, or 2.0%, which was based on a market basket update of 2.5% less an adjustment of 0.5% to account for changes in documentation and coding practices. The 2009 Final Rule also included a decrease in the high-cost outlier fixed-loss amount to $18,425 from $22,960. Additionally, the 2009 Final Rule included updates to the weighting of MS-LTC-DRGs, which CMS indicated will be budget neutral for aggregate LTAC hospital payments. CMS estimated that the changes for the 2010 rate year, taken as a whole, would result in an increase of 3.3% in Medicare reimbursement to LTAC hospitals.
The 2009 Final Rule also finalized the interim final rule issued on June 3, 2009 as described below, as well as the June 3, 2009 supplement to the proposed rule previously published by CMS on May 1, 2009. This rule updated the rate year 2010 LTAC- PPS payments by revising the table of MS-LTC-DRG relative weights for the rate year 2010, which was based on the amended fiscal year 2009 weights. These changes have been taken into account in CMS’s impact calculations outlined above.
2009 Interim Final Rule
On June 3, 2009, CMS published an interim final rule whereby CMS adopted a new table of MS-LTC-DRGs relative weights for all discharges from LTAC hospitals on or after June 3, 2009 through the remainder of fiscal year 2009, which ended on September 30, 2009 (the “2009 Interim Final Rule”). CMS indicated in the interim final rule that it misapplied its established methodology in the calculation of the budget neutrality factor in determining the relative weights for the 2009 fiscal year. Accordingly, CMS revised the MS-LTC-DRG relative weights with this interim final rule to correct the misapplication. The initial budget neutrality factor used by CMS was 1.04186, which CMS states was calculated using unadjusted recalibrated relative weights rather than using the normalized relative weights. The revised calculation resulted in a budget neutrality factor of 1.0030401. The application of this revised budget neutrality factor resulted in a reduction in the relative weights of approximately 3.9% for the 2009 fiscal year (beginning October 1, 2008). There are certain regulatory restrictions that prevent a retroactive correction of this calculation adjustment; therefore, CMS only applied the corrected weights to LTAC hospital discharges occurring on or after June 3, 2009 through September 30, 2009.
Other Regulatory Changes
Budget Control Act of 2011
On August 2, 2011, Congress created the Joint Select Committee on Deficit Reduction. The purpose of this committee was to propose legislation to reduce the United States federal deficit by $1.5 trillion for fiscal years 2012 to 2021. However, the committee was not successful in creating legislation to obtain the $1.5 trillion in deficit reduction, and as a result, $1.2 trillion in domestic and defense spending reduction is scheduled to automatically begin February 1, 2013. Medicare provider payments are subject to the automatic spending reductions, subject to a 2% cap, which we believe will result in a 2% reduction to our claims submitted to Medicare after February 1, 2013. This could have a material impact on our business, financial position, results of operations or liquidity.
2010 Healthcare Reform Law
On March 23, 2010, the President signed into law the PPACA. This act made dramatic changes to the Medicare and Medicaid programs by adopting numerous initiatives intended to improve the quality of healthcare, promote patient safety, reduce the cost of healthcare, increase transparency and reduce fraud and abuse of federal healthcare programs. Additionally, on March 30, 2010, the President signed the Health Care and Education Affordability Reconciliation Act of 2010, which made certain amendments to the law signed by the President on March 23, 2010.
The PPACA, together with the Health Care and Education Affordability Reconciliation Act of 2010, also made changes to the Medicare program relevant to the LTAC industry, including the following key provisions, among other things:
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a two-year extension of the LTAC provisions originally included in the Medicare, Medicaid and SCHIP Extension Act of 2007, which is discussed below,
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the implementation of quality reporting requirements for LTAC hospitals beginning in rate year 2014,
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reductions in the annual market basket rate increases of 0.25% for rate year 2010, and ranging from 0.1% to 0.75% for rate years beginning 2011 through 2019,
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additional reductions in the annual market basket rate increases as the result of productivity adjustments beginning in 2012, which are expected to approximate 1% annually, and
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the development of a new hospital wage index system to replace the current system of calculating the hospital wage index based on cost report data.
In addition, the PPACA created an “Independent Payment Advisory Board” to develop and submit proposals to the President and Congress designed to reduce Medicare spending, and provided for pilot programs to explore a bundled payment system for an episode of care that includes an inpatient stay in a hospital and post-acute care provided within 30 days after discharge.
LTAC Hospital Facility Admission and Moratorium Regulations
Effective for cost reporting years beginning on or after October 1, 2004, LTAC hospitals operated as HIH facilities and freestanding LTAC hospitals located within 250 yards of an acute care hospital, became subject to new regulations that reduced reimbursement for certain admissions. Subject to certain exemptions under the regulations, the facilities subject to these rules receive lower rates of reimbursement for those Medicare patients admitted from their host hospitals in excess of a specified percentage of the HIH’s total admitted patients. For new HIH facilities, the Medicare admissions threshold was established at 25%. For HIH facilities that met specified criteria and were in existence as of October 1, 2004, the Medicare admissions threshold was being phased-in over a four-year period starting with hospital cost reporting periods beginning on or after October 1, 2004. The regulations provide exceptions to the Medicare admissions threshold for (i) patients who have reached “outlier” status at the referring short-term acute care hospitals, (ii) HIH facilities located in a metropolitan statistical area (“MSA”) dominant hospital, and (iii) HIH facilities located in rural areas.
For cost reporting periods beginning or after July 1, 2007, CMS expanded the 25 Percent Rule to apply to any Medicare patients admitted from any individual hospital in excess of the specified threshold. This expanded application subjects free-standing LTAC hospitals, grandfathered HIHs and grandfathered satellites to the Medicare percentage threshold payment adjustment, as well as HIHs that admit Medicare patients from non-co-located hospitals. Grandfathered HIHs refer to certain HIHs that were in existence on or before September 30, 1995, and grandfathered satellite facilities refer to satellites of grandfathered HIHs that were in existence on or before September 30, 1999.
On December 29, 2007, the SCHIP Extension Act was signed into law and became effective for cost reporting periods beginning after December 29, 2007. This legislation provided for, among other things:
1) enhanced medical necessity reviews of LTAC hospital cases and a mandated study by the Secretary of Health and Human Services on the establishment of LTAC hospital certification criteria;
2) three-year moratoriums on the following:
a. the establishment of a LTAC hospital or satellite facility, subject to exceptions for facilities under development;
b. an increase in the number of beds at a LTAC hospital or satellite facility, subject to exceptions for states where there is only one LTAC hospital or upon request following the closure or decrease in the number of beds at a LTAC hospital within the state;
c. the application of the so-called “25 Percent Rule” to freestanding and grandfathered LTAC hospitals;
d. the very short-stay outlier payment reductions to LTAC hospitals initially implemented on May 11, 2007; and
e. the application of a one-time budget neutrality adjustment of payment rates to LTAC hospitals under the PPS;
3) a three-year period during which certain types of LTAC hospitals that are co-located within another hospital may admit up to 50% of their patients from the host hospitals and still be paid according to the LTAC hospital PPS;
4) a three-year period during which certain types of LTAC hospitals that are co-located with an urban single hospital or a hospital that generates more than 25% of the Medicare discharges in a MSA may admit up to 75% of their patients from such urban single hospital or MSA dominant hospital and still be paid according to the LTAC prospective payment system; and
5) the elimination of the July 1, 2007 market basket increase in the standard federal payment rate of 0.71%, effective for discharges occurring on or after April 1, 2008.
Additionally, the SCHIP Extension Act expanded the definition of a LTAC hospital. Historically, for a hospital to be certified as a LTAC hospital, the primary requirement was that the average length of stay for Medicare patients, measured annually at the end of a cost report period, be in excess of 25 days. The SCHIP Extension Act modified this definition to require, among other items, that the LTAC hospital have a patient review process that screens patients prior to admission for appropriateness of admission, validates within 48 hours of admission that patients meet admission criteria, regularly evaluates patients during their stay and assesses available discharge options when patients fail to continue to meet stay criteria.
We believe that the additional certification criteria has not impacted the certification status of our LTAC hospitals.
On February 17, 2009, legislation known as the American Recovery and Reinvestment Act of 2009 (“2009 Act”) was signed into law. This legislation included certain amendments to the SCHIP Extension, including the application of the moratorium granted to LTAC hospitals regarding the 25 Percent Rule as it applies to certain grandfathered LTAC satellite hospitals. Prior to the 2009 Act amendment, CMS’s interpretation of the moratorium provisions was such that grandfathered “satellites” were excluded from the moratorium; however, the 2009 Act clarified that the provisions of the moratorium are applicable to “grandfathered” LTAC satellite hospitals.
As of December 31, 2011, two of our HIH facilities were subject to admission limitations at the 25% level for both co-located and non-co-located referrals. Five of our HIH facilities were subject to admission limitations at the 25% level for non-co-located referrals. As a result of the phase-in of the admission limitations and certain grandfathering and SCHIP Extension Act provisions, all of our other HIH facilities have limitations ranging from 50% to 100%. These admission limitation rules have not had a significant effect on our 2011, 2010 or 2009 financial results. The PPACA, together with the Health Care and Education Affordability Reconciliation Act of 2010, added a two-year extension of the LTAC provisions originally included in the Medicare, Medicaid and SCHIP Extension Act.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional discussion regarding the impact of these regulatory changes on our operations.
Other Healthcare Regulations
Fraud and Abuse Enforcement. Various federal laws prohibit the submission of false or fraudulent claims, including claims to obtain payment under Medicare, Medicaid and other government healthcare programs. Penalties for violation of these laws include civil and criminal fines, imprisonment and exclusion from participation in federal and state healthcare programs. In recent years, federal and state government agencies have increased the level of enforcement resources and activities targeted at the healthcare industry. In addition, the federal False Claims Act allows an individual to bring lawsuits on behalf of the government, in what are known as qui tam or “whistleblower” actions, alleging false or fraudulent Medicare or Medicaid claims or other violations of the statute. The use of these private enforcement actions against healthcare providers has increased dramatically in the recent past, in part because the individual filing the initial complaint is entitled to share in a portion of any settlement or judgment. See “Legal and Administrative Proceedings.”
From time to time, various federal and state agencies, such as the Office of Inspector General of the Department of Health and Human Services, issue a variety of pronouncements, including fraud alerts, the Office of Inspector General’s Annual Work Plan and other reports, identifying practices that may be subject to heightened scrutiny. These pronouncements can identify issues relating to LTAC hospitals. For example, the Office of Inspector General’s 2008 Work Plan describes the government’s intention to review the appropriateness of payments for interrupted stays and short stay outlier payments. In addition, the government expressed its plan to review the application of special payment provisions for patients who were transferred to onsite providers and readmitted to LTAC hospitals as well as patients who are discharged to collocated or satellite providers. We monitor government publications applicable to us and focus a portion of our compliance efforts towards these areas targeted for enforcement.
We endeavor to conduct our operations in compliance with applicable laws, including healthcare fraud and abuse laws. If we identify any practices as being potentially contrary to applicable law, we will take appropriate action to address the matter, including, where appropriate, disclosure to the proper authorities.
Remuneration and Fraud Measures. The federal “anti-kickback” statute prohibits some business practices and relationships under Medicare, Medicaid and other federal healthcare programs. These practices include the payment, receipt, offer or solicitation of remuneration in connection with, to induce, or to arrange for, the referral of patients covered by a federal or state healthcare program. Violations of the anti-kickback law may be punished by a criminal fine of up to $25,000 or imprisonment for each violation, or both, civil monetary penalties of $50,000 and damages of up to three times the total amount of remuneration, and exclusion from participation in federal or state healthcare programs.
Sections 1877 and 1903(s) of the Social Security Act, commonly known as the “Stark Law,” prohibit referrals for designated health services by physicians under the Medicare and Medicaid programs to other healthcare providers in which the physicians have an ownership or compensation arrangement unless an exception applies. Sanctions for violating the Stark Law include civil monetary penalties of up to $15,000 per prohibited service provided, assessments equal to three times the dollar value of each such service provided and exclusion from the Medicare and Medicaid programs and other federal and state healthcare programs. The statute also provides a penalty of up to $100,000 for a circumvention scheme. In addition, many states have adopted or may adopt similar anti-kickback or anti-self-referral statutes. Some of these statutes prohibit the payment or receipt of remuneration for the referral of patients, regardless of the source of the payment for the care.
Provider-Based Status. The designation “provider-based” refers to circumstances in which a subordinate facility (e.g., a separately certified Medicare provider, a department of a provider or a satellite facility) is treated as part of a provider for Medicare payment purposes. In these cases, the services of the subordinate facility are included on the “main” provider’s cost report and overhead costs of the main provider can be allocated to the subordinate facility, to the extent that they are shared. We currently operate seven hospitals that are treated as provider-based satellites or remote locations of certain of our other facilities. These facilities are required to satisfy certain operational standards in order to retain their provider-based status.
Privacy and Security Requirements. There are currently numerous legislative and regulatory initiatives at the state and federal levels addressing the privacy and security of patient health and other identifying information. The privacy and security regulations promulgated pursuant to the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) extensively regulate the use and disclosure of individually identifiable health information and require healthcare providers to implement administrative, physical and technical safeguards to protect the security of such information. Violations of the regulations may result in civil and criminal penalties. Recently, the 2009 Act strengthened the requirements of the HIPAA privacy and security regulations and significantly increased the penalties for violations, with penalties of up to $50,000 per violation for a maximum civil penalty of $1.5 million in a calendar year for violations of the same requirement. Under the 2009 Act, the Department of Health and Human Services (“DHHS”) is required to conduct periodic compliance audits of covered entities and their business associates (entities that handle identifiable health information on behalf of covered entities). In addition, the 2009 Act authorized State Attorney Generals to bring civil actions seeking either injunctions or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents. The 2009 Act required DHHS to issue regulations requiring covered entities to report certain security breaches to individuals affected by the breach and, in some cases, to DHHS or to the public via a website posting. This reporting obligation became effective September 23, 2009 and is applied broadly to breaches involving unsecured protected health information.
Our facilities remain subject to any state laws that relate to privacy or the reporting of security breaches that are more restrictive than the regulations issued under HIPAA and the requirements of the 2009 Act. For example, various state laws and regulations may require us to notify affected individuals in the event of a data breach involving certain individually identifiable health or financial information.
Our Compliance Program
We voluntarily adopted a Code of Conduct, which serves as the basis for our company-wide compliance program. Our written Code of Conduct provides guidelines for principles and regulatory rules that are applicable to our patient care and business activities. These guidelines are implemented by our Chief Compliance Officer, who works with each facility compliance officer and our corporate HIPAA Privacy Officer. We have also established a reporting system, auditing and monitoring programs and a disciplinary system as a means for enforcing the Code of Conduct’s policies.
We focus on integrating our compliance and HIPAA-related responsibilities with operational and staff functions. We recognize that our compliance with applicable laws and regulations depends upon individual actions as well as company operations. As a result, we have adopted an operations team approach to compliance. Our corporate executives and staff, with the assistance of both corporate and outside experts, have reviewed and adopted our core compliance program through our Compliance Committee. We utilize facility compliance officers to ensure facility-level implementation of our Code of Conduct. This approach is intended to reinforce our company-wide commitment to operate in accordance with the laws and regulations that govern our business.
Our Compliance Committee is made up of members of our senior executives and staff. The Compliance Committee meets on a periodic basis and reviews the activities, reports and operation of our compliance program. In addition, any significant compliance initiatives are presented to the board of directors. Finally, our Chief Compliance Officer reports quarterly to our board of directors to review the activities, reports and operation of our compliance program.
In order to facilitate our employees’ ability to report known, suspected or potential violations of our Code of Conduct, we have developed a system of anonymous reporting. This anonymous reporting may be accomplished by communication to our toll-free, third party compliance hotline provider. In addition, compliance-related issues are presented and reviewed by our Chief Compliance Officer with the assistance of outside counsel as deemed necessary by the Chief Compliance Officer. The Chief Compliance Officer and his staff are responsible for reviewing and investigating compliance incidents in accordance with the compliance department’s Policy on Reporting of Potential Issues or Areas of Noncompliance, and presenting the findings to our Chief Executive Officer, the Compliance Committee, or an executive or administrative officer as necessary. All significant issues are reported to our board of directors.
We train and educate our employees regarding the Code of Conduct, as well as the legal and regulatory requirements relevant to the employees’ work environment. New and current employees are annually required to sign a form certifying that the employee has read, understood, and agreed to abide by the Code of Conduct.
We review our policies and procedures for our compliance program from to time to time in order to improve operations and to ensure compliance with requirements of standards, laws and regulations and to reflect the on-going compliance focus areas which have been identified by the Compliance Committee.
Katrina Related Matters
Refer to Item 3. “Legal Proceedings” for a discussion of the Katrina related matters.
Additional Information
We file our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other information with the SEC under the Exchange Act.
You may read or obtain copies of this information in person or by mail from the Public Reference Room of the SEC, 100 F Street, NE, Room 1580, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. Our filings with the SEC also are available to the public free of charge on the SEC’s website at www.sec.gov.
Our website, www.lifecare-hospitals.com, contains additional information about our company, and our Code of Conduct. Information made available on our website is not a part of this document.
In addition, you may request a copy of our SEC filings (excluding exhibits) at no cost by writing or telephoning us at the following address or telephone number:
LifeCare Holdings, Inc
Legacy Drive
Building 4 Suite 150
Plano, TX 75024
Attention: Chief Financial Officer
(469) 241-2100
Item 1A.
Item 1A. Risk Factors
Risks Factors Relating to Our Capital and Liquidity
We may not be able to maintain compliance with covenants contained in our senior secured credit facility.
We are significantly leveraged, and our senior secured credit facility requires us to comply on a quarterly basis with certain financial covenants, including an interest coverage ratio test and a maximum leverage ratio test. These financial covenant tests will become more restrictive over time. We cannot guarantee that we will be able to continue to satisfy these covenant requirements in the future. The margins by which we have adhered to the financial ratios required by our senior secured credit facility have been consistently small.
If we are unable to maintain compliance with the covenants contained in our current senior secured credit facility, an event of default could occur, unless we are able to obtain a waiver or enter into another amendment with the senior lenders to revise the covenant requirements. If we are required to obtain a waiver or execute another amendment, it is likely we will incur additional fees and expenses, and will be required to pay a higher interest margin on our outstanding indebtedness in subsequent periods. In the event of a default, the lenders under the senior secured credit facility are entitled to take various actions, including accelerating amounts due under the senior secured credit facility, terminating our access to our revolving credit facility and all other actions generally available to a secured creditor. An event of default would have a material adverse effect on our financial position, results of operations and cash flow.
We completed a refinancing of our previous senior secured credit facility with a new $257.5 million senior secured credit facility and a new $30.0 million revolving credit facility on February 1, 2011. On May 17, 2011, we entered into an amendment to the senior secured credit facility to provide for an additional $47.2 million in new senior secured term loans to finance the acquisition of LTAC hospitals from HealthSouth Corporation. This new credit facility contains a new required interest coverage ratio and a maximum leverage ratio requirement that became effective for the trailing-12 month period ended December 31, 2011.
The amount of our outstanding indebtedness, the high interest rates applicable to our indebtedness and the restrictive covenants in the agreements governing our indebtedness increase the difficulty of operating on a profitable basis and may limit our operating and financial flexibility.
We are required to make mandatory payments on our outstanding indebtedness, which requires us to dedicate a substantial portion of our cash flows from operations to payments on our indebtedness, thereby reducing the availability of our cash flows to fund working capital, capital expenditures, and other general corporate purposes and could limit our flexibility in planning for, or reacting to, changes in our business and in the industry. The amount of our indebtedness and the high interest rates applicable to our indebtedness increase the difficulty of operating on a profitable basis.
In addition, the debt instruments impose certain operating and financial restrictions on us and limit management’s discretion in operating our businesses. For example, restrictions in our senior secured credit facility require us to comply with or maintain a minimum interest coverage ratio and maximum leverage ratio and limit or prohibit our ability to, among other things:
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incur, assume or permit to exist additional indebtedness or guarantees;
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incur liens and engage in sale and leaseback transactions;
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make capital expenditures;
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make loans and investments;
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declare dividends, make payments or redeem or repurchase capital stock;
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engage in mergers, acquisitions and other business combinations;
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prepay, redeem or purchase certain indebtedness;
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amend or otherwise alter terms of our indebtedness including the notes;
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enter into agreements limiting subsidiary distributions;
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sell assets;
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transact business with affiliates; and
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alter the business that we conduct.
The condition of the financial markets, including volatility in the capital and credit markets, could have a material adverse effect on the availability and terms of our financing sources.
As a result of the turmoil during the past few years within the financial markets nationally and globally, there is no assurance that the availability of future borrowings under the revolving credit facility will not be impacted by volatility and disruptions in the financial credit markets. Availability of borrowings under a revolving credit facility is one of our primary sources of liquidity. Additionally, acquiring and developing facilities may involve significant cash expenditures and debt incurrence. We may fail to obtain financing for acquisitions at a reasonable cost, and any such financing might contain restrictive covenants that limit our operating flexibility. As a result of the February 1, 2011 refinancing of our senior credit facility and our revolving credit facility, the maturity dates on these facilities are now February 1, 2016 and February 1, 2015, respectively. However, our senior subordinated notes are scheduled to mature on August 11, 2013. In the event these notes are not paid off or refinanced by May 15, 2013, the new senior credit facility and revolving credit facility maturities will accelerate to May 15, 2013. We cannot assure that a downturn in the credit markets or other circumstances will not impact our ability to access our revolving credit facility or to refinance our indebtedness as it matures. In addition, tighter credit standards may adversely affect our ability to refinance our indebtedness at maturity. Our inability to access our revolving credit facility or refinance indebtedness would have a material adverse effect on our business, financial position, results of operations and liquidity.
