Item 1.
Business
Overview
We were incorporated in Delaware in 2001 as a healthcare provider and are focused primarily on providing high acuity services, including the diagnosis and treatment of cardiovascular disease. We own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence. We opened our first hospital in 1996 and currently have ownership interests in and operate 11 hospitals, including nine in which we own a majority interest. Each of our majority-owned hospitals is a freestanding, licensed general acute care hospital that provides a wide range of health services with a focus on cardiovascular care. Each of our hospitals has a 24-hour emergency room staffed by emergency department physicians. The hospitals in which we have ownership interests have a total of 667 licensed beds and are located in predominantly high growth markets in eight states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, and Texas. We are currently developing a new acute care hospital in Kingman, Arizona which we expect to open in Fall 2009. This hospital is designed to accommodate a total of 106 licensed beds and will initially open with 70 licensed beds.
In addition to our hospitals, we currently own and/or manage 25 cardiac diagnostic and therapeutic facilities. Nine of these facilities are located at hospitals operated by other parties and one of these facilities is located at a hospital in which we own a minority interest. These facilities offer invasive diagnostic and, in some cases, therapeutic procedures. The remaining 11 facilities are not located at hospitals and offer only diagnostic procedures. Effective January 1, 2007, we renamed our diagnostics division “MedCath Partners.” See Note 19 to our consolidated financial statements in Item 8 of this report for financial information by segment.
We believe our facilities provide superior clinical outcomes, which, together with our ability to provide management capabilities and capital resources, positions us to expand upon our relationships with physicians and community hospitals to increase our presence in existing and new markets. Specifically, we plan to increase our revenue and income from operations through a combination of:
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improved operating performance at our existing facilities;
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increased capacity and expanded scope of services provided at certain of our existing hospitals;
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the development of new relationships with physicians in certain of our existing markets;
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the establishment of new ventures with physicians in new markets; and
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selective evaluation of acquisitions of specialty and general acute care facilities.
We are subject to the informational requirements of the Securities Exchange Act of 1934 (the Exchange Act) and therefore, we file periodic reports, proxy statements and other information with the Securities and Exchange Commission (SEC). Such reports may be read and copied at the Public Reference Room of the SEC at 100 F Street NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at (800) SEC-0330. In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.
We maintain an Internet website at www.medcath.com that investors and interested parties can access, free-of-charge, to obtain copies of all reports, proxy and information statements and other information that the Company submits to the SEC as soon as reasonably practicable after we electronically submit such material to the SEC. This information includes copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act.
Investors and interested parties can also submit electronic requests for information directly to the Company at the following e-mail address: ir@medcath.com. Alternatively, communications can be mailed to the attention of “Investor Relations” at the Company’s executive offices.
Information on our website is not incorporated into this Form 10-K or our other securities filings and is not a part of them.
Our Strengths
Superior Clinical Outcomes. We believe our hospitals, on average, provide more complex cardiac care, achieve lower mortality rates and a shorter average length of stay, adjusted for patient severity of illness, as compared to our competitors. Since 1999, we have engaged The Lewin Group, a national health and human services consulting group, to conduct a study on cardiovascular patient outcomes based on Medicare hospital inpatient discharge data. The Lewin study, which is updated annually, has consistently concluded that, on average, we treat a more complex mix of cardiac cases as measured by the Medicare case mix index, and our hospitals have lower mortality rates and shorter length of stay, adjusted for severity, for cardiac cases, than peer community hospitals. Specifically, the most recent Lewin study, which is based on 2006 Medicare reimbursement data, concluded that when compared to peer community hospitals, our hospitals, on average and adjusted for severity, had a 21.7% higher case mix for cardiac patients, exhibited a 31.6% lower mortality rate for cardiac cases, and had a shorter length of stay for cardiac cases at 3.26 days as compared to 4.50 days. We believe quality of care is becoming increasingly important in government reimbursement. We continuously monitor quality of care standards to meet and exceed expectations.
Leading Local Market Positions in Growing Markets. Of our majority-owned hospitals that have been open for at least three years, all eight are ranked number one or two in the local market based on procedures performed in our core business diagnosis-related group (DRG), as reported by Solucient, a leading source of healthcare business information, based on 2006 MedPar data. Historically, 90% to 95% of patients treated in our hospitals reside in markets where the population of those 55 years and older, the primary recipients of cardiac care services, is anticipated to increase on average by 17.6%, from 2007 to 2012, versus the national average of 16.1%, according to U.S. census data.
Efficient Quality Care Delivery Model. Our hospitals have innovative facility designs and operating characteristics that we believe enhance the quality of patient care and service and improve physician and staff productivity. The innovative characteristics of our hospital designs include:
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fully-equipped patient rooms capable of providing the majority of services needed during a patient’s entire length of stay;
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centrally located inpatient ancillary services that reduce the amount of transportation patients must endure;
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focus on resource allocation and care management through the use of protocols for more consistent and predictable outcomes and expenses.
We believe our care delivery model leads to a high level of patient satisfaction and quality care. We selected NRC Picker to administer our inpatient satisfaction surveys as of January 1, 2006. We have performed well when compared to the NRC Picker Comparative Group with an overall rating of our hospitals of 82.6% compared to 59.9%. Our overall hospital rating increased to 85.1% during our second quarter of fiscal 2007 compared to 64.5%.
Proven Ability to Partner with Physicians. We partner with physicians and share capital commitments in all of our hospitals and many of our cardiac diagnostic and therapeutic facilities. Physicians practicing at our hospitals participate in shared governance where decisions are made on a wide range of strategic and operational matters, such as development of clinical care protocols, patient procedure scheduling, development of hospital formularies, selection of vendors for high-cost supplies and devices, review of annual operating budgets and significant capital expenditures. The opportunity to have a role in how our hospitals are managed empowers physicians and encourages them to share new ideas, concepts and practices. We attribute our success in partnering with physicians to our ability to develop and effectively manage facilities in a manner that promotes physician productivity, satisfaction and professional success while enhancing the quality and efficiency of patient care services that we provide.
Established Relationships with Community Hospital Systems. We have management and partnership arrangements with community hospital systems in many of our cardiac diagnostic and therapeutic facilities, and in certain of our hospitals. We attribute our success in establishing relationships with community hospital systems to our proven ability to work effectively with physicians and deliver quality health care. As community hospital systems seek to enhance their networks for patient access and reputation for providing quality health care
and physician relationships, we believe they will continue to seek alliances and partnerships with other entities in order to accomplish these goals. This partnership approach provides benefits to us in the form of further sharing of capital commitments and enhanced access to managed care relationships. Because of our experience in focused care, quality outcomes and partnering with physicians, we believe we offer expertise that differentiates us in the provider community.
Strong Management Team. Our management team has extensive experience and relationships in the healthcare industry. Our president and chief executive officer, O. Edwin French, was appointed to this position in February 2006 and has over 39 years of experience in the healthcare industry, most recently serving as president of the Acute Care Hospital Division for Universal Health Services. In March 2006, Phillip J. Mazzuca was named chief operating officer and brings with him over two decades of proprietary hospital operations experience either as chief executive officer or with divisional operations responsibilities. James E. Harris has been our executive vice president and chief financial officer since 1999.
Our Strategy
Key components of our strategy include:
Improve Operating Performance at Our Existing Facilities. In markets where we have well-established hospitals and cardiac diagnostic and therapeutic facilities, we intend to continue to focus on strengthening management processes and systems in an effort to improve operating performance. We will seek to:
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improve labor efficiencies by staffing to patient volumes and clinical needs;
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proactively manage the delivery of health care to achieve appropriate and efficient lengths of stay through the application of technology, medicines, and other resources which have a positive impact on the quality and cost of health care;
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control supplies expense through more favorable group purchasing arrangements and inventory management;
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focus efforts on the management of bad debt through improvement in our registration process and upfront collections as well as continued refinement of our business office operations after discharge;
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consolidate the purchased services contracts for all of our facilities to achieve better pricing; and
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improve the systems related to patient registration, billing, collections and managed care contracting to improve revenue cycle management.
Increase Patient Capacity and Expand Services at Existing Hospitals. We intend to invest in our facilities to build out existing capacity and broaden the scope of services provided based on the needs of the communities we serve. We believe demand exists in certain of our existing markets to support the development of currently unutilized space within our existing facilities. We are currently adding 28 beds to our Arkansas Heart Hospital at an estimated cost of $2.8 million and we expect to invest between $15 million and $20 million over the next 18 to 24 months to increase the number of licensed beds in certain of our existing facilities by 107 beds. We believe capital investments to expand capacity in our existing facilities represents an attractive return on invested capital and enables us to better leverage our existing fixed asset base. We expect execution of this strategy will allow us to increase patient volume, improve operating efficiency and better utilize fixed operating costs while maintaining our quality of care.
Furthermore, to increase occupancy and utilization at our hospitals, we intend to expand the scope of procedures performed in certain of our facilities. While we continue to operate some of our facilities with a primary focus on serving the unique needs of patients suffering from cardiovascular disease, we believe we will be able to expand our quality of care service offerings and improve the performance of our facilities by utilizing our expertise in partnering with physicians and operating hospitals by broadening our services to include other high acuity surgical and medical services.
Develop New Relationships with Physicians in Our Existing Markets. We intend to develop new relationships with physicians to strengthen our competitive position in certain of our existing markets. We believe that our
relationships with physicians who have a reputation for clinical excellence gives us important insights into the operation and management of our facilities and provides further motivation to provide quality, cost-effective healthcare. Further, as we strengthen our market position, we believe we will improve our ability to develop favorable managed care relationships with, and market the quality of our services to, the communities we serve. We believe this focus on the provision of quality healthcare will continue to increase patient volume.
Pursue Growth Opportunities in New Markets with Physicians and Community Hospital Systems. We will pursue growth opportunities in new markets by partnering with physicians and community hospital systems. These opportunities are expected to continue our historic focus on providing inpatient and outpatient cardiovascular care while also broadening our services to include other high acuity surgical and medical services. Community hospital systems often have limited access to the resources needed to invest in certain services, including cardiology. We believe that as a result of these limitations, our record of success in providing quality cardiovascular care, partnering with physicians and community hospital systems, and providing capital resources interests many other physicians and community hospital systems in partnering with us to provide cardiovascular care services and/or other surgical and medical services. During the fourth quarter of fiscal 2007, we announced plans to develop a 105 bed general acute care hospital in Kingman, Arizona, which we expect to open in Fall 2009.
Selectively Evaluate Acquisitions and Dispositions. We may selectively evaluate acquisitions of specialty and general acute care facilities in attractive markets throughout the United States and we will potentially consider acquisitions of facilities where we believe we can improve clinical outcomes and operating performance. We also may consider opportunistic dispositions of hospitals or other facilities where a motivated buyer emerges or the facility does not meet our overall growth or financial return objectives. We will employ a disciplined approach to evaluating and qualifying acquisition and disposition opportunities.
Our Hospitals
We currently have ownership interests in and operate 11 hospitals and have one hospital under development. The following table identifies key characteristics of these hospitals.
(1)
Avera Heart Hospital of South Dakota and Harlingen Medical Center are the only hospitals in which we do not have a majority ownership interest as of September 30, 2007. We use the equity method of accounting for these hospitals, which means that we include in our consolidated statements of operations only a percentage of the hospitals’ reported net income (loss) for each reporting period. Harlingen Medical Center was consolidated prior to July 2007 and is included in the consolidated statements of operations for the years ended September 30,
2005 and 2006 and for the first three quarters of fiscal 2007 and was included in the consolidated balance sheet as of September 30, 2006 as a consolidated hospital.
(2)
We are currently expanding Louisiana Medical Center and Heart Hospital by 120 general acute care beds. After expansion, the hospital will contain capacity for 178 private rooms.
(3)
Based upon our review of the long-term outlook for Heart Hospital of Lafayette, we decided to seek to dispose of our interest in the facility and entered into a confidentiality and exclusivity agreement with a potential buyer during the fourth quarter of fiscal 2006. Subsequent to September 30, 2007, we completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians.
(4)
This hospital is under development and is expected to open in the month indicated.
(5)
Hualapai Mountain Medical Center is designed to accommodate 106 inpatient beds, but will initially open with 70 licensed beds.
Before designing and constructing our first hospital, we consulted with our physician partners to analyze the operations, facilities and work flow of existing hospitals and found what we believed to be many inefficiencies in the way cardiovascular care was provided in existing hospitals. Based upon this analysis and our physician partners input, we designed a hospital that we believed would enhance physician and staff productivity and allow for the provision of patient-focused care. Using subsequent operating experience and further input from physicians at our other hospitals, we have refined our basic hospital layout to enable us to combine site selection, facility size and layout, staff and equipment to deliver quality high acuity care and will continue to do so at our existing facilities.
The innovative characteristics of our hospitals include:
Universal Patient Rooms. Our large, single-patient rooms enable our staff to provide all levels of care required for our patients during their entire hospital stay, including critical care, telemetry and post-surgical care. Each room is equipped as an intensive care unit, which enables us to keep a patient in the same room throughout their recovery. This approach differs from the general acute care hospital model of moving patients, potentially several times, as they recover from surgical procedures.
Centrally Located Inpatient Services. We have centrally located all services required for inpatients, including radiology, laboratory, pharmacy and respiratory therapy, in close proximity to the patient rooms, which are usually all located on a single floor in the hospital. This arrangement reduces scheduling conflicts and patient waiting time. Additionally, this eliminates the need for costly transportation staff to move patients from floor to floor and department to department.
Strategically Placed Nursing Stations. Unlike traditional hospitals with large central nursing stations, which serve as many as 30 patients, we have corner configuration nursing stations on our patient floors where each station serves six to eight patients and is located in close proximity to the patient rooms. This design provides for excellent visual monitoring of patients, allows for flexibility in staffing to accommodate the required levels of care, shortens travel distances for nurses, allows for fast response to patient calls and offers proximity to the nursing station for family members.
Efficient Workflow. We have designed and constructed our various procedure areas in close proximity to each other allowing for both patient safety and efficient staff workflow. For example, our cardiac catheterization laboratories are located in close proximity to our operating rooms, outpatient services are located immediately next to procedure areas and emergency services are located off the staff work corridor leading directly to the diagnostic and treatment areas.
Additional Capacity for Critical Cardiac Procedures. We design and construct our hospitals with more operating rooms and cardiac catheterization laboratories than we believe are available in the cardiovascular program of a typical general acute care hospital and we believe this increases physician productivity and patient satisfaction. This feature of our hospitals ensures that the physicians practicing in our hospitals will experience fewer conflicts in scheduling procedures for their patients. In addition, all of our operating rooms are designed primarily for cardiovascular procedures, which enable them to be used more efficiently by physicians and staff.
Diagnostic and Therapeutic Facilities
We have participated in the development of or have acquired interests in, and provide management services to facilities where physicians diagnose and treat cardiovascular disease and manage hospital-based cardiac catheterization laboratories. We also own and operate mobile cardiac catheterization laboratories serving hospital networks and maintain a number of mobile and modular cardiac catheterization laboratories that we lease on a short-term basis. These diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories are equipped to allow the physicians using them to employ a range of diagnostic and treatment options for patients suffering from cardiovascular disease.
Managed Diagnostic and Therapeutic Facilities. Currently we own and/or manage the operations of 25 cardiac diagnostic and therapeutic facilities. The following table provides information about these facilities.
(1)
Our management agreement with each of these facilities includes an option for us to extend the initial term at increments ranging from one to 10 years, through an aggregate of up to an additional 40 years for some of the facilities.
(2)
The ownership interest refers to our ownership in the entities that have entered into, and provided services to, the facilities under management services agreements or professional services agreements.
(3)
Calendar year.
Our management services generally include providing all non-physician personnel required to deliver patient care and the administrative, management and support functions required in the operation of the facility. The physicians who supervise or perform diagnostic and therapeutic procedures at these facilities have complete control over the delivery of cardiovascular healthcare services. The management agreements for each of these centers generally have an extended initial term and several renewal options ranging from one to 10 years each. The physicians and hospitals with which we have contracts to operate these centers may terminate the agreements under certain circumstances. We may terminate most of these agreements for cause or upon the occurrence of specified material adverse changes in the business of the facilities. We intend to develop with hospitals and physician groups, or acquire contracts to manage, additional diagnostic and therapeutic facilities in the future.
Interim Mobile Catheterization Labs. We maintain a rental fleet of mobile and modular cardiac catheterization laboratories. We lease these laboratories on a short-term basis to hospitals while they are either adding capacity to their existing facilities or replacing or upgrading their equipment. We also lease these laboratories to hospitals that experience a higher demand for cardiac catheterization procedures during a particular season of the year and choose not to expand their own facilities to meet peak period demand. Our rental and modular laboratories are manufactured by leading original equipment manufacturers and have advanced technology and enable cardiologists to perform both diagnostic and interventional therapeutic procedures. Each of our rental units is generally in service for an average of nine months of the year. These units enable us to be responsive to immediate demand and create flexibility in our operations.
Major Procedures Performed at Our Facilities
The following is a brief description of the major cardiovascular procedures physicians perform at our hospitals and other facilities.
Invasive Procedures
Cardiac catheterization: percutaneous intravascular insertion of a catheter into any chamber of the heart or great vessels for diagnosis, assessment of abnormalities, interventional treatment and evaluation of the effects of pathology on the heart and great vessels.
Percutaneous cardiac intervention, including the following:
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Atherectomy: a technique using a cutting device to remove plaque from an artery. This technique can be used for coronary and non-coronary arteries.
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Angioplasty: a method of treating narrowing of a vessel using a balloon catheter to dilate the narrowed vessel. If the procedure is performed on a coronary vessel, it is commonly referred to as a percutaneous transluminal coronary angioplasty, or PTCA.
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Percutaneous balloon angioplasty: the insertion of one or more balloons across a stenotic heart valve.
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Stent: a small expandable wire tube, usually stainless steel, with a self-expanding mesh introduced into an artery. It is used to prevent lumen closure or restenosis. Stents can be placed in coronary arteries as well as renal, aortic and other peripheral arteries. A drug-eluting stent is coated with a drug that is intended to prevent the stent from reclogging with scar tissue after a procedure.
Brachytherapy: a radiation therapy using implants of radioactive material placed inside a coronary stent with restenosis.
Electrophysiology study: a diagnostic study of the electrical system of the heart. Procedures include the following:
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Cardiac ablation: removal of a part, pathway or function of the heart by surgery, chemical destruction, electrocautery or radio frequency.
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Pacemaker implant: an electrical device that can substitute for a defective natural pacemaker and control the beating of the heart by a series of rhythmic electrical discharges.
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Automatic Internal Cardiac Defibrillator: cardioverter implanted in patients at high risk for sudden death from ventricular arrhythmias.
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Cardiac assist devices: a mechanical device placed inside of a person’s chest where it helps the heart pump oxygen rich blood throughout the body.
Coronary artery bypass graft surgery: a surgical establishment of a shunt that permits blood to travel from the aorta to a branch of the coronary artery at a point past the obstruction.
Valve Replacement Surgery: an open-heart surgical procedure involving the replacement of valves that regulate the flow of blood between chambers in the heart, which have become narrowed or ineffective due to the build-up of calcium or scar tissue or the presence of some other physical damage.
Non-Invasive Procedures
Cardiac magnetic resonance imaging: a test using a powerful magnet to produce highly detailed, accurate and reproducible images of the heart and surrounding structures as well as the blood vessels in the body without the need for contrast agents.
Echocardiogram with color flow doppler, or ultrasound test: a test which produces real time images of the interior of the heart muscle and valves, which are used to accurately evaluate heart valve and muscle problems and measure heart muscle damage.
Nuclear treadmill exercise test or nuclear angiogram: a test which involves the injection of a low level radioactive tracer isotope into the patient’s bloodstream during exercise on a motorized treadmill, which is frequently used to screen patients who may need cardiac catheterization and to evaluate the results in patients who have undergone angioplasty or cardiac surgery.
Standard treadmill exercise test: a test which involves a patient exercising on a motorized treadmill while the electrical activity of the patient’s heart is measured, which is frequently used to screen for heart disease.
Ultrafast computerized tomography: a test which can detect the buildup of calcified plaque in coronary arteries before the patient experiences any symptoms.
Employees
As of September 30, 2007, we employed 3,444 persons, including 2,501 full-time and 943 part-time employees. None of our employees is a party to a collective bargaining agreement and we consider our relationships with our employees to be good. There currently is a nationwide shortage of nurses and other medical support personnel, which makes recruiting and retaining these employees difficult. We provide competitive wages and benefits and offer our employees a professional work environment that we believe helps us recruit and retain the staff we need to operate our hospitals and other facilities.
We do not currently employ any practicing physicians at any of our hospitals or other facilities. Our hospitals are staffed by licensed physicians who have been admitted to the medical staffs of individual hospitals. Any licensed physician - not just our physician partners - may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by the hospital’s medical staff and governing board in accordance with established credentialing criteria.
Environmental Matters
We are subject to various federal, state and local laws and regulations governing the use, storage, discharge and disposal of hazardous materials, including medical waste products. We believe that all of our facilities and practices comply with these laws and regulations and we do not anticipate that any of these laws will have a material adverse effect on our operations. We cannot predict, however, whether environmental issues may arise in the future.
Insurance
Like most health care providers, we are subject to claims and legal actions in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts and with deductibles and levels of self-insured retention that we believe are sufficient for our operations. We also maintain umbrella liability coverage to cover claims not covered by our professional malpractice liability or general liability insurance policies. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - General and Professional Liability Risk.”
We can offer no assurances that our professional liability and general liability insurance, nor our recorded reserves for self-insured retention, will cover all claims against us or continue to be available at reasonable costs for us to maintain adequate levels of insurance in the future.
Competition
In executing our business strategy, we compete primarily with other cardiovascular care providers, principally for-profit and not-for-profit general acute care hospitals. We also compete with other companies pursuing strategies similar to ours, and with not-for-profit general acute care hospitals that may elect to develop a hospital. In most of our markets we compete for market share of cardiovascular procedures with two to three hospitals. Some of the hospitals that compete with our hospitals are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Some of our competitors are larger, are more established, have greater geographic coverage, offer a wider range of services or have more capital or other resources than we do. If our competitors are able to finance capital improvements, recruit physicians, expand services or obtain favorable managed care contracts at their facilities, we may experience a decline in market share. In operating our hospitals, particularly in performing outpatient procedures, we compete with free-standing diagnostic and therapeutic facilities located in the same markets.
Reimbursement
Medicare. Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease. Under the Medicare program, we are paid for certain inpatient and outpatient services performed by our hospitals and also for services provided at our diagnostic and therapeutic facilities.
Medicare payments for inpatient acute services are generally made pursuant to a prospective payment system. Under this system, hospitals are paid a prospectively determined fixed amount for each hospital discharge based on the patient’s diagnosis. Specifically, each discharge is assigned to a diagnosis-related group (DRG). Based upon the patient’s condition and treatment during the relevant inpatient stay, each DRG is assigned a fixed payment rate that is prospectively set using national average costs per case for treating a patient for a particular diagnosis. The DRG rates are adjusted by an update factor each federal fiscal year, which begins on October 1. The update factor is determined, in part, by the projected increase in the cost of goods and services that are purchased by hospitals, referred to as the market basket index. DRG payments do not consider the actual costs incurred by a hospital in providing a particular inpatient service; however, such payments are adjusted by a predetermined geographic adjustment factor assigned to the geographic area in which the hospital is located.
While hospitals generally do not receive direct payments in addition to a DRG payment, hospitals may qualify for an outlier payment when the relevant patient’s treatment costs are extraordinarily high and exceed a specified threshold. Outlier payments, which were established by Congress as part of the DRG prospective payment system, are additional payments made to hospitals for treating patients who are costlier to treat than the average patient. In general, a hospital receives outlier payments when its costs, as determined by using gross charges adjusted by the hospital’s cost-to-charge ratio, exceed a certain threshold established annually by the Centers for Medicare and Medicaid Services (CMS). Outlier payments are currently subject to multiple factors including but not limited to: (1) the hospital’s estimated operating costs based on its historical ratio of costs to gross charges; (2) the patient’s case acuity; (3) the CMS established threshold; and, (4) the hospital’s geographic location. CMS is required by law to limit total outlier payments to between five and six percent of total DRG payments. CMS periodically changes the
threshold in order to bring expected outlier payments within the mandated limit. An increase to the cost threshold reduces total outlier payments by (1) reducing the number of cases that qualify for outlier payments and (2) reducing the dollar amount hospitals receive for those cases that qualify. CMS historically has used a hospital’s most recently settled cost report to set the hospital’s cost-to-charge ratios. Those cost reports are typically two to three years old.
On August 22, 2007, CMS issued its final inpatient hospital prospective payment system rule for fiscal year 2008, which begins October 1, 2007. The final rule continues major DRG reforms designed to improve the accuracy of hospital payments. As introduced in the fiscal year 2007 final rule, CMS will continue to use hospital costs rather than charges to set payment rates. For fiscal year 2008, hospitals will be paid based upon a blend of 1/3 charge-based weights and 2/3 hospital cost-based weights for DRGs. Additionally, CMS adopted its proposal to restructure the current 538 DRGs to 745 MS-DRGs (severity-adjusted DRGs) to better recognize severity of patient illness. These MS-DRGs will be phased in over a two-year period..
Outpatient services are also subject to a prospective payment system. Services provided at our freestanding diagnostic facilities are typically reimbursed on the basis of the physician fee schedule, which is revised periodically, and bases payment on various factors including resource-based practice expense relative value units and geographic practice cost indices.
Future legislation may modify Medicare reimbursement for inpatient and outpatient services provided at our hospitals or services provided at our diagnostic and therapeutic facilities, but we are not able to predict the method or amount of any such reimbursement changes or the effect that such changes will have on us.
Medicaid. Medicaid is a state-administered program for low-income individuals, which is funded jointly by the federal and individual state governments. Most state Medicaid payments for hospitals are made under a prospective payment system or under programs that negotiate payment levels with individual hospitals. Medicaid reimbursement is often less than a hospital’s cost of services. States periodically consider significantly reducing Medicaid funding, while at the same time in some cases expanding Medicaid benefits. This could adversely affect future levels of Medicaid payments received by our hospitals. We are unable to predict what impact, if any, future Medicaid managed care systems might have on our operations.
The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, court decisions, executive orders and freezes and funding reductions, all of which may adversely affect our business. There can be no assurance that payments for hospital services and cardiac diagnostic and other procedures under the Medicare and Medicaid programs will continue to be based on current methodologies or remain comparable to present levels. In this regard, we may be subject to rate reductions as a result of federal budgetary or other legislation related to the Medicare and Medicaid programs. In addition, various state Medicaid programs periodically experience budgetary shortfalls, which may result in Medicaid payment reductions and delays in payment to us.
Utilization Review. Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of DRG classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department of Health and Human Services (HHS) that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.
Annual Cost Reports. Hospitals participating in the Medicare and some Medicaid programs, whether paid on a reasonable cost basis or under a prospective payment system, are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients.
Annual cost reports required under the Medicare and some Medicaid programs are subject to routine governmental audits. These audits may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs and result in a recoupment of monies paid. Finalization of these audits and determination of amounts earned under these programs often takes several years. Providers can appeal any final determination made in connection with an audit.
Program Adjustments. The Medicare, Medicaid and other federal health care programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations, and requirements for utilization review and new governmental funding restrictions, all of which may materially increase or decrease program payments as well as affect the cost of providing services and the timing of payment to facilities. The final determination of amounts earned under the programs often requires many years, because of audits by the program representatives, providers’ rights of appeal and the application of numerous technical reimbursement provisions. We believe that we have made adequate provision for such adjustments. Until final adjustment, however, previously determined allowances could become either inadequate or more than ultimately required.
Managed Care. The percentage of admissions and net revenue attributable at our hospitals and other facilities to managed care plans has increased as a result of pressures to control the cost of healthcare services. We expect that the trend toward increasing percentages related to managed care plans will continue in the future. Generally, we receive lower payments from managed care plans than from traditional commercial/indemnity insurers; however, as part of our business strategy, we intend to take steps to improve our managed care position.
Commercial Insurance. Our hospitals provide services to individuals covered by private healthcare insurance. Private insurance carriers pay our hospitals or in some cases reimburse their policyholders based upon the hospital’s established charges and the coverage provided in the insurance policy. Commercial insurers are trying to limit the costs of hospital services by negotiating discounts, and including the use of prospective payment systems, which would reduce payments by commercial insurers to our hospitals. Reductions in payments for services provided by our hospitals to individuals covered by commercial insurers could adversely affect us. We cannot predict whether or how payment by third party payors for the services provided by all hospitals and other facilities may change. Modifications in methodology or reductions in payment could adversely affect us.
Regulation
Overview. The healthcare industry is required to comply with extensive government regulation at the federal, state and local levels. Under these laws and regulations, hospitals must meet requirements to be licensed under state law and be certified to participate in government programs, including the Medicare and Medicaid programs. These requirements relate to matters such as the adequacy of medical care, equipment, personnel, operating policies and procedures, emergency medical care, maintenance of records, relationships with physicians, cost reporting and claim submission, rate-setting, compliance with building codes and environmental protection. There are also extensive government regulations that apply to our owned and managed diagnostic facilities and the physician practices that we manage. If we fail to comply with applicable laws and regulations, we could be subject to criminal penalties and civil sanctions and our hospitals and other facilities could lose their licenses and their ability to participate in the Medicare, Medicaid and other federal and state health care programs. In addition, government laws and regulations, or the interpretation of such laws and regulations, may change. If that happens, we may have to make changes in our facilities, equipment, personnel, services or business structures so that our hospitals and other healthcare facilities remain qualified to participate in these programs. We believe that our hospitals and other health care facilities are in substantial compliance with current federal, state, and local regulations and standards.
The Medicare Modernization Act and Other Healthcare Reform Initiatives
The Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Medicare Modernization Act) made significant changes to the Medicare program, particularly with respect to the coverage of prescription drugs. These modifications also include provisions affecting Medicare coverage and reimbursement to general acute care hospitals, as well as other types of providers.
The healthcare industry continues to attract much legislative interest and public attention. In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state
legislatures that, like the Medicare Modernization Act, would effect major changes in the healthcare system. Proposals that have been considered include changes in Medicare, Medicaid, and other state and federal programs, cost controls on hospitals and mandatory health insurance coverage for employees. We cannot predict the course of future healthcare legislation or other changes in the administration or interpretation of governmental healthcare programs and the effect that any legislation, interpretation, or change may have on us.
Licensure and Certification
Licensure and Accreditation. Our hospitals are subject to state and local licensing requirements. In order to verify compliance with these requirements, our hospitals are subject to periodic inspection by state and local authorities. All of our majority-owned hospitals are licensed as general acute care hospitals under applicable state law. In addition, our hospitals are accredited by the Joint Commission for Accreditation of Health Organizations (JCAHO), a nationwide commission which establishes standards relating to physical plant, administration, quality of patient care and operation of hospital medical staffs.
Certification. In order to participate in the Medicare and Medicaid programs, each provider must meet applicable regulations of the Department of Health and Human Services (HHS) and similar state entities relating to, among other things, the type of facility, equipment, personnel, standards of medical care and compliance with applicable federal, state and local laws. As part of such participation requirements and effective October 1, 2007, all physician-owned hospitals are required to provide written notice to patients that the hospital is physician-owned. Additionally, as part of a patient safety measure, all Medicare-participating hospitals must provide written notice to patients if a doctor is not present in the hospital 24 hours per day, 7 days a week. All our hospitals and our diagnostic and therapeutic facilities are certified to participate in the Medicare and Medicaid programs.
Emergency Medical Treatment and Active Labor Act. The Emergency Medical Treatment and Active Labor Act (EMTALA) imposes requirements as to the care that must be provided to anyone who seeks care at facilities providing emergency medical services. In addition, CMS has issued final regulations clarifying those areas within a hospital system that must provide emergency treatment, procedures to meet on-call requirements, as well as other requirements under EMTALA. Sanctions for failing to fulfill these requirements include exclusion from participation in the Medicare and Medicaid programs and civil monetary penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law to sue the offending hospital for damages and equitable relief. A hospital that suffers a financial loss as a direct result of another participating hospital’s violation of the law also has a similar right. Although we believe that our emergency care practices are in compliance with the law and applicable regulations, we cannot assure you that governmental officials responsible for enforcing the law or others will not assert that we are in violation of these laws nor what obligations may be imposed by regulations to be issued in the future.
Certificate of Need Laws. In some states, the construction of new facilities, the acquisition of existing facilities or the addition of new beds or services may be subject to review by state regulatory agencies under a certificate of need program. These laws generally require appropriate state agency determination of public need and approval prior to the addition of beds or services. Currently, we do not operate any hospitals in states that have adopted certificate of need laws. However, these laws may limit our ability to acquire or develop new facilities in states that have such laws. We operate diagnostic facilities in some states with certificate of need laws and we believe they are operated in compliance with applicable requirements or are exempt from such requirements. However, we cannot assure you that government officials will agree with our interpretation of these laws.
Professional Licensure. Healthcare professionals who perform services at our hospitals and diagnostic and therapeutic facilities are required to be individually licensed or certified under applicable state law. Our facilities are required to have by-laws relating to the credentialing process, or otherwise document appropriate medical staff credentialing. We take steps to ensure that our employees and agents and physicians on each hospital’s medical staff have all necessary licenses and certifications, and we believe that the medical staff members, as well as our employees and agents comply with all applicable state licensure laws as well as any hospital by-laws applicable to credentialing activities. However, we cannot assure you that government officials will agree with our position.
Corporate Practice of Medicine and Fee-Splitting. Some states have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians. Some states also have adopted laws that
prohibit direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties, and rescission of the business arrangements. These laws vary from state to state, are often vague, and in most states have seldom been interpreted by the courts or regulatory agencies. We have attempted to structure our arrangements with healthcare providers to comply with the relevant state law. However, we cannot assure you that governmental officials charged with responsibility for enforcing these laws will not assert that we, or the transactions in which we are involved, are in violation of these laws. These laws may also be interpreted by the courts in a manner inconsistent with our interpretations.
Fraud and Abuse Laws
Overview. Various federal and state laws govern financial and other arrangements among healthcare providers and prohibit the submission of false or fraudulent claims to the 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. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) broadened the scope of certain fraud and abuse laws by adding several civil and criminal statutes that apply to all healthcare services, whether or not they are reimbursed under a federal healthcare program. Among other things, HIPAA established civil monetary penalties for certain conduct, including upcoding and billing for medically unnecessary goods or services. In addition, the federal False Claims Act allows an individual to bring a lawsuit on behalf of the government, in what are known as qui tam or whistleblower actions, alleging false 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 may be entitled to share in a portion of any settlement or judgment.
Anti-Kickback Statute. The federal anti-kickback statute prohibits providers of healthcare and others from soliciting, receiving, offering, or paying, directly or indirectly, any type of remuneration in connection with the referral of patients covered by the federal healthcare programs. Violations of the anti-kickback statute may be punished by a criminal fine of up to $25,000 or imprisonment for each violation, civil fines of up to $50,000, damages of up to three times the total dollar amount involved, and exclusion from federal healthcare programs, including Medicare and Medicaid.
As authorized by Congress, the Office of Inspector General of the Department of HHS (OIG) has published safe harbor regulations that describe activities and business relationships that are deemed protected from prosecution under the anti-kickback statute. However, the failure of a particular activity to comply with the safe harbor regulations does not mean that the activity violates the anti-kickback statute. There are safe harbors for various types of arrangements, including those for personal services and management contracts and others for investment interests, such as stock ownership in companies with more than $50 million in undepreciated net tangible assets related to healthcare items and services. This publicly traded company safe harbor contains additional criteria, including that the stock must be obtained on terms and at a price equally available to the public when trading on a registered securities exchange.
The OIG is primarily responsible for enforcing the anti-kickback statute and generally for identifying fraud and abuse activities affecting government programs. In order to fulfill its duties, the OIG performs audits and investigations. In addition, the agency provides guidance to healthcare providers by issuing Special Fraud Alerts and Bulletins that identify types of activities that could violate the anti-kickback statute and other fraud and abuse laws. The OIG has identified the following arrangements with physicians as potential violations of the statute:
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payment of any incentive by the hospital each time a physician refers a patient to the hospital,
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use of free or significantly discounted office space or equipment for physicians,
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provision of free or significantly discounted billing, nursing, or other staff services,
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free training for a physician’s office staff including management and laboratory techniques,
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guarantees which provide that if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder,
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low-interest or interest-free loans, or loans which may be forgiven if a physician refers patients to the hospital,
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payment of the costs of a physician’s travel and expenses for conferences,
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payment of services which require few, if any, substantive duties by the physician, or payment for services in excess of the fair market value of the services rendered, or
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purchasing goods or services from physicians at prices in excess of their fair market value.