We pay interest at floating rates on borrowings under our senior secured credit facility. Higher interest rates could have a material adverse effect on our business, financial position, results of operations and liquidity. In addition, current market conditions and our level of leverage make it likely that we would not be able to refinance our senior subordinated notes without incurring higher interest rates.
Our business development plan may use significant resources, may be unsuccessful and could expose us to unforeseen liabilities.
As part of our growth strategy and pursuant to our business development plan, we may on our own or through a joint venture, selectively acquire and develop, as permitted by current regulations, LTAC hospitals or other specialized hospitals. Acquiring and developing facilities may involve significant cash expenditures, debt incurrence, additional operating losses and expenses that could have a material adverse effect on our financial condition and results of operations. Acquiring and developing facilities also involves numerous risks, including:
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the difficulty and expense of integrating new facilities into our business;
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diversion of management’s time from existing operations;
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potential loss of key employees or professional relationships of acquired facilities;
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project delays and cost overruns associated with new hospital development;
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assumption of the liabilities and exposure to unforeseen liabilities of acquired companies, including liabilities for failure to comply with healthcare regulations; and
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competition for suitable acquisition candidates, which may raise the cost of acquisition.
We may fail to obtain financing for acquisitions at a reasonable cost, and any such financing might contain restrictive covenants that limit our operating flexibility. We also may be unable to operate acquired hospitals profitably or succeed in achieving improvements in their financial performance.
Our failure to comply with the provisions of any of our Master Lease Agreements could materially adversely affect our financial position, results of operations and liquidity.
We currently lease seven of our hospitals from Health Care REIT, Inc. under our Master Lease Agreements. Our failure to comply with the provisions of any of our Master Lease Agreements with Health Care REIT, Inc. would result in an “Event of Default” under such Master Lease Agreement. Upon an Event of Default, remedies available to Health Care REIT, Inc. include, without limitation, terminating such Master Lease Agreement, repossessing and reletting the leased properties and requiring us to remain liable for all obligations under such Master Lease Agreement, including the difference between the rent under such Master Lease Agreement and the rent payable as a result of reletting the leased properties, or requiring us to pay the net present value of the rent due for the balance of the term of such Master Lease Agreement. The exercise of such remedies could have a material adverse effect on our financial condition and our businesses.
Risk Factors Relating to Reimbursement and Regulation of Our Business
We conduct our business in a heavily regulated industry, and healthcare reform or changes in regulations, including the rates or methods of government reimbursements for our services, may result in reduced net revenues and profitability.
The healthcare industry is subject to extensive federal, state and local laws and regulations relating to:
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payment for services
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facility and professional licensure, including certificates of need;
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conduct of operations, including financial relationships among healthcare providers, Medicare fraud and abuse, and physician self-referral; and
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addition of facilities and services and enrollment of newly developed facilities in the Medicare program.
During 2011, 2010 and 2009, we derived 60.5%, 59.2% and 57.1%, respectively, of our net patient service revenue from the highly regulated federal Medicare program. In recent years, through legislative and regulatory actions, the federal government has made substantial changes to various payment systems under the Medicare program. Additional changes to these payment systems have been proposed or may be proposed and could be adopted, either in Congress or by CMS. Because these kinds of changes may be adopted at any time, the availability, methods and rates of Medicare reimbursements for services of the type furnished at our facilities could change at any time. Some of these changes and proposed changes could adversely affect our business strategy, operations and financial results. In addition, any increases in Medicare reimbursement rates established by CMS may not fully reflect increases in our operating costs. Other changes in regulations relating to how we conduct our operations could also result in increased expenses or reduced net revenues. See “Business-Government Regulations.”
We cannot predict the effect that healthcare reform and other changes in government programs may have on our business, financial condition, results of operations or cash flows.
On March 23, 2010, the President signed into law the “Patient Protection and Affordable Care Act,” which contained reforms to the insurance markets and made dramatic changes to the Medicare and Medicaid programs by adopting numerous
initiatives intended to improve the quality of healthcare, promote patient safety, reduce the cost of healthcare, increase transparency and reduce fraud and abuse of federal healthcare programs. Additionally, on March 30, 2010, the President signed the Health Care and Education Affordability Reconciliation Act of 2010, which made certain amendments to the law signed by the President on March 23, 2010.
Most of the provisions of this healthcare legislation did not go into effect immediately and may be delayed for several years, during which time the bill will be subject to further adjustments through future legislation or even constitutional challenges. These legislative acts, however, will make significant changes to the U.S. healthcare system by requiring most individuals to have health insurance coverage, and would mandate material changes to the delivery of healthcare services and the reimbursement paid for such services in order to generate savings in the Medicare program. A primary focus of health care reform is to ultimately reduce costs, which could include material reductions in reimbursement paid to us and other healthcare providers. Healthcare reform could increase our operating costs and have a negative impact on third party payors and insurance companies. Additionally, there are numerous other changes contained in the bill that relate to Medicare Advantage payments, bundling of acute and post-acute care, readmissions and value-based purchasing, among other items. Several states are also considering separate healthcare reform measures.
Due to the uncertainty of the resulting regulatory changes that will be needed to implement these reforms, we cannot predict the effects these reforms may have on our business; however, they may have a material adverse effect on our business, financial condition, results of operations and cash flows.
Violations of federal industry regulations may result in sanctions that reduce our net revenues and profitability or affect our eligibility for government program reimbursement.
In recent years, there have been heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry. The investigations relate to, among other things, various referral practices, cost reporting, billing practices, clinical standards physician ownership and joint ventures involving hospitals. In the future, different interpretations or enforcement of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services and capital expenditure programs, increase our operating expenses and reduce our net revenues. Likewise, additional or revised laws and regulations could require us to make operational changes and incur increased operational expenses. If we fail to comply with these extensive laws and government regulations or if we discover that we have failed to comply in the past, we could become ineligible to receive government program reimbursement, suffer civil or criminal penalties or be required to make significant changes to our operations. In addition, we could be forced to expend considerable resources responding to an investigation or other enforcement action under these laws or regulations.
Federal and state government agencies and private payors conduct periodic reviews, surveys, audits and investigations which could have adverse findings that may negatively impact our business.
As a result of our hospital’s state licensures and certifications under the Medicare and various Medicaid programs, we are subject to regular reviews, surveys, audits and investigations conducted by, or on the behalf of, the federal and state agencies, including CMS, that are responsible for the oversight of these programs. These agency’s reviews may include reviews or surveys of our compliance with required conditions of participation regulations. The purpose of these surveys is to ensure that healthcare providers are in compliance with governmental requirements, including requirements such as adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse. These surveys may identify deficiencies with conditions of participation which require corrective actions to be made by the hospital within a given timeline. If a hospital is not successful in addressing the deficiencies and conditions in a timely manner, then CMS reserves the right to deem the hospital to be out of compliance with Medicare conditions of participation and may terminate the hospital from participation in the Medicare program. Termination of a hospital from the Medicare program would have a material adverse effect on our results of operations and cash flows.
Additionally, these agencies may review our compliance with various payment regulations, including enhanced medical necessity reviews of LTAC hospital cases pursuant to the SCHIP Extension Act, and conduct audits under CMS’s RAC program. The RAC program has been made permanent and was expanded broadly to healthcare providers pursuant to the Tax Relief and Health Care Act of 2006. Many private payors also reserve the right to conduct audits of billed claims for their covered participants.
To the extent these reviews result in an adverse finding, we may contest the adverse finding vigorously; however, these matters can result in significant legal expense and consume our resources. The findings of these audits, reviews and investigations, which could include repayment of amounts we have been previously paid, fines, penalties and other sanctions, could have a material adverse effect on our financial position, results of operations and cash flow.
We may be subjected to actions brought by individuals on the government’s behalf under the False Claims Act’s “qui tam” or whistleblower provisions.
Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under a false claim case may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law, and have submitted claims to a governmental payor during the time period they allegedly violated these other statutes have thereby submitted false claims under the False Claims Act. In addition, a number of states have adopted their own false claims provisions as well as their own whistleblower provisions allowing a private party to file a civil lawsuit in state court. See “Business-Government Regulations.”
If our LTAC hospitals fail to maintain their qualification as LTAC hospitals, or if our facilities operated as HIH facilities fail to qualify as hospitals separate from their host hospitals, then our net revenues and profitability may decline.
If our facilities fail to meet or maintain the standards for qualification as LTAC hospitals, namely minimum average length of patient stay and any other requirements that might be imposed in the future, they will receive payments under the prospective payment system applicable to general acute care hospitals rather than payment under the system applicable to LTAC hospitals. Payments at rates applicable to general acute care hospitals would likely result in our LTAC hospitals receiving significantly less Medicare reimbursement than they currently receive for their patient services.
Eight of our LTAC hospitals operate as HIH facilities and as a result are subject to additional Medicare criteria that require certain indications of separateness from their host hospitals. If any of our HIH facilities fail to meet the separateness requirements, they will be reimbursed at the lower general acute care hospital rate, which would likely adversely affect our results of operations. See “Business-Government Regulations-Overview of U.S. and State Government Reimbursements.”
If one of our “satellite” facilities that shares a Medicare provider number with our applicable “main” facility fails to qualify for provider-based status, then our results of operations may be adversely affected.
Medicare regulations on provider-based status require that when two or more hospital facilities share the same provider number and are considered to be a single hospital, the “remote” or “satellite” facility must meet certain criteria with respect to the “main” facility. These criteria relate largely to demonstrating a high level of integration between the two facilities. If the criteria are not met, each facility would need to meet all Medicare requirements independently. It is advantageous for certain “satellite” facilities that may not independently be able to meet these Medicare requirements to maintain provider-based status so that they will be reimbursed at the higher rate for LTAC hospitals under Medicare. If CMS determines that facilities claiming to be provider-based and being reimbursed accordingly do not meet the integration requirements of the regulations, CMS may recover the amount of any excess reimbursements based on that claimed status. We have several situations in which multiple facilities share a Medicare provider number, and the failure of any one or more of them to meet the provider-based status regulations could adversely affect our results of operations.
Risk Factors Relating to Our Operations
Future cost containment initiatives undertaken by private third party payors or further consolidation of managed care organizations and other third party payors may limit our future net revenues and profitability.
Initiatives undertaken by major insurers and managed care companies to contain healthcare costs or further consolidation of these organizations may affect the profitability of our hospitals. Further consolidations of these companies will increase their ability to cut cost and influence how healthcare services are provided. These payors attempt to control healthcare costs by contracting with hospitals and other healthcare providers to obtain services on a discounted basis. We believe that this trend will continue and may limit reimbursements for healthcare services. If insurers or managed care companies from whom we receive substantial payments reduce the amounts they pay for services, our profit margins may decline, or we may lose patients if we choose not to renew our contracts with these insurers at lower rates.
A deterioration in the collectibility of the accounts receivables could harm our results of operations.
Collection of receivables from third party payors and patients is our primary source of cash and is critical to our operating performance. Significant changes in business office operations, payor mix, economic conditions or trends in federal and state governmental health coverage could affect our collection of accounts receivable, cash flow and results of operations.
If we fail to maintain established relationships with the physicians in our markets, our net revenues may decrease.
Our success is, in part, dependent upon the admissions and referral practices of the physicians in the markets our hospitals serve, and our ability to maintain good relations with these physicians. Physicians referring patients to our hospitals are generally not our employees and, in many of the markets that we serve, most physicians have admitting privileges at other hospitals and are free to refer their patients to other providers. If we are unable to successfully cultivate and maintain strong relationships with these physicians, our hospitals’ admissions and businesses may decrease, and our net revenues may decline.
Shortages in qualified nurses or therapists could significantly increase our operating costs.
The market for qualified nurses, therapists and other healthcare professionals is highly competitive. We, like other healthcare providers, have experienced some difficulty in attracting and retaining qualified personnel such as nurses, certified nurse’s assistants, nurse’s aides, therapists and other providers of healthcare services. The difficulty we have experienced in hiring and retaining qualified personnel has increased our average wage rates and may force us to increase our use of contract personnel.
In addition, healthcare providers are continuing to see an increase in the amount of union activity across the country. Although we cannot predict the degree to which we will be affected by future union activity, there are continuing legislative proposals that could result in increased union activity.
Various states in which we operate hospitals have established minimum staffing requirements or may establish minimum staffing requirements in the future. The implementation of these staffing requirements in some states is not contingent upon any additional appropriation of state funds in any budget act or other statute. Our ability to satisfy such staffing requirements will depend upon our ability to attract and retain qualified healthcare professionals. Failure to comply with such minimum staffing requirements may result in the imposition of fines or other sanctions. If states do not appropriate sufficient additional funds (through Medicaid program appropriations or otherwise) to pay for any additional operating costs resulting from such minimum staffing requirements, our profitability may be materially adversely affected.
We expect to continue to experience increases in our labor costs primarily due to higher wages and greater benefits required to attract and retain qualified healthcare personnel. Our ability to manage labor costs may significantly affect our future operating results.
If we fail to compete effectively with other hospitals, our net revenues and profitability may decline.
The LTAC hospital industry is highly competitive. Our hospitals face competition from general acute care hospitals and LTAC hospitals that provide services comparable to those offered by our hospitals. Many competing general acute care hospitals are larger and more established than our hospitals. Some of our competitors operate newer facilities and may offer services not provided by us or are operated by entities having greater financial and other resources than us. Certain of our competitors are operated by not-for-profit, non-taxpaying or governmental agencies that can finance capital expenditures on a tax-exempt basis and that receive funds and charitable contributions unavailable to us. Our facilities compete based on factors such as reputation for quality care; the commitment and expertise of staff and physicians; the quality and comprehensiveness of treatment programs; charges for services; and the physical appearance, location and condition of facilities. We cannot assure you that we will be able to compete effectively in our markets or that increased competition in the future will not adversely affect our financial position, results of operations and liquidity.
Our business operations could be significantly disrupted if we lose key members of our management team.
Our success depends to a significant degree upon the continued contributions of our new and incumbent senior officers and key employees, both individually and as a group. Our future performance will be substantially dependent on our ability to retain and motivate these individuals. The loss of the services of any of our senior officers or key employees, particularly our executive officers named in “Management,” could prevent us from successfully executing our business strategy and could have a material adverse effect on our results of operations.
Our operations are heavily concentrated in Texas, Pennsylvania and Louisiana, which makes us sensitive to economic, regulatory, environmental and other developments in Texas, Pennsylvania and Louisiana.
For the twelve months ended December 31, 2011, 32.3%, 19.9% and 10.4% of our revenues were generated in Texas, Pennsylvania and Louisiana, respectively. Such a concentration increases the risk that, should any adverse economic, regulatory, environmental or other developments occur within these states, our business, financial position, results of operations or cash flows could be materially adversely affected.
Our business operations could be materially affected if we incur adverse changes in individual markets in which we have significant operations.
A natural disaster, terrorism or other catastrophic event could affect us more significantly than other companies with less geographic concentration. In the past, a hurricane had a material adverse effect on the operations of hospitals we previously owned in Louisiana. Any disruptive event in any of our major markets in the future could have similar negative effects.
Significant legal actions as well as the cost and possible lack of available insurance could subject us to substantial uninsured liabilities.
In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice or related legal theories. Many of these actions involve large claims and significant defense costs. We maintain professional malpractice liability insurance and general liability insurance coverage. In order to obtain malpractice insurance at a reasonable cost, we are required to assume substantial self-insured retentions for our professional liability claims. A self-insured retention is a minimum amount of damages and expenses (including legal fees) that we must pay for each claim. We use actuarial methods to determine the value of the losses that may occur within this self-insured retention level. Because of the high retention levels, we cannot predict with certainty the actual amount of the losses we will assume and pay. To the extent that subsequent claims information varies from loss estimates, the liabilities will be adjusted to reflect current loss data. There can be no assurance that in the future malpractice insurance will be available at a reasonable price or at all or that we will not have to further increase our levels of self-insurance. In addition, plaintiffs’ attorneys are increasingly seeking significant punitive damages. Our insurance coverage does not cover punitive damages and may not cover all claims against us.
The inability or failure of management in the future to conclude that we maintain effective internal controls over financial reporting, could have a material adverse effect on our financial position, results of operations and liquidity.
Under the Sarbanes-Oxley Act of 2002, our management is required to report in our Annual Report on Form 10-K on the effectiveness of our internal controls over financial reporting. Significant resources are required to establish that we are in full compliance with the financial reporting controls and procedures. If we fail to have effective internal controls and procedures for financial reporting, we could be unable to provide timely and reliable financial information which could have a material adverse effect on our financial position, results of operations and liquidity.
We depend on the proper functioning of our information systems and may incur substantial cost to maintain information systems that conform to regulatory standards.
We are dependent on the proper functioning and availability of our information systems. Although we have taken steps to protect the security and safety of our information systems, there can be no assurance that those measures will prevent damage or interruption to our systems and operations and we may incur losses associated with improper functioning or security breaches of our information systems. In addition, the 2009 Act sets a goal for the utilization of a certified electronic health record for each person in the United States by 2014. It establishes two federal advisory committees on health information technology through which the government will work with the private sector and consumer groups to develop the specifics of a nationwide health information network. In 2011 Medicare and Medicaid began to provide certain financial incentives to eligible hospitals for “meaningful” use of health information technology. However, beginning in 2015, eligible hospitals not using certified products in a meaningful way will be subject to penalties. Currently, LTAC hospitals are not considered “eligible” hospitals for purposes of qualifying for incentives or being subject to penalties under the 2009 Act. Nevertheless, we may incur substantial costs to maintain information systems that continue to conform to regulatory standards.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Properties
As of December 31, 2011, we leased eight HIH facilities, 17 freestanding hospitals, and our corporate headquarters. Additionally, we owned two freestanding hospitals.
We generally seek ten to fifteen-year leases for our LTAC hospitals, with one or more renewal options ranging from five to 15 years.
Our corporate headquarters is located in a 36,000 square foot building in Plano, Texas.
ITEM 3.
ITEM 3. Legal Proceedings
We are a party to several legal actions that arose in the ordinary course of business. The majority of these actions are related to malpractice claims that are covered under various insurance policies; however, there may be some actions which are not insured. We are unable to predict the ultimate outcome of pending litigation and government investigations, nor can there be any guarantee that the resolution of any litigation or investigation, either individually or in the aggregate, would not have a material adverse effect on our financial position, results of operations or liquidity. However, in our opinion, the outcome of these actions will not have a material adverse effect on the financial position, results of operations or liquidity of our company.
All claims raised in connection with Hurricane Katrina have been settled with no significant impact to us, except as follows. We maintained $15.0 million of general and professional liability insurance during this period, subject to a $1.0 million per claim retention. We believe that under our insurance policies, only one retention was applicable to the Hurricane Katrina matters since these matters all arose from a single event, process or condition. However, our insurance carrier sent reservation of rights letters which challenged, among other things, the application of one retention to the Hurricane Katrina related matters. On June 5, 2009, we reached an agreement with the insurance carrier regarding the reservation of rights matters whereby they would continue to pay all costs, indemnification and related expenses for the Hurricane Katrina claims in consideration for an additional $1.0 million, which was paid by us in three equal installments, on July 1, 2009, March 31, 2010, and March 31, 2011.
ITEM 4.
ITEM 4. Mine Safety Disclosures
Not Applicable.
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
LifeCare Holdings, Inc. (the “Company”) is wholly-owned by LCI Holdco, LLC (“Holdco”), which is a wholly owned subsidiary of LCI Intermediate Holdco, Inc. (“Intermediate Holdco”), which is a wholly-owned subsidiary of LCI Holding Company, Inc., (“Holdings”), all of which are privately owned. There is no public trading market for our equity securities or for those of Holdco, Intermediate Holdco, or Holdings. As of March 15, 2012, there were nine holders of Holdings’ common stock. In addition, HealthCare REIT, Inc. held a warrant to purchase 6.25% of Holdings’ common stock.
Our senior secured credit facility contains customary restrictions on our ability, Holdings’ ability and the ability of certain of our subsidiaries to declare or pay any dividends. The indenture governing our 9 1/4% senior subordinated notes due 2013 contains customary terms restricting our ability and the ability of certain of our subsidiaries to declare or pay any dividends.
ITEM 6.
ITEM 6. Selected Financial Data
The selected historical consolidated financial and other data set forth below should be read in conjunction with management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and related notes thereto included elsewhere in this report.
(1) In the years ended December 31, 2011, 2008 and 2007, earnings were insufficient to cover fixed charges by $34,104, $19,670 and $60,705, respectively.
ITEM 7.
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis in conjunction with our consolidated financial statements and the accompanying notes.
Company Overview
We began operations in 1993 and have grown our business through developing and acquiring hospitals to become a leading operator of LTAC hospitals in the United States. As of December 31, 2011, we operated 27 hospitals located in ten states, consisting of eight “hospital within a hospital” facilities (20% of beds) and 19 freestanding facilities (80% of beds). Through these 27 long-term acute care hospitals, we operate 1,390 licensed LTAC beds and 40 transitional care beds, and employ approximately 4,500 people, the majority of whom are registered or licensed nurses and respiratory therapists. Additionally, we hold a 50% investment in a joint venture for a 51-bed LTAC hospital located in Muskegon, Michigan.