We have a variety of financial relationships with physicians who refer patients to our hospitals and our other facilities. Physicians own interests in each of our hospitals and some of our cardiac catheterization laboratories. Physicians may also own MedCath Corporation common stock. We also have contracts with physicians providing for a variety of financial arrangements, including leases, management agreements, independent contractor agreements, right of first refusal agreements, and professional service agreements. Although we believe that our arrangements with physicians have been structured to comply with the current law and available interpretations, some of our arrangements do not expressly meet the requirements for safe harbor protection. We cannot assure you that regulatory authorities will not determine that these arrangements violate the anti-kickback statute or other applicable laws. Also, most of the states in which we operate have adopted anti-kickback laws, some of which apply more broadly to all payors, not just to federal health care programs. Many of these state laws do not have safe harbor regulations comparable to the federal anti-kickback law and have only rarely been interpreted by the courts or other government agencies. If our arrangements were found to violate any of these anti-kickback laws we could be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid, or other governmental healthcare programs.
Physician Self-Referral Law. Section 1877 of the Social Security Act, commonly known as the Stark Law, prohibits physicians from referring Medicare and Medicaid patients for certain designated health services to entities in which they or any of their immediate family members have a direct or indirect ownership or compensation arrangement unless an exception applies. The initial Stark Law applied only to referrals of clinical laboratory services. The statute was expanded in Stark II to apply to ten additional “designated health services,” including inpatient and outpatient hospital services, and some radiology services. Sanctions for violating the Stark Law include civil monetary penalties, including up to $15,000 for each improper claim and $100,000 for any circumvention scheme, and exclusion from the Medicare or Medicaid programs. There are various ownership and compensation arrangement exceptions to the self-referral prohibition, including an exception for a physician’s ownership in an entire hospital - as opposed to an ownership interest in a hospital department - if the physician is authorized to perform services at the hospital. This exception is commonly referred to as the “whole hospital exception.” There is also an exception for ownership of publicly traded securities in a company that has stockholder equity exceeding $75 million at the end of its most recent fiscal year or on average during the three previous fiscal years, as long as the physician acquired the securities on terms generally available to the public and the securities are traded on one of the major exchanges. Exceptions are also provided for many of the customary financial arrangements between physicians and providers, including employment contracts, personal service arrangements, isolated financial transactions, payments by physicians, leases, and recruitment agreements, as long as these arrangements meet certain conditions.
As noted above, the Stark Law prohibits a physician who has a financial relationship with an entity from referring Medicare or Medicaid patients to that entity for certain designated health services. Federal regulations promulgated under the Stark Law clarify that, with respect to indirect ownership interests, common ownership in an entity does not create an indirect ownership interest by one common owner in another common owner. The Stark regulations reiterate the concept that there is no affirmative duty to investigate whether an indirect financial relationship with a referring physician exists, absent information that puts one on notice of such a relationship.
As discussed, there are various ownership and compensation arrangement exceptions to the Stark Law. In addressing the whole hospital exception, the Stark regulations specifically reiterate the statutory requirements for the exception. Additionally, the exception requires that the hospital qualify as a “hospital” under the Medicare program. The Stark Law and the Stark Regulations may also apply to certain compensation arrangements between hospitals and physicians.
The Deficit Reduction Act of 2005 (DRA) required the Secretary of HHS to develop a plan addressing several issues concerning physician investment in specialty hospitals. In August 2006, HHS submitted its required final report to Congress addressing: (1) proportionality of investment return; (2) bona fide investment; (3) annual disclosure of investment; (4) provision of care to Medicaid beneficiaries; (5) charity care; and (6) appropriate enforcement. The report reaffirms HHS’ intention to implement reforms to increase Medicare payment accuracy in the hospital inpatient prospective and ambulatory surgical center payment systems. HHS also has implemented certain “gainsharing” demonstrations are required by the DRA and other value-based payment approaches designed to align physician and hospital incentives while achieving measurable improvements in quality to care. In addition, HHS now requires transparency in hospital financial arrangements with physicians. Specifically, all hospitals are required to provide HHS information concerning physician investment and compensation arrangements that potentially implicate the physician self-referral statute, and to disclose to patients whether they have physician investors. Hospitals that do not comply in a timely manner with this new disclosure requirement may face civil penalties of $10,000 per day that they are in violation. HHS also announced its position that non-proportional returns on investments and non-bona fide investments may violate the physician self-referral statute and are suspect under the anti-kickback statute. Other components of the plan include providing further guidance concerning what is expected of hospitals that do not have emergency departments under EMTALA and changes in the Medicare enrollment form to identify specialty hospitals. Issuance of the strategic plan coincided with the sunset of a DRA provision suspending enrollment of new specialty hospitals into the Medicare program.
In connection with congressional efforts to reauthorize the State Children’s Health Insurance Program (SCHIP), the Ways and Means Committee of the United States House of Representatives passed a bill which included an amendment to the Stark Law’s whole hospital exception. Under the amendment, the exception would only be available to hospitals having a Medicare provider agreement in effect on July 24, 2007, and adhering to certain additional requirements. As part of these additional requirements, hospitals would be prohibited from increasing the number of their operating rooms and or beds, and aggregate physician ownership would be limited to 40% of the value of the investment interest and any individual physician owner could not exceed 2% of the total investment interests. These provisions of the House SCHIP bill were not included in the compromise SCHIP legislation which was ultimately vetoed by President Bush in October 2007. In November 2007, Congress sent to President Bush another compromise bill which similarly did not include any amendments to the whole hospital exception. President Bush has indicated that he will veto this legislation as well. There can be no assurance that the above amendment to the whole hospital exception, or some variation thereof, would not be enacted into law at some point either as part of the SCHIP legislation or in other legislation.
In July 2007 as part of proposed revisions to the Medicare physician fee scheduled for fiscal year 2008, CMS proposed certain additional changes to the Stark Law. In particular, the proposed rule would revise the Stark Law exception for space and equipment rentals. In instances where a physician leases space or equipment to an entity who accepts patients referred by that physician, the CMS proposal would no longer allow unit-of-service or “per click” payments for such leases. Additionally, the proposed rule would no longer treat “under arrangements” between hospitals and physician-owned entities as compensation instead of ownership relationships. Specifically, the proposal would revise the definition of “entity” under the Stark Law to include not only the entity billing for the service (as is the current definition), but also the entity that has performed the designated health service. If the proposed rule is enacted in its current form, physician-owned entities deemed to be “performing designated health services” would only be protected by satisfying an appropriate Stark Law ownership, rather than compensation, exception.
In November 2007, CMS released its final rule regarding the Medicare physician fee scheduled for fiscal year 2008. The final rule does not finalize the proposals regarding lease payments and under arrangements. Instead, CMS intends to publish a separate final rule addressing these provisions given the numerous comments received and significance of the proposals.
In September 2007, CMS published the third phase of Stark regulations. While these regulations are intended to be the final phase of the Stark rulemaking process, based upon the above and several comments by CMS in the preamble, it is likely that significant additional Stark Law changes will be proposed and perhaps adopted. None of the provisions published in September 2007 impact the Stark Law’s whole hospital exception or otherwise affect our business.
There have been few enforcement actions taken and relatively few cases interpreting the Stark Law to date, although one case struck down an aspect of the Stark regulations relating to the Stark Law’s applicability to certain types of services. As a result, there is little indication as to how courts will interpret and apply the Stark Law; however, enforcement is expected to increase. We believe we have structured our financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and the Stark regulations. In particular, we believe that our physician ownership arrangements meet the whole hospital exception. In addition, we expect to meet the exception for publicly traded securities or indirect compensation arrangements, as appropriate. The diagnostic and other facilities that we own do not furnish any designated health services as defined under the Stark regulations, and thus referrals to them are not subject to the Stark Law’s prohibitions. Similarly, our consulting and management services to physician group practices are not subject to the Stark Law’s prohibitions.
Possible amendments to the Stark Law, including any modification or revocation of the whole hospital exception upon which we rely in establishing many of our relationships with physicians, could require us to change or adversely impact the manner in which we establish relationships with physicians to develop and operate a facility, as well as our other business relationships such as joint ventures and physician practice management arrangements. We note that legislation has been introduced in Congress recently and in the past seeking to limit or restrict the whole hospital exception. There can be no assurance that future legislation will not seek to modify, limit, restrict, or revoke the whole hospital exception.
Moreover, states in which we operate periodically consider adopting physician self-referral laws, which may prohibit certain physician referrals or require certain disclosures. Some of these state laws would apply regardless of the source of payment for care. These statutes typically provide criminal and civil penalties as well as loss of licensure and may have broader prohibitions than the Stark Law or more limited exceptions. While there is little precedent for the interpretation or enforcement of these state laws, we believe we have structured our financial relationships with physicians and others to comply with applicable state laws. In addition, existing state self-referral laws may be amended. We cannot predict whether new state self-referral laws or amendments to existing laws will be enacted or, once enacted, their effect on us, and we have not researched pending legislation in all the states in which our hospitals are located.
Civil Monetary Penalties. The Social Security Act contains provisions imposing civil monetary penalties for various fraudulent and/or abusive practices, including, among others, hospitals which knowingly make payments to a physician as an inducement to reduce or limit medically necessary care or services provided to Medicare or Medicaid beneficiaries. In July 1999, the OIG issued a Special Advisory Bulletin on gainsharing arrangements. The bulletin warns that clinical joint ventures between hospitals and physicians may implicate these provisions as well as the anti-kickback statute, and specifically refers to specialty hospitals, which are marketed to physicians in a position to refer patients to the hospital, and structured to take advantage of the whole hospital exception. Hospitals specializing in heart, orthopedic, and maternity care are mentioned, and the bulletin states that these hospitals may induce investor-physicians to reduce services to patients through participation in profits generated by cost savings, in violation of a civil monetary penalty provision. Despite this initial broad interpretation of this civil monetary penalty law, in 2005 the OIG issued six advisory opinions which declined to sanction a particular gainsharing arrangement under this civil monetary penalty provision, or the anti-kickback statute, because of the specific circumstances and safeguards built into the arrangement. We believe that the ownership distributions paid to physicians by our hospitals do not constitute payments made to physicians under gainsharing arrangements. We cannot assure you, however, that government officials will agree with our interpretation of applicable law.
False Claims Prohibitions. False claims are prohibited by various federal criminal and civil statutes. In addition, the federal False Claims Act prohibits the submission of false or fraudulent claims to the Medicare, Medicaid, and other government healthcare programs. Penalties for violation of the False Claims Act include substantial civil and criminal fines, including treble damages, imprisonment, and exclusion from participation in federal health care programs. In addition, the 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 Medicare or Medicaid claims or other violations of the statute.
A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. In fact, the
DRA contains provisions which create incentives for states to enact anti-fraud legislation modeled after the federal False Claims Act.
Healthcare Industry Investigations
The federal government, private insurers and various state enforcement agencies have increased their scrutiny of providers’ business arrangements and claims in an effort to identify and prosecute fraudulent and abusive practices. There are ongoing federal and state investigations in the healthcare industry regarding multiple issues including cost reporting, billing and charge-setting practices, unnecessary utilization, physician recruitment practices, physician ownership of healthcare providers and joint ventures with hospitals. Certain of these investigations have targeted hospitals and physicians. We have substantial Medicare, Medicaid and other governmental billings, which could result in heightened scrutiny of our operations. We continue to monitor these and all other aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices are consistent with both legal requirements and current industry standards. However, because the federal and state fraud and abuse laws are complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations that are inconsistent with industry practices, including ours. Evolving interpretations of current, or the adoption of new federal or state laws or regulations could affect many of the arrangements entered into by each of our hospitals. In public statements surrounding current investigations, governmental authorities have taken positions on a number of issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some instances, government investigations that in the past have been conducted under the civil provisions of federal law may now be conducted as criminal investigations.
A number of healthcare investigations are national initiatives in which federal agencies target an entire segment of the healthcare industry. One example involved the federal government’s initiative regarding hospitals’ improper requests for separate payments for services rendered to a patient on an outpatient basis within three days prior to the patient’s admission to the hospital, where reimbursement for such services is included as part of the reimbursement for services furnished during an inpatient stay. The government targeted all hospital providers to ensure conformity with this reimbursement rule. Further, the federal government continues to investigate Medicare overpayments to prospective payment system hospitals that incorrectly report transfers of patients to other prospective payment system hospitals as discharges. Law enforcement authorities, including the OIG and the United States Department of Justice, are also increasing scrutiny of various types of arrangements between healthcare providers and potential referral sources, including so-called contractual joint ventures, to ensure that the arrangements are not designed as a mechanism to exchange remuneration for patient care referrals and business opportunities. Investigators have also demonstrated a willingness to look behind the formalities of a business transaction to determine the underlying purpose of payments between healthcare providers and potential referral sources. Recently, the OIG has also begun to investigate certain hospitals with a particularly high proportion of Medicare reimbursement resulting from outlier payments. The OIG’s workplan has indicated its intention to review hospital privileging activities within the context of Medicare conditions of participation.
It is possible that governmental or regulatory authorities could initiate investigations on these or other subjects at our facilities and such investigations could result in significant costs in responding to such investigations and penalties to us, as well as adverse publicity, declines in the value of our equity and debt securities and lawsuits brought by holders of those securities. It is also possible that our executives, managers and hospital board members, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. The positions taken by authorities in any investigations of us, our executives, managers, hospital board members or other healthcare providers, and the liabilities or penalties that may be imposed could have a material adverse effect on our business, financial condition and results of operations.
Clinical Trials at Hospitals
Our hospitals serve as research sites for physician clinical trials sponsored by pharmaceutical and device manufacturers and therefore may perform services on patients enrolled in those studies, including implantation of
experimental devices. Only physicians who are members of the medical staff of the hospital may participate in such studies at the hospital. All trials are approved by an Institutional Review Board (IRB), which has the responsibility to review and monitor each study pursuant to applicable law and regulations. Such clinical trials are subject to numerous regulatory requirements.
The industry standard for conducting preclinical testing is embodied in the investigational new drug regulations administered by the federal Food and Drug Administration (the FDA). Research conducted at institutions supported by funds from the National Institutes of Health must also comply with multiple project assurance agreements and with regulations and guidelines governing the conduct of clinical research that are administered by the National Institutes of Health, the HHS Office of Research Integrity, and the Office of Human Research Protection. Research funded by the National Institutes of Health must also comply with the federal financial reporting and record keeping requirements incorporated into any grant contract awarded. The requirements for facilities engaging in clinical trials are set forth in the code of federal regulations and published guidelines. Regulations related to good clinical practices and investigational new drugs have been mandated by the FDA and have been adopted by similar regulatory authorities in other countries. These regulations contain requirements for research, sponsors, investigators, IRBs, and personnel engaged in the conduct of studies to which these regulations apply. The regulations require that written protocols and standard operating procedures are followed during the conduct of studies and for the recording, reporting, and retention of study data and records. CMS also imposes certain requirements for billing of services provided in connection with clinical trials.
The FDA and other regulatory authorities require that study results and data submitted to such authorities are based on studies conducted in accordance with the provisions related to good clinical practices and investigational new drugs. These provisions include:
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complying with specific regulations governing the selection of qualified investigators,
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obtaining specific written commitments from the investigators,
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disclosure of financial conflicts-of-interest,
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verifying that patient informed consent is obtained,
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instructing investigators to maintain records and reports,
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verifying drug or device safety and efficacy, and
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permitting appropriate governmental authorities access to data for their review.
Records for clinical studies must be maintained for specific periods for inspection by the FDA or other authorities during audits. Non-compliance with the good clinical practices or investigational new drug requirements can result in the disqualification of data collected during the clinical trial. It may also lead to debarment of an investigator or institution or False Claims Act allegations if fraud or substantial non-compliance is detected, and subject a hospital to a recoupment of payments for services that are not covered by federal health care programs. Finally, non-compliance could lead to revocation or non-renewal of government research grants.
Failure to comply with new or revised applicable federal, state, and international clinical trial laws existing laws and regulations could subject us and physician investigators to loss of the right to conduct research, civil fines, criminal penalties, and other enforcement actions.
Finally, new final rules have been adopted by HHS related to the responsibilities of healthcare entities to maintain the privacy of patient identifiable medical information. See “- Privacy and Security Requirements.” We have implemented new policies in an attempt to comply with these rules as they apply to clinical research, including procedures to obtain all required patient authorizations. However, there is little or no guidance available as to how these rules will be enforced.
Privacy and Security Requirements
HIPAA requires the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce
in the healthcare industry. HHS has adopted final regulations establishing electronic data transmission standards that all healthcare providers must use when submitting or receiving certain healthcare transactions electronically. We believe we have complied in all material respects with these electronic data transmission standards.
HHS has also adopted final regulations containing privacy standards as required by HIPAA. The privacy regulations extensively regulate the use and disclosure of individually identifiable health-related information. We have taken extensive measures to comply with the final privacy regulations, but since there is little guidance about how these regulations will be enforced by the government, we cannot predict whether the government will agree that our healthcare facilities are in compliance.
HHS has adopted final regulations regarding security standards. These security regulations require healthcare providers to implement organizational and technical practices to protect the security of electronically maintained or transmitted health-related information. We believe we have complied in all material respects with these security standards.
Violations of the Administrative Simplification Provisions of HIPAA could result in civil penalties of up to $25,000 per type of violation in each calendar year and criminal penalties of up to $250,000 per violation. In addition, our facilities continue to remain subject to state laws that may be more restrictive than the regulations issued under HIPAA. These statutes vary by state and could impose additional penalties.
Compliance Program
The OIG has issued guidelines to promote voluntarily developed and implemented compliance programs for the healthcare industry. In response to these guidelines, we adopted a code of ethics, designated compliance officers at the parent company level and individual hospitals, established a toll-free compliance line, which permits anonymous reporting, implemented various compliance training programs, and developed a process for screening all employees through applicable federal and state databases.
We have established a reporting system, auditing and monitoring programs, and a disciplinary system to enforce the code of ethics, and other compliance policies. Auditing and monitoring activities include claims preparation and submission, and cover numerous issues such as coding, billing, cost reporting, and financial arrangements with physicians and other referral sources. These areas are also the focus of training programs.
Our policy is to require our officers and employees to participate in compliance training programs. The board of directors has established a compliance committee, which oversees implementation of the compliance program.