We believe we have developed a reputation for excellence in providing treatment for patients with complex medical needs requiring extended treatment. Our patients have serious medical conditions such as respiratory failure, chronic pulmonary disease, nervous system disorders, infectious diseases and severe wounds. They generally require a high level of monitoring and specialized care, yet may not require the continued services of an intensive care unit. Due to their serious medical conditions, our patients are generally not clinically appropriate for admission to a skilled nursing facility or inpatient rehabilitation facility. By combining general acute care services with a focus on long-term treatment, we believe that our hospitals provide medically complex patients with better and more cost-effective outcomes.
The Transactions
On August 11, 2005, we consummated an acquisition pursuant to which Rainier Acquisition Corp., a Delaware corporation formed by investment funds associated with The Carlyle Group, merged with and into our company, with our company continuing as the surviving corporation. The funds necessary to consummate the Transactions were approximately $552.0 million, including approximately $512.2 million to pay the then current stockholders and option holders, approximately $10.7 million to repay existing indebtedness and approximately $29.1 million to pay related fees and expenses. The effective date of the merger was August 11, 2005.
In connection with the Transactions, we borrowed $255.0 million under a senior credit facility and issued $150.0 million principal amount of senior subordinated notes. We also entered into a revolving credit facility (“Revolver”) that provided up to $75.0 million (amended to $60.0 million in 2007) of borrowing capacity. The senior credit facility and revolver were refinanced in 2011. See our discussion of the refinancing in the Liquidity and Capital Resources section herein.
As a result of the Transactions, our assets and liabilities were adjusted to their fair value as of the consummation of the merger. The excess of the total purchase price over the fair value of our tangible assets and liabilities was allocated to goodwill and other identifiable intangible assets. Goodwill is subject to an annual impairment test, and goodwill and identifiable intangible assets are subject to more frequent tests if circumstances warrant such a test.
Recent Trends and Events
Hospital Openings and Closings
On December 1, 2011, we purchased selected assets of a long-term acute care hospital operated by Vibra Specialty Hospital (“Vibra”) located in Dallas, Texas for approximately $10.9 million, less adjustments for certain equipment items and liabilities assumed. We relocated 60 beds from our existing Dallas location into Vibra’s facility and discontinued operations in our existing facility.
On August 1, 2011, we purchased five long-term acute care hospitals (the “Facilities”), which operate at seven locations, from HealthSouth Corporation and certain affiliates of HealthSouth Corporation (collectively, the “Sellers”), pursuant to an Asset Purchase Agreement (the “Purchase Agreement”). According to the Purchase Agreement, we acquired substantially all of the non-real estate assets (excluding accounts receivable and certain other components of working capital) in exchange for a cash purchase price of approximately $42.5 million less the value of working capital associated with the Facilities. We financed the acquisition with a combination of an incremental term loan from our existing senior secured credit facility and cash on hand. In addition, Health Care REIT, Inc. purchased the real estate assets associated with four of these Facilities from the Sellers for $75.0 million. We simultaneously entered into a lease with Health Care REIT, Inc. for these properties as discussed below.
The results of operations of the Facilities are included in our consolidated results of operations beginning August 1, 2011. The assets acquired and liabilities assumed of the Facilities were recognized at their acquisition date fair values. The allocation of the purchase price to the assets acquired and liabilities assumed of the Facilities (and the related estimated lives of depreciable tangible and identifiable intangible assets) required a significant amount of judgment. The initial allocation of the purchase price has been determined based upon the analysis performed. Any premium paid by us in this transaction is attributable to strategic benefits, including enhanced financial and operational scale, and market diversification. The goodwill associated with this transaction is fully deductible for income tax purposes.
On August 1, 2011, we entered into a Second Amended and Restated Master Lease Agreement (the “Second Amended and Restated Lease”) with Health Care REIT, Inc., which included the real estate properties for two of our existing operations and the four new Facilities discussed previously. The Second Amended and Restated Lease became effective with respect to the hospitals on August 1, 2011 and its initial 15-year term ends on July 31, 2026. The Second Amended and Restated Lease contains an option to renew for one 14-year, 11-month renewal term. The rent for the hospitals under the Second Amended and Restated Lease is computed based upon the Health Care REIT, Inc.’s investment amount multiplied by the greater of (i) a spread over the trading yield on 10-year U.S. Treasury Notes, or (ii) 9.71%, and is subject to an annual inflation adjustment. In addition, on August 1, 2011 we paid a transaction fee of $750,000 to Health Care REIT, Inc., and an indirect parent of the Company granted a warrant to HealthCare REIT, Inc. to purchase 6.25% of the shares of such parent’s common stock on August 1, 2011, with an exercise price of $0.01 per share.
On May 17, 2011, we entered into an amendment, (the “Incremental Amendment”), to our current credit agreement (the “Credit Agreement”), with JPMorgan Chase Bank, N.A., the lenders party thereto, and the other agents named therein. The Incremental Amendment provided for an additional $47.2 million in new senior secured term loans. Proceeds were restricted to (i) payment of consideration for the acquisition of the Facilities, (ii) payment of fees and expenses in connection with the acquisition of the Facilities and (iii) working capital purposes of the Company and its subsidiaries. The new senior secured term loans have the same terms as the outstanding senior secured term loans, including with respect to interest rate, amortization, maturity date and optional and mandatory prepayments. On August 1, 2011, in connection with the completion of the acquisition and the funding of the additional term loan proceeds, we paid a consent fee of $1.4 million to the lenders under the Credit Agreement for consenting to the Incremental Amendment.
On September 6, 2011 we opened a new 40 bed transitional care unit located at one of our Pittsburgh, PA hospital locations. This unit operates as a sub-provider of an existing Pittsburgh, PA operation.
On October 16, 2010, we relocated an existing campus including 35 beds in our Pittsburgh market to a new location in the market, and on November 19, 2010, we opened a third hospital campus in Pittsburgh with 32 beds that we reallocated from our existing licensed and LTAC certified beds in the market.
On September 1, 2009, we, along with a subsidiary of Select Medical Corporation (“Select”), each contributed our hospital operations, located in the Muskegon, Michigan market, and related licenses and provider numbers, along with $1.5 million in cash and net assets, into a newly formed limited liability company in exchange for each receiving a 50% ownership in the newly formed entity. The joint venture, which is currently comprised of 51 beds in two separate locations in the Muskegon market, is managed by Select. The $1.5 million cash contributions made by each party were comprised of a $0.1 million equity contribution and a $1.4 million note receivable (“Subordinated Note”). The 50% ownership we have in the joint venture is held by a newly formed subsidiary of the Company and has been designated as a Nonguarantor subsidiary pursuant to our senior secured credit facility. The Subordinated Note bears an interest rate of 10% and will mature on August 31, 2019. The joint venture may make quarterly payments with available cash flows prior to the maturity.
Financing
On February 1, 2011, we entered into a new senior secured credit facility that consisted of a $257.5 million senior secured term loan and a $30.0 million senior secured revolving credit facility. The proceeds of the senior secured term loan along with available cash on hand were used to retire our existing $255.0 million senior secured credit facility, our $60.0 million revolving credit facility and to pay related fees and expenses of the new credit facility. We elected not to draw down under our new $30.0 million senior secured revolving credit facility at closing. See the “Liquidity and Capital Resources” section contained herein for further discussion.
Regulatory Matters
Sources of Revenue
We are reimbursed for our services provided to patients by a number of sources, including the federal Medicare program and commercial payors. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges and per diem rates. Our net patient service revenue consists of the amounts that we estimate to be reimbursable from each of the applicable non-governmental payors and the Medicare and Medicaid programs. We account
for the differences between the estimated reimbursement rates and our standard billing rates as contractual adjustments, which are deducted from gross revenues to arrive at net revenues. We record accounts receivable resulting from such payment arrangements net of contractual allowances. Net patient service revenue generated directly from the Medicare program approximated 60.5%, 59.2% and 57.1% of total net patient service revenue for the twelve months ended December 31, 2011, 2010, and 2009, respectively. Net patient service revenue generated from non-Medicare payors were substantially from commercial payors.
Laws and regulations governing provider reimbursement pursuant to the Medicare program are complex and subject to interpretation. The Medicare reimbursement amounts reported in our financial statements are based upon estimates and, as such, are subject to adjustment until such time as our billings and cost reports are filed and settled with the appropriate regulatory authorities. Federal regulations require that providers participating in the Medicare program submit annual cost reports associated with services provided to program beneficiaries. In addition, payments under LTAC hospital PPS are subject to review by the regulatory authorities, including enhanced medical necessity reviews pursuant the SCHIP Extension Act and the RAC program pursuant to the Tax Relief and Health Care Act of 2006. These reviews primarily focus on the accuracy of the DRG assigned to each discharged patient and normally occur after the completion of the billing process.
See Item 1. Business under the caption “Government Regulations” for additional discussions regarding reimbursements from governmental payors and related recent regulatory changes.
The annual cost reports are subject to review and adjustment by CMS through its fiscal intermediaries. These reviews may not occur until several years after a provider files its cost reports, and often result in adjustments to amounts reported by providers in their cost reports as a result of the complexity of the regulations and the inherent judgment that is required in the application of certain provisions of provider reimbursement regulations. Since these reviews of filed cost reports occur periodically, there is a possibility that recorded estimated Medicare reimbursement reflected in our consolidated financial statements and previously filed cost reports may change by a material amount in future periods. We recognize in our consolidated financial statements the impact of adjustments, if any, to estimated Medicare reimbursement when the amounts can be reasonably determined.
Total Expenses
Total expenses consist of salaries, wages and benefits, supplies, which includes expenses related to drug and medical supplies, rent, other operating expenses, provision for doubtful accounts, depreciation and amortization and interest expense. Other operating expenses include expenses such as contract labor, legal and accounting fees, insurance and services from host hospitals.
Other Operating Metrics
We use certain operating metrics in the management of our facility operations. These include:
Licensed beds. Licensed beds represent beds for which a facility has been granted approval to operate from the applicable state licensing agency. These licensed beds are used in the determination of average licensed beds and occupancy rates.
Average licensed beds. We compute average licensed beds by computing a weighted average based upon the number of licensed beds in place for each month within the reporting period.
Admissions. Admissions are the total number of patients admitted to our facilities during the reporting period.
Patient days. Patient days are the cumulative number of days that licensed beds are occupied in our facilities for the entire reporting period. We also refer to patient days as our census.
Average length of stay (days). We compute average length of stay in days by dividing patient days for discharged patients by discharges.
Occupancy rates. We compute our occupancy rate by determining the percentage of average licensed beds that are occupied for a 24-hour period during a reporting period. The occupancy rate provides a measure of the utilization of inpatient rooms.
Net patient service revenue per patient day. This measure is determined by dividing our total net patient service revenue by the number of patient days in a reporting period. We use this metric to provide a measure of the net patient service revenue generated for each patient day.
Critical Accounting Matters
This discussion and analysis of our financial condition and results of operation is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of those financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures. We rely on historical experience and other assumptions that we believe are reasonable at the time in forming the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates.
We believe that the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition
Patient service revenue is reported net of provisions for contractual allowances from third party payors and patients. We have agreements with third party payors that provide for payments to us at amounts different from our established rates. The differences between the estimated program reimbursement rates and the standard billing rates are accounted for as contractual adjustments, which are deducted from gross revenues to arrive at net operating revenues. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges, and per diem payments. Accounts receivable resulting from such payment arrangements are recorded net of contractual allowances.
Insurance Arrangements
Under a number of our insurance programs, including employee health, general and professional liability and workers’ compensation, we self-insure a portion of our losses. In these cases, actuarial methods are used in estimating the losses, which we accrue for in the accounting period. These actuarial estimates of losses are prepared at least annually. There are many factors used in determining these actuarial estimates, including amount and timing of historical loss payments, severity of individual cases, and anticipated volume of services provided. The amounts of any ultimate actual payments for general and professional liabilities and workers’ compensation liabilities may not become known for several years after incurrence. Any factors changing the underlying data used in determining these estimates would result in revisions to the liabilities, which could result in an adjustment to operating expenses in future periods.
Allowance for Doubtful Accounts
Substantially all of our accounts receivable are related to providing healthcare services to patients. Our accounts receivable are primarily due from the Medicare program, managed healthcare plans, commercial insurance companies and individual patients.
We estimate and record an allowance for doubtful accounts based on various factors including the age of the accounts, changes in collection patterns and the composition of patient accounts receivable by payor type. Actual collections of accounts receivable balances in subsequent periods may require changes in the estimated allowance for doubtful accounts. Adverse changes in business operations, payor mix or patient insurance coverage could affect our collection of accounts receivable and our cash flow from operations. To date, there has not been a material difference between our bad debt allowances and the ultimate historical collection rates on accounts receivables.
Goodwill
We review our goodwill annually, or more frequently if circumstances warrant a more timely review, to determine if there has been an impairment. We review goodwill based upon one reporting unit, as our company is managed as one operating segment. In calculating the fair value of the reporting unit, we use various assumptions including projected cash flows and discount rates. If projected future cash flows decline from the current amounts projected by management, an impairment charge may be recorded.
We determined that there was no impairment for the years ended December 31, 2011, 2010 and 2009.
Impairment of Long-Lived Assets
Intangible assets of our company that have a finite useful life, consisting primarily of non-compete agreements, are amortized over their respective estimated useful lives to their estimated residual values on a straight-line basis over 2-5 years.
Long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset.
Income Taxes
Our provision for income taxes is based upon our estimate of taxable income. We also establish valuation allowances, as appropriate, to reduce our deferred tax assets to an amount that we believe will more likely than not be realized in future periods. Our state and federal tax filings are subject to tax audits by various state and federal tax authorities. While we believe the tax return positions we have taken are accurate and supportable, there is no assurance that the various authorities engaged in the income tax return examinations will not challenge our positions.
Business Combinations
We have accounted for our acquisitions under the acquisition method of accounting, whereby the tangible and separately identifiable intangible assets acquired and liabilities assumed are recognized at their estimated fair values at the acquisition date. We record goodwill for the portion of the purchase price in excess of the estimated fair value of the net tangible and separately identifiable intangible assets acquired. We make estimates and judgments to determine the fair value of assets acquired and liabilities assumed in business combinations. These estimates and judgments may be adjusted during the measurement period, but in no case beyond one year from the acquisition date. In arriving at the fair values of assets acquired and liabilities assumed, we consider the following generally accepted valuation approaches: the cost approach, income approach and market approach. We also make assumptions about projected growth rates, cost of capital, effective tax rates, tax amortization periods, the regulatory and legal environment, and industry and economic trends. Small changes in the underlying assumptions can impact the estimates of fair value by material amounts, which can in turn materially impact our results of operations.
Recent Accounting Pronouncements
In July 2011, the Financial Accounting Standards Board issued authoritative guidance for health care entities that recognize significant amounts of patient service revenue at the time the services are rendered even though they do not assess the patient’s ability to pay. These health care entities are required to present the provision for bad debts related to patient service revenue as a deduction from patient service revenue (net of contractual allowances and discounts) on their statement of operations. Additionally, those health care entities are required to provide enhanced disclosure about their policies for recognizing revenue and assessing bad debts. The amendments also require disclosures of patient service revenue (net of contractual allowances and discounts) as well as qualitative and quantitative information about changes in the allowance for doubtful accounts. The guidance is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2011, with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our business, financial position, results of operations or liquidity.
In September 2011, the Financial Accounting Standards Board issued authoritative guidance that simplifies the goodwill impairment assessment by allowing a company to first review qualitative factors to determine the likelihood of whether the fair value of a reporting unit is less than its carrying amount before applying the two-step goodwill impairment test. If it is determined that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, the company would not be required to perform the two-step goodwill impairment test for that reporting unit. This update is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011 with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our business, financial position, results of operations or liquidity.
Results of Operations
A historical summary of operations for the twelve months ended December 31, 2011, 2010, and 2009 appears below (in thousands):
Operating Statistics
The following table sets forth operating statistics for each of the periods presented.
(1) The average licensed beds are only calculated on the beds at locations that were open for operations during the applicable periods.
(2) The percentage of net patient service revenue from Medicaid is less than three percent for each of the years presented.
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
Net Revenues
Our net patient service revenue of $415.4 million for the year ended December 31, 2011, increased by $57.2 million, or 16.0%, from the comparable period in 2010. Patient days increased by 36,079, or 15.7%, while admissions increased by 1,262, or 15.5%, for the year ended December 31, 2011, as compared to the same period in 2010. On a same store basis, which excludes the hospitals acquired from HealthSouth and the new transitional care unit, patient days increased by 5,991, or 2.6%, and admissions increased by 160, or 2.0%, for the year ended December 31, 2011, as compared to the same period in 2010.
The increase of $57.2 million in net patient service revenue was attributable to an increase of $41.7 million from the recently acquired hospitals and the new transitional care unit and an increase of $15.5 million on a same store basis. The net increase on a same store basis was comprised of a favorable variance of $9.4 million attributable to an increase in patient days, a net increase of $3.4 million attributable to a decrease in adjustments related to changes in estimates and settlements on cost reports filed with the Medicare program, and a favorable variance of $2.7 million as the result of the increase in net patient service revenue on a per patient day basis. During the years ended December 31, 2011 and 2010, we recorded reductions in net patient service revenue of $0.9 million and $4.3 million, respectively, related to changes in estimates and settlements on cost reports filed with the Medicare program.
Our net patient service revenue per patient day during the years ended December 31, 2011 and 2010, was $1,561 and $1,558, respectively. However, exclusive of the cost report reimbursement adjustments and results of the new hospitals and the new transitional care unit, net patient service revenue per patient day for the years ended December 31, 2011 and 2010, was $1,587 and $1,576, respectively.
Total Expenses
Total expenses increased by $93.9 million to $449.9 million for the year ended December 31, 2011, as compared to the same period in 2010. A portion of this increase was attributable to the addition of the recently acquired hospitals and new transitional care unit. On a same store basis, total expenses increased $51.2 million for the year ended December 31, 2011, as compared to the same period in 2010.
The same store increase of $51.2 million in expenses was primarily attributable to an increase of $29.5 million in net interest expense, a $5.3 million loss related to the exit cost and write off of disposed assets related to the relocation of one of our facilities, a $2.8 million loss related to the write-off of deferred financing cost as a result of the refinancing of the senior secured credit facility during the period and $3.2 million of expenses associated with the acquisition of the new hospitals. The remaining $10.4 million increase in expenses was principally attributable to an increase of $10.9 million in salary, wages and benefits during the 2011 period. This increase was the result of an increase of $2.7 million in employee healthcare cost during the period, the increase in patient days during the period and other annual inflationary increases. The $29.5 million increase in net interest expense was the result of the higher margin rate associated with the new senior secured credit agreement and interest on the additional borrowing related to the purchase of the new hospitals. The term loan facility at December 31, 2011 and 2010, was $313.2 million and $241.6 million, respectively, and had an average interest rate of 13.05% and 4.65% for the years ended December 31, 2011 and 2010, respectively.
Income Tax Expense
For the year ended December 31, 2011, we recorded income tax expense of $0.7 million which represented the estimated income tax liability for certain state income taxes based on gross margins or taxable income at the individual state level. The federal and state income tax expense for 2011 and 2010 is less than expected due primarily to changes in the valuation allowance on deferred tax assets as of December 31, 2011 and 2010.
Net Income
For the year ended December 31, 2011, we reported a net loss of $34.8 million as compared to net income of $2.6 million for the year ended December 31, 2010. As discussed previously, this change of $37.4 million was principally the result of higher net interest expense and the fees and expenses incurred associated with the debt refinancing and acquisitions occurring during the 2011 period.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Net Revenues
Our net patient service revenue of $358.3 million for the year ended December 31, 2010, decreased by $2.1 million, or 0.6%, from the comparable period in 2009. Patient days and admissions increased by 2.0% and 2.4%, respectively, for the year ended December 31, 2010 as compared to the same period in 2009.
However, on a same store basis, which excludes the operations of our former hospital in Muskegon, MI, from the 2009 period, our net patient service revenue of $358.3 million increased by $1.1 million, or 0.3%, from the 2009 period. Patient days in the 2010 period of 229,999 increased by 6,739, or 3.0%, while admissions of 8,141 increased by 277, or 3.5%. The increase in net patient service revenue of $1.1 million during the 2010 period was attributable to a favorable variance of $10.8 million as the result of the increase in patient days, offset by an unfavorable variance of $9.7 million attributable to a decrease in net patient service revenue on a per patient day basis. The decrease in net patient service revenue on a per patient day basis was principally attributable to a decline in revenue per patient day for non-Medicare patients, including commercially insured and Medicare Advantage patients. Additionally, the number of Medicare patient days, which generally have a lower average net revenue per patient day than non-Medicare patient days, increased as a percentage of total days during the 2010 period as compared to the 2009 period.
Total Expenses
Total expenses decreased by $0.2 million to $356.0 million for the year ended December 31, 2010 as compared to $356.2 million for the comparable period in 2009. On a same store basis however, which excludes the operations of our former hospital in Muskegon, MI, from the 2009 period, total expenses of $356.0 million in the 2010 period increased by $3.3 million from the 2009 period.
This increase on a same store basis was primarily attributable to a gain of $5.2 million in 2009 related to the early extinguishment of debt. During the year ended December 31, 2009, we repurchased $11.2 million of our outstanding senior subordinated notes for $5.8 million. This resulted in us recording a $5.2 million gain, net of the write-off of $0.2 million of capitalized financing costs, on the early extinguishment of this indebtedness. There was also a decrease in insurance expense of $0.7 million and a decrease of $3.0 million in net interest expense, offset by an increase of $1.5 million in salaries, wages and benefits and an increase of $2.4 million in supplies. The decrease in insurance expense was the result of a $1.0 million charge recorded in the 2009 period attributable to an agreement with the insurance carriers on Hurricane Katrina matters. The decrease in net interest expense was the result of lower interest rates on outstanding borrowings during the 2010 period and the decrease of $11.2 million in outstanding principal of our senior subordinated notes as a result of the repurchase of these notes during the year ended December 31, 2009. The increase in salaries, wages and benefits was the result of higher patient volumes in the 2010 period, however, these expenses were lower on a per patient day basis by $15, or 2.1%.