The committee consists of three outside directors, and is chaired by Galen Powers, a former chief counsel for the Health Care Financing Administration (now known as CMS), where he was responsible for providing legal advice on federal healthcare programs, particularly Medicare and Medicaid. The compliance committee of the board meets at least quarterly.
Joan McCanless, the Chief Clinical and Compliance Officer reports to the chief executive officer for day-to-day compliance matters and at least quarterly to the compliance committee of the board. The corporate compliance officer is a senior vice president, and has a background in nursing and hospital administration. Each hospital has its own compliance committee and compliance officer that reports to its governing board. The compliance committee of the board of directors assesses each hospital’s compliance program at least annually. The corporate compliance officer annually assesses the hospitals for compliance reviews, provides an audit guide to the hospitals to evaluate compliance with our policies and procedures and serves on the compliance committee of each hospital.
The objective of the program is to ensure that our operations at all levels are conducted in compliance with applicable federal and state laws regarding both public and private healthcare programs.
Executive Officers of MedCath Corporation
The following table sets forth information regarding MedCath’s executive officers.
O. Edwin French has served as MedCath’s President and Chief Executive Officer since February 2006. Mr. French served as MedCath’s Interim Chief Operating Officer from October 2005 to February 2006. Prior to joining MedCath, Mr. French served as president of the Acute Care Hospital Division of Universal Health Services, Inc. until his early retirement in 2005. Since then, he has served as president of French Healthcare Consulting, Inc., a consulting firm specializing in operations improvement and joint ventures. He also served as president and chief operating officer of Physician Reliance Network from 1997 to 2000, as senior vice president for healthcare companies of American Medical from 1992 to 1995, as executive vice president of Samaritan Health Systems of Phoenix (Samaritan) from 1991 to 1992 and as senior vice president of Methodist Health Systems, Inc. (Methodist) in Memphis from 1985 to 1991. Both Samaritan and Methodist are large not-for-profit hospital systems. Mr. French received his undergraduate degree in occupational education from Southern Illinois University.
Phillip J. Mazzuca has served as MedCath’s Executive Vice President and Chief Operating Officer since March 2006. From 2001 to 2006, Mr. Mazzuca served as the president of the Florida and Texas divisions of IASIS Healthcare LLC. From 1999 to 2001, Mr. Mazzuca was the chief executive officer of Town and Country Hospital, an acute care hospital in Tampa, Florida. Mr. Mazzuca received his undergraduate degree from Valparaiso University and a masters degree in hospital and healthcare administration from the University of Alabama in Birmingham.
James E. Harris has served as MedCath’s Executive Vice President and Chief Financial Officer since December 1999. From 1998 to 1999, Mr. Harris was chief financial officer of Fresh Foods, Inc., a manufacturer of fully cooked food products. From 1987 to 1998, Mr. Harris served in several different officer positions with The Shelton Companies, Inc., a private investment company. Prior to joining The Shelton Companies, Inc., Mr. Harris served two years with Ernst & Young LLP as a senior accountant. Mr. Harris received his undergraduate degree from Appalachian State University and a masters degree in business administration from Wake Forest University’s Babcock School of Management. Mr. Harris is a director of Coca-Cola Bottling Co. Consolidated.
Joan McCanless has served as MedCath’s Senior Vice President and Chief Clinical and Compliance Officer since May 2006. From 1996 to May 2006, she served as Senior Vice President of Risk Management and Decision Support. From 1993 to 1996, Ms. McCanless served as a principal of Decision Support Systems, Inc., a healthcare software and consulting firm that she co-founded. Prior to that, she was employed at the Charlotte Mecklenburg Hospital Authority where she served as vice president of administration, a department director, head nurse and staff nurse. Ms. McCanless received her undergraduate degree in nursing from the University of North Carolina at Charlotte.
Item 1A.
Item 1A.
Risk Factors
You should carefully consider and evaluate all of the information included in this report, including the risk factors set forth below before making an investment decision with respect to our securities. The following is not an exhaustive discussion of all of the risks facing our company. Additional risks not presently known to us or that we currently deem immaterial may impair our business operations and results of operations.
If the anti-kickback, physician self-referral or other fraud and abuse laws are modified, interpreted differently or if other regulatory restrictions become effective, we could incur significant civil or criminal penalties and loss of reimbursement or be required to revise or restructure aspects of our business arrangements.
The federal anti-kickback statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring items or services payable by Medicare, Medicaid or any other federal healthcare program. The anti-kickback statute also prohibits any form of remuneration in return for purchasing, leasing or ordering or arranging for or recommending the purchasing, leasing or ordering of items or services payable by these programs. The anti-kickback statute is very broad in scope and many of its provisions have not been uniformly or definitively interpreted by existing case law, regulations or advisory opinions.
Violations of the anti-kickback statute may result in substantial civil or criminal penalties, including criminal fines of up to $25,000 for each violation or imprisonment and civil penalties of up to $50,000 for each violation, plus three times the amount claimed and exclusion from participation in the Medicare, Medicaid and other federal healthcare reimbursement programs. Any exclusion of our hospitals or diagnostic and therapeutic facilities from these programs would result in significant reductions in revenue and would have a material adverse effect on our business.
The requirements of the physician self-referral statute, or Stark Law, are very complex and while federal regulations have been issued to implement all of its provisions, proper interpretation and application of the statute remains challenging. The Stark Law prohibits a physician who has a “financial relationship” with an entity from referring Medicare or Medicaid patients to that entity for certain “designated health services.” A “financial relationship” includes a direct or indirect ownership or investment interest in the entity, and a compensation arrangement between the physician and the entity. Designated health services include some radiology services and inpatient and outpatient services.
There are various ownership and compensation arrangement exceptions to this self-referral prohibition. Our hospitals rely upon the whole hospital exception to allow referrals from physician investors. Under this ownership exception, physicians may make referrals to a hospital in which he or she has an ownership interest if (1) the physician is authorized to perform services at the hospital and (2) the ownership interest is in the entire hospital, as opposed to a department or a subdivision of the hospital. Another exception for ownership of publicly traded securities permits physicians who own shares of our common stock to make referrals to our hospitals, provided our stockholders’ equity exceeded $75.0 million at the end of our most recent fiscal year or on average during the three previous fiscal years. This exception applies if, prior to the time the physician makes a referral for a designated health service to a hospital, the physician acquired the securities on terms generally available to the public and the securities are traded on one of the major exchanges.
In connection with congressional efforts to reauthorize SCHIP, the Ways and Means Committee of the United States House of Representatives passed a bill which included an amendment to the Stark Law’s whole hospital exception. Under the amendment, the exception would only be available to hospitals having a Medicare provider agreement in effect on July 24, 2007, and adhering to certain additional requirements. As part of these additional requirements, hospitals would be prohibited from increasing the number of their operating rooms and or beds, and aggregate physician ownership would be limited to 40% of the value of the investment interest and any individual physician owner could not exceed 2% of the total investment interests. These provisions of the House SCHIP bill were not included in the compromise SCHIP legislation which was ultimately vetoed by President Bush in October 2007. In November 2007, Congress sent to President Bush another compromise bill which similarly did not include any amendments to the whole hospital exception. President Bush has indicated that he will veto this legislation as well. There can be no assurance that the above amendment to the whole hospital exception, or some variation thereof, would not be enacted into law at some point in the future either as part of the SCHIP legislation or in other legislation.
In July 2007 as part of proposed revisions to the Medicare physician fee scheduled for fiscal year 2008, CMS proposed certain additional changes to the Stark Law. In particular, the proposed rule would revise the Stark Law exception for space and equipment rentals. In instances where a physician leases space or equipment to an entity who accepts patients referred by that physician, the CMS proposal would no longer allow unit-of-service or “per
click” payments for such leases. Additionally, the proposed rule would no longer treat “under arrangements” between hospitals and physician-owned entities as compensation instead of ownership relationships. Specifically, the proposal would revise the definition of “entity” under the Stark Law to include not only the entity billing for the service (as is the current definition), but also the entity that has performed the designated health service. If the proposed rule is enacted in its current form, physician-owned entities deemed to be “performing designated health services” would only be protected by satisfying an appropriate Stark Law ownership, rather than compensation, exception.
In November 2007, CMS released its final rule regarding the Medicare physician fee scheduled for fiscal year 2008. The final rule does not finalize the proposals regarding lease payments and under arrangements. Instead, CMS intends to publish a separate final rule addressing these provisions given the numerous comments received and significance of the proposals.
In September 2007, CMS published the third phase of the Stark Law final regulations. While these regulations are intended to be the final phase of the Stark Law rulemaking process, based upon the above and several comments by CMS in the preamble to the new regulations, it is likely that significant additional Stark Law changes will be proposed and perhaps adopted. None of the recently adopted regulations impact the Stark Law’s whole hospital exception or otherwise affect our business.
Possible amendments to the Stark Law, the federal anti-kickback law or other applicable regulations, including the proposed amendments to SCHIP and the CMS proposal described above, could require us to change or adversely impact the manner in which we establish relationships with physicians to develop and operate a hospital, as well as our other business relationships such as joint ventures and physician practice management arrangements. We rely on the whole hospital exception in structuring our hospital ownership relationships with physicians. There can be no assurance that future legislation will not seek to further restrict or eliminate the whole hospital exception. Any such legislation could adversely affect our business and cause us to reorganize our relationships with physicians. Moreover, many states in which we operate also have adopted, or are considering adopting, similar or more restrictive physician self-referral laws. Some of these laws prohibit referrals of patients by physicians in certain cases and others require disclosure of the physician’s interest in the healthcare facility if the physician refers a patient to the facility. Some of these state laws apply even if the payment for care does not come from the government.
Reductions or changes in reimbursement from government or third-party payors could adversely impact our operating results.
Historically, Congress and some state legislatures have, from time to time, proposed significant changes in the healthcare system. Many of these changes have resulted in limitations on, and in some cases, significant reductions in the levels of, payments to healthcare providers for services under many government reimbursement programs. Recent budget proposals, if enacted in their current form, would freeze and/or reduce reimbursement for inpatient and outpatient hospital services. The Medicare hospital inpatient prospective payment system is evaluated on an annual basis. On August 22, 2007, CMS issued its final inpatient hospital prospective payment system rule for fiscal year 2008, which begins October 1, 2007. The final rule continues major DRG reforms designed to improve the accuracy of hospital payments. As introduced in the fiscal year 2007 final rule, CMS will continue to use hospital costs rather than charges to set payment rates. For fiscal year 2008, hospitals will be paid based upon a blend of 1/3 charge-based weights and 2/3 hospital cost-based weights for DRGs. Additionally, CMS adopted its proposal to restructure the current 538 DRGs to 745 MS-DRGs (severity-adjusted DRGs) to better recognize severity of patient illness. These MS-DRGs will be phased in over a two-year period. Effective fiscal year 2009, CMS has identified eight conditions that will not be paid at a higher rate unless they were present on admission, including three serious preventable events deemed “never events.”
During the fiscal years ended September 30, 2007 and 2006, we derived 46.3% and 49.4%, respectively, of our net revenue from the Medicare and Medicaid programs. We derived an even higher percentage of our net revenue in each of these fiscal periods from these programs in our hospital division, which for our most recent fiscal quarter represented 47.8% of our net revenue. Changes in laws or regulations governing the Medicare and Medicaid
programs or changes in the manner in which government agencies interpret them could materially and adversely affect our operating results or financial position.
Our relationships with third-party payors are generally governed by negotiated agreements or out of network arrangements. These agreements set forth the amounts we are entitled to receive for our services. Third-party payors have undertaken cost-containment initiatives during the past several years, including different payment methods, monitoring healthcare expenditures and anti-fraud initiatives, that have made these relationships more difficult to establish and less profitable to maintain. We could be adversely affected in some of the markets where we operate if we are unable to establish favorable agreements with third-party payors or satisfactory out of network arrangements.
If we fail to comply with the extensive laws and government regulations applicable to us, we could suffer penalties or be required to make significant changes to our operations.
We are required to comply with extensive and complex laws and regulations at the federal, state and local government levels. These laws and regulations relate to, among other things:
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licensure, certification and accreditation,
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billing, coverage and reimbursement for supplies and services,
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relationships with physicians and other referral sources,
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adequacy and quality of medical care,
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quality of medical equipment and services,
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qualifications of medical and support personnel,
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confidentiality, maintenance and security issues associated with medical records,
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the screening, stabilization and transfer of patients who have emergency medical conditions,
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building codes,
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environmental protection,
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clinical research,
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operating policies and procedures, and
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addition of facilities and services.
Many of these laws and regulations are expansive, and we do not always have the benefit of significant regulatory or judicial interpretation of them. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.
If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including:
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criminal penalties,
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civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our facilities, and
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exclusion of one or more of our facilities from participation in the Medicare, Medicaid and other federal and state healthcare programs.
A number of initiatives have been proposed during the past several years to reform various aspects of the healthcare system at the federal level and in the states in which we operate. Current or future legislative initiatives, government regulations or other government actions may have a material adverse effect on us.
Companies within the healthcare industry continue to be the subject of federal and state investigations.
Both federal and state government agencies as well as private payors have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare organizations including hospital companies. Like others in the healthcare industry, we receive requests for information from these governmental agencies in connection with their regulatory or investigative authority which, if determined adversely to us, could have a material adverse effect on our financial condition or our results of operations.
In addition, the Office of Inspector General and the U.S. Department of Justice have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Moreover, healthcare providers are subject to civil and criminal false claims laws, including the federal False Claims Act, which allows private parties to bring what are called whistleblower lawsuits against private companies doing business with or receiving reimbursement under government programs. These are sometimes referred to as “qui tam” lawsuits.
Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware or which cannot be disclosed until the court lifts the seal from the case. 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 a federal health care program. 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, have thereby submitted false claims under the False Claims Act. Thus, it is possible that we have liability exposure under the False Claims Act.
Some states have adopted similar state whistleblower and false claims provisions. Publicity associated with the substantial amounts paid by other healthcare providers to settle these lawsuits may encourage current and former employees of ours and other healthcare providers to seek to bring more whistleblower lawsuits. Some of our activities could become the subject of governmental investigations or inquiries. Any such investigations of us, our executives or managers could result in significant liabilities or penalties to us, as well as adverse publicity.
In October 2007, we reached an agreement with the DOJ and the United States Attorneys’ Office in Phoenix, Arizona regarding clinical trials at the Arizona Heart Hospital, one of the 11 hospitals in which we own an interest. The settlement concerns Medicare claims submitted between June 1998 and October 2002 for physician services involving the implantation of certain endoluminal graft devices (utilized to treat aneurysms) that had not received final marketing approval from the FDA, and allegedly were either implanted without an approved investigational device exception (IDE) or were implanted outside of the approved IDE protocol. The DOJ allegations did not involve patient care and related solely to whether the procedures were properly reimbursable by Medicare. The parties reached a settlement of the allegations to avoid the delay, uncertainty, inconvenience, and expense of protracted litigation. Further, the hospital denies engagement in any wrongdoing or illegal conduct, and the settlement agreement does not contain any admission of liability. As disclosed in previous filings, the hospital agreed to pay approximately $5.8 million to settle and obtain a release from any civil or administrative monetary claims related to the DOJ’s investigation. Additionally, the hospital has entered into a five-year corporate integrity agreement with the OIG under which the hospital will continue to maintain its existing corporate compliance program and which relates to clinical trials conducted at the hospital. The $5.8 million was paid to the DOJ subsequent to September 30, 2007.
If laws governing the corporate practice of medicine change, we may be required to restructure some of our relationships.
The laws of various states in which we operate or may operate in the future do not permit business corporations to practice medicine, exercise control over physicians who practice medicine or engage in various business practices, such as fee-splitting with physicians. The interpretation and enforcement of these laws vary significantly from state to state. We are not required to obtain a license to practice medicine in any jurisdiction in which we own or operate a hospital or other facility because our facilities are not engaged in the practice of medicine. The
physicians who use our facilities to provide care to their patients are individually licensed to practice medicine. In most instances, the physicians and physician group practices are not affiliated with us other than through the physicians’ ownership interests in the facility and through the service and lease agreements we have with some of these physicians. Should the interpretation, enforcement or laws of the states in which we operate or may operate change, we cannot assure you that such changes would not require us to restructure some of our physician relationships.
If government laws or regulations change or the enforcement or interpretation of them change, we may be obligated to purchase some or all of the ownership interests of the physicians associated with us.
Changes in government regulation or changes in the enforcement or interpretation of existing laws or regulations could obligate us to purchase at the then fair market value some or all of the ownership interests of the physicians who have invested in the ventures that own and operate our hospitals and other healthcare businesses. Regulatory changes that could create this obligation include changes that:
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make illegal the referral of Medicare or other patients to our hospitals and other healthcare businesses by physicians affiliated with us,
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create the substantial likelihood that cash distributions from the hospitals and other healthcare businesses to our physician partners will be illegal, or
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make illegal the ownership by our physician partners of their interests in the hospitals and other healthcare businesses.
From time to time, we may voluntarily seek to increase our ownership interest in one or more of our hospitals and other healthcare businesses, in accordance with any applicable limitations. We may seek to use shares of our common stock to purchase physicians’ ownership interests instead of cash. If the use of our stock is not permitted or attractive to us or our physician partners, we may use cash or promissory notes to purchase the physicians’ ownership interests. Our existing capital resources may not be sufficient for the acquisition or the use of cash may limit our ability to use our capital resources elsewhere, limiting our growth and impairing our operations. The creation of these obligations and the possible adverse effect on our affiliation with these physicians could have a material adverse effect on us.
We may have fiduciary duties to our partners that may prevent us from acting solely in our best interests.
We hold our ownership interests in hospitals and other healthcare businesses through ventures organized as limited liability companies or limited partnerships. As general partner, manager or owner of the majority interest in these entities, we may have special legal responsibilities, known as fiduciary duties, to our partners who own an interest in a particular entity. Our fiduciary duties include not only a duty of care and a duty of full disclosure but also a duty to act in good faith at all times as manager or general partner of the limited liability company or limited partnership. This duty of good faith includes primarily an obligation to act in the best interest of each business, without being influenced by any conflict of interest we may have as a result of our own business interests.
We also have a duty to operate our business for the benefit of our stockholders. As a result, we may encounter conflicts between our fiduciary duties to our partners in our hospitals and other healthcare businesses, and our responsibility to our stockholders. For example, we have entered into management agreements to provide management services to our hospitals in exchange for a fee. Disputes may arise with our partners as to the nature of the services to be provided or the amount of the fee to be paid. In these cases, as manager or general partner we may be obligated to exercise reasonable, good faith judgment to resolve the disputes and may not be free to act solely in our own best interests or the interests of our stockholders. We cannot assure you that any dispute between us and our partners with respect to a particular business decision or regarding the interpretation of the provisions of the hospital operating agreement will be resolved or that, as a result of our fiduciary duties, any dispute resolution will be on terms favorable or satisfactory to us.
Material decisions regarding the operations of our facilities require consent of our physician and community hospital partners, and we may be unable as a result to take actions that we believe are in our best interest.
The physician and community hospital partners in our healthcare businesses participate in material strategic and operating decisions we make for these facilities. They may do so through their representatives on the governing
board of the subsidiary that owns the facility or a requirement in the governing documents that we obtain the consent of their representatives before taking specified material actions. We generally must obtain the consent of our physician and other hospital partners or their representatives before making any material amendments to the operating or partnership agreement for the venture or admitting additional members or partners. Although they have not done so to date, these rights to approve material decisions could in the future limit our ability to take actions that we believe are in our best interest and the best interest of the venture. We may not be able to resolve favorably, or at all, any dispute regarding material decisions with our physician or other hospital partners.
We may experience difficulties in executing our growth strategy.
Our growth strategy depends on our ability to identify attractive markets in which to expand existing facilities and establish new business ventures. We may have difficulty in identifying potential markets that satisfy our criteria for expansion or developing a new facility or for entering into other business arrangements. Identifying physician and community hospital partners and negotiating and implementing the terms of an agreement with them can be a lengthy and complex process. As a result, we may not be able to develop new business ventures at the rate we currently anticipate.
Our growth strategy will also increase demands on our management, operational and financial information systems and other resources. To accommodate our growth, we will need to continue to implement operational and financial information systems and controls, and expand, train, manage and motivate our employees. Our personnel, information systems, procedures or controls may not adequately support our operations in the future. Failure to recruit and retain strong management, implement operational and financial information systems and controls, or expand, train, manage or motivate our workforce, could lead to delays in developing and achieving expected operating results for new facilities.
Our growth strategy depends on our ability to identify attractive markets in which to expand existing facilities and establish new business ventures. We may have difficulty in identifying potential markets that satisfy our criteria for expansion or developing a new facility or for entering into other business arrangements. Identifying physician and community hospital partners and negotiating and implementing the terms of an agreement with them can be a lengthy and complex process. As a result, we may not be able to develop new business ventures at the rate we currently anticipate.
Our growth strategy will also increase demands on our management, operational and financial information systems and other resources. To accommodate our growth, we will need to continue to implement operational and financial information systems and controls, and expand, train, manage and motivate our employees. Our personnel, information systems, procedures or controls may not adequately support our operations in the future. Failure to recruit and retain strong management, implement operational and financial information systems and controls, or expand, train, manage or motivate our workforce, could lead to delays in developing and achieving expected operating results for new facilities.
Unfavorable or unexpected results at one of our hospitals or in one of our markets could significantly impact our consolidated operating results.
Each of our individual hospitals comprise a significant portion of our operating results and a majority of our hospitals are located in the southwestern United States. Any material change in the current demographic, economic, competitive or regulatory conditions in this region, a particular market in which one of our other hospitals operates or the United States in general could adversely affect our operating results. In particular, if economic conditions deteriorate in one or more of these markets, we may experience a shift in payor mix arising from patients’ loss of or changes in employer-provided health insurance resulting in higher co-payments and deductibles or an increased number of uninsured patients.
Growth of self-pay patients and a deterioration in the collectibility of these accounts could adversely affect our results of operations.
We have experienced growth in our self-pay patients, which includes situations in which each patient is responsible for the entire bill, as well as cases where deductibles are due from insured patients after insurance pays.
We may have greater amounts of uninsured receivables in the future and if the collectibility of those uninsured receivables deteriorates, increases in our allowance for doubtful accounts may be required, which could materially adversely impact our operating results and financial condition.
Our hospitals and other facilities face competition for patients from other healthcare companies.
The healthcare industry is highly competitive. Our facilities face competition for patients from other providers in our markets. In most of our markets we compete for market share of cardiovascular and other healthcare procedures that are the focus of our facilities with two to three providers. Some of these providers are part of large for-profit or not-for-profit hospital systems with greater financial resources than we have available to us and have been operating in the markets they serve for many years. Some of the hospitals that we compete against in certain of our markets and elsewhere have attempted to use their market position and managed care networks to influence physicians not to enter into or to abandon joint ventures that own facilities such as ours by, for example, revoking the admission privileges of our physician partners at the competing hospital. These practices of “economic credentialing” appear to be on the increase. Although these practices have not been successful to date in either preventing us from developing new ventures with physicians or causing us to lose existing investors, the future inability to attract new investors or loss of a significant number of our physician partners in one or more of our existing ventures could have a material adverse effect on our business and operating results.
We depend on our relationships with the physicians who use our facilities.
Our business depends upon the efforts and success of the physicians who provide healthcare services at our facilities and the strength of our relationships with these physicians. We generally do not employ any practicing physicians at any of our hospitals or other facilities. Each member of the medical staffs at our hospitals may also serve on the medical staffs of, and practice at, hospitals not owned by us.
At each of our hospitals, our business could be adversely affected if a significant number of key physicians or a group of physicians:
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terminated their relationship with, or reduced their use of, our facilities,
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failed to maintain the quality of care provided or to otherwise adhere to the legal professional standards or the legal requirements for the granting and renewal of privileges at our hospitals or other facilities,
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suffered any damage to their reputation,
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exited the market entirely, or
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experienced major changes in its composition or leadership.
Based upon our management’s general knowledge of the operations of our hospitals, we believe that, consistent with most hospitals in our industry, a significant portion of the patient admissions at most of our hospitals are attributable to approximately 10% of the total number of physicians on the hospital’s medical staff. Historically, the medical staff at each hospital ranges from approximately 175 to 450 physicians depending upon the size of the hospital and the number of practicing physicians in the market. If we fail to maintain our relationships with the physicians in this group at a particular hospital, many of whom are investors in our hospitals, the revenues of that hospital would be reduced. None of the physicians practicing at our hospitals has a legal commitment, or any other obligation or arrangement that requires the physician to refer patients to any of our hospitals or other facilities.
A shortage of qualified nurses could affect our ability to grow and deliver quality, cost-effective care services.
We depend on qualified nurses to provide quality service to patients in our facilities. There is currently a shortage of qualified nurses in the markets where we operate our facilities. This shortage of qualified nurses and the more stressful working conditions it creates for those remaining in the profession are increasingly viewed as a threat to patient safety and may trigger the adoption of state and federal laws and regulations intended to reduce that risk. For example, some states have adopted or are considering legislation that would prohibit forced overtime for nurses and/or establish mandatory staffing level requirements. Growing numbers of nurses are also joining unions that threaten and sometimes call work stoppages.
Historically, we have employed between approximately 100 and 240 nurses at each of our hospitals and between one and 15 at each of our diagnostic and therapeutic facilities. When we need to hire a replacement member of our nursing staff, it can several weeks to recruit for the position. We estimate the cost of recruiting and training a replacement nurse to range from $63,000 to $77,000.
In response to the shortage of qualified nurses, we have increased and are likely to have to continue to increase our wages and benefits to recruit and retain nurses or to engage expensive contract nurses until we hire permanent staff nurses. We may not be able to increase the rates we charge to offset increased costs. The shortage of qualified nurses has in the past and may in the future delay our ability to achieve our operational goals at a hospital by limiting the number of patient beds available during the start-up phase of the hospital. The shortage of nurses also makes it difficult for us in some markets to reduce personnel expense at our facilities by implementing a reduction in the size of the nursing staff during periods of reduced patient admissions and procedure volumes.
We rely heavily on our information systems and if our access to this technology is impaired or interrupted, or if such technology does not perform as warranted by the vendor, our business could be harmed and we may not comply with applicable laws and regulations.
Increasingly, our business depends in large part upon our ability to store, retrieve, process and manage substantial amounts of information. To achieve our strategic objectives and to remain in compliance with various regulations, we must continue to develop and enhance our information systems. This may require the acquisition of equipment and third-party software. Our inability to implement and utilize, in a cost-effective manner, information systems that provide the capabilities necessary for us to operate effectively, or any interruption or loss of our information processing capabilities, for any reason including if such systems do not perform appropriately, could harm our business, results of operations or financial condition.
Uninsured risks from legal actions related to professional liability could adversely affect our cash flow and operating results.
In recent years, physicians, hospitals, diagnostic centers and other healthcare providers have become subject, in the normal course of business, to an increasing number of legal actions alleging negligence in performing services, negligence in allowing unqualified physicians to perform services or other legal theories as a basis for liability. Many of these actions involve large monetary claims and significant defense costs. We may be subject to such legal actions even though a particular physician at one of our hospitals or other facilities is not our employee and the governing documents for the medical staffs of each of our hospitals require physicians who provide services, or conduct procedures, at our hospitals to meet all licensing and specialty credentialing requirements and to maintain their own professional liability insurance.
We have established a reserve for malpractice claims based on actuarial estimates made by an independent third party, who based the estimates on our historical experience with malpractice claims and assumptions about future events. Due to the considerable variability that is inherent in such estimates, including such factors as changes in medical costs and changes in actual experience, there is a reasonable possibility that the recorded estimates will change by a material amount in the near term. Also, there can be no assurance that the ultimate liability we experience under our self-insured retention for medical malpractice claims will not exceed our estimates. It is also possible that such claims could exceed the scope of coverage, or that coverage could be denied.
Our results of operations may be adversely affected from time to time by changes in treatment practice and new medical technologies.
One major element of our business model is to focus on the treatment of patients suffering from cardiovascular disease. Our commitment and that of our physician partners to treating cardiovascular disease often requires us to purchase newly approved pharmaceuticals and devices that have been developed by pharmaceutical and device manufacturers to treat cardiovascular disease. At times, these new technologies receive required regulatory approval and become widely available to the healthcare market prior to becoming eligible for reimbursement by government and other payors. In addition, the clinical application of existing technologies may expand, resulting in their increased utilization. We cannot predict when new technologies will be available to the marketplace, the rate
of acceptance of the new technologies by physicians who practice at our facilities, and when or if, government and third-party payors will provide adequate reimbursement to compensate us for all or some of the additional cost required to purchase new technologies. As such, our results of operations may be adversely affected from time to time by the additional, unreimbursed cost of these new technologies.
For example, the utilization of automatic implantable cardioverter defibrillators (AICDs) has increased due to their clinical efficacy in treating certain types of cardiovascular disease. AICDs are high-cost cardiac devices that cost often exceeds the related reimbursement. We are unable to determine if the reimbursement for these procedures will increase to a level necessary to consistently reimburse us for the cost of the devices.
In addition, advances in alternative cardiovascular treatments or in cardiovascular disease prevention techniques could reduce demand or eliminate the need for some of the services provided at our facilities, which could adversely affect our results of operations. Further, certain technologies may require significant capital investments or render existing capital obsolete which may adversely impact our cash flows or operations.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
Our executive offices are located in Charlotte, North Carolina in approximately 32,580 square feet of leased commercial office space.
Each of the ventures we have formed to develop a hospital owns the land and buildings of the hospital, with the exception of the land underlying the Heart Hospital of Austin and the land and building at Harlingen Medical Center, which we lease. Each hospital has pledged its interest in the land and hospital building to secure the long-term debt incurred to develop the hospital, and substantially all the equipment located at these hospitals is pledged as collateral to secure long-term debt. Each entity formed to own and operate a diagnostic and therapeutic facility leases its facility.
Item 3.
Item 3.
Legal Proceedings
We are involved in various litigation and proceedings in the ordinary course of our business. We do not believe, based on our experience with past litigation, and taking into account our applicable insurance coverage and the expectations of counsel with respect to the amount of our potential liability, the outcome of any such litigation, individually or in the aggregate, will have a material adverse effect upon our business, financial condition or results of operations.
In October 2007, we reached an agreement with the DOJ and the United States Attorneys’ Office in Phoenix, Arizona regarding clinical trials at the Arizona Heart Hospital, one of the 11 hospitals in which we own an interest. The settlement concerns Medicare claims submitted between June 1998 and October 2002 for physician services involving the implantation of certain endoluminal graft devices (utilized to treat aneurysms) that had not received final marketing approval from the FDA, and allegedly were either implanted without an approved investigational device exception (IDE) or were implanted outside of the approved IDE protocol. The DOJ allegations did not involve patient care and related solely to whether the procedures were properly reimbursable by Medicare. The parties reached a settlement of the allegations to avoid the delay, uncertainty, inconvenience and expense of protracted litigation. Further, the hospital denies engagement in any wrongdoing or illegal conduct, and the settlement agreement does not contain any admission of liability. As disclosed in previous filings, the hospital agreed to pay approximately $5.8 million to settle and obtain a release from any civil or administrative monetary claims related to the DOJ’s investigation. The settlement was paid to the United States in full in November 2007. Additionally, the hospital has entered into a five-year corporate integrity agreement with the OIG under which the hospital will continue to maintain its existing corporate compliance program and which relates to clinical trials conducted at the hospital. The $5.8 million was paid to the DOJ subsequent to September 30, 2007.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock began trading on July 24, 2001, on the predecessor to the Nasdaq Global Market® under the symbol “MDTH.” At December 12, 2007, there were 21,272,644 shares of common stock outstanding, the sale price of our common stock per share was $23.79, and there were 44 holders of record. The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock as reported by the Nasdaq Global Market®:
We have not declared or paid any cash dividends on our common stock and do not anticipate paying cash dividends on our common stock for the foreseeable future. The terms of our credit agreements and the indenture governing our senior notes also restrict our ability to pay and the amount of any cash dividends or other distributions to our stockholders. We anticipate that we will retain all earnings, if any, to develop and expand our business. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.” Payment of dividends in the future will be at the discretion of our board of directors and will depend upon our financial condition and operating results.
During August 2007, our board of directors approved a stock repurchase program of up to $59.0 million. The purchases will be made from time to time in the open market or in privately negotiated transactions in accordance with applicable federal and state securities laws and regulations. The extent to which we repurchase common shares and the timing of such repurchases will depend upon stock price, general economic and market conditions and other corporate considerations. The repurchase program may be discontinued at any time.
The following table summarizes our equity compensation plans as of September 30, 2007:
The following graph illustrates, for the period from September 30, 2002 through September 30, 2007, the cumulative total shareholder return of $100 invested (assuming that all dividends, if any, were reinvested) in (1) our common stock, (2) the NASDAQ Composite Stock Index and (3) the S&P Health Care Facilities Index.
The comparisons in this table are required by the rules of the Securities and Exchange Commission and, therefore, are not intended to forecast or be indicative of possible future performance of our common stock.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among MedCath Corporation, The NASDAQ Composite Index
And The S&P Health Care Facilities Index
*
$100 invested on 9/30/02 in stock or index-including reinvestment of dividends. Fiscal year ending September 30.
Copyright © 2007, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. www.researchdatagroup.com/S&P.htm
Item 6.
Item 6.
Selected Financial Data
The selected consolidated financial data have been derived from our audited consolidated financial statements. The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes, appearing elsewhere in this report.
The following table sets forth our selected consolidated financial data as of and for the years ended September 30, 2007, 2006, 2005, 2004 and 2003.
(a)
See Note 14 to the consolidated financial statements included elsewhere in this report.
(b)
Selected operating data includes consolidated hospitals in operation as of the end of the period reported in continuing operations but does not include hospitals which were accounted for using the equity method or as discontinued operations in our consolidated financial statements. During the fourth quarter of fiscal 2007, Harlingen Medical Center ceased to be a consolidated subsidiary due to the sale of a portion of the hospital.
(c)
Licensed beds represent the number of beds for which the appropriate state agency licenses a facility regardless of whether the beds are actually available for patient use.
(d)
Staffed and available beds represent the number of beds that are readily available for patient use at the end of the period.
(e)
Admissions represent the number of patients admitted for inpatient treatment.
(f)
Adjusted admissions is a general measure of combined inpatient and outpatient volume. We computed adjusted admissions by dividing gross patient revenue by gross inpatient revenue and then multiplying the quotient by admissions.
(g)
Patient days represent the total number of days of care provided to inpatients.
(h)
Adjusted patient days is a general measure of combined inpatient and outpatient volume. We computed adjusted patient days by dividing gross patient revenue by gross inpatient revenue and then multiplying the quotient by patient days.
(i)
Average length of stay (days) represents the average number of days inpatients stay in our hospitals.
(j)
We computed occupancy by dividing patient days by the number of days in the period and then dividing the quotient by the number of staffed and available beds.
(k)
Inpatients with a catheterization procedure represent the number of inpatients with a procedure performed in one of the hospitals’ catheterization labs during the period.
(l)
Inpatient surgical procedures represent the number of surgical procedures performed on inpatients during the period.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.
Overview
We are a healthcare provider focused primarily on providing high acuity services, including the diagnosis and treatment of cardiovascular disease. We own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence. We also have partnerships with community hospital systems, and we manage the cardiovascular program of various hospitals operated by other parties. We opened our first hospital in 1996 and currently have ownership interests in and operate 11 hospitals, including nine in which we own a majority interest. Each of our majority-owned hospitals is a freestanding, licensed general acute care hospital that provides a wide range of health services with a focus on cardiovascular care. Each of our hospitals has a twenty-four hour emergency room staffed by emergency department physicians. The hospitals in which we have ownership interests have a total of 667 licensed beds and are located in predominately high growth markets in eight states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, and Texas. We are currently in the process of developing a new hospital in Kingman, Arizona. We expect this hospital to open in September 2009. This hospital is designed to accommodate a total of 105 licensed beds and will initially open with 72 licensed beds.
In addition to our hospitals, we currently own and/or manage 21 cardiac diagnostic and therapeutic facilities. Nine of these facilities are located at hospitals operated by other parties and one of these facilities is located at a hospital in which we own a minority interest. These facilities offer invasive diagnostic and, in some cases, therapeutic procedures. The remaining 11 facilities are not located at hospitals and offer only diagnostic procedures. Effective January 1, 2007, we renamed our diagnostic and therapeutic division “MedCath Partners.”