Income Tax Expense
For the year ended December 31, 2010, we recorded income tax expense of $0.3 million which represented the estimated income tax liability for certain state income taxes based on gross margins or taxable income at the individual state level. The federal and state income tax expense for 2010 and 2009 is less than expected due primarily to changes in the valuation allowance on deferred tax assets as of December 31, 2010 and 2009.
Net Income
For the year ended December 31, 2010, we reported net income of $2.6 million as compared to net income of $3.0 million for the year ended December 31, 2009. However, excluding the gains on the early extinguishments of debt for 2009, there would have been a net loss of $2.2 million for the year ended December 31, 2009. As discussed previously, this improvement of $4.8 million was principally the result of lower net interest expense in the 2010 period.
Liquidity and Capital Resources
Our primary sources of liquidity are cash on hand, expected cash flows generated by operations, and availability of borrowings under a revolving credit facility. Availability of borrowings under our revolving credit facility are generally dependent upon our ability to meet the maximum leverage ratio test included in the senior secured credit facility. Our primary liquidity requirements are for debt service on our senior secured credit facilities and the notes, capital expenditures and working capital.
As a result of impending maturities and increasingly more restrictive covenant requirements under our previous senior secured credit facility, we completed a refinancing of our previous senior secured credit facility with a new senior secured credit facility that consisted of an initial $257.5 million senior secured term loan (subject to paid-in-kind interest options as
discussed below) and a new $30.0 million senior secured revolving credit facility on February 1, 2011 (the “Credit Agreement”). The proceeds of this new Credit Agreement along with available cash on hand were utilized to pay off our existing senior secured credit facility and revolving credit facility and the fees and expenses associated with the new Credit Agreement.
The terms of the Credit Agreement also provide that we have the right to request additional term loan commitments of up to $50.0 million. This right was exercised in connection with the HealthSouth acquisition, which occurred on August 1, 2011, as previously discussed.
As of December 31, 2011, we had $437.0 million of long-term debt outstanding consisting of our $30.0 million senior secured revolving credit facility, which matures on February 1, 2015, of which there was no outstanding balance, our senior secured term loan credit facility in an outstanding principal amount of $313.2 million, which matures on February 1, 2016, our senior subordinated notes in an outstanding principal amount of $119.3 million, which mature on August 11, 2013, and our note payable to Vibra in an outstanding principal amount of $4.5 million, which matures on June 1, 2013. The revolving credit facility includes sub-facilities for letters of credit, of which $5.6 million was outstanding. Availability of borrowings under the revolving credit facility are reduced by outstanding letters of credit. We also had capital lease obligations of $0.5 million with varying maturities. The full amount available under the initial term loan facility was used in connection with the February 1, 2011 refinancing.
Borrowings under the term loan facility of the Credit Agreement bear interest at a rate per annum equal to an applicable margin plus, at our option, either (a) an alternate base rate determined by reference to the highest of (1) the prime rate of JPMorgan Chase Bank, N.A., (2) the federal funds rate in effect on such date plus 1/2 of 1% and (3) the LIBOR rate for a one month interest period plus 1% or (b) a LIBOR rate determined by reference to the cost of funds for U.S. dollar deposits for the relevant interest period adjusted for certain additional costs. The applicable margin percentage is 12.25% for term loans that are alternate base rate loans and 13.25% for term loans based on the LIBOR rate. For the term loans, we may, in our discretion, elect for the relevant interest period (a) to pay the entire amount of interest in cash or (b) to pay 5.50% of such interest “in-kind” by adding such interest to the outstanding principal of the term loans as of the applicable interest payment date. At December 31, 2011, the weighted average interest rate applicable to the $313.2 million outstanding under our term loan facility was 13.65%.
The applicable margin percentages for the revolving loans are 6.75% for alternate base loans and 7.75% for loans that are based on the LIBOR rate, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). In addition to paying interest on outstanding principal under the senior secured credit agreement, we are required to pay a commitment fee of 0.50% per annum in respect of the unutilized commitments under the revolving credit facility, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). We are also required to pay annual customary agency fees.
We are required to make scheduled quarterly payments under the senior secured term loan facility equal to 0.25% of the original principal amount of the term loan and the additional principal amount borrowed on August 1, 2011, with the balance payable on February 1, 2016. Additionally, we are required to prepay outstanding term loans under this agreement with (a) 100% of the net cash proceeds of any debt or equity issued by us or our restricted subsidiaries (with exceptions for certain debt permitted to be incurred or equity permitted to be issued under the agreement), (b) commencing with the year ending December 31, 2011, 75% (which percentage will be reduced to 50% if our senior secured leverage ratio (as defined in the Credit Agreement) is less than 4:00 to 1:00) of our annual excess cash flow (as defined in the Credit Agreement), and (c) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us or our restricted subsidiaries, subject to reinvestment rights and certain other exceptions specified in the Credit Agreement. Mandatory prepayments of the term loans, subject to certain exceptions, are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such repayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014.
We may voluntarily prepay outstanding loans under the term loan facility and reduce the unutilized portion of the commitment amount in respect of the senior secured revolving credit facility at any time. Any such voluntary prepayments are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such prepayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014. Other than as described above, prepayments are not subject to any premium or penalty other than customary “breakage” costs with respect to loans based on the LIBOR rate.
The term loan and revolving credit facility under the Credit Agreement have scheduled maturity dates of February 1, 2016, and February 1, 2015, respectively. However, if our outstanding senior subordinated notes are not refinanced, purchased or defeased in full by May 15, 2013, then the term loan and the then outstanding balance under the revolving credit facility will be due in full on May 15, 2013.
The Credit Agreement also imposes certain financial covenants on us including: minimum cumulative consolidated EBITDA requirements that began with the first fiscal quarter of 2011 and continued through the end of the third fiscal quarter
of 2011; a maximum ratio of 6.0x consolidated EBITDA to total senior secured indebtedness tested quarterly on a trailing 12 month basis, beginning on the last day of the fourth quarter of 2011; and a minimum ratio of 1.25x consolidated EBITDA to consolidated cash interest expense, tested quarterly on a trailing 12 month basis beginning on the last day of the fourth fiscal quarter of 2011. The maximum leverage ratio is scheduled to adjust to 5.75x beginning with the trailing four quarter period ending June 30, 2012.
The Credit Agreement is secured by substantially all of our tangible and intangible assets, except for assets held by subsidiaries that have been designated as nonguarantor subsidiaries. The Credit Agreement also contains certain customary representations and warranties, affirmative covenants and events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross defaults to certain material indebtedness, certain events of bankruptcy, certain events under ERISA, change of control, material judgments, failure of certain guaranty documents to be in full force and effect and failure of a lien to have the priority or otherwise be valid and perfected with respect to material collateral.
We believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under the revolving portion of our senior secured credit facilities will be sufficient to finance our operations, and meet our scheduled debt service requirements for at least the next twelve months, absent an acceleration of repayment due to an event of default as discussed in the previous paragraph.
We actively seek to identify and evaluate potential acquisition candidates and, from time to time, we review potential acquisitions of businesses. Any acquisitions may require us to issue additional equity or incur additional indebtedness, subject to the limitations contained in our senior secured credit facility. We intend to seek opportunities to refinance our senior subordinated notes, subject to financial performance and market conditions, and we continue to explore various strategic transactions, including an acquisition, as a means to reduce our leverage and strengthen our operating and financial condition. However, there is no assurance that we will be able to refinance our senior subordinated notes on commercially reasonable terms or at all, or to complete an acquisition on desirable terms.
We and our subsidiaries, affiliates or significant stockholders may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.
Capital Expenditures
We anticipate that we will incur capital expenditures of approximately $6.0 million in 2012 based on our current plans, primarily for ongoing maintenance expenditures in our existing facilities. We may enter into lease arrangements to finance a portion of these equipment expenditures.
Historical Cash Flow
For the year ended December 31, 2011, operating activities used $2.5 million in cash compared to generating $16.0 million for the year ended December 31, 2010. This use of cash during the 2011 period was principally the result of the expenditures incurred during the period associated with the refinancing of our senior secured credit agreement and the facility acquisitions during 2011, along with the build-up of working capital associated with the recently acquired facilities, as working capital accounts were primarily retained by the sellers. Accounts receivable increased by $31.0 million during 2011 as compared to an increase of $4.2 million during 2010. The recently acquired hospitals and new transitional care unit contributed $29.5 million of this increase Days of net patient service revenue in net accounts receivable at December 31, 2011 was 69.2 as compared to 70.6 at December 31, 2010. Accounts payable and accrued expenses increased by $19.1 million in 2011 compared to a decrease of $3.3 million in 2010, primarily due to the timing of interest payments associated with our senior secured credit facility, the timing of bi-weekly payroll funding requirements, and the increase in expenditures as a result of the recently acquired hospitals and the new transitional care unit. Estimated third party payor settlements increased by $5.0 million in 2011 compared to a decrease of $5.6 million in 2010.
For the year ended December 31, 2010, operating activities generated $16.0 million in cash compared to generating $13.7 million for the year ended December 31, 2009. Accounts receivable increased by $4.2 million during 2010 as compared to an increase of $8.5 million during 2009. Days of net patient service revenue in net accounts receivable at December 31, 2010 was 70.6 as compared to 69.4 at December 31, 2009. Accounts payable and accrued expenses decreased by $3.3 million in 2010 compared to a decrease of $1.6 million in 2009, due in part to the timing of payments of interest expense associated with our senior secured credit facility through the rate setting process, and in part due to the timing of bi-weekly payroll funding requirements. Estimated third party payor settlements decreased by $5.6 million in 2010 compared to an increase of $3.7 million in 2009.
For the year ended December 31, 2009, operating activities generated $13.7 million in cash. The increase in cash provided by operations as compared to 2008 was partially the result of net income in 2009 as compared to a net loss during 2008. Accounts receivable increased by $8.5 million during 2009 as compared to an increase of $5.1 million during 2008. Days of net patient service revenue in net accounts receivable at December 31, 2009 was 69.2 as compared to 67.0 at December 31, 2008. Accounts payable and accrued expenses decreased by $1.6 million in 2009 compared to an increase of $12.9 million in 2008, due in part to the timing of payments of interest expense associated with our senior secured credit facility through the rate setting process, and in part due to the timing of bi-weekly payroll funding requirements. Estimated third party payor settlements increased by $3.7 million in 2009 compared to an increase of $0.5 million in 2008.
Cash used in investing activities was $42.8 million during 2011, primarily related to the acquisitions completed during 2011, as previously discussed.
Cash used in investing activities was $4.0 million during 2010, primarily to purchase property and equipment.
Cash used in investing activities was $7.2 million during 2009. We used $5.8 million to purchase property and equipment during 2009. In addition, $1.4 million was loaned to our joint venture in Muskegon, Michigan, as discussed previously.
Cash provided by financing activities was $2.3 million during 2011 as compared to cash used in financing activities of $4.2 million in 2010. The increase included proceeds of $257.5 million from the refinancing of the senior secured credit facility and an additional $47.2 million in new senior secured term loans in relation to the HealthSouth acquisition previously discussed, offset by outflows to pay down the previous senior secured credit facility and scheduled payments on the current secured credit facility. We also paid down $35.0 million for the outstanding balance under the previous revolving line of credit. During 2011 we made payments of $22.3 million for deferred financing cost associated with the debt refinance and new senior secured term loans utilized for the hospitals acquired from HealthSouth.
Cash used in financing activities during 2010 was $4.2 million, principally for payments of long-term debt and capital leases and payments on the lease financing obligation.
Cash provided by financing activities during 2009 was $14.9 million. This included $25.0 million in borrowings under the revolving line of credit. This was offset by $8.4 million in payments of notes payable and long-term debt, which included $5.8 million paid for the early retirement of $11.2 million in face value of senior subordinated notes.
At December 31, 2011, we had cash and cash equivalents of $11.6 million and working capital of $25.5 million.
Contractual Obligations
The following table summarizes our contractual obligations as of December 31, 2011 (in thousands):
(1) This table does not include payments that we are required to make under a management agreement with an affiliate of The Carlyle Group. Under that agreement we pay an annual management fee initially set at $500,000. See “Certain Relationships and Related Transactions-Management Agreement.”
(2) The interest obligations were calculated using interest rates as of December 31, 2011 of approximately 13.65% for the senior secured term loans and the stated interest rate of 9 1/4% for the senior subordinated notes. See the “Liquidity and Capital Resources” section.
(3) This table does not reflect future excess cash flow prepayments, if any, that may be required under our new senior secured term loan or additional principal amounts that could become outstanding as a result of any future paid in kind interest elections that we may make under our new secured term loan. See the “Liquidity and Capital Resources” section.
Seasonality
Our business experiences seasonality as a result of variation in census levels, with historically the highest census in the first quarter of the year and the lowest census in the third quarter of the year.
Inflation
We derive a substantial portion of our revenue from the Medicare program. LTAC hospital PPS payments are fixed payments that generally are adjusted annually for inflation. However, there can be no assurance that these adjustments, if received, will reflect the actual increase in our costs for providing healthcare services. As discussed previously, the 2011 Final Rule issued by CMS for LTAC hospitals included a 1.6% increase in the standard federal rate, while the 2010 Final Rule included a decrease of 0.5% in the standard federal rate.
Labor and supply expenses make up a substantial portion of our operating expense structure. These expenses can be subject to increase in periods of rising inflation. To date, we have been able to partially offset such increases with the implementation of cost control measures. There can, however, be no assurance that we will be successful in offsetting future cost increases.
ITEM 7A.
ITEM 7A. Qualitative and Quantitative Disclosures about Market Risk
At December 31, 2011, we had $313.2 million in senior term loans outstanding and a borrowing availability of $30 million under our revolving credit facility, each bearing interest at variable rates. This excludes the letters of credit outstanding of $5.6 million that reduce our borrowing capacity of our revolving credit facility, as they have fixed rates and have maturity dates over the next year. Each 0.125% point change in interest rates would result in a $0.4 million change in interest expense on our term loans and revolving credit facility loans, assuming that our revolving credit facility is fully drawn. We currently have no outstanding interest rate swap agreements; however, in the future, we may enter into interest rate swap agreements, involving the exchange of floating for fixed rate interest payments, to reduce interest rate volatility.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
See Consolidated Financial Statements and Notes thereto commencing at Page.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures and Changes in Internal Control Over Financial Reporting
We carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered in this report. The disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within required time periods, and include controls and disclosures designed to ensure that this information is accumulated and communicated to the company’s management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and principal financial officer have concluded that as of December 31, 2011 our disclosure controls and procedures were effective to provide reasonable assurance that information required to be included in our periodic SEC reports is recorded accurately, and processed, summarized and reported within the time periods specified in the relevant SEC rules and forms.
In addition, we reviewed our internal controls, and there have been no changes in our internal controls over financial reporting identified in connection with an evaluation that occurred during the quarter ended December 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that:
(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2011. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. We acquired several new facilities during 2011. Accordingly, management’s evaluation excluded the operations of the following subsidiaries acquired during 2011 with total assets of approximately $63.3 million and approximately $40.9 million of revenues included in our consolidated financial statements as of December 31, 2011:
•
LifeCare Hospitals of Mechanicsburg
•
LifeCare Specialty Hospital of North Louisiana
•
LifeCare Specialty Hospital of North Louisiana - Homer
•
LifeCare Specialty Hospital of North Louisiana - Farmerville
•
LifeCare Hospitals of Pittsburgh - Monroeville
•
Complex Care Hospital at Tenaya
•
Complex Care Hospital at Ridgelake
Based upon our assessment and those criteria, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2011.
ITEM 9B.
ITEM 9B. Other Information
None.
PART III
ITEM 10.
ITEM 10. Directors and Executive Officers of the Registrant
The following table sets forth information about our executive officers and directors as of December 31, 2011.
Set forth below is a brief description of the business experience of each of our directors and executive officers, as of December 31, 2011.
Phillip B. Douglas has served as Chairman and Chief Executive Officer since March 2011. He previously served as President from April 2008 to March 2011. From January 2006 to April 2008, he served as our Chief Financial Officer. Prior to joining LifeCare, Mr. Douglas was Chief Financial Officer of Workscape, Inc., a private-equity owned company, from 2000 until 2005. From 1996 until 1999 Mr. Douglas was founder and Chief Executive Officer of Management and Technology Solutions, Inc., a developer and provider of IT solutions to physician organizations. From 1992 to 1995 Mr. Douglas was the Chief Financial Officer and Co-Founder of HealthSpring, Inc., a physician practice management company that was later acquired by The MetraHealth Companies (“MetraHealth”). MetraHealth was ultimately acquired by United HealthCare Corporation, where Mr. Douglas served as Senior Vice President of Finance for the combined companies from 1995 to 1996.
Grant B. Asay has served as Executive Vice President of Operations since September 2009. He previously served as Regional Senior Vice President of Operations for our company from June 2006 through September 2009. From 2002 until June 2006, he served as a Regional Director for Select Medical Corporation. Prior to joining Select Medical Corporation, Mr. Asay served as the Chief Executive Officer of community hospitals in Montana, Nevada and Alaska.
Chris A. Walker has served as our Chief Financial Officer since April 2008. Previously, he served as our Senior Vice President-Chief Accounting Officer and Treasurer since 1997. Prior to joining LifeCare, he worked as a Certified Public Accountant with KPMG LLP from 1991 until 1997.
Erik C. Pahl has served as our General Counsel and Chief Compliance Officer since August 2009. His previous positions include General Counsel for a national home care corporation, Intrepid USA, Inc., and a national staffing company, Snelling Staffing LLC. He has also served as Assistant General Counsel for Triad Hospitals, and Senior Counsel for Texas Health Resources.
Catherine A. Conner has served as the Senior Vice President of Human Resources since May 2006. She was previously the Executive Director of Strategic Staffing with Applebee’s International, Inc. from 2001 to 2006 and Vice President of Human Resources at Rehab Designs of America, a prosthetic and orthotic provider, from 1997 to 2000. Ms. Conner also previously served as Director of HR for a Boston Market franchisee and headed up staffing for Houlihan’s restaurant group.
T. Brian Callister, M.D. is a Board Certified Internal Medicine and Hospitalist specialist, and he currently serves as our National Medical Director. He is the Chairman of Clinical Outcome Benchmarks for the Acute Long Term Hospital Association (ALTHA), and is both the President of the Nevada State Medical Association and the Nevada State Chairman for the American Medical Association’s (AMA) Organized Medical Staff Section (OMSS). He has served as a Clinical Associate Professor of Medicine at the University of Nevada for over 20 years and is a nationally recognized lecturer on multiple subjects including Long Term Acute Care and Hospitalist programs. Additionally, Dr. Callister was named to the Center for Medicare and Medicaid Services (CMS) Technical Expert Panels for both Long Term Acute Care and Inpatient Rehabilitation Facilities. Recently, Dr. Callister was nominated as one of Modern Healthcare’s 50 Most Influential Physician Executives for 2012.
Karen H. Bechtel has served as a director since August 2005 and Chairman from August 2007 until April 2008. Ms. Bechtel is a Managing Director of The Carlyle Group and head of the U.S. buyout group that focuses on opportunities in the healthcare sector. Previously, Ms. Bechtel was a Managing Director of Morgan Stanley’s Private Equity Group, where she was a member of the investment committee. From 1993 to 1997, Ms. Bechtel was Co-head of the Strategic Finance Group. She was also a founder and head of Princes Gate Private Equity Investors, a $650.0 million bridge equity fund.
Stephen H. Wise has served as a director since July 2006. Mr. Wise is a Managing Director of The Carlyle Group focused on U.S. buyout investments in the healthcare industry. Prior to joining Carlyle, Mr. Wise worked with JLL Partners where he focused on healthcare related investments. Previously he worked with J. W. Childs, a private equity firm, and prior to that worked in the leverage finance group of Credit Suisse First Boston.
William Hamburg has served as director since August 2007. Mr. Hamburg served as interim President and Chief Executive Officer of LifeCare from August 2007 until January 2008. Mr. Hamburg served as the interim CEO and a director of OptimalIMX, Inc. from January 2010 till October 2010. Mr. Hamburg served as interim CEO of Guardian Home Care Holdings, Inc. from October 2008 till September 2009. Mr. Hamburg has served as the interim Chief Operating Officer and interim Chief Development Officer of HealthSouth during its management transition. He was also interim Chief Executive Officer for Cogent Healthcare, Inc., a privately held hospitalist company. Previously, Mr. Hamburg was the Chairman, President and Chief Executive Officer of MediSphere Health Partners, a privately owned, venture capital-backed, alternate site healthcare facility company. Before his services with MediSphere, Mr. Hamburg was President and Chief Operating Officer of Surgical Care Affiliates, Inc., a NYSE company that was one of the nation’s largest independent owners and operators of outpatient surgery centers. Prior to his services with Surgical Care Affiliates, Inc., Mr. Hamburg held several senior administrative positions with several major non-profit acute care hospitals.
William P. Johnston has served as a director since August 2007. Mr. Johnston is a former Chairman of Renal Care Group and serves as a director and advisor for several healthcare and financial services companies, including The Carlyle Group, the principal owner of our company.