We believe our facilities provide superior clinical outcomes, which, together with our ability to provide management capabilities and capital resources, positions us to expand upon our relationships with physicians and
community hospitals to increase our presence in existing and new markets. Specifically, we plan to increase our revenue and income from operations through a combination of:
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improved operating performance at our existing facilities;
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increased capacity and expanded scope of services provided at certain of our existing hospitals;
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the development of new relationships with physicians in certain of our existing markets; and
•
the establishment of new ventures with physicians in new markets.
Basis of Consolidation. We have included in our consolidated financial statements hospitals and cardiac diagnostic and therapeutic facilities over which we exercise substantive control, including all entities in which we own more than a 50% interest, as well as variable interest entities in which we are the primary beneficiary. We have used the equity method of accounting for entities, including variable interest entities, in which we hold less than a 50% interest and over which we do not exercise substantive control, and are not the primary beneficiary. Accordingly, for all periods presented, one of the hospitals in which we hold a minority interest, Avera Heart Hospital of South Dakota, is excluded from the net revenue and operating results of our consolidated company and our consolidated hospital division. During the fourth quarter of fiscal 2007, we sold a portion of our equity interest in Harlingen Medical Center; therefore, beginning in July 2007, we began excluding this hospital from net revenue and operating results of our consolidated company and our consolidated hospital division. Similarly, a number of our diagnostic and therapeutic facilities are excluded from the net revenue and operating results of our consolidated company and our consolidated MedCath Partners division. Our minority interest in the results of operations for the periods discussed for these entities is recognized as part of the equity in net earnings of unconsolidated affiliates in our statements of operations in accordance with the equity method of accounting.
During the first quarter of fiscal 2005, we closed The Heart Hospital of Milwaukee and sold substantially all of the hospital’s assets. During the fourth quarter of fiscal 2006, we sold our equity interest in Tucson Heart Hospital and we decided to seek to dispose of our interest in Heart Hospital of Lafayette and entered into a confidentiality and exclusivity agreement with a potential buyer. Accordingly, for all periods presented, the results of operations for these hospitals have been excluded from continuing operations and are reported in income (loss) from discontinued operations, net of taxes. Subsequent to September 30, 2007, we completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians. See Note 21 - Subsequent Events to the Consolidated Financial Statements.
Same Facility Hospitals. Our policy is to include, on a same facility basis, only those facilities that were open and operational during the full current and prior fiscal year comparable periods. For example, on a same facility basis for our consolidated hospital division for the fiscal year ended September 30, 2007, we exclude the results of operations of Harlingen Medical Center, which, during the fourth quarter of fiscal 2007, ceased to be a consolidated subsidiary due to the sale of a portion of the hospital.
Revenue Sources by Division. The largest percentage of our net revenue is attributable to our hospital division. The following table sets forth the percentage contribution of each of our consolidating divisions to consolidated net revenue in the periods indicated below.
Revenue Sources by Payor. We receive payments for our services rendered to patients from the Medicare and Medicaid programs, commercial insurers, health maintenance organizations, and our patients directly. Generally, our net revenue is determined by a number of factors, including the payor mix, the number and nature of procedures performed and the rate of payment for the procedures. Since cardiovascular disease disproportionately affects those
age 55 and older, the proportion of net revenue we derive from the Medicare program is higher than that of most general acute care hospitals. The following table sets forth the percentage of consolidated net revenue we earned by category of payor in each of our last three fiscal years.
A significant portion of our net revenue is derived from federal and state governmental healthcare programs, including Medicare and Medicaid, and we expect the net revenue that we receive from the Medicare program as a percentage of total consolidated net revenue will remain significant in future periods. Our payor mix may fluctuate in future periods due to changes in reimbursement, market and industry trends with self-pay patients and other similar factors.
The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, court decisions, executive orders and freezes and funding reductions, all of which may significantly affect our business. In addition, reimbursement is generally subject to adjustment following audit by third party payors, including the fiscal intermediaries who administer the Medicare program for Centers for Medicare and Medicaid Services (CMS). Final determination of amounts due providers under the Medicare program often takes several years because of such audits, as well as resulting provider appeals and the application of technical reimbursement provisions. We believe that adequate provision has been made for any adjustments that might result from these programs; however, due to the complexity of laws and regulations governing the Medicare and Medicaid programs, the manner in which they are interpreted and the other complexities involved in estimating our net revenue, there is a possibility that recorded estimates will change by a material amount in the near term. See “Business - Reimbursement” and “- Regulation.”
Critical Accounting Policies and Estimates
General. The discussion and analysis of our financial condition and results of operations are based on our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on a regular basis and make changes as experience develops or new information becomes known. Actual results may differ from these estimates under different assumptions or conditions.
We define critical accounting policies as those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine and (3) have the potential to result in materially different results under different assumptions and conditions. We believe that our critical accounting policies are those described below. For a detailed discussion of the application of these and other accounting policies, see Note 2 to the consolidated financial statements included elsewhere in this report.
Revenue Recognition. Amounts we receive for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as commercial insurers, health maintenance organizations and preferred provider organizations are generally less than our established billing rates. Payment arrangements with third-party payors may include prospectively determined rates per discharge or per visit, a discount from established charges, per diem payments, reimbursed costs (subject to limits) and/or other similar contractual arrangements. As a result, net revenue for services rendered to patients is reported at the estimated net
realizable amounts as services are rendered. We account for the difference between the estimated realizable rates under the reimbursement program and the standard billing rates as contractual adjustments.
The majority of our contractual adjustments are system-generated at the time of billing based on either government fee schedules or fee schedules contained in our managed care agreements with various insurance plans. Portions of our contractual adjustments are performed manually and these adjustments primarily relate to patients that have insurance plans with whom our hospitals do not have contracts containing discounted fee schedules, also referred to as non-contracted payors and patients that have secondary insurance plans following adjudication by the primary payor. Estimates of contractual adjustments are made on a payor-specific basis and based on the best information available regarding our interpretation of the applicable laws, regulations and contract terms. While subsequent adjustments to the systematic contractual allowances can arise due to denials, short payments deemed immaterial for continued collection effort and a variety of other reasons, such amounts have not historically been significant.
We continually review the contractual estimation process to consider and incorporate updates to the laws and regulations and any changes in the contractual terms of our programs. Final settlements under some of these programs are subject to adjustment based on administrative review and audit by third parties, which can take several years to determine. From a procedural standpoint, for government payors, primarily Medicare, we recognize estimated settlements in our consolidated financial statements based on filed cost reports. We subsequently adjust those settlements as we obtain new information from audits or reviews by the fiscal intermediary and, if the result of the fiscal intermediary audit or review impacts other unsettled and open cost reports, then we recognize the impact of those adjustments. We estimate current year settlements based on models designed to approximate our cost report filings and revise our estimates in February of each year upon completion of the actual cost report and tentative settlement. Due to the complexity of laws and regulations governing the Medicare and Medicaid programs, the manner in which they are interpreted, and the other complexities involved in estimating our net revenue, there is a reasonable possibility that recorded estimates will change by a material amount in the near term.
We provide care to patients who meet certain criteria under our charity care policy without charge or at amounts less than our established rates. Because we do not pursue collection of amounts determined to qualify as charity care, they are not reported as net revenue.
Our managed diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories operate under various contracts where management fee revenue is recognized under fixed-rate and percentage-of-income arrangements as services are rendered. In addition, certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories recognize additional revenue under cost reimbursement and equipment lease arrangements. Net revenue from our owned diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories is reported at the estimated net realizable amounts due from patients, third party payors, and others as services are rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors.
Allowance for Doubtful Accounts. Accounts receivable primarily consist of amounts due from third-party payors and patients in our hospital division. The remainder of our accounts receivable principally consist of amounts due from billings to hospitals for various cardiovascular care services performed in our MedCath Partners division and amounts due under consulting and management contracts. To provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. We estimate this allowance based on such factors as payor mix, aging and the historical collection experience and write-offs of our respective hospitals and other business units. Adverse changes in business office operations, payor mix, economic conditions or trends in federal and state governmental health care reimbursement could affect our collection of accounts receivable.
When possible, we will attempt to collect co-payments from patients prior to admission for inpatient services as a part of the pre-registration and registration processes. If unsuccessful, we will also attempt to reach a mutually agreed-upon payment arrangement at that time. To the extent possible, the estimated amount of the patient’s financial responsibility is determined based on the services to be performed, the patient’s applicable co-payment amount or percentage and any identified remaining deductible and co-insurance percentages. If payment arrangements are not provided upon admission or only a partial payment is obtained, we will attempt to collect any
estimated remaining patient balance upon discharge. We also comply with the requirements under applicable law concerning collection of Medicare co-payments and deductibles. Patients who come to our hospitals for outpatient services are expected to make payment or adequate financial arrangements before receiving services. Patients who come to the emergency room are screened and stabilized to the extent of the hospital’s capability for any emergency medical condition in accordance with applicable laws, rules and other regulations in order that financial arrangements do not delay such screening, stabilization, and appropriate disposition.
General and Professional Liability Risk. For the past three fiscal years we carried a one-year claims-made policy providing coverage for medical malpractice claim amounts of retained liability per claim, subject to an additional amounts of retained liability per claim and an aggregate for claims reported if deemed necessary. In June 2007, we entered into a new one-year claims-made policy providing coverage for medical malpractice claim amounts in excess of $3.0 million of retained liability per claim.
Because of our self-insured retention levels, we are required to recognize an estimated expense/ liability for the amount of our retained liability applicable to each malpractice claim. As of September 30, 2007 and September 30, 2006, the total estimated liability for our self-insured retention on medical malpractice claims, including an estimated amount for incurred but not reported claims, was approximately $4.2 million and $5.9 million, respectively, which is included in other accrued liabilities on our consolidated balance sheets. We maintain this reserve based on actuarial estimates prepared by an independent third party, who bases the estimates on our historical experience with claims and assumptions about future events. The liability is also impacted by the nonconsolidation of Harlingen Medical Center at September 30, 2007.
In addition to reserves for medical malpractice, we also maintain reserves for our self-insured healthcare and dental coverage provided to our employees. As of September 30, 2007 and September 30, 2006, our total estimated reserve for self-insured liabilities on employee health and dental claims was $2.5 million and $3.1 million, respectively, which is included in current liabilities in our consolidated balance sheets. We maintain this reserve based on our historical experience with claims. Further, until June 30, 2007, we maintained commercial stop loss coverage for our health and dental insurance program of $125,000 per plan participant. At July 1, 2007, this coverage was increased to $150,000 per plan participant.
We continually review our estimates for self-insured liabilities and record adjustments as experience develops or new information becomes known. The changes to the estimated liabilities are included in current operating results. Due to the considerable variability that is inherent in such estimates, including such factors as changes in medical costs and changes in actual experience, there is a reasonable possibility that the recorded estimates will change by a material amount in the near term. Also, there can be no assurance that the ultimate liability will not exceed our estimates.
Goodwill and Intangible Assets. Goodwill represents acquisition costs in excess of the fair value of net identifiable tangible and intangible assets of businesses purchased. Other intangible assets primarily consist of the value of management contracts. With the exception of goodwill, intangible assets are being amortized over periods ranging from 11 to 29 years. In accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS No. 142), we evaluate goodwill annually on September 30 for impairment, or earlier if indicators of potential impairment exist. The determination of whether or not goodwill has become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the value of our reporting units. Changes in our strategy and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of intangible assets.
For the years ended September 30, 2007, 2006 and 2005, we performed annual goodwill impairment tests. The results of the tests indicated that our goodwill was not impaired and no additional impairment was required in fiscal 2007, 2006 or 2005 for our continuing operations. The goodwill calculation for fiscal 2007 excluded Heart Hospital of Lafayette, which is reported as a discontinued operation. A separate goodwill impairment test related to this hospital was performed and it was determined that goodwill impairment for this hospital did exist. Accordingly, we recorded an impairment charge of approximately $2.8 million during the first quarter of fiscal 2007. The impairment charge is included as a component of income (loss) from discontinued operations in the statement of operations for the fiscal year ended September 30, 2007.
Long-Lived Assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144), long-lived assets, other than goodwill, are evaluated for impairment when events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of an asset and its eventual disposition are less than its carrying amount. The determination of whether or not long-lived assets have become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the estimated future cash flows expected to result from the use of those assets. Changes in our strategy, assumptions and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of long-lived assets.
During the year ended September 30, 2006, the operating performance of one of our facilities, Heart Hospital of Lafayette, was significantly below expectations. Following the consideration of the performance of the hospital as well as other strategic alternatives for the hospital, we decided to seek to dispose of the Heart Hospital of Lafayette. Accordingly, the hospital is classified as a discontinued operation in the accompanying financial statements. We evaluated the carrying value of our interest in the hospital at September 30, 2006, to ensure it was equal to or greater than the fair market value to determine whether or not impairment existed. Based upon this evaluation it was determined that our investment in Heart Hospital of Lafayette was not impaired and recorded no impairment charge for the year ended September 30, 2006 related to this asset. During the year ended September 30, 2007 our impairment evaluation resulted in total impairment charges of $4.8 million, which are included in income (loss) from discontinued operations, net of taxes. Subsequent to September 30, 2007, we completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians. See Note 21 - Subsequent Events to the Consolidated Financial Statements.
Also during the year ended September 30, 2006, we decided to discontinue the implementation of certain nurse staffing software and as a result, a $0.5 million impairment charge was recognized to write-off the costs incurred to date on such software.
During the year ended September 30, 2005, we recorded a $2.7 million impairment charge, which was comprised of $1.7 million relating to license fees associated with the use of certain accounting software and $1.0 million relating to a management contract. The accounting software was installed in two hospitals and was intended to be installed in the remaining hospitals; however, due to a lack of additional benefits provided by the system and additional installation costs required, it was determined that the system would not be installed in any additional hospitals. Therefore, the impairment charge reflects the unused license fees associated with this system. The remaining $1.0 million impairment charge relates to the excess carrying value over the fair value of a management contract due to lack of volumes and other economic factors at one managed diagnostic venture.
Earnings Allocated to Minority Interests. Earnings allocated to minority interests represent the allocation of profits and losses to minority owners in our consolidated subsidiaries. Because our hospitals are owned as joint ventures, each hospital’s earnings and losses are generally allocated for accounting purposes to us and our physician and community hospital partners on a pro-rata basis in accordance with the respective ownership percentages in the hospital. If, however, the cumulative net losses of a hospital exceed its initial capitalization and committed capital obligations of our partners, then we are required, due to the respective at-risk capital positions, by accounting principles generally accepted in the United States of America, to recognize a disproportionately higher share, up to 100%, of the hospital’s losses, instead of the smaller pro-rata share of the losses that normally would be allocated to us based upon our percentage ownership. The disproportionate allocation to us of a hospital’s losses would reduce our consolidated net income in that reporting period. When the same hospital has earnings in a subsequent period, a disproportionately higher share, up to 100%, of the hospital’s earnings will be allocated to us to the extent we have previously recognized a disproportionate share of that hospital’s losses. The disproportionate allocation to us of a hospital’s earnings would increase our consolidated net income in that reporting period.
The determination of at-risk capital position is based on the specific terms of each hospital’s operating agreement, including each partner’s contributed capital, obligation to contribute additional capital to provide working capital loans, or to guarantee the outstanding obligations of the hospital. During each of our fiscal years 2007, 2006 and 2005, our disproportionate recognition of earnings and losses in our hospitals had a net negative
impact of $0.2 million, $2.0 million, and $4.5 million, respectively, on our reported income from continuing operations before income taxes and discontinued operations.
We expect our earnings allocated to minority interests to fluctuate in future periods as we either recognize disproportionate losses and/or recoveries thereof through disproportionate profits of our hospitals. As of September 30, 2007, we have remaining cumulative disproportionate loss allocations of approximately $2.8 million that we may recover in future periods, or we may be required to recognize additional disproportionate losses, depending on the results of operations of each of our hospitals. We could also be required to recognize disproportionate losses at our other hospitals not currently in a disproportionate allocation position depending on their results of operations in future periods.
Accounting for Gains on Capital Transactions of Subsidiary. A gain on the issuance of units in one of our subsidiaries, Harlingen Medical Center, LLC (HMC), is reflected in our consolidated balance sheets for fiscal 2007 as a component of stockholders’ equity, in accordance with the provisions of Staff Accounting Bulletin 51, Revenue Recognition in Financial Statements, (SAB 51). The gain resulted from the difference between the carrying amount of our investment in HMC prior to the issuance of units and our equity investment immediately following the issuance of units. We determined that recognition of the gain as a component of equity was appropriate since HMC has historically experienced net operating losses and due to uncertainty surrounding future transactions that may involve further dilution of our equity interest in HMC. Future issuances of units to third parties will further dilute our ownership percentage and may give rise to additional gains or losses based on the offering price in comparison to the carrying value of our investment.
Income Taxes. Income taxes are computed on the pretax income based on current tax law. Deferred income taxes are recognized for the expected future tax consequences or benefits of differences between the tax bases of assets or liabilities and their carrying amounts in the consolidated financial statements. A valuation allowance is provided for deferred tax assets if it is more likely than not that these items will either expire before we are able to realize their benefit or their future deductibility is uncertain.
Developing the provision for income taxes requires significant judgment and expertise in federal and state income tax laws, regulations and strategies, including the determination of deferred tax assets and liabilities and, if necessary, any valuation allowances that may be required for deferred tax assets. Our judgments and tax strategies are subject to audit by various taxing authorities. While we believe we have provided adequately for our income tax liabilities in our consolidated financial statements, adverse determinations by these taxing authorities could have a material adverse effect on our consolidated financial condition and results of operations.
Results of Operations
Fiscal Year 2007 Compared to Fiscal Year 2006
Statement of Operations Data. The following table presents our results of operations in dollars and as a percentage of net revenue:
During the fourth quarter of fiscal 2007, we completed a recapitalization of Harlingen Medical Center. As part of the recapitalization, our ownership in Harlingen Medical Center was reduced from a majority ownership of 51.0% to a minority ownership of 36.0%. Due to this change in ownership, we began accounting for Harlingen Medical Center as an equity investment at the beginning of the fiscal quarter ended September 30, 2007 as opposed to including Harlingen Medical Center in our consolidated results of operations. As such, our fourth quarter of fiscal 2007 consolidated results exclude the financials results of Harlingen Medical Center. The following management discussion and analysis focuses on same facility fluctuations which excludes Harlingen Medical Center from the results of both fiscal 2007 and fiscal 2006 when appropriate.