William H. McMullan, Jr. has served as a director since September 2007. Mr. McMullan is a Vice President of The Carlyle Group focused on U.S. buyout investments in the healthcare industry. Prior to joining Carlyle, Mr. McMullan worked with J. W. Childs, a private equity firm. Previously he worked with UBS Investment Bank.
Board and Management Structure
Our board directs the management of our business as provided by Delaware law and conducts its business through regularly scheduled meetings. The board reviews and approves, among other matters, the compensation of our Chief Executive Officer, and our equity incentive plans. Our board has considered the risks that may arise from our compensation policies and practices and determined that they are not reasonably likely to have an adverse effect on us. Furthermore, the board monitors our corporate financial reporting, external audits, internal control functions and compliance with laws and regulations that could have a significant effect on our financial condition or results of operations. Our board has the responsibility to appoint and to review fee arrangements with our independent auditors.
Mr. McAlister served as both our Chairman of the Board and Chief Executive Officer until his retirement in March 2011, and Mr. Douglas was named Chairman and Chief Executive Officer in March 2011. Our board believes that in light of our size and the experience and capabilities of Mr. McAlister and Mr. Douglas, the combined Chairman of the Board/Chief Executive Officer position is an effective management structure.
While our board does not have a diversity policy, diversity of experience, skills, age, gender and race is viewed as a positive factor when determining the composition of the board. Pursuant to a stockholders agreement, a majority of our outstanding shares must vote for board designees of our principal stockholder, Carlyle Partners, IV, L.P. In connection with the selection of the current board members, our board noted that Mr. McAlister and Mr. Hamburg have years of management experience in the healthcare industry and Ms. Bechtel, Mr. Wise, Mr. Johnston and Mr. McMullan have a wide range of experience with healthcare investments, opportunities and transactions.
Our securities are not listed on a securities exchange and we are not subject to the corporate governance requirements of a securities exchange. The audit committee is currently the only separate committee of the board of directors. We anticipate we may establish additional standing committees of the board, including a compensation committee, in the future. We will consider establishing other committees of the board, from time to time, when necessary to address specific issues. Our board of directors consulted with our Chief Executive Officer concerning the compensation of our executive officers, other than the Chief Executive Officer.
Code of Ethics
We have adopted a written code of business conduct and ethics, known as our code of conduct, which applies to all of our directors, officers, and employees, including our chief executive officer, our president, and our chief financial officer. Our code of conduct is available on our internet website, www.lifecare-hospitals.com. Our code of conduct may also be obtained by contacting us at 469-241-2100. Any amendments to our code of conduct or waivers from the provisions of the code for our chief executive officer, our president, or our chief financial officer will be disclosed on our Internet website promptly following the date of such amendment or waiver.
Item 11.
Item 11. EXECUTIVE COMPENSATION - COMPENSATION DISCUSSION AND ANALYSIS
The following analysis relates to compensation for each person who served as our Chief Executive Officer, our Chief Financial Officer and the three other executive officers who were the most highly compensated for the year ended December 31, 2011. We refer to these individuals collectively as our “Named Executive Officers.” On March 3, 2011, G. Wayne McAlister retired as Chairman and Chief Executive Officer and Phillip B. Douglas was promoted to Chairman and Chief Executive Officer. Except as otherwise noted, our discussion in this Item 11 refers to the Named Executive Officers in their respective positions as of December 31, 2011.
Overview of Compensation Process. The Board of Directors sets the compensation of our executive officers, evaluates their performance and administers our incentive plans. Our securities are not listed on a stock exchange. Accordingly, we are not subject to stock exchange corporate governance standards, such as the requirement to establish a compensation committee. Although Mr. McAlister served on our Board of Directors prior to his retirement as our Chief Executive Officer in March 2011, and Mr. Douglas, our current Chief Executive Officer, now serves on our Board of Directors, neither Mr. McAlister nor Mr. Douglas participated in the determination of his own compensation.
The Board annually reviews executive compensation and our policies to ensure that the Chief Executive Officer and other executive officers are appropriately rewarded for their contributions to our company. The Board seeks to align our compensation strategy with the objectives of our company, as well as stockholder interests. In addition, the Board solicits the views and recommendations of our Chief Executive Officer when setting the salaries of our other executive officers, given his insight into internal pay equity, as well as executive officer performance. The Board considers these recommendations in the final compensation decisions and gives them significant weight, provided such recommendations are otherwise consistent with our compensation philosophies. However, the Board makes all final decisions concerning executive officer compensation.
Compensation Philosophy. The fundamental objective of our compensation program is to attract, retain and motivate executive leadership for our company who will execute our business strategy, uphold our company’s values and enhance the value of our company. To fulfill this objective, the Board has developed compensation policies and plans designed to attract, retain and motivate highly qualified and high-performing executives through compensation that is:
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Aligned with Stockholder Interests - Equity incentives should be used to align the interests of our executive officers with stockholder interests.
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Performance-based - A meaningful component of compensation should be tied to our performance.
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Equitable - Executive compensation should consider internal pay equity as well as compensation paid by similarly situated companies.
The Board’s compensation philosophy for each executive officer focuses on an analysis of the executive officer’s performance for the year, projected responsibilities, importance to the execution of our business strategy, external pay practices and total compensation positioning. The Board’s philosophy also takes into account employee retention, potential recruitment by other companies, compensation policies of other companies, and the expense and difficulty of replacing executives.
Compensation Program for 2011. Based on our compensation philosophy, the Board determined that we should provide executive officers with compensation comprised of three primary elements: (1) base salary; (2) annual performance awards payable in cash; and (3) long-term equity incentive awards. The analysis regarding the establishment of these three components of executive compensation for 2011 is set forth below.
Base Salary. In 2011, our company was a party to employment agreements (“Employment Agreements”) with our Named Executive Officers. While the Employment Agreements established a base salary for each of these executive officers, their salaries are subject to adjustment after their initial term by the Board of Directors in its sole discretion. Each year, the Board reviews and approves salaries for our executive officers, including those executive officers who are parties to an Employment Agreement. The Board seeks to provide base salaries for our executive officers appropriate to their experience, professional status, job responsibilities and performance. The Board’s decision also takes into account factors such as prior year salary, tenure, performance, responsibilities and salaries paid by other companies. However, the Board did not “benchmark” the salaries of our executive officers to those of other companies or groups of companies. The Board also considers recommendations presented to the Board by the Chief Executive Officer with respect to the salaries of the other executive officers. Based on these factors, the Board approved base salaries for our Named Executive Officers for 2011 in the amounts shown in the table below.
(1) Mr. McAlister received total salary in 2011 in the amount of $226,923, which represents salary through June 1, 2011, the last day of the transaction period following his retirement on March 3, 2011.
(2) Mr. Douglas received total salary in 2011 in the amount of $507,089, which represents salary through March 2, 2011 based on an annual base salary rate of $339,518 and salary from March 3, 2011 (the day on which he became our Chief Executive Officer and Chairman of the Board) to December 31, 2011, based on an annual base salary rate of $550,000.
Performance-Based Cash Incentive Awards. In addition to base salary, performance-based cash incentives are provided to our executive officers based on the extent to which performance targets are met. The Board believes these bonuses reward executives for achieving our shorter-term goals and values. The Board established target cash incentive opportunities for 2011. Seventy-five percent (75%) of our Named Executive Officers’ incentive opportunity was based on the achievement of target EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, with the remaining 25% of the incentive opportunity to be paid at the discretion of the Board of Directors.
For 2011, the base target incentive opportunity was equal to 60% of base salary for our Chief Executive Officer, Chief Financial Officer, and Executive Vice President of Operations and 50% of base salary for our General Counsel, Chief Compliance Officer and our Senior Vice President of Human Resources. No amounts would be paid unless target EBITDA was achieved. The plan also provided for the payment of incremental performance-based cash incentives to the extent actual EBITDA exceeds target EBITDA. Our Chief Executive Officer and Chief Financial Officer were eligible to receive a maximum performance-based cash incentive of 100% of base salary. The incremental performance-based cash incentive would be earned on a pro-rata basis for EBITDA in excess of 100% of target up to a maximum of 110% of target.
Based on the foregoing criteria, the Board reviewed our performance and individual performance objectives of the Named Executive Officers and determined that no cash incentive awards would be paid to the Named Executive Officers with respect to the year ended December 31, 2011.
Long-Term Equity Incentive Compensation. One of our primary compensation philosophies is that long-term equity compensation should strengthen and align the interests of our executive officers with stockholder interests. The Board believes that the use of stock-based awards is an effective means to enable us to attract and retain high quality executives. In addition, we believe that stock ownership encourages our executive officers to think and act as stockholders.
Our 2005 Equity Incentive Plan provides for grants of restricted shares and options to purchase shares of LCI Holding Company, Inc’s (“Holdings”) common stock. Employees, as well as independent directors, are eligible to receive grants under the 2005 Equity Incentive Plan. Awards are generally granted to our executive officers upon hiring and on a periodic basis thereafter as the Board deems appropriate. The Board may approve these awards annually after considering the actual performance of our company for the prior year as compared to performance targets set by the Board. The Board may approve additional awards under other circumstances, such as the promotion of a person to a higher position or in recognition of special contributions made by the executive officer. Outstanding options have a term of 10 years, vest in three to four equal annual installments commencing on the first anniversary of the date of grant and have an option price equal to or in excess of the fair market value of our stock at the date of grant. Options are designed to facilitate our efforts to retain our executive officers as well as provide incentive to maximize their performance on our behalf.
During the year ended December 31, 2011, no new options or restricted shares were granted to the Named Executive Officers other than an option to purchase 450,000 shares (with a term of 10 years and an exercise price of $2.50 per share) and a restricted stock award of 100,000 shares of our common stock granted to Mr. Douglas upon his becoming our Chief Executive Officer.
Retirement Plan. All employees of our company are eligible to participate in our 401(k) plan, and can contribute up to 50% of their base salary (subject to statutory limitations). Prior to 2010, we had the discretion to match up to 33.3% of the first six percent of eligible employee contributions to our 401(k) plan. The matching contributions were made in cash and vested over a three-year period. For the years ended December 31, 2010 and 2011, matching contributions were suspended; however, in a future period, we may make a one-time matching contribution on a discretionary basis or we may reinstate the matching program.
Severance and Change in Control Benefits. The Board believes that reasonable severance and change in control benefits are necessary in order to secure and retain highly qualified executive officers. These benefits reflect the fact that it may be difficult for executive officers to find comparable employment within a short period of time. They also reflect the generally competitive recruiting environment within our industry. The Board does not typically consider the value of potential severance and change in control provisions when assessing annual compensation because these payouts are contingent and have a primary purpose unrelated to those of ordinary compensation.
As of December 31, 2011, we had Employment Agreements in place with each of our Named Executive Officers. In general, the agreements with our Chief Executive Officer, Executive Vice President of Operations and Chief Financial Officer provide for severance payments where the executive officer is terminated “without cause” or if the executive officer resigns with “good reason.” If such executive officer’s employment is terminated by us “without cause” or by the executive officer for “good reason” (each as defined in the executive officer’s Employment Agreement), the executive officer is entitled to receive: (1) all accrued benefits, (2) a severance payment equal to a continuation of his annual base salary for a period of one to two years, (3) a potential bonus amount; and (4) payment of health insurance benefits for one to two years following the date of termination. If such executive officers are terminated as a result of death or disability, the executive officer is entitled to receive accrued salary, unpaid bonus and a bonus (pro-rated through the termination date) and other benefits required by applicable law or our employee benefit plans. Under her agreement, our Senior Vice President of Human Resources is entitled to receive 18 months of salary upon her death or termination of employment due to disability. Our General Counsel, Chief Compliance Officer, is entitled to six months of salary if his employment is terminated by death, by us because of his disability, by us “without cause” or if the term of his agreement expires based on our nonrenewal. The following table summarizes severance payments and bonuses provided for under our Employment Agreements with our Named Executive Officers as of December 31, 2011. The table also summarizes severance payments and bonuses provided for under our Employment Agreement with Mr. McAlister, our former Chief Executive Officer. However, actual payments made to Mr. McAlister following his retirement in March 2011 are described below under “2011 Separation Agreement with Mr. McAlister; Amendments to Agreements with Mr. Douglas.”
* If employment was terminated as a result of his death or disability, the bonus amount would be a pro-rated amount determined by multiplying the target annual bonus he would have been eligible to receive if he had continued to serve for the full fiscal year by a fraction, the numerator of which is the number of days he was employed in the fiscal year divided by 365.
In April 2008, we entered into transaction bonus agreements with certain members of our management, including Messrs. McAlister, Douglas, Asay and Walker, and Ms. Conner. Mr. Asay’s agreement was amended with his promotion to Executive Vice President of Operations on September 22, 2009. Mr. Pahl entered into the transaction bonus agreement on February 28, 2010. The transaction bonus agreements will provide a one-time bonus opportunity in connection with a change of control transaction (“Transaction Bonus Opportunity”). The Transaction Bonus Opportunity for Mr. McAlister ranged from 1x to 15x of his base salary at the time the transaction bonus agreement was entered into by Mr. McAlister and our company. However, the separation agreement entered into by Mr. McAlister and our company following his retirement in as Chief Executive Officer (described below under “2011 Separation Agreement with Mr. McAlister; Amendments to Agreements with Mr. Douglas”) provided that Mr. McAlister will no longer be entitled to benefits under the transaction bonus agreement. As of December 31, 2011, the Transaction Bonus Opportunity for Mr. Douglas, as a multiple of his base salary as of March 3, 2011, ranged from 1x to 14x base salary. As of December 31, 2011, the Transaction Bonus Opportunity for each of Messrs. Asay, Walker and Pahl, and Ms. Conner, as a multiple of such Named Executive Officer’s base salary at the time the transaction bonus agreement was entered into, ranged from approximately 1x to 7x for Mr. Asay, from approximately 1x to 10x for Mr. Walker, from approximately 0.35x to 1.75x for Ms. Conner and from approximately 0.33x to 1.67x for Mr. Pahl. The actual amount to be paid will be based on the value associated with our company upon a change of control.
The following table provides the amount of potential cash severance payable and the estimated value of continuing insurance benefits to each of the Named Executive Officers, based on the assumption that the Named Executive Officer’s employment terminated on December 31, 2011, under circumstances that entitled the Named Executive Officer to the maximum potential severance payment immediately thereafter. The table also includes the value of accelerated vesting of options and restricted stock if severance rights are triggered pursuant to a change of control event. Finally, the table includes the maximum Transaction Bonus Opportunity available to Messrs. Douglas, Asay, Walker and Pahl, and Ms. Conner, as of December 31, 2011. The terms of the separation agreement between Mr. McAlister and our company entered into following his retirement as Chief Executive Officer are described below under “2011 Separation Agreement with Mr. McAlister; Amendments to Agreements with Mr. Douglas.”
(1) The Employment Agreements with Messrs. Douglas, Asay and Walker provide for potential bonus payments if their employment is terminated by us without cause, they terminate employment for good reason or we terminate them within twelve months of a change in control. However, because no bonus was paid with respect to 2010, assuming termination as of December 31, 2011, no bonus would have been payable to them.
(2) As of December 31, 2011, the stock option exercise price of $2.50 per share exceeded the per share fair value of the underlying common stock and the fair value of restricted stock was nominal based on our valuation. Accordingly, no amounts are shown in this column attributable to the acceleration of stock options or accelerated vesting of restricted stock as of December 31, 2011.
Non-Competition, Non-Solicitation and Confidentiality. Each of the Named Executive Officers is subject to certain confidentiality provisions and to certain non-solicitation and non-competition provisions for a period of one year to two years following the termination of employment with our company.
Perquisites and Other Benefits. The Named Executive Officers are eligible for benefits generally available to other employees of our company who are exempt for purposes of the Fair Labor Standards Act, including health insurance, disability and life insurance. We also reimburse the Named Executive Officers for reasonable, customary and necessary business expenses incurred or paid by them in the performance of their duties and responsibilities to our company.
2011 Separation Agreement with Mr. McAlister; Amendments to Agreements with Mr. Douglas. On March 3, 2011, Mr. McAlister retired as Chairman and Chief Executive Officer. In addition, on March 3, 2011, the Board of Directors named Mr. Douglas as Chairman and Chief Executive Officer and also elected Mr. Douglas as a director of our company.
On March 17, 2011, we entered into a separation agreement with Mr. McAlister. The separation agreement provided for the accelerated vesting of Mr. McAlister’s restricted stock award covering 400,000 shares of our common stock and the cancellation of all of Mr. McAlister’s vested stock options. In addition, the separation agreement provided for Mr. McAlister to remain employed by us for a transition period ending on June 1, 2011, and for Mr. McAlister to receive his base salary and continuation of participation in our group medical, dental and life insurance plans during such transition period. The separation agreement provided that no further compensation or benefits will be owed or paid to Mr. McAlister under his employment agreement or his transaction bonus agreement, except as otherwise provided in the separation agreement. The separation agreement provided for certain continuing indemnification and directors’ and officers’ insurance, as well as continuing obligations of Mr. McAlister with respect to confidentiality, return of our company’s property, non-competition, non-solicitation and assignment of intellectual property.
On March 3, 2011, we entered into an amendment to Mr. Douglas’ employment agreement. The amendment includes a change in his title to Chairman and Chief Executive Officer and an increase in his annual base salary to $550,000. It also provides that if Mr. Douglas is terminated other than for cause or resigns voluntarily for good reason, he will be entitled to receive continued salary and bonus for two years (or a lump sum payment in the case of any such termination within twelve months following a change of control), with the amount of the annual bonus equal to the lesser of 60% of Mr. Douglas’ base salary in effect on the date of termination or the annual bonus paid to him in respect of the immediately preceding fiscal year. Mr. Douglas is subject to non-competition, non-solicitation and certain confidentiality provisions for a period of two years following the termination of his employment. We also entered into an amended and restated transaction bonus agreement with Mr. Douglas on March 3, 2011 to increase the amount of the one-time bonus opportunity available to Mr. Douglas under the agreement in connection with a change of control transaction from a range of approximately 1x to 15x his prior base salary to a range of approximately 1x to 14x his new base salary. The actual amount to be earned will be based upon the value associated with our company upon a change of control. In addition, in connection with Mr. Douglas’ appointment as Chairman and Chief Executive Officer, on March 3, 2011, Mr. Douglas was granted an option to purchase 450,000 shares of our common stock, with an exercise price of $2.50 per share, and a restricted stock award covering 100,000 shares of our common stock.
Salaries for 2012. The salaries as of December 31, 2011 for our Named Executive Officers currently remain unchanged for 2012. Our Employment Agreements as of December 31, 2011 with our Named Executive Officers also remain in effect for 2012.
Performance-Based Cash Incentive Awards - Targets for 2012. As previously discussed, in addition to base salary, performance-based cash incentives are provided to our Named Executive Officers based on the extent to which performance targets are met. The Board has established target cash incentive opportunities for 2012. Seventy-five percent (75%) of our Named Executive Officers’ incentive opportunity will be based on the achievement of target EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, with the remaining 25% of the incentive opportunity paid in the discretion of the Board of Directors.
For 2012, the base target incentive opportunity will be equal to 60% of base salary for our Chief Executive Officer, Chief Financial Officer and Executive Vice President of Operations, 50% for our Senior Vice President of Human Resources and 35% for our General Counsel, Chief Compliance Officer. No amounts will be paid unless target EBITDA is achieved. The plan also provides for the payment of incremental performance-based cash incentives to the extent actual EBITDA exceeds target EBITDA. The Chief Executive Officer and Chief Financial Officer are eligible to receive a maximum performance-based cash incentive of 100% of base salary. The incremental performance-based cash incentive is earned on a pro-rata basis for EBITDA in excess of 100% of target up to a maximum of 110% of target.
Summary Compensation Table
for the Year Ended December 31, 2011
(1) Bonuses shown for a specified year relate to amounts earned during that year but which were paid during the following year.
(2)
Amounts relate to the aggregate grant date fair value of stock awards. The value of these shares was nominal on the grant dates. See note 4 to the consolidated financial statements for a discussion of the valuation of our stock awards.
(3)
This column represents the aggregate grant date fair value of the option awards. These amounts do not correspond to the actual value that may be recognized by the Named Executive Officer. The actual value, if any, the Named Executive Officer may realize upon exercise of the options will depend on the excess of the calculated stock price over the exercise price on the date the options are exercised. See note 4 to the consolidated financial statements for a discussion of the valuation of our option awards.
(4)
For 2011, All Other Compensation of Mr. Douglas and Ms. Conner includes travel cost reimbursement and related taxes of $24,623 and $3,071, respectively. For 2010, All Other Compensation of Mr. Douglas and Ms. Conner includes travel cost reimbursement and related taxes of $23,842 and $3,055, respectively. For 2010, All Other Compensation of Mr. Pahl included his sign-on bonus of $25,000. For 2009, All Other Compensation of Mr. Douglas and Ms. Conner includes travel cost reimbursement and related taxes of $11,041 and $2,640, respectively, along with insurance payments and our 401(k) matching contribution. For 2009, All Other Compensation of Mr. McAlister, Mr. Asay and Mr. Walker includes insurance payments and our 401(k) matching contribution.
(5)
On March 3, 2011, Mr. McAlister retired as Chairman and Chief Executive Officer and Mr. Douglas was named Chairman and Chief Executive Officer.
Grants of Plan-Based Awards. During 2011, no new options were granted to our Named Executive Officers, other than an option to purchase 450,000 shares granted to Mr. Douglas upon his becoming our Chief Executive Officer. Each option has a term of 10 years, vests in three equal annual installments commencing on the first anniversary of the date of grant and has an option price equal to $2.50 per share, which was in excess of the fair market value of our stock at the date of grant. The options are designed to facilitate our efforts to retain our executive officers as well as provide incentive to maximize their performance on our behalf. Additionally, Mr. Douglas was granted a restricted stock award covering 100,000 shares of our common stock. This award vests in three equal annual installments beginning on March 24, 2010.
The following table summarizes plan-based awards granted to Named Executive Officers during the year ended December 31, 2011.
(1) Amounts relate to the aggregate grant date fair value of restricted stock awards and option grants, which was nominal based on our valuation. See note 4 to the consolidated financial statements for a discussion of the valuation of the company’s stock awards. Grant date fair value does not correspond to the actual value that may be recognized by the Named Executive Officer.
Agreements with Named Executive Officers. During the year ended December 31, 2011, our company was a party to Employment Agreements with the Named Executive Officers as described below.
Agreements with Former Chief Executive Officer. Prior to his retirement, our Employment Agreement with Mr. McAlister provided for an initial term of two years, subject to automatic one year renewals thereafter unless the agreement was terminated in accordance with its terms. Pursuant to the Employment Agreement, Mr. McAlister was entitled to receive an annual base salary ($500,000 in 2011) and was eligible for an annual bonus based on the achievement of performance objectives established by our board. The target amount of the annual bonus was 60% of his base salary and the maximum amount of the annual bonus was 100% of his base salary. In 2008, we granted Mr. McAlister an option to purchase 1,000,000 shares of our common stock for $2.50 per share. All options granted by us, including Mr. McAlister’s option, have
been granted with an exercise price not less than fair value at date of grant. The Employment Agreement also provided that he would receive a restricted stock award of up to 400,000 shares if certain 2008 financial targets were attained. Based on the attainment of these targets, Mr. McAlister was granted 400,000 restricted shares on March 24, 2009. In addition, the Employment Agreement provided that Mr. McAlister could earn an additional one-time bonus in connection with a change of control transaction in an amount ranging from a multiple of 1x to 15x his base salary. If Mr. McAlister was terminated other than for cause or resigned voluntarily for good reason, he was entitled to receive continued salary and bonus for two years, with the amount of the annual bonus equal to the lesser of 60% of his base salary in effect on the date of termination or the annual bonus paid to him in the immediately preceding fiscal year. Under the agreement, Mr. McAlister was also subject to non-competition provisions, and to non-solicitation and certain confidentiality provisions for a period of two years following the termination of his employment.
In connection with Mr. McAlister’s retirement as Chairman and Chief Executive Officer, on March 17, 2011 we entered into a separation agreement with Mr. McAlister. The separation agreement provided for the accelerated vesting of Mr. McAlister’s restricted stock award covering 400,000 shares of our common stock and the cancellation of all of Mr. McAlister’s vested stock options. In addition, the separation agreement provided for Mr. McAlister to remain employed for a transition period ending on June 1, 2011 and for Mr. McAlister to receive his base salary during such transition period. The separation agreement provided that no further compensation or benefits will be owed or paid to Mr. McAlister under his Employment Agreement or his transaction bonus agreement, except as otherwise provided in the separation agreement. The separation agreement provided for certain continuing indemnification and directors’ and officers’ insurance, as well as continuing obligations of Mr. McAlister with respect to confidentiality, return of our company’s property, non-competition, non-solicitation and assignment of intellectual property.
Amended Employment Agreement with New Chief Executive Officer. On March 3, 2011, Mr. Douglas was named Chairman and Chief Executive Officer and we amended Mr. Douglas’ employment agreement. The amendment provides for an increase in his annual base salary to $550,000. It also provides that if Mr. Douglas is terminated other than for cause or resigns voluntarily for good reason, he will be entitled to receive continued salary and bonus for two years (or a lump sum payment in the case of any such termination within twelve months following a change of control), with the amount of the annual bonus equal to the lesser of 60% of Mr. Douglas’ base salary in effect on the date of termination or the annual bonus paid to him in respect of the immediately preceding fiscal year. Mr. Douglas is subject to non-competition, non-solicitation and certain confidentiality provisions for a period of two years following the termination of his employment. We also entered into an amended and restated transaction bonus agreement with Mr. Douglas on March 3, 2011 to increase the amount of the one-time bonus opportunity available to him under the agreement in connection with a change of control transaction from a range of approximately 1x to 15x his prior base salary to a range of approximately 1x to 14x his new base salary. The actual amount to be earned will be based upon the value associated with our company upon a change of control. On March 3, 2011, we also granted Mr. Douglas an option to purchase 450,000 shares of our common stock, with an exercise price of $2.50 per share, and a restricted stock award covering 100,000 shares of our common stock.
Each of our other Named Executive Officers is employed pursuant to a written agreement, terminable at will by either party. Under each Employment Agreement, the Named Executive Officer is entitled to receive an annual salary and eligible to receive an annual formula bonus based on performance objectives for our company or for such Named Executive Officer and a discretionary bonus. The other Named Executive Officers are subject to confidentiality provisions, and to non-competition and non-solicitation provisions for a period of one year.
In general, the agreements with our new Chairman and Chief Executive Officer, Executive Vice President of Operations, and Chief Financial Officer provide for severance payments where the executive officer is terminated “without cause” or if the executive officer resigns with “good reason.” If such executive officer’s employment is terminated by us “without cause” or by the executive officer with “good reason,” (each as defined in the Employment Agreements), the executive officer is entitled to receive: (i) all accrued benefits; (ii) a severance payment equal to a continuation of his annual base salary for a period of one year to two years, (iii) payment of health insurance benefits for one year to two years; and (iv) a potential bonus amount. For Messrs. Asay and Walker (our Executive Vice President of Operations and Chief Financial Officer), such bonus amount equals the lesser of: (a) 60% of base salary, or (b) the bonus paid for the previous year. Mr. Douglas’ bonus amount would equal two times the lesser of: (a) 60% of base salary, or (b) the bonus paid for the previous year. If such executive officers are terminated as a result of death or disability, they are entitled to receive accrued salary, any unpaid bonus and a bonus (pro-rated through the termination date), and any other benefits required by applicable law or our employee benefit plans. Our Senior Vice President of Human Resources is entitled to 18 months salary if her employment is terminated to death or disability. Our General Counsel, Chief Compliance Officer is entitled to six months of salary if his employment is terminated by death, by us because of his disability, by us “without cause,” or if the term of his agreement expires based on our nonrenewal.
Management Incentive Plan. On November 4, 2005, our parent company’s board of directors and shareholders ratified the 2005 Equity Incentive Plan (“Plan”) that covers 2,860,000 shares of the our parent company’s common stock, and accordingly, our parent company has reserved a like number of shares out of its authorized, but unissued shares of common stock for issuance under the Plan. At December 31, 2011, there are 880,000 restricted stock awards and 1,691,250 million stock options to certain of our employees outstanding that have been approved by our Board. All stock options granted prior to August 11, 2006 pursuant to the Plan were granted with an exercise price of $10.00 per share and had 10-year terms. Stock option grants on and after August 11, 2006 (but before December 11, 2007), have been granted with an exercise price of $6.00 per share and have 10-year terms. On August 10, 2006, we cancelled and regranted the options granted prior to August 10, 2006. The exercise price of these options was lowered from $10.00 per share to $6.00 per share. No other changes were made to the terms and conditions of these options. On December 11, 2007, we cancelled and regranted all outstanding stock options. The exercise price of these options was lowered from $6.00 per share to $2.50 per share, but no other changes were made to the terms and conditions of these options. Based on the attainment of certain fiscal year 2008 financial targets, Mr. McAlister and Mr. Douglas were granted 400,000 shares and 300,000 shares, respectively, of restricted stock, which vest in three equal annual installments beginning on March 24, 2010. We granted an option to purchase 450,000 shares of our common stock (with a term of 10 years and an exercise price of $2.50 per shares) and a restricted stock award covering 100,000 shares (vesting in three equal annual installments beginning on March 24, 2010) to Mr. Douglas after he became our Chief Executive Officer in March 2011.
In connection with his retirement as Chairman and Chief Executive Officer on March 3, 2011, we entered into a separation agreement with Mr. McAlister. The separation agreement provides for the cancellation of all of Mr. McAlister’s outstanding stock options and the accelerated vesting of all of his shares of restricted stock.
Outstanding Equity Awards at Fiscal Year-End. The following table includes certain information with respect to the value of all unexercised options and restricted stock previously awarded to the Named Executive Officers at December 31, 2011.
(1)
The per share fair value is nominal based upon our valuation.
(2)
On March 17, 2011, we entered into a separation agreement with Mr. McAlister which provides for the cancellation of all of Mr. McAlister’s outstanding stock options and the accelerated vesting of his shares of restricted stock.
Option Exercises and Stock Vested. The following table includes certain information with respect to restricted stock held by the Named Executive Officers that vested during the year ended December 31, 2011. During the year ended December 31, 2011, no options were exercised by the Named Executive Officers.
(1) The per share fair value is nominal based upon our valuation.
Director Compensation
Other than Mr. Johnston and Mr. Hamburg, the members of our board of directors are not separately compensated for their services as directors, other than reimbursement for out-of-pocket expenses incurred in connection with rendering such services. Mr. Johnston and Mr. Hamburg receive compensation of $60,000 annually for their services as a director of our company. The director fee is paid in the form of cash or shares of our common stock at the discretion of the director. Each director may elect to have his director fee deferred pursuant to the Director Deferred Compensation Plan.
The following table includes compensation awarded to the directors of our company during the year ended December 31, 2011.
(1) Ms. Bechtel, Mr. McMullan, and Mr. Wise were all employed by The Carlyle Group, our principal stockholder, and Mr. Douglas was employed as our Chief Executive Officer during the year ended December 31, 2011, and did not receive separate compensation for their services as directors, other than reimbursement for out-of-pocket expenses incurred in connection with rendering such services.
(2) Mr. Johnston elected to receive stock for his compensation for services provided during the year ended December 31, 2011, which he has elected to defer pursuant to the deferral option of the Director Deferred Compensation Plan. During 2011, his deferral account was credited with 24,000 shares at an agreed upon value of $2.50 per share. These shares have a nominal value based on our valuation used in our financial statements.
(3) Mr. Hamburg received cash for services provided during the year ended December 31, 2011.
Board Report Concerning Compensation Discussion & Analysis
Although we do not have a compensation committee, the Board of Directors has reviewed and discussed the foregoing Compensation Discussion & Analysis with management and approved its inclusion in this Annual Report on Form 10-K.
Members of the Board of Directors:
Karen H. Bechtel
William H. McMullan, Jr.
Phillip B. Douglas
William P. Johnston
William Hamburg
Stephen H. Wise
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth information as of March 15, 2012, with respect to the beneficial ownership of our parent’s capital stock by (i) Mr. McAlister, our Chief Executive Officer until March 3, 2011, Mr. Douglas, our current Chief Executive Officer and each of the other Named Executive Officers; (ii) each of our directors, (iii) all of our directors and executive officers as a group and (iv) each holder of five percent (5%) or more of any class of our parent’s outstanding capital stock.
A stockholders’ agreement governs the stockholders’ exercise of their voting rights with respect to election of directors and certain other material events and the shares are also subject to a registration rights agreement. See “Certain Relationships and Related Transactions.” Except as described in the agreements mentioned above, each of the beneficial owners listed has, to our knowledge, sole voting and investment power with respect to the indicated shares of common stock. Unless otherwise indicated in a footnote, the address for each individual listed below is c/o LifeCare Holdings, Inc., 5340 Legacy Drive, Building 4, Suite 150, Plano, Texas 75024.
* Less than 1%.
(1) Consists of 16,359,302 shares owned by Carlyle Partners, IV, L.P. and 660,698 shares owned by CP IV Coinvestment, L.P. The principal executive offices for Carlyle Partners, IV, L.P. and CP IV Coinvestment, L.P. are 1001 Pennsylvania Avenue, NW, Suite 220 South, Washington, D.C. 20004.
(2) Includes the vested portion of the 400,000 restricted shares held by Mr. Douglas. Mr. Douglas’ restricted shares vest in three equal annual installments beginning on March 24, 2010.
(3) Consists of 16,359,302 shares owned by Carlyle Partners, IV, L.P. and 660,698 shares owned by CP IV Coinvestment, L.P. Ms. Bechtel is a member of Carlyle Partners, IV, L.P. and CP IV Coinvestment, L.P. and accordingly may be deemed to beneficially own the shares owned by such entities. Ms. Bechtel disclaims beneficial ownership of such shares except to the extent of her pecuniary interest therein. The address for Ms. Bechtel is c/o The Carlyle Group, 520 Madison Avenue, 42nd Floor, New York, NY 10022.
(4) The address for Mr. Hamburg is 12 Breckenridge, Nashville, TN 37215.
(5) Mr. McMullan is a Vice President of The Carlyle Group. The business address for Mr. McMullan is c/o The Carlyle Group, 520 Madison Avenue, 42nd Floor, New York, NY 10022.
(6) The principal address for William P. Johnston is 3100 West End Avenue, Suite 875, Nashville, TN 37203. See the discussion of director compensation in Item 11.
(7) Mr. Wise is a Managing Director of The Carlyle Group. The business address for Mr. Wise is c/o The Carlyle Group, 520 Madison Avenue, 42nd Floor, New York, NY 10022.
(8) Includes shares held by Carlyle Partners, IV, L.P. and CP IV Coinvestment, L.P.
(9) In addition, Named Executive Officers hold vested options for the following shares: Mr. Douglas-457,500; Mr. Asay-95,000 shares; Mr. Walker-126,000 shares; Ms Conner-68,750 shares; and Mr. Pahl-20,000 shares.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions
Management Agreement
We and our parent company have entered into a management agreement with an affiliate of The Carlyle Group pursuant to which The Carlyle Group or its affiliate provides us management services. Pursuant to the agreement, The Carlyle Group or its affiliate receives an aggregate annual management fee of $500,000, reimbursement for out-of-pocket expenses and a fee in the event that the agreement is terminated in accordance with its terms. In addition, pursuant to the agreement, The Carlyle Group or its affiliates also received a transaction fee of approximately $6.0 million in connection with services provided by such entities related to the Transactions. Also, the management agreement provides that The Carlyle Group and its affiliates will receive fees equal to 1% of the gross transaction value in connection with certain subsequent financing and acquisition transactions. The management agreement includes customary indemnification provisions in favor of The Carlyle Group and its affiliates.
Stockholder’s Agreement and Registration Rights Agreement
Simultaneously with the closing of the Transactions, we and our stockholders entered into a stockholders agreement. The stockholders agreement includes terms relating to the election of our directors, restrictions on the issuance or transfer of shares, including the right of a minority stockholder to sell shares in a sale transaction entered into by a majority stockholder, commonly known as a tag-along right, the right of a majority stockholder to force a minority stockholder to sell shares upon the sale of a majority owner’s interest, at the same price and on the same terms and conditions as the majority owner, commonly known as a drag-along right, other special corporate governance provisions (including the right to approve various corporate actions) and customary expense reimbursement provisions.
On April 14, 2006, we filed a Form S-4 registration statement with the SEC as required by a Registration Rights Agreement we entered into in connection with the Transactions. This filing was declared effective by the SEC on May 12, 2006. We completed the exchange offer for all outstanding Notes as of June 21, 2006, which satisfied the requirements of the Registration Rights Agreement.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services
During fiscal 2011 and 2010, we incurred the following fees for services performed by KPMG LLP, an independent registered public accounting firm:
(1) The Audit Fees for the years ended December 31, 2011 and 2010, were for professional services rendered for the audits of the consolidated financial statements of our company, consents and assistance with reviews of documents filed with the SEC.
(2) The Audit Related Fees are primarily for audits of our company’s 401(k) plan.
(3) Tax Fees for the years ended December 31, 2011 and 2010 were for services related to tax compliance, tax planning, and tax advice on mergers and acquisitions and employee benefits.
Subsequent to May 12, 2006, the effective date of the Company’s SEC registration, all services performed by the independent registered public accounting firm have been approved by the board of directors prior to performance.
PART IV
ITEM 15.
ITEM 15. Exhibits, Financial Statement Schedules
(a) The financial statements and schedules filed as part of this Annual Report on Form 10-K are described in the Index to Financial Statements appearing on page.
(b) The exhibits incorporated herein by reference or filed as part of this Annual Report on Form 10-K are set forth in the attached Exhibit Index.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholder’s Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Schedule II-Valuation and Qualifying Accounts
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
LifeCare Holdings, Inc.
We have audited the accompanying consolidated balance sheets of LifeCare Holdings, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholder’s equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2011. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule included in Part IV of the Company’s Annual Report on Form 10-K. These consolidated financial statements and consolidated financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LifeCare Holdings, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
Dallas, Texas
March 30, 2012
LIFECARE HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(In thousands, except share data)
See Accompanying Notes to Consolidated Financial Statements
LIFECARE HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(In thousands)
See Accompanying Notes to Consolidated Financial Statements
LIFECARE HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholder’s Equity (Deficit)
(In thousands)
See Accompanying Notes to Consolidated Financial Statements
LIFECARE HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)
See Accompanying Notes to Consolidated Financial Statements.
LIFECARE HOLDINGS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Basis of Presentation
On July 19, 2005, LifeCare Holdings, Inc. (the “Company”) entered into a merger agreement (the “Merger”) with Rainier Acquisition Corporation and LCI Holdco, LLC (“Holdco”), as discussed in note 3, resulting in the Company becoming a wholly owned subsidiary of Holdco. Holdco is a wholly owned subsidiary of LCI Holding Company, Inc., (“Holdings”) which is owned by an investor group that includes affiliates of The Carlyle Group and members of our board of directors.
(2) Liquidity and Uncertainties Related to Going Concern
As of December 31, 2011, we had $437.0 million of long-term debt outstanding consisting of our $30.0 million senior secured revolving credit facility, which matures on February 1, 2015, of which there is no outstanding balance, our senior secured term loan credit facility in an outstanding principal amount of $313.2 million, which matures on February 1, 2016, our senior subordinated notes in an outstanding principal amount of $119.3 million, which mature on August 11, 2013, and our note payable, as discussed in note 8, in an outstanding principal amount of $4.5 million, which matures on June 1, 2013. Although we are highly leveraged, we believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under our senior secured revolving credit facility will be sufficient to finance our operations and meet our scheduled debt service requirements for at least the next twelve months, absent certain actions of lenders in the case of an event of default under our senior secured credit facility as discussed below.
We are required to comply on a quarterly basis with certain financial and other covenants under our senior secured credit facility, including a minimum consolidated cash interest expense coverage ratio test and a maximum senior secured leverage ratio test which are tested quarterly. We are required to meet a leverage ratio of 6.00x at December 31, 2011, which reduces to 5.75x at June 30, 2012. Our leverage ratio at December 31, 2011 is 5.49x. We are required to meet an interest coverage ratio of 1.25x at December 31, 2011 and throughout 2012, which increases to 1.30x on March 31, 2013. Our interest coverage ratio is 1.65x at December 31, 2011. We are currently in compliance with the covenants under our senior secured credit facility for the quarterly period ended December 31, 2011. We expect to maintain compliance under the covenants of our senior secured credit facility for the next twelve months. See more discussion in note 8.
We may not be able to continue to satisfy the covenant requirements in subsequent periods. In the event we are unable to comply with the covenants under our senior secured credit facility, an event of default may occur. If we are unable to obtain waivers or amendments to cure such event of default, the lenders would be entitled to take various actions, including the acceleration of amounts due under our senior secured credit facility, terminating our access to our revolving credit facility and all actions permitted to be taken by a secured creditor. Acceleration under our senior secured credit facility would further create a cross-default under our senior subordinated notes indenture. Such acceleration would have a material adverse effect on our financial position, results of operations and cash flow.
We are continuing to pursue operational and strategic objectives that may result in profitability and lower total indebtedness in order to remain in compliance with the financial covenants under our senior secured credit facility. These objectives include, among other items, increasing the occupancy levels of our hospitals, reducing administrative and operating expenses, and reducing days of net patient service revenue in accounts receivable. We also continue to seek opportunities to refinance our senior subordinated notes and explore various strategic transactions, such as an acquisition, as a means to reduce our leverage and strengthen our operating and financial conditions.
There can be no assurance, however, that we will be able to refinance our senior subordinated notes on commercially reasonable terms or at all, achieve profitability or be able to successfully execute strategic transactions. In that case, we may be required to consider all of our alternatives in restructuring our business and our capital structure.
(3) Merger and Related Transactions
On August 11, 2005, the Merger transaction was consummated and we became a wholly owned subsidiary of Holdco. The funds necessary to consummate the “Transactions” were approximately $552.0 million, including approximately $512.2 million to pay the then current stockholders and option holders, approximately $10.7 million to repay existing indebtedness and approximately $29.1 million to pay related fees and expenses.
The Merger agreement provided for additional purchase price consideration of $40.5 million that was contingent upon the resolution of certain specific issues. Through December 31, 2011, $40.3 million of the original amount had been settled and disbursed. The remaining funds in the escrow accounts will be disbursed upon resolution of the remaining contingent issues.
During the year ended December 31, 2010, goodwill was increased by $3.0 million due to distributions to the prior stockholders of our company from one of the escrow accounts, as the result of the resolution of a specific matter.
In connection with the Merger, we entered into an agreement with The Carlyle Group to pay a $0.5 million annual advisory fee, which has been expensed each of the years ended December 31, 2011, 2010, and 2009.