Net revenue. Net revenue increased 1.8% to $719.0 million for our fiscal year ended September 30, 2007 from $706.4 million for our fiscal year ended September 30, 2006. Of this $12.6 million increase in net revenue, our hospitals generated a $17.0 million increase, which was partially offset by a $2.9 million decrease in our MedCath Partners division, a $0.3 million decrease in our cardiology consulting and management operations and a $1.2 million decrease in our corporate and other division.
On a same facility basis, excluding HMC from the results of both fiscal 2007 and fiscal 2006, our hospital net revenue increased $24.1 million, or 4.2% from the prior year.
•
Same facility adjusted admissions increased 1.5% and revenue per adjusted admissions increased 2.6% for the fiscal year ended September 30, 2007 as compared to the fiscal year ended September 30, 2006.
•
We have focused a significant amount of time and resources on the improvement of our clinical documentation process, both on an inpatient and outpatient basis. This focus has helped improve our reimbursement on a per adjusted admissions basis in both areas.
•
We have successfully renegotiated a number of managed care contracts during the course of this fiscal year, which has led to higher net revenue per admission.
Also attributing to the increase in net revenue over the prior fiscal year, during the second quarter of fiscal 2007, we recognized net positive contractual adjustments to our net revenue of $1.5 million related to the filing of our 2006 Medicare cost reports as well as other Medicare and Medicaid settlement adjustments. By contrast, we recognized adjustments that increased our net revenue by $0.8 million for prior period cost reports for fiscal 2006.
Further, the fiscal year ended September 30, 2007 was negatively impacted as a result of recording a $5.8 million reduction in net revenue for a portion of certain federal healthcare billings reimbursed in prior years. See Note 12 - Contingencies and Commitments.
Personnel expense. Personnel expense increased 0.7% to $229.8 million for fiscal 2007 from $228.4 million for fiscal 2006. As a percentage of net revenue, personnel expense decreased to 31.9% from 32.3% for the comparable periods. The $1.4 million increase in personnel expense was primarily due to a $13.9 million increase for our same facility hospital division offset by an $8.9 million reduction in share-based compensation.
On October 1, 2005, we adopted SFAS No. 123-R (revised 2004), Share-Based Payment, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. Using this methodology and since all options are immediately vested, we recognized share-based compensation of $4.3 million and $13.2 million for the fiscal year ended September 2007 and 2006, respectively. Due to the appointment of a new president and chief executive officer as well as a new chief operating officer, the issuance of stock options during fiscal 2006 was above normal historical activity.
For our same facility hospitals, on an adjusted patient day basis, personnel expense increased by 2.5% to $1,262 per adjusted patient day for the fiscal year ended September 30, 2007 from $1,231 per adjusted patient day for the comparable period in the prior year. Further, excluding the share-based compensation and the consolidated results of Harlingen Medical Center, as a percentage of net revenue, personnel expense increased to 31.3% for the fiscal year ended September 30, 2007 from 30.1% for the fiscal year ended September 30, 2006. This increase is mainly due to cost of living wage adjustments made during the first quarter of fiscal 2007.
Medical supplies expense. Medical supplies expense decreased 2.0% to $192.0 million for fiscal 2007 from $196.0 million for fiscal 2006. Further, same facility hospital medical supplies expense per adjusted patient day decreased 5.0% to $1,103 for fiscal 2007 as compared to $1,162 for fiscal 2006, reflecting the decrease in overall supplies volume as well as the shift in procedural mix from drug eluting stents to bare metal stents. Also, our supply chain initiatives helped us experience price reductions during the fiscal year as we experienced a decline in our most costly medical devices.
Bad debt expense. Bad debt expense decreased 3.0% to $55.2 million for fiscal 2007 from $56.8 million for fiscal 2006. On a same facility basis, bad debt expense decreased 2.7% to $42.6 million for fiscal 2007 compared to $43.8 million for fiscal 2006. We have experienced reductions in bad debt expense due to our continued initiatives
to improve our registration process to more timely and accurately identify patients eligible for third party benefits and to improve processes surrounding our billing and collection procedures.
Other operating expenses. Other operating expenses increased 0.8% to $142.6 million for fiscal 2007 from $141.5 million for fiscal 2006. Same facility other operating expenses increased 2.9% from $129.4 million for fiscal 2007 compared to $125.7 million for fiscal 2006. During fiscal 2007, we have experienced an increase in contract services due to the growth in volume at several of our facilities as well as increased maintenance costs at our hospitals as machinery warranties have expired at several of our facilities.
Pre-opening expenses. We incurred approximately $0.6 million in pre-opening expenses during fiscal 2007 while there were no pre-opening expenses incurred in fiscal 2006. Pre-opening expenses represent costs specifically related to projects under development, primarily new hospitals. As of September 30, 2007, we have one hospital under development, Hualapai Medcial Center in Kingman, Arizona. The amount of pre-opening expenses, if any, we incur in future periods will depend on the nature, timing and size of our development activities.
Depreciation. Depreciation decreased 3.4% to $33.6 million for the fiscal year ended September 30, 2007 as compared to $34.8 million for the fiscal year ended September 30, 2006. Excluding Harlingen Medical Center, which we began accounting for as an equity investment during the fourth quarter of fiscal 2007, depreciation remained flat at $29.8 million for the fiscal years 2007 and 2006.
Loss (gain) on disposal of property, equipment and other assets. We incurred a gain on the disposal of property, equipment and other assets of $0.1 million in fiscal 2006 compared to a loss of $1.5 million in fiscal 2007. The current year loss is a result of several assets that were disposed and replaced with improved technology to ensure the highest state of the art care for our patients.
Impairment of long-lived assets. Impairment of long-lived assets was $0.5 million in fiscal 2006. During fiscal 2006, management decided to discontinue the implementation of certain nurse staffing software and as a result, a $0.5 million impairment charge was recognized to write-off the costs incurred to date on such software. During fiscal 2007, no such impairment was recorded. See “Critical Accounting Policies - Long-Lived Assets.”
Interest expense. Interest expense decreased 29.4% to $22.5 million for fiscal 2007 compared to $31.8 million for fiscal 2006. This $9.3 million decrease in interest expense is primarily attributable to the overall reduction in our outstanding debt as we repurchased approximately $36.2 million of our senior notes, repaid $21.2 million of our REIT loan at one of our facilities, repaid $11.1 million of our equipment loan at another of our facilities, and repaid $39.9 million of our senior secured credit facility during the fiscal year ended September 30, 2007.
Loss on early extinguishment of debt. Loss on early extinguishment of debt increased to $9.9 million for fiscal 2007 compared to $1.4 million for fiscal 2006. During the fiscal year ended September 30, 2007, this loss consisted of a $3.5 million repurchase premium and the write off of approximately $1.0 million of deferred loan acquisition costs related to the prepayment of a portion of our senior notes in December 2006. We also wrote off $0.5 million in deferred loan acquisition costs during fiscal 2007 related to the prepayment of $39.9 million of our senior secured credit facility. Further, upon early repayment of $11.1 million of our equipment loan at one of our facilities, we expensed approximately $0.2 million of deferred loan acquisition costs, and as part of the Harlingen Medical Center recapitalization transaction, we incurred a $3.5 million repurchase premium and expensed approximately $1.2 million of deferred loan acquisition costs. During the fiscal year ended September 30, 2006, this loss consists of approximately $1.4 million of deferred loan acquisition costs related to the prepayment of $58.0 million of the outstanding balance of our senior secured credit facility and the prepayment of $11.9 million of our senior notes.
Interest and other income, net. Interest and other income, net remained relatively flat at $7.9 million for fiscal 2007 as compared to $7.7 million for fiscal 2006. During the fiscal year ended September 30, 2006, we received $2.0 million as a part of a settlement agreement related to a lawsuit. The proceeds received from the settlement were offset in part by $0.6 million of legal fees incurred related to the settlement. Excluding this net receipt of $1.4 million, interest and other income, net, increased $1.6 million from fiscal 2006 to fiscal 2007. This increase is due to higher interest earned on available cash and cash equivalents during the comparable periods, as well as higher rates of return on our short-term investments.
Equity in net earnings of unconsolidated affiliates. Equity in net earnings of unconsolidated affiliates increased to $5.7 million in fiscal 2007 from $4.9 million in fiscal 2006. The increase is attributable to growth in earnings at one of the hospitals in which we hold less than a 50% interest, as well as growth in earnings in various diagnostic ventures in which we hold less than a 50% interest.
Minority interest share of earnings of consolidated subsidiaries. Minority interest share of earnings of consolidated subsidiaries decreased $0.9 million in fiscal 2007 compared to fiscal 2006. Our minority interest share of earnings can fluctuate as a result of our disproportionate share accounting for our partnership interests. Our partnership operating agreements may call for the recognition of losses or profits at amounts that are disproportionate to our partnership interest.
Income tax expense. Income tax expense was $12.5 million for fiscal 2007 compared to $4.7 million for fiscal 2006, which represented an effective tax rate of approximately 42.0% and 41.3%, respectively. The overall increase in the effective rate is the result of several items that are not deductible for tax such as the exercise of incentive stock options and penalties incurred on contingencies.
Income (loss) from discontinued operations, net of taxes. During the fourth quarter of fiscal 2006, we sold our equity interest in Tucson Heart Hospital, and we decided to seek to dispose of our interest in Heart Hospital of Lafayette and we entered into a confidentiality and exclusivity agreement with a potential buyer. Accordingly, these hospitals are accounted for as discontinued operations. Subsequent to September 30, 2007, we completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians. See Note 21, Subsequent Events, to the Consolidated Financial Statements.
In accordance with SFAS No. 144, we evaluated the carrying value of the long-lived assets related to Heart Hospital of Lafayette and determined that the carrying value was in excess of the fair value. Accordingly, an impairment charge of $4.1 million was recorded in accordance with SFAS No. 144 during the first quarter of fiscal 2007. An additional impairment charge of $3.5 million was recorded during the fourth quarter of fiscal 2007. At March 31, 2007 and June 30, 2007, it was determined that the carrying value approximated fair value and no further impairment was necessary.
Fiscal Year 2006 Compared to Fiscal Year 2005
Statement of Operations Data. The following table presents our results of operations in dollars and as a percentage of net revenue:
Net revenue. Net revenue increased 5.1% to $706.4 million for our fiscal year ended September 30, 2006 from $672.0 million for our fiscal year ended September 30, 2005. Of this $34.4 million increase in net revenue, our hospital division generated a $35.1 million increase and our MedCath Partners division generated a $0.5 million increase, both of which were partially offset by a $0.9 million decrease in our cardiology consulting and management operations and a $0.3 million decrease in our corporate and other division.
The $35.1 million increase in hospital division net revenue was a result of year over year growth at the majority of our facilities driven by a 3.8% increase in hospital admissions. Adjusted admissions, which adjusts for outpatient volume, increased 4.3% over fiscal 2005. Outpatient services accounted for approximately 22.4% of revenue in fiscal 2006, up from approximately 20.3% in fiscal 2005. Also, on a consolidated basis, total catheterization procedures increased 1.9% and inpatient surgical procedures increased 0.9% for fiscal 2006, while average length of stay decreased to 3.30 days for fiscal 2006 from 3.49 days for fiscal 2005.
During the second quarter of fiscal 2006, we filed Medicare cost reports for fiscal 2005 and as a result of changes in our estimates of final settlements based on additional information, we recognized contractual allowance adjustments that increased net revenue by approximately $0.8 million. Similarly, during the second quarter of fiscal
2005 we filed Medicare cost reports for fiscal year 2004 and recognized adjustments that increased net revenue by approximately $2.3 million. Additionally, during fiscal 2006, we recognized approximately $0.4 million of contractual allowance adjustments that decreased net revenue as a result of our calculation of amounts owed to us by Medicare under disproportionate share hospital (DSH) provisions for fiscal 2005 and fiscal 2006 based on rates that are not published by Medicare until the fourth quarter of our fiscal year. DSH amounts are provided to facilities that have a high proportion of Medicaid payors and the calculation of the amounts owed is based on formulas that incorporate the number of Medicaid days among other factors. Similarly, we recognized $2.1 million in the fourth quarter of fiscal 2005 for amounts owed under the DSH provisions for fiscal 2004 and fiscal 2005.
Personnel expense. Personnel expense increased 11.1% to $228.4 million for fiscal 2006 from $205.5 million for fiscal 2005. As a percentage of net revenue, personnel expense increased to 32.3% from 30.5% for the comparable periods. The $22.9 million increase in personnel expense is a result of recording $13.2 million in share-based compensation in fiscal 2006 with the remainder of the increase due to the increase in full-time employees and contract labor to accommodate the increase in hospital admissions. Share-based compensation was not reflected in the statement of operations prior to fiscal 2006 as we adopted the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123-R) on October 1, 2005. SFAS No. 123-R requires that all share-based payments to employees be recognized as compensation expense in our consolidated financial statements based on their fair values. Excluding the share-based compensation, personnel expense increased $11.1 million, or 5.5% year over year and as a percentage of net revenue, personnel expense increased marginally to 30.5% from 30.4%. On an adjusted patient day basis, personnel expense increased 6.2% for the hospital division to $1,143 per adjusted patient day for fiscal 2006 compared to $1,076 per adjusted patient day for fiscal 2005. This increase was also impacted by a 5.4% decrease in average length of stay for our hospitalized patients.
Medical supplies expense. Medical supplies expense increased 3.2% to $196.0 million for fiscal 2006 from $190.0 million for fiscal 2005. The increase in our medical supplies expense was primarily attributable to increases in catheterization and surgical procedures performed during fiscal 2006 compared to fiscal 2005. The increase in surgical procedures during fiscal 2006 was disproportionately comprised of cardiac procedures that use high-cost medical devices and supplies such as pacemaker implants and drug-eluting stents. During fiscal 2006, we experienced a 1.0% increase in the number of implanted pacemakers compared to fiscal 2005. Further, our utilization rate for drug-eluting stents was 1.48 stents per case during fiscal 2006 as compared to 1.42 stents per case during fiscal 2005.
Hospital division medical supplies expense per adjusted patient day increased 4.6% to $1,016 for fiscal 2006 as compared to $971 for fiscal 2005, reflecting the increase in procedures that use high-cost medical devices and drug-eluting stents. We have continued to improve our net pricing on items purchased through our group purchasing vendors, which has minimized the impact of general inflationary cost increases.
Bad debt expense. Our hospitals have been impacted by changes in commercial health insurance benefits which have contributed to an increase in both the number of uninsured and, as co-pays and co-insurance amounts have increased, the number of underinsured patients seeking health care. In addition, we have experienced an increase in the number of self-pay patients in several of our markets in fiscal 2006. Self-pay patients represented 8.1% of hospital division revenue in fiscal 2006 as compared to 7.1% in fiscal 2005. As a result, bad debt expense increased 17.9% to $56.8 million for fiscal 2006 from $48.2 million for fiscal 2005. In addition to the economic conditions, this $8.6 million increase in bad debt expense was also driven by the increase in admissions for the hospital division. Adjusted admissions increased 4.3% in fiscal 2006 compared to fiscal 2005 and revenue per adjusted admission increased 1.0% year over year. As a percentage of net revenue, bad debt expense increased to 8.0% for fiscal 2006 from 7.2% for fiscal 2005.
Other operating expenses. Other operating expenses increased 4.3% to $141.5 million for fiscal 2006 from $135.6 million for fiscal 2005. This $5.9 million increase in other operating expenses was due to overall combined increases in the hospital and corporate and other divisions of $7.1 million, and overall decreases in the MedCath Partners and cardiology consulting and management divisions of $1.1 million and $0.1 million, respectively. The $7.1 million increase in the hospital and corporate and other divisions was primarily due to higher fixed costs associated with the management of our facilities and executive severances. In addition, we experienced increases in contract services due to the growth in volume at several facilities during fiscal 2006 and we incurred higher
maintenance costs at our newest facility as it is completing its second year of operations. The $1.1 million decrease in the MedCath Partners division other operating expenses for fiscal 2006 relates to the reduction in development expenses for the division as these expenses were incurred at the corporate level. As a percentage of revenue, other operating expenses decreased to 20.0% from 20.2% for the years ended September 30, 2006 and 2005, respectively.
Pre-opening expenses. There were no pre-opening expenses incurred in either fiscal 2006 or 2005. Pre-opening expenses represent costs specifically related to projects under development, primarily new hospitals.
Depreciation. Depreciation remained flat at $34.8 million for the year ended September 30, 2006 as compared to $34.9 million for the year ended September 30, 2005.
Impairment of long-lived assets. Impairment of long-lived assets was $0.5 million and $2.7 million in fiscal 2006 and 2005, respectively. During fiscal 2006, management decided to discontinue the implementation of certain nurse staffing software and as a result, a $0.5 million impairment charge was recognized to write-off the costs incurred to date on such software. The $2.7 million impairment in fiscal 2005 represents management’s decision to discontinue implementation of certain accounting software, as well as the determination that the carrying value of a management contract in the MedCath Partners division exceeded its fair value. See “Critical Accounting Policies - Long-Lived Assets.”
Interest expense. Interest expense increased 4.3% to $33.2 million for fiscal 2006 compared to $31.8 million for fiscal 2005. This $1.4 million increase in interest expense is primarily attributable to deferred loan acquisition costs that were expensed during fiscal 2006 as a result of the prepayment of $11.9 million of our senior notes and the prepayment of $58.0 million of our senior secured credit facility. Further, we experienced an increase in the variable interest rates on portions of our debt. As of September 30, 2006, approximately 16.2% of our outstanding debt bears interest at variable rates.
Interest and other income, net. Interest and other income, net increased to $7.7 million for fiscal 2006 compared to $3.0 million for fiscal 2005. This $4.7 million increase is primarily due to interest earned on available cash and cash equivalents as our cash position has increased by approximately $53.5 million year over year.
Equity in net earnings of unconsolidated affiliates. Equity in net earnings of unconsolidated affiliates increased to $4.9 million in fiscal 2006 from $3.4 million in fiscal 2005. The majority of the increase is attributable to growth in earnings at the one hospital in which we hold less than a 50% interest, with the remainder being attributable to growth in earnings in various diagnostic ventures in which we hold less than a 50% interest.
Income tax expense. Income tax expense was $4.7 million for fiscal 2006 compared to $5.6 million for fiscal 2005, which represented an effective tax rate of approximately 41.3% and 42.5%, respectively. The overall decrease in the effective rate represents the lower impact of certain non-deductible expenses period to period on overall taxable income.