(4) Summary of Significant Accounting Policies
(a) Principles of Consolidation
The consolidated financial statements include the financial statements of LifeCare Holdings, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
(b) Nature of Business
We develop and operate hospitals specializing in the treatment of critically ill or injured patients whose average length of stay exceeds 25 days. We operate these hospitals as freestanding facilities or as hospitals within hospitals (“HIH”), whereby space is leased from existing unrelated acute-care hospitals and separately licensed as one of our hospitals. At December 31, 2011, we operated 27 facilities and had operations in ten states. At December 31, 2010, we operated 20 facilities and had operations in nine states. At December 31, 2009, we operated 19 facilities and had operations in nine states.
(c) Use of Estimates
The preparation of the financial statements requires us to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual amounts could differ from those estimates.
(d) Cash and Cash Equivalents
Cash and cash equivalents consist of cash and highly liquid short-term investments with original maturities of three months or less.
(e) Accounts Receivable
Accounts receivable consist primarily of amounts due from the Medicare program, other government programs, managed care health plans, commercial insurance companies and individual patients. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collectible.
In evaluating the collectibility of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type, the status of ongoing disputes with third party payors and general industry conditions.
(f) Inventories
Inventories, which consist principally of medical and pharmaceutical supplies, are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. Inventories are reported as a component of other current assets.
(g) Estimated Third Party Payor Settlements
Estimated third party payor settlements represent the difference between amounts received under interim payment plans from governmental payors, primarily Medicare, for services rendered and the estimated amounts to be reimbursed by those payors upon settlement of cost reports.
(h) Property and Equipment
Property and equipment are carried at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Equipment under capital leases is stated at the lower of the present value of minimum lease payments at the beginning of the lease term or fair value at the inception of the lease. Equipment under capital leases is amortized using the straight-line method over the lease term or the estimated useful life of the equipment, as appropriate depending on the nature of the lease. All maintenance and repair costs are charged to expense as incurred.
(i) Goodwill and Other Intangible Assets
Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized. We review our goodwill annually, or more frequently if circumstances warrant a more timely review, to determine if there has been an impairment. We review goodwill based upon one reporting unit, as our company is managed as one operating segment, including, among other things, the level of review by segment management, organizational structure and the evaluation of similar economic characteristics. In calculating the fair value of the reporting unit, we use various assumptions including projected cash flows and discount rates. If projected future cash flows decline from the current amounts projected by management, additional impairments may be recorded. The annual evaluation was performed as of December 31, 2011, 2010, and 2009.
Intangible assets of our company that have a finite useful life, consisting primarily of non-compete agreements, are amortized over their respective estimated useful lives to their estimated residual values on a straight-line basis over 2-5 years and are reviewed for impairment annually, or more frequently if circumstances warrant a more timely review.
(j) Other Assets
Other assets are comprised primarily of deferred financing costs incurred in connection with the current senior secured credit facility and our senior subordinated notes. We account for amortization of deferred financing costs utilizing the effective interest method.
(k) Impairment of Long-Lived Assets
Long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell and are no longer depreciated.
(l) Insurance Risks
We are liable for a portion of our losses under a number of our insurance programs, which primarily include general and professional liability risk, workers’ compensation and our employee health insurance programs. For these matters, we record estimated losses that may have been incurred in a respective accounting period utilizing actuarial methods. To the extent that subsequent actual claims costs vary from the historical provisions for losses as recorded, future earnings will be charged or credited.
(m) Revenue Recognition
Net patient service revenue is recognized as services are rendered. Patient service revenue is reported net of provisions for contractual allowances from third party payors and patients. We have agreements with third party payors that provide for payments to us at amounts different from our established rates. The differences between the estimated program reimbursement rates and the standard billing rates are accounted for as contractual adjustments, which are deducted from gross patient revenues to arrive at net patient service revenues. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges, and per diem payments.
Laws and regulations governing provider reimbursement pursuant to the Medicare program are complex and subject to interpretation. We are reimbursed by the Medicare program pursuant to a prospective payment system (“PPS”) methodology. Payments received by us under PPS are subject to review by the regulatory authorities. These reviews primarily focus on the accuracy of the DRG assigned to each discharged patient and normally occur after the completion of the billing process.
We submit annual cost reports to the Medicare program, and these annual cost reports are subject to review and adjustment by the Centers for Medicare & Medicaid Services (“CMS”) through its fiscal intermediaries. These reviews may not occur until several years after a provider files its cost reports, and often result in adjustments to amounts reported by providers in their cost reports as a result of the complexity of the regulations and the inherent judgment that is required in the application of certain provisions of provider reimbursement regulations. Since these reviews of filed cost reports occur
periodically, there is at least a reasonable possibility that recorded estimated Medicare reimbursement reflected in our consolidated financial statements and previously filed cost reports may change by a material amount in future periods. We recognize in our consolidated financial statements the impact of adjustments, if any, to estimated Medicare reimbursement when the amounts can be reasonably determined. Net revenue in the years ended December 31, 2011, 2010, and 2009 included increases/(decreases) of $0.4 million, $(0.1) million, and $1.7 million, respectively, related to changes in estimates and settlements on cost reports filed with the Medicare program relating to prior years.
(n) Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance on deferred tax assets is provided to the extent it is not considered more likely than not that such assets will be realized.
We recognize tax positions which are more likely than not to be substained. We record accrued interest and penalties, if any, associated with uncertain tax positions as income tax expense in the consolidated statement of operations. We have determined that we have no uncertain tax positions as of December 31, 2011.
The federal statute of limitations remains open for tax years 2008 through 2010. State jurisdictions generally have statutes of limitations ranging from three to five years. The state income tax impact of federal income tax changes remains subject to examination by various states for a period up to one year after formal notification to the states.
(o) Stock Compensation
We estimate the fair value of awards on the date of grant, or the date of award modification if applicable, using the Black-Scholes option pricing model. The weighted average fair value of options granted during the year ended December 31, 2011 was nominal, which was calculated based on the following assumptions: expected volatility of 40%, expected dividend yield of 0%, expected life of 6.25 years, and a risk-free interest rate of 3.00%. Expected volatility was derived using data drawn from other healthcare public companies for five to seven years prior to the date of grant and award modification. The expected life was computed utilizing the simplified method as permitted by the Securities and Exchange Commission’s Staff Accounting Bulletin No. 110, Share-Based Payment. The expected forfeiture rates are 50% and are based upon a review of our recent history and expectations as segregated between our senior officers and other grantees. The risk-free interest rate is based on the approximate yield on seven-year United States Treasury Bonds as of the date of grant and award modification. There were 450,000 options granted during the year ended December 31, 2011 (see note 14). There were no options granted during the year ended December 31, 2010. The weighted average fair value of options granted during the year ended December 31, 2009 was nominal.
The restricted stock awards are valued on the date of grant based on the fair value of our company. This value was determined to be nominal.
(p) Recent Accounting Pronouncements
In July 2011, the Financial Accounting Standards Board issued authoritative guidance for health care entities that recognize significant amounts of patient service revenue at the time the services are rendered even though they do not assess the patient’s ability to pay. These health care entities are required to present the provision for bad debts related to patient service revenue as a deduction from patient service revenue (net of contractual allowances and discounts) on their statement of operations. Additionally, those health care entities are required to provide enhanced disclosure about their policies for recognizing revenue and assessing bad debts. The amendments also require disclosures of patient service revenue (net of contractual allowances and discounts) as well as qualitative and quantitative information about changes in the allowance for doubtful accounts. The guidance is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2011, with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our business, financial position, results of operations or liquidity.
In September 2011, the Financial Accounting Standards Board issued authoritative guidance that simplifies the goodwill impairment assessment by allowing a company to first review qualitative factors to determine the likelihood of whether the fair value of a reporting unit is less than its carrying amount before applying the two-step goodwill impairment test. If it is determined that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, the company would not be required to perform the two-step goodwill impairment test for that reporting unit. This update
became effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011 with early adoption permitted. The adoption of this guidance is not expected to have a material impact on our business, financial position, results of operations or liquidity.
(5) Acquisitions
On August 1, 2011, we purchased five long-term acute care hospitals (the “Facilities”), which operate at seven locations, from HealthSouth Corporation and certain affiliates of HealthSouth Corporation (collectively, the “Sellers”), pursuant to an Asset Purchase Agreement (the “Purchase Agreement”). According to the Purchase Agreement, we acquired substantially all of the non-real estate assets (excluding accounts receivable and certain other components of working capital) in exchange for a cash purchase price of approximately $42.5 million less the value of working capital associated with the Facilities. We financed the acquisition with a combination of an incremental term loan from our existing senior secured credit facility and cash on hand. In addition, Health Care REIT, Inc. purchased the real estate assets associated with four of these Facilities from the Sellers for $75.0 million. We simultaneously entered into a lease with Health Care REIT, Inc. for these properties as discussed below.
On May 17, 2011, we entered into an amendment, (the “Incremental Amendment”), to our current credit agreement (the “Credit Agreement”), with JPMorgan Chase Bank, N.A., the lenders party thereto, and the other agents named therein. The Incremental Amendment provided for an additional $47.2 million in new senior secured term loans. Proceeds were restricted to (i) payment of consideration for the acquisition of the Facilities, (ii) payment of fees and expenses in connection with the acquisition of the Facilities and (iii) working capital purposes of the Company and its subsidiaries. The new senior secured term loans have the same terms as the outstanding senior secured term loans, including with respect to interest rate, amortization, maturity date and optional and mandatory prepayments. On August 1, 2011, in connection with the completion of the acquisition and the funding of the additional term loan proceeds, we paid a consent fee of $1.4 million to the lenders under the Credit Agreement for consenting to the Incremental Amendment.
On August 1, 2011, we entered into a Second Amended and Restated Master Lease Agreement (the “Second Amended and Restated Lease”) with Health Care REIT, Inc., which includes the real estate properties for two of our existing operations and the four new Facilities discussed previously. The Second Amended and Restated Lease became effective with respect to the hospitals on August 1, 2011 and its initial 15-year term ends on July 31, 2026. The Second Amended and Restated Lease contains an option to renew for one 14-year, 11-month renewal term. The rent for the hospitals under the Second Amended and Restated Lease is computed based upon Health Care REIT, Inc.’s investment amount multiplied by the greater of (i) a spread over the trading yield on 10-year U.S. Treasury Notes, or (ii) 9.71%, and is subject to an annual inflation adjustment. In addition, on August 1, 2011 we paid a transaction fee of $750,000 to Health Care REIT, Inc., and an indirect parent of the Company granted a warrant to HealthCare REIT, Inc. to purchase 6.25% of the shares of Holdings’ common stock on August 1, 2011, with an exercise price of $0.01 per share.
The assets acquired and liabilities assumed of the Facilities have been recognized at their acquisition date fair values. The allocation of the purchase price to the assets acquired and liabilities assumed of the Facilities (and the related estimated lives of depreciable tangible and identifiable intangible assets) requires a significant amount of judgment. The initial allocation of the purchase price has been determined based upon the analysis performed. Any premium paid by us in this transaction is attributable to strategic benefits, including enhanced financial and operational scale, and market diversification. The goodwill associated with this transaction is fully deductible for income tax purposes.
In connection with this transaction, we recorded acquisition-related expenses of approximately $3.0 million in the year ended December 31, 2011. Acquisition-related expenses are included in other operating expenses in our consolidated statements of earnings.
The following table presents the amounts we recognized as of the acquisition date for each major class of assets acquired and liabilities assumed in the transaction. Amounts are in thousands of dollars.
The Facilities’ results of operations have been included in our consolidated financial statements prospectively beginning August 1, 2011. Our statement of earnings for the year ended December 31, 2011 includes net patient service revenues and operating net loss of approximately $40.9 million and $0.1 million, respectively, related to the Facilities.
On December 1, 2011, we purchased selected assets of a long-term acute care hospital from Vibra Specialty Hospital (“Vibra”), pursuant to an Asset Purchase Agreement. According to the agreement, we acquired substantially all of the inventory and equipment, along with some indentified liabilities. We financed the acquisition with a combination of $5.6 million available cash and a $5.0 million noninterest bearing note payable to Vibra. We recorded the note payable at its discounted net present value, as discussed in note 8. The note payable is to be paid in six equal quarterly payments of $0.8 million beginning March 1, 2012.
The assets acquired and liabilities assumed in the acquisition have been recognized at their acquisition date fair values. The allocation of the purchase price to the assets acquired and liabilities assumed (and the related estimated lives of depreciable tangible and identifiable intangible assets) requires a significant amount of judgment. The allocation of the purchase price has been determined based upon the analysis performed. Any premium paid by us in this transaction is attributable to strategic benefits, including enhanced financial and operational scale. The goodwill associated with this transaction is fully deductible for income tax purposes.
The following table presents the amounts we recognized as of the acquisition date for each major class of assets acquired and liabilities assumed in the transaction. Amounts are in thousands of dollars.
In connection with the acquisition, we relocated and merged our existing operations into the operating location formerly utilized by Vibra. In addition, we entered into an early termination agreement with the landlord for the lease of our former operating location whereby we will pay an early termination fee of $1.8 million, payable over an 18 month period. This fee, along with other costs associated with the abandonment of the facility, was accrued as exit cost as of December 31, 2011. We also recorded a loss of $3.0 million for the write-off of unamortized leasehold improvements and abandonment of equipment no longer in service associated with our former operating location.
The following pro forma information assumes the acquisitions had occurred at the beginning of the earliest period presented. Such results have been prepared by adjusting our historical results to include the results of operations, exit cost, depreciation, amortization of acquired definite-lived intangibles and incremental interest related to acquisition debt related to the entities acquired during the year. The pro forma results do not include any cost savings that may result from the combination of the Company’s and facilities acquired. The pro forma results may not necessarily reflect the consolidated operations that would have existed had the acquisition been completed at the beginning of such period nor are they necessarily indicative of future results. Amounts are in thousands of dollars.
(6) Property and Equipment
Property and equipment at December 31, 2011 and 2010 consist of the following (in thousands):
Depreciation expense for property and equipment for the years ended December 31, 2011, 2010, and 2009 was $9.0 million, $8.9 million, and $9.6 million, respectively.
(7) Goodwill and Other Intangible Assets
Goodwill and other intangible assets at December 31, 2011 and 2010 consist of the following (in thousands):
The fair values of the identifiable intangibles acquired and the amount of goodwill recorded as a result of the Merger and the acquisitions of operations from HealthSouth Corporation and Vibra Specialty Hospital, as discussed in note 5, were determined based primarily on our valuation. Amortization of intangible assets for the years ended December 31, 2011, 2010, and 2009 was $46,000, $0.7 million, and $1.1 million, respectively.
Estimated amortization expense is as follows: $0.3 million for the year 2012, $0.3 million for the year 2013, $0.3 million for the year 2014, $0.2 million for the year 2015, and $0.2 million in 2016. This amortization primarily related to the value associated with the non-compete agreements entered into in connection with acquisitions completed during 2011. The useful lives of the non-compete agreements are 4 to 5 years.
The changes in the carrying amount of goodwill are as follows (in thousands):
The Merger agreement provided for additional purchase price considerations that were contingent upon the resolution of certain specific issues. During the year ended December 31, 2010, goodwill was increased by $3.0 million due to distributions to the prior stockholders of our company from one of the escrow accounts, as the result of the resolution of a specific matter.
See discussion of the increase to goodwill during the year ended December 31, 2011 in note 5.
(8) Debt
Long-term debt at December 31, 2011 and 2010 consists of the following (in thousands):
During the year ended December 31, 2009, we repurchased $11.2 million of our outstanding senior subordinated notes for $5.8 million. This resulted in us recording a $5.2 million gain, net of the write-off of $0.2 million of capitalized financing costs, on the early extinguishment of this indebtedness.
Senior Secured Credit Facility
As a result of the impending maturities and increasingly more restrictive covenant requirements under our previous senior secured credit facility, we entered into a new senior secured credit facility on February 1, 2011, that consisted of (a) an initial $257.5 million senior secured term loan (subject to paid in kind interest options as discussed below) and (b) a senior secured revolving credit facility providing for borrowings of up to $30.0 million (the “Credit Agreement”). Availability of borrowings under the revolving credit facility are reduced by outstanding letters of credit, which were $5.6 million as of December 31, 2011. The proceeds of this new Credit Agreement along with available cash on hand were utilized to pay off our previous senior secured credit facility, revolving credit facility and the fees and expenses associated with the new Credit Agreement.
The terms of the Credit Agreement also provide that we had the right to request additional term loan commitments of up to $50.0 million. See note 5 discussing the utilization of this right.
Borrowings under the term loan facility of the Credit Agreement bear interest at a rate per annum equal to an applicable margin plus, at our option, either (a) an alternate base rate determined by reference to the highest of (1) the prime rate of JPMorgan Chase Bank, N.A., (2) the federal funds rate in effect on such date plus 1/2 of 1% and (3) the LIBOR rate for a one month interest period plus 1% or (b) a LIBOR rate determined by reference to the cost of funds for U.S. dollar deposits for the relevant interest period adjusted for certain additional costs. The applicable margin percentage is 12.25% for term loans that are alternate base rate loans and 13.25% for term loans based on the LIBOR rate. For the term loans, we may, in our discretion, elect for the relevant interest period (a) to pay the entire amount of interest in cash or (b) to pay 5.50% of such interest “in-kind” by adding such interest to the outstanding principal of the term loans as of the applicable interest payment date. The average interest rate for the term loan facility for the years ended December 31, 2011, 2010, and 2009 was 13.05%, 4.65%, and 5.33%, respectively, and the average rate at December 31, 2011 and 2010 was 13.65% and 4.54%, respectively.
The applicable margin percentage is 6.75% for revolving loans that are alternate base loans and 7.75% for revolving loans that are based on the LIBOR rate, subject to quarterly adjustments based on our leverage ratio (as defined in the new senior secured credit agreement). In addition to paying interest on outstanding principal under the senior secured credit agreement, we are required to pay a commitment fee of 0.50% per annum in respect of the unutilized commitments under the revolving credit facility, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). We are also required to pay annual customary agency fees.
We are required to make scheduled quarterly payments under the senior secured term loan facility equal to 0.25% of the original principal amount of the term loan and the additional principal amount borrowed on August 1, 2011, with the balance payable on February 1, 2016. Additionally, we are required to prepay outstanding term loans under this agreement with (a) 100% of the net cash proceeds of any debt or equity issued by us or our restricted subsidiaries (with exceptions for certain debt permitted to be incurred or equity permitted to be issued under the agreement), (b) commencing with the year ending December 31, 2011, 75% (which percentage will be reduced to 50% if our senior secured leverage ratio (as defined in the Credit Agreement) is less than 4:00 to 1:00) of our annual excess cash flow (as defined in the Credit Agreement), and (c) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us or our restricted subsidiaries, subject to reinvestment rights and certain other exceptions specified in the Credit Agreement. Mandatory prepayments of the term loans, subject to certain exceptions, are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such repayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014.
We may voluntarily prepay outstanding loans under the term loan facility and reduce the unutilized portion of the commitment amount in respect of the senior secured revolving credit facility at any time. Any such voluntary prepayments are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such prepayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014. Other than as described above, prepayments are not subject to any premium or penalty other than customary “breakage” costs with respect to loans based on the LIBOR rate.
The term loan and revolving credit facility under the Credit Agreement have scheduled maturity dates of February 1, 2016, and February 1, 2015, respectively. However, if our outstanding senior subordinated notes are not refinanced, purchased or defeased in full by May 15, 2013, then the term loan and the then outstanding balance under the revolving credit facility will be due in full on May 15, 2013.
The Credit Agreement also imposes certain financial covenants on us including: a maximum ratio of 6.0x consolidated EBITDA to total senior secured indebtedness tested quarterly, beginning on the last day of the fourth quarter of 2011; and a minimum ratio of 1.25x consolidated EBITDA to consolidated cash interest expense, tested quarterly beginning on the last day of the fourth fiscal quarter of 2011. The maximum leverage ratio is scheduled to adjust to 5.75x beginning with the
trailing four quarter period ending June 30, 2012. The minimum interest coverage ratio is scheduled to adjust to 1.30x beginning with the trailing four quarter period ending March 31, 2013. We believe we are currently in compliance with the covenants of our senior secured credit facility.
The Credit Agreement is secured by substantially all of our tangible and intangible assets, except for assets held by subsidiaries that have been designated as nonguarantor subsidiaries. The Credit Agreement also contains certain customary representations and warranties, affirmative covenants and events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross defaults to certain material indebtedness, certain events of bankruptcy, certain events under ERISA, change of control, material judgments, failure of certain guaranty documents to be in full force and effect and failure of a lien to have the priority or otherwise be valid and perfected with respect to material collateral.
If we are unable to maintain compliance with the covenants and requirements contained in the Credit Agreement, an event of default could occur, unless we are able to obtain a waiver or enter into an amendment with the senior lenders to revise the covenants and requirements. If any such event of default occurs, the lenders under the Credit Agreement would be entitled to take various actions, including the acceleration of amounts due under the Credit Agreement, terminating access to our revolving credit facility, and all actions permitted to be taken by a secured creditor. If we are required to obtain a waiver or execute an amendment to the Credit Agreement, it is likely we will incur additional fees and expenses, and will be required to pay a higher interest margin on our outstanding indebtedness in subsequent periods. An event of default would have a material adverse effect on our financial position, results of operations and cash flow.
Senior Subordinated Notes
On August 11, 2005, we sold $150.0 million of our 9 1/4% Senior Subordinated Notes (the “Notes”) due 2013. The Notes are unconditionally guaranteed on a senior subordinated basis by substantially all of our wholly owned subsidiaries (the “Subsidiary Guarantors”) on a joint and several basis, except for assets held by subsidiaries that have been designated as nonguarantor subsidiaries, as noted previously. See note 20 for the condensed consolidating financial information for LifeCare Holdings, Inc., the Subsidiary Guarantors, and the nonguarantor subsidiaries. There are no restrictions on our ability to obtain funds from Subsidiary Guarantors. The guarantees of the Notes are subordinated in right of payment to all existing and future senior indebtedness of the Subsidiary Guarantors, including any borrowings or guarantees by those subsidiaries under the senior credit facility. The Notes rank equally in right of payment with all of our existing and future senior subordinated indebtedness and senior to all of our existing and future subordinated indebtedness.
We are currently entitled at our option to redeem all or a portion of the Notes at the principal amount on the redemption date, plus accrued interest to the redemption date
We are not required to make any mandatory redemption or sinking fund payments with respect to the Notes. However, upon the occurrence of any change of control of our company, each holder of the Notes shall have the right to require us to repurchase such holder’s notes at a purchase price in cash equal to 101% of the principal amount thereof on the date of purchase plus accrued and unpaid interest, if any, to the date of purchase.
The indenture governing the Notes contains customary events of default and affirmative and negative covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to incur or guarantee additional indebtedness, pay dividends or make other equity distributions, purchase or redeem capital stock, make certain investments, enter into arrangements that restrict dividends from subsidiaries, transfer and sell assets, engage in certain transactions with affiliates and effect a consolidation or merger.
Note Payable
On December 1, 2011, in connection with the acquisition of operations from Vibra Specialty Hospital (“Vibra”), we entered into a $5.0 million note payable with Vibra. The note is noninterest bearing; therefore we have discounted the note using a rate based on our estimated incremental borrowing rate for a similarly structured debt. The note payable is paid in six equal quarterly payments of $0.8 million beginning March 1, 2012.
Other
Capitalized costs of $26.3 million incurred in obtaining financing under the credit facility including the revolving line of credit, the Notes, and the amendment to the credit facility as of December 31, 2011 are being amortized over the terms of the related debt using the effective interest method. The capitalized cost associated with the senior secured credit facility are being amortized through the accelerated maturity date of May 15, 2013, which is the maturity date in the event the senior subordinated notes are not refinanced, purchased or defeased in full prior to May 15, 2013.
Amortization expense for capitalized financing costs for the years ended December 31, 2011, 2010, and 2009 was $7.8 million, $2.3 million, and $2.2 million, respectively.
Maturities of long-term debt as of December 31, 2011 are as follows (in thousands):
The above table does not reflect future excess cash flow prepayments, if any, that may be required under our new senior secured term loan or additional principal amounts that could become outstanding as a result of any future paid in kind interest elections that we may make under our new secured term loan.
(9) Leases
We lease healthcare facilities, corporate office space, and certain equipment under cancelable and noncancelable operating lease agreements generally with initial terms of one to 15 years with varying renewal terms.
Total future minimum lease payments under all noncancelable operating leases are as follows (in thousands):
We are obligated under capital equipment leases that expire at various dates. At December 31, 2011 and 2010, equipment under capital leases included in property and equipment totaled $8.8 million, less accumulated amortization of $6.7 million, and $8.7 million, less accumulated amortization of $6.0 million, respectively. Future minimum lease payment obligations at December 31, 2011 under these leases are as follows (in thousands):
For the years ended December 31, 2011, 2010, and 2009, amortization of approximately $0.7 million, $0.8 million, and $0.7 million, respectively, of equipment under capital leases was included in our depreciation and amortization expense.
We, as lessor, also sublease medical office space at our North Texas-Dallas facility. We have operating leases with tenants with initial terms of one to three years with varying renewal terms. Annual rents collected from these tenants approximate $0.2 million. Due to the move of this facility related to the Vibra acquisition, as discussed in note 5, these subleases have been terminated in 2012.
(10) Lease Financing Obligation
On September 1, 2006, a newly formed subsidiary (“Nonguarantor Tenant”) of the Company entered into a separate Master Lease Agreement (“Nonguarantor Lease”) with Health Care REIT, Inc. to acquire and develop hospital facilities (“Nonguarantor Facilities”). The Company granted Health Care REIT, Inc. the limited right and option, for a three-year period, to acquire or develop and subsequently lease Nonguarantor Facilities to Nonguarantor Tenant. Nonguarantor Tenant would sublease each Facility to a wholly-owned subsidiary of Nonguarantor Tenant (“Subtenant”) and the licensed operator of each Nonguarantor Facility would be the Nonguarantor Tenant or a Subtenant. In connection with this Lease, Health Care REIT, Inc. agreed to make available up to $250.0 million for investments in hospital facilities, subject to certain terms and conditions. The initial term of the Nonguarantor Lease is 15 years and the Nonguarantor Tenant has one 15-year renewal option. Upon each addition of a Nonguarantor Facility, the term would be extended to a date 15 years from the date of the addition. At the end of the term, the Nonguarantor Tenant may exercise an option to purchase the Nonguarantor Facilities at a price equal to the greater of the investment amount (which will include acquisition costs, development costs, renovation costs, closing cost and fees) or fair value.
The initial rent for each Nonguarantor Facility under the Nonguarantor Lease was computed based on a predetermined spread over the rate of a 15-year U.S. Treasury Note and is subject to an annual inflation adjustment. Nonguarantor Lease payments are secured by receivables, assignment of leases and rents, assignment of management agreements, subordination of management fees and distributions, and cross-defaults, as well as a second lien on personal property and equipment owned by the Nonguarantor Tenant. The Nonguarantor Lease contains customary covenants, representations and warranties.
Our Boise, Idaho facility was the first facility to be developed under this Nonguarantor Lease. This facility was completed in March 2008 with construction cost of approximately $19.1 million. This particular facility under this Nonguarantor Lease was accounted for as a lease financing obligation whereby the asset remains capitalized on our balance sheet. This facility opened during April 2008.
In connection with this facility and in accordance with the terms of the Nonguarantor Lease, we have $1.4 million in letters of credit outstanding at December 31, 2011, payable to the Health Care REIT, Inc. utilizing capacity available for letters of credit under our revolving credit agreement.
The Nonguarantor Tenant and any future subsidiaries established under Nonguarantor Tenant, will not be guarantors of the Senior Secured Credit Facility or the 9 1/4% Senior Subordinated Notes as discussed in note 8.
(11) Income Taxes
Income tax expense attributable to loss before income taxes consists of the following for the years ended December 31, 2011, 2010, and 2009 (in thousands):
A reconciliation of the expected federal income tax expense attributable to loss from continuing operations (computed by applying the federal corporate income tax rate of 35% to loss before income taxes) to actual income tax expense attributable to loss from continuing operations follows (in thousands):
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 2011 and 2010, are as follows (in thousands):
Pursuant to federal income tax regulations, the Merger discussed in note 2 was considered to be a non-taxable transaction. As a result, we had approximately $6.0 million of tax deductible goodwill for federal income tax purposes. Net deferred tax liabilities relate to indefinite lived intangibles and therefore are all long-term.
At December 31, 2011 we had net operating loss carry forwards for federal income tax purposes of approximately $34.1 million, which are available to offset future taxable income, if any, through 2031.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deductible temporary differences giving rise to the deferred tax assets are deductible, management believes that it is not more likely than not that we will realize the benefits of these deductible temporary differences. Accordingly, a valuation allowance of $20.7 million has been recorded as of December 31, 2011.
(12) Insurance Arrangements
Our professional and general liability insurance is provided through a combination of self-insurance, purchased insurance coverage from commercial carriers, and through participation in certain state-sponsored malpractice programs. Claims are covered under the policy limits in the year the claims are reported. We use independent third party actuarial estimates prepared at least annually as the basis for our accrual of the ultimate liability related to these claims.
For the year ended December 31, 2011, we have an initial $1.5 million aggregate self-insured retention for professional and general liability claims. After obtaining the $1.5 million, it reverts to a $1.0 million self-insured retention per claim, along with excess liability coverage of $20.0 million. For the year ended December 31, 2010, self-insurance for professional and general liability claims generally was provided up to $1.0 million per occurrence, along with excess liability coverage of $20.0 million. Estimated liabilities for general and professional liability risks were $4.8 million at December 31, 2011 and $4.7 million at December 31, 2010.
Our workers’ compensation coverage was provided through a traditional fully insured plan for claims reported through August 14, 2011. Under this prior plan, the regular premiums covered the full cost of any workers’ compensation claims with no deductibles. Beginning August 15, 2011, the majority of our workers’ compensation incidents occurring on or after August 15, 2011 are now covered by a high-deductible plan whereby we are responsible for the first $0.3 million per claim. We used independent third party actuarial estimates as the basis to record the estimated ultimate liability under this plan as of December 31, 2011. The estimated liability associated with this high-deductible workers’ compensation plan was $0.5 million at December 31, 2011.
We are self-insured for employee health and dental claims up to an annual individual stop-loss limitation of $0.2 million with no lifetime maximum benefit. Estimated liabilities for employee health and dental claims were $2.4 million and $1.3 million at December 31, 2011 and 2010, respectively.
(13) 401(k) Savings Plan
Substantially all employees are eligible to participate in a profit sharing plan (“Plan”) sponsored by our company. The Plan, designed to qualify under Section 401(k) of the Internal Revenue Code, also provides for employee deferrals of compensation and discretionary company matching. For the years ended December 31, 2011 and 2010, matching contributions were suspended; however, in a future period, we may make a one-time matching contribution on a discretionary basis or we may reinstate the matching program. Employer contributions made to the Plan for the year ended December 31, 2009 totaled $1.2 million.
(14) Stock Options
At December 31, 2011, there were 2.9 million shares of common stock of Holdings available under the 2005 Equity Incentive Plan (“Plan”) for stock option grants and other incentive awards, including restricted stock units. Options granted generally have an exercise price equal to the estimated fair value of the shares on the date of grant and expire 10 years from the date of grant. A restricted stock unit is a contractual right to receive one share of Holdings common stock in the future. Options typically vest one-quarter on each of the first four anniversary dates of the grant and restricted stock units typically vest in three equal annual installments.
The year ended December 31, 2011 included no pre-tax compensation costs related to stock-based compensation arrangements. The years ended December 31, 2010, and 2009 $0.2 million and $0.3 million, respectively, of pre-tax compensation costs related to stock-based compensation arrangements.
At December 31, 2011 and 2010, there were 1,053,000 and 1,538,916, respectively, stock options vested and exercisable. At December 31, 2011 and 2010, the weighted average exercise price of the vested stock options was $2.50, and the remaining weighted average contractual life of the vested stock options was 5.6 and 6.7 years, respectively. The vested stock option shares had no intrinsic value at December 31, 2011 and 2010.
As of December 31, 2011, there was no unrecognized compensation costs related to stock options. At December 31, 2011, the weighted average remaining contractual life of outstanding options was 6.6 years.
Restricted Stock Awards
The following table summarizes restricted stock award activity:
In March 24, 2009, our former chief executive officer and former president were granted 400,000 and 300,000 shares, respectively, according to our restricted stock award agreement for meeting certain financial goals for the year ended December 31, 2008. The grant date per share fair value of these awards was nominal. The shares vest in three equal annual installments beginning on March 24, 2010.
On March 17, 2011, we entered into a separation agreement with our previous chief executive officer. The separation agreement provided for the accelerated vesting of his restricted stock award covering 400,000 shares of our common stock. On March 3, 2011, we entered into an amendment to our current chief executive officer’s employment agreement, which provided a restricted stock award covering 100,000 shares of our common stock. The shares vest in three equal annual installments beginning on March 24, 2010.
As of December 31, 2011, there was no unrecognized compensation costs related to restricted stock awards.
Warrants
In connection with the acquisition, as discussed in note 5, we granted warrants to purchase 1.3 million shares, or 6.25%, of Holdings’ common stock, with an exercise price of $0.01 per share to HealthCare REIT, Inc. The warrants expire on the later of December 31, 2026 or the termination of the lease agreement. These warrants were determined to have no value on the grant date.
(15) Fair Value of Financial Instruments
The carrying amount of cash and cash equivalents, accounts receivable, third party payor settlements, and accounts payable and accrued expenses approximates fair value because of the short-term maturity of these instruments. The carrying amount of these obligations is a reasonable estimate of fair value.
We follow the guidance for the fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of subjective inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:
Level 1 - Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
Level 2 - Inputs (other than prices included in Level 1) are either directly or indirectly observable, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Inputs are unobservable and reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
The Senior Secured Credit Facility and the Senior Subordinated Notes are traded in private institutional markets. The carrying amount of the Senior Secured Credit Facility and the Senior Subordinated Notes was $313.2 million and $119.3 million, respectively, at December 31, 2011. Using available quoted market prices, the fair values of the Senior Secured Credit Facility and the Senior Subordinated Notes were approximately $261.5 million and $92.5 million, respectively, at December 31, 2011. The carrying amount of the Senior Secured Credit Facility and the Senior Subordinated Notes was $241.6 million and $119.3 million, respectively, at December 31, 2010. Using available quoted market prices, the fair values of the Senior Secured Credit Facility and the Senior Subordinated Notes were approximately $233.8 million and $85.9 million, respectively, at December 31, 2010. The fair values are based on quoted market prices at each balance sheet date; however, these quoted market prices represent Level 2 inputs as the markets in which the Senior Secured Credit Facility and the Senior Subordinated Notes trade are not active. The carrying value of the note payable related to the Vibra acquisition, see note 5, was $4.5 million at December 31, 2011. Using available quoted market prices for our other debt as a basis, we estimated the fair market value of the note payable at $4.5 million at December 31, 2011. This valuation is categorized as a Level 2 in the valuation hierocracy. The revolving credit facility has a carrying value of $35.0 million at December 31, 2010. Using available quoted market prices for the Senior Secured Credit Facility as a basis, we estimated the fair market value of the revolving credit facility at $34.5 million at December 31, 2010. This valuation is categorized as a Level 2 in the valuation hierocracy.
(16) Business and Credit Concentrations
Our hospitals grant credit to patients under terms requiring timely payment. The hospitals generally do not require collateral or other security in extending credit to patients; however, they routinely obtain assignment of (or are otherwise entitled to receive) patients’ benefits payable under patients’ health insurance programs, plans, or policies (e.g., Medicare, Medicaid, Blue Cross, and commercial insurance policies). Because of the geographic diversity of our facilities and non-governmental third party payors, Medicare represents our largest concentration of credit risk. Net patient service revenue generated directly from the Medicare program represented approximately 60.5% for the year ended December 31, 2011, 59.2% for the year ended December 31, 2010, and 57.1% for the year ended December 31, 2009, of net patient service revenue. Approximately 46.9% and 36.3% of our gross accounts receivable at December 31, 2011 and 2010, respectively, are from this payor source.
(17) Regulatory Matters
All healthcare providers are required to comply with a significant number of laws and regulations at the federal and state government levels. These laws are extremely complex, and in many instances, providers do not have the benefit of significant regulatory or judicial interpretation as to how to interpret and/or apply these laws and regulations. The U.S. Department of Justice and other federal and state agencies are increasing resources dedicated to regulatory investigations and compliance audits of healthcare providers. As a healthcare provider, we are subject to these regulatory efforts. Healthcare providers that do not comply with these laws and regulations may be subject to civil or criminal penalties, the loss of their licenses, or restriction in their ability to participate in various federal and state healthcare programs. We endeavor to conduct our business in compliance with applicable laws and regulations, including healthcare fraud and abuse laws.
As a result of our hospital’s state licensures and certifications under the Medicare and various Medicaid programs, we are subject to regular reviews, surveys, audits and investigations conducted by, or on the behalf of, the federal and state agencies, including CMS, that are responsible for the oversight of these programs. These agency’s reviews may include reviews or surveys of our compliance with required conditions of participation regulations. The purpose of these surveys is to ensure that healthcare providers are in compliance with governmental requirements, including requirements such as adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse. These surveys may identify deficiencies with conditions of participation which require corrective actions to be made by the hospital within a given timeline. If a hospital is not successful in addressing the deficiencies and conditions in a timely manner, then CMS reserves the right to deem the hospital to be out of compliance with Medicare conditions of participation and may terminate the hospital from participation in the Medicare program. Termination of a hospital from the Medicare program would have a material adverse effect on our results of operations and cash flows.
On October 24, 2011, one of our hospitals received a notice from a surveying agency pursuant to an unannounced recertification survey that cited certain operational deficiencies and conditions that existed at the time of their survey which must be corrected in a timely manner. If the hospital was not successful in correcting the deficiencies and conditions set forth in the notification, CMS would have had the right to terminate the hospital from participation in the Medicare program as a result of the hospital being out of compliance with certain Medicare conditions of participation. On December 6, 2011, a follow-up survey was completed and the surveying agency noted the deficiencies had been corrected and that our hospital was in compliance for the recertification survey.
(18) Commitments and Contingencies
All claims raised in connection with Hurricane Katrina have been settled with no significant impact to us, except as follows. We maintained $15.0 million of general and professional liability insurance during this period, subject to a $1.0 million per claim retention. We believed that under our insurance policies, only one retention was applicable to the Hurricane Katrina matters since these matters all arose from a single event, process or condition. However, our insurance carrier sent reservation of rights letters which challenged, among other things, the application of one retention to the Hurricane Katrina related matters. On June 5, 2009, we reached an agreement with the insurance carrier regarding the reservation of rights matters whereby they would continue to pay all costs, indemnification and related expenses for the Hurricane Katrina claims in consideration for an additional $1.0 million, which was paid by us in three equal installments, on July 1, 2009, March 31, 2010, and March 31, 2011.
Significant reductions in the patient service revenues earned by a hospital may occur if we are unable to maintain the certification of the hospital as a LTAC hospital in accordance with Medicare regulations. Additionally, many of our hospitals operate in space leased from general acute care hospitals (“host hospitals”); consequently, these “hospitals within a hospital” (“HIH”) are subject to additional specific Medicare HIH regulations in addition to the general LTAC hospital regulations. The HIH regulations are designed to ensure that the hospitals are organizationally and functionally independent of their host hospitals. If a LTAC hospital located in a host hospital fails to meet the HIH regulations, it may also lose its status as a LTAC hospital. The determinations are made on an annual basis.
A provider that loses its ability to receive Medicare payments pursuant to the LTAC PPS must go through the same certification process as new LTAC hospital providers must go through to obtain their initial certification to be reimbursed pursuant to PPS. During this re-certification period, which could range from six to nine months, the provider would be paid for providing services to Medicare beneficiaries at rates that are lower than rates currently paid pursuant to PPS.
We have certain other pending and threatened litigation and claims incurred in the ordinary course of business. We believe (based, in part, on the advice of legal counsel) that the probable resolution of such contingencies will not exceed our insurance coverage and will not materially affect our consolidated financial position, results of operations or liquidity.
(19) Joint Venture
On September 1, 2009, we, along with a subsidiary of Select Medical Corporation (“Select”), each contributed our hospital operations, located in the Muskegon, Michigan market, and related licenses and provider numbers, along with $1.5 million in cash and net assets, into a newly formed limited liability company, in exchange for each receiving a 50% ownership in the newly formed entity. The joint venture, which is currently comprised of 51 beds in two separate locations in the Muskegon market, is managed by Select. The $1.5 million cash contributions made by each party were comprised of a $0.1 million equity contribution and a $1.4 million note receivable (“Subordinated Note”). The 50% ownership we have in the joint venture is held by a newly formed subsidiary of the Company and has been designated as a Nonguarantor subsidiary pursuant to our senior secured credit facility. The investment is accounted for using the equity method of accounting. The Subordinated Notes bear an interest rate of 10% and will mature on August 31, 2019. The joint venture may make quarterly payments on the Subordinated Notes with available cash flows prior to the maturity.
(20) Financial Information for Subsidiary Guarantors and Nonguarantor Subsidiaries under the Senior Subordinated Notes
The senior subordinated notes are fully and unconditionally guaranteed by substantially all of our wholly-owned subsidiaries (the “Subsidiary Guarantors”), however, certain of our subsidiaries did not guarantee the senior subordinated notes (the Nonguarantor Subsidiaries”).
Presented below is condensed consolidating financial information for LifeCare Holdings, Inc., the Subsidiary Guarantors, and the Nonguarantor Subsidiaries for the years ended December 31, 2011, 2010, and 2009. The equity method has been used with respect to investments in subsidiaries. Separate financial statements of the Subsidiary Guarantors are not presented.
LifeCare Holdings, Inc.
Condensed Consolidating Balance Sheet
December 31, 2011
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Balance Sheet
December 31, 2010
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2011
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2010
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Statement of Operations
For the Year Ended December 31, 2009
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2011
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2010
(in thousands)
LifeCare Holdings, Inc.
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2009
(in thousands)
(21) Selected Quarterly Financial Information (Unaudited)
The table below sets forth selected unaudited financial data for each quarter or the last two years (in thousands).
Operating results for the fourth quarter of 2011 included $5.3 million in exit charges and losses on disposal of assets due to the relocation of our Dallas operations. Operating results for the fourth quarter of 2010 included a charge of $0.5 million for an estimated cost-to-charge ratio reconciliation for one of our hospitals.
Part IV
Schedule II
Valuation and Qualifying Accounts
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
LIFECARE HOLDINGS, INC.
/s/ Phillip B. Douglas
Phillip B. Douglas
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed by the following persons of the registrant in the capacities and as of the dates indicated.
EXHIBIT INDEX