Income from discontinued operations, net of taxes. During the third quarter of fiscal 2006, we sold our equity interest in Tucson Heart Hospital and during the fourth quarter of fiscal 2006, we decided to seek to dispose of our interest in Heart Hospital of Lafayette and we entered into a confidentiality and exclusivity agreement with a potential buyer. During the first quarter of fiscal 2005, we closed and sold substantially all of the assets of The Heart Hospital of Milwaukee. Accordingly, these hospitals are accounted for as discontinued operations. Income from discontinued operations, net of taxes, in fiscal 2006 reflects the gain on the sale of Tucson Heart Hospital of approximately $13.0 million, partially offset by operating losses and the overall income tax expense associated with the facility. It also includes the operating losses and related tax benefit associated with Heart Hospital of Lafayette during the period. Income from discontinued operations, net of taxes, in fiscal 2005 reflects the gain on the sale of the assets of The Heart Hospital of Milwaukee of approximately $9.1 million, partially offset by operating losses, shut-down costs and the overall income tax expense associated with the facility. It also includes the operating income (losses) and related tax expense (benefit) associated with Tucson Heart Hospital and Heart Hospital of Lafayette during the period.
Selected Quarterly Results of Operations
The following table sets forth quarterly consolidated operating results for each of our last five quarters. We have prepared this information on a basis consistent with our audited consolidated financial statements and included all adjustments that we consider necessary for a fair presentation of the data. These quarterly results are not necessarily indicative of future results of operations. This information should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report.
Our results of operations historically have fluctuated on a quarterly basis and can be expected to continue to be subject to quarterly fluctuations. Cardiovascular procedures can often be scheduled ahead of time, permitting some patients to choose to undergo the procedure at a time and location of their preference. Some of the types of trends that we have experienced in the past and may experience again in the future include:
•
the markets where some of our hospitals are located are susceptible to seasonal population changes with part-time residents living in the area only during certain months of the year;
•
patients choosing to schedule procedures around significant dates, such as holidays; and
•
physicians in the market where a hospital is located schedule vacation from their practice during the summer months of the year, around holidays and for various professional meetings held throughout the world during the year.
To the extent these types of events occur in the future, as in the past, we expect they will affect the quarterly results of operations of our hospitals.
Liquidity and Capital Resources
Working Capital and Cash Flow Activities. Our consolidated working capital was $179.0 million at September 30, 2007 and $197.3 million at September 30, 2006. The decrease of $18.3 million in working capital primarily resulted from a decrease in cash and cash equivalents and accounts receivable, net, combined with a decrease in current portion of long-term debt and obligations under capital leases. The change in accounts receivable was driven by overall operations, as further described below. The decrease in current portion of long-term debt and obligations under capital leases is primarily the result of payments in the amounts of $21.2 million and $11.1 million to pay off a REIT loan and an equipment loan, respectively, at two of our facilities and the repayment of the remaining $39.9 million due under our senior secured credit facility. The REIT loan matured in December 2006; therefore, the entire balance was considered current at September 30, 2006. Further, at September 30, 2006, we had received a waiver for a covenant violation related to the equipment loan; however, since is was our intent to pay the total outstanding balance of the equipment loan during fiscal 2007, the entire balance of the equipment loan was included in the current portion of long-term debt and obligations under capital leases as of September 30, 2006.
During the second quarter of fiscal 2007, we were informed by one of our Medicare fiscal intermediaries that outlier payments received prior to January 1, 2004 would not be disputed; therefore, we reversed a reserve of $2.2 million that was originally recorded to account for outlier payments that had been received in 2003. At September 30, 2007, we continued to carry a reserve of $8.5 million for outlier payments received in 2004.
The cash provided by operating activities of continuing operations was $64.0 million and $67.1 million for the years ending September 30, 2007 and 2006, respectively. The $3.1 million decrease can be primarily attributed to a decrease in accounts receivable due to successful efforts in our business office to qualify patients for Medicaid and significant improvement in our collections of self-pay patient revenue.
Our investing activities from continuing operations used net cash of $32.9 million for fiscal 2007 compared to net cash provided of $12.3 million for fiscal 2006. The $32.9 million of net cash used by investing activities for the year ended September 30, 2007 was primarily for capital expenditures as we began the development of our hospital in Kingman, Arizona and started expansion projects at two of our existing hospitals. The $28.3 million of net cash used in investing activities for the year ended September 30, 2006 can be primarily attributed to the purchase of capital equipment.
Our financing activities from continuing operations used net cash of $79.0 million during fiscal 2007 compared to net cash used of $22.4 million during fiscal 2006. The $79.0 million of net cash used for financing activities for the year ended September 30, 2007 is primarily a result of distributions to minority partners and the repayment of long-term debt and obligations under capital leases, including a payment of $39.9 million to pay off our senior secured credit facility, a payment of $21.2 million to pay off one of our facility’s REIT loans, which matured in December 2006, and a payment of $11.1 million to pay off the equipment loan at another of our facilities. Further, during fiscal 2007, we completed a secondary public offering in which we sold an additional 1.7 million shares of common stock. The proceeds from this offering were used to prepay $36.2 million of our senior notes. The $22.4 million of net cash used for financing activities for the year ended September 30, 2006 was primarily the result of the receipt of funds, net of loan acquisition costs, obtained through the issuance of long-term debt at Harlingen Medical Center, the proceeds of which were used to prepay a portion of our senior secured credit facility loan as well as distributions to minority partners.
Lease Transaction with HMC Realty. During July 2007, Harlingen Medical Center transferred real property with a net book value of approximately $34.3 million (fair value of $57.8 million) to a newly formed wholly-owned limited liability subsidiary, HMC Realty, LLC (HMC Realty), in exchange for HMC Realty’s assumption of related
party and third party debt of approximately $57.8 million. Subsequently, Harlingen Medical Center entered into a lease agreement with HMC Realty whereby Harlingen Medical Center will lease the real property from HMC Realty for approximately $5.5 million annually for 25 years. Subsequent to the transfer of assets and debt, HMC Realty received capital contributions as described below, and Harlingen Medical Center canceled its membership in HMC Realty. The $57.8 million debt assumed by HMC Realty consisted of $2.9 million owed to Valley Baptist Health System (Valley Baptist), $11.3 million owed to us for working capital loans, and the assumption of $43.5 million in real estate debt with a third party. We converted $9.6 million of the working capital loan with HMC Realty into a 36% interest in HMC Realty.
Recapitalization of Harlingen Medical Center. During fiscal 2006, Harlingen Medical Center entered into two $10.0 million convertible notes with Valley Baptist. The first note could have been voluntarily converted by the health system into a 13.2% ownership interest in Harlingen Medical Center after the third anniversary date of issuance, or it could have been automatically converted into an ownership interest in Harlingen Medical Center upon the achievement of specified financial targets contained in the debt agreement, up until the third anniversary date of the agreement or the fourth anniversary date of the agreement, if extended by Harlingen Medical Center. The second note was convertible into the same ownership interest percentage as the first note at the discretion of the health system after the conversion of the first note. The potential ownership interest in Harlingen Medical Center by the health system was capped at 49%. The notes accrued interest at 5% per annum up until the third anniversary date, after which time the interest rate would have been increased to 8% if the notes had not been converted.
Interest payments were due quarterly. In accordance with the provisions of EITF 99-1, Accounting for Debt Convertible into the Stock of a Consolidated Subsidiary, EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and EITF 01-6, The Meaning of Indexed to a Company’s Own Stock, the convertible notes were accounted for as convertible debt in the accompanying consolidated balance sheets and the embedded conversion option in the convertible notes were not accounted for as a separate derivative.
During July 2007, we elected, along with the original physician investors and Valley Baptist, to allow early conversion of the Valley Baptist notes into an equity interest in Harlingen Medical Center (the “Recapitalization”). Valley Baptist converted $17.1 million of the convertible notes into a 32.1% equity interest in Harlingen Medical Center. The remaining $2.9 million was converted into a membership interest in HMC Realty. Prior to the Recapitalization, Harlingen Medical Center had approximately $12.5 million in working capital debt outstanding with us. As a result of the Recapitalization, we converted $1.2 million of the debt into additional capital in Harlingen Medical Center, converted $9.5 million into a membership interest of HMC Realty, and was repaid the remaining balance of the working capital note. As a result of the transactions described above, we now own a 36% interest in Harlingen Medical Center, and a 36% interest in HMC Realty. In addition, Valley Baptist holds a 32% interest in Harlingen Medical Center and a 19% interest in HMC Realty, and the remaining ownership interests in both entities are held by unrelated physician investor groups.
Prior to the Recapitalization, we consolidated Harlingen Medical Center. As a result of the Recapitalization, our interest in Harlingen Medical Center was diluted from 51.0% to 36.0% effective for the fourth quarter of fiscal year 2007. We recorded the gain resulting from the change in ownership interest in accordance with SAB Topic 5H. The gain resulted from the difference between the carrying amount of our investment in Harlingen Medical Center prior to the issuance of units and our equity investment immediately following the issuance of units. We determined that recognition of the gain as a capital transaction was appropriate because Harlingen Medical Center had historically experienced net losses, and because of uncertainty regarding the possible future occurrence of transactions that may involve further dilution of our equity interest in Harlingen Medical Center. Future issuances of units to third parties, if any, will further dilute our ownership percentage and may give rise to additional gains or losses based on the offering price in comparison to the carrying value of our investment.
Capital Expenditures. Expenditures for property and equipment for fiscal years 2007 and 2006 were $37.4 million and $30.5 million, respectively. For the year ended September 30, 2007, we began the development of our hospital in Kingman, Arizona and started expansion projects at two of our existing hospitals. For the year ended September 30, 2006, our capital expenditures were principally focused on improvement to and expansion of
existing facilities. The amount of capital expenditures we incur in future periods will depend largely on the type and size of strategic investments we make in future periods.
Obligations, Commitments and Availability of Financing. As described more fully in the notes to our consolidated financial statements included elsewhere in this report, we had certain cash obligations at September 30, 2007, which are due as follows (in thousands):
(1)
Other long-term obligations, excluding interest rate swaps, consist of the non-current portion of deferred compensation under nurse retention arrangements at one of our hospitals and the potential future obligations pursuant to professional service guarantees.
(2)
Interest on indebtedness represents only fixed rate indebtedness; variable rate indebtedness, which is not included in the table above, is based on LIBOR or the prime rate.
During the fourth quarter of fiscal 2004, we completed our offering of $150.0 million in aggregate principal amount of 97/8% senior notes. Concurrent with our offering of the notes, we entered into a $200.0 million senior secured credit facility with a syndicate of banks and other institutional lenders. The credit facility provides for a seven-year term loan facility in the amount of $100.0 million, all of which was drawn in July 2004, and a five-year senior secured revolving credit facility in the amount of $100.0 million which includes a $25.0 million sub-limit for the issuance of stand-by and commercial letters of credit and a $10.0 million sub-limit for swing-line loans. Proceeds from these debt facilities combined with cash on hand were used to repay $276.9 million of the long-term debt outstanding at that time.
At September 30, 2007, we had $152.3 million of outstanding debt, $4.1 million of which was classified as current. Of the outstanding debt, $102.0 million was outstanding under our 97/8% senior notes and $49.4 million was outstanding to lenders to our hospitals. The remaining $0.9 million of debt was outstanding to lenders for MedCath Partners’ diagnostic services under capital leases and other miscellaneous indebtedness. No amounts were outstanding to lenders under our $100.0 million revolving credit facility at September 30, 2007. At the same date, however, we had letters of credit outstanding of $1.7 million, which reduced our availability under this facility to $98.3 million.
During the first quarter of fiscal 2007, we sold 1.7 million shares of common stock to the public. The $39.7 million in net proceeds from this offering were used to repurchase approximately $36.2 million of our outstanding senior notes and to pay approximately $3.5 million of associated premiums and expenses associated with the note repurchase.
Covenants related to our long-term debt restrict the payment of dividends and require the maintenance of specific financial ratios and amounts and periodic financial reporting. At September 30, 2007 and 2006, we were in violation of a financial covenant under an equipment loan to Heart Hospital of Lafayette. Heart Hospital of Lafayette is classified as a discontinued operation. Accordingly, the total outstanding balance of this loan has been included in current liabilities of discontinued operations on the consolidated balance sheets as of September 30,
2007 and 2006. Subsequent to September 30, 2007, we completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians. See Note 21 - Subsequent Events to the Consolidated Financial Statements. We were in compliance with all other covenants in the instruments governing our outstanding debt at September 30, 2007.
At September 30, 2007, we guaranteed either all or a portion of the obligations of our subsidiary hospitals for equipment and other notes payable. We provide these guarantees in accordance with the related hospital operating agreements, and we receive a fee for providing these guarantees from the hospitals or the physician investors.
We also guarantee approximately 30% of the equipment debt of Avera Heart Hospital of South Dakota, a hospital in which we own a minority interest at September 30, 2007, and therefore do not consolidate the hospital’s results of operations and financial position. We provide this guarantee in exchange for a fee from the hospital. At September 30, 2007, Avera Heart Hospital of South Dakota was in compliance with all covenants in the instruments governing its debt. The total amount of the hospital’s equipment debt was approximately $1.1 million at September 30, 2007. Accordingly, the equipment debt guaranteed by us was approximately $0.3 million at September 30, 2007.
See Note 9 to the consolidated financial statements included elsewhere in this report for additional discussion of the terms, covenants and repayment schedule surrounding our debt.
We believe that internally generated cash flows and available borrowings under our senior secured credit facility will be sufficient to finance our business plan, capital expenditures and our working capital requirements for the next 12 to 18 months.
Intercompany Financing Arrangements. We provide secured real estate, equipment and working capital financings to our majority-owned hospitals. The aggregate amount of the intercompany real estate, equipment and working capital and other loans outstanding as of September 30, 2007 was $257.3 million.
Each intercompany real estate loan is separately documented and secured with a lien on the borrowing hospital’s real estate, building and equipment and certain other assets. Each intercompany real estate loan typically matures in 7 to 10 years and accrues interest at variable rates based on LIBOR plus an applicable margin or a fixed rate similar to terms commercially available.
Each intercompany equipment loan is separately documented and secured with a lien on the borrowing hospital’s equipment and certain other assets. Amounts borrowed under the intercompany equipment loans are payable in monthly installments of principal and interest over terms that range from 5 to 7 years. The intercompany equipment loans accrue interest at fixed rates ranging from 8.03% to 8.58% or variable rates based on LIBOR plus an applicable margin. The weighted average interest rate for the intercompany equipment loans at September 30, 2007 was 8.22%.
We typically receive a fee from the minority partners in the subsidiary hospitals as consideration for providing these intercompany real estate and equipment loans.
We also use intercompany financing arrangements to provide cash support to individual hospitals for their working capital and other corporate needs. We provide these working capital loans pursuant to the terms of the operating agreements between our physician and hospital investor partners and us at each of our hospitals. These intercompany loans are evidenced by promissory notes that establish borrowing limits and provide for a market rate of interest to be paid to us on outstanding balances. These intercompany loans are subordinate to each hospital’s mortgage and equipment debt outstanding, but are senior to our equity interests and our partners’ equity interests in the hospital venture and are secured, subject to the prior rights of the senior lenders, in each instance by a pledge of certain of the borrowing hospital’s assets. Also as part of our intercompany financing and cash management structure, we sweep cash from individual hospitals as amounts are available in excess of the individual hospital’s working capital needs. These funds are advanced pursuant to cash management agreements with the individual hospitals that establish the terms of the advances and provide for a rate of interest to be paid consistent with the market rate earned by us on the investment of its funds. These cash advances are due back to the individual hospital on demand and are subordinate to our equity investment in the hospital venture. As of September 30, 2007 and
September 30, 2006, we held $33.0 million and $55.5 million, respectively, of intercompany working capital and other notes and related accrued interest, net of advances from our hospitals.
Because these intercompany notes receivable and related interest income are eliminated with the corresponding notes payable and interest expense at our consolidating hospitals in the process of preparing our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, the amounts outstanding under these notes do not appear in our consolidated financial statements or accompanying notes. Information about the aggregate amount of these notes outstanding from time to time may be helpful, however, in understanding the amount of our total investment in our hospitals. In addition, we believe investors and others will benefit from a greater understanding of the significance of the priority rights we have under these intercompany notes receivable to distributions of cash by our hospitals as funds are generated from future operations, a potential sale of a hospital, or other sources. Because these notes receivable are senior to the equity interests of MedCath and our partners in each hospital, in the event of a sale of a hospital, the hospital would be required first to pay to us any balance outstanding under its intercompany notes prior to distributing any of the net proceeds of the sale to any of the hospital’s equity investors as a return on their investment based on their pro-rata ownership interests. Also, appropriate payments to us to amortize principal balances outstanding and to pay interest due under these notes are generally made to us from a hospital’s available cash flows prior to any pro-rata distributions of a hospital’s earnings to the equity investors in the hospitals.
On December 1, 2004, we completed the sale of certain assets of The Heart Hospital of Milwaukee for $42.5 million. Of the $42.5 million in proceeds received, approximately $37.0 million was used to repay The Heart Hospital of Milwaukee’s intercompany secured loans, thereby increasing our consolidated cash position on such date. As part of the terms of the sale, we were required to close the hospital. As such, we incurred costs associated with the closing of the hospital, in addition to costs associated with completing the sale and additional operating expenses. As stipulated by the covenants of our senior secured credit facility, within 300 days after the receipt of the net proceeds, we could identify a use of the net proceeds for capital expenditures or other permitted investments, so long as such usage occurred within 300 days of the date identified, which we have done. Any net proceeds not identified or invested within this time period were to be used to repay principal of senior secured indebtedness. The lenders under our senior secured credit facility waived this requirement. However, the indenture governing our senior notes contains a similar requirement. Accordingly, we offered to repurchase up to $30.3 million of our senior notes. The tender offer for the notes expired during fiscal year 2006 and we accepted for purchase and paid for $11.9 million principal amount of senior notes tendered prior to the expiration of the tender offer.
On August 31, 2006, we completed the divestiture of our equity interest in Tucson Heart Hospital for $40.7 million. Of the $40.7 million proceeds received, approximately $40.2 million was used to repay Tucson Heart Hospital’s intercompany secured loans, thereby increasing our consolidated cash position on such date.
We have, during fiscal 2006, and will continue in future periods, provided information on a quarterly basis about the aggregate amount of these intercompany loans outstanding to assist investors in better understanding the total amount of our investment in our hospitals, our claim to the future cash flows of our hospitals, and our capital structure.
Off-Balance Sheet Arrangements. We do not have any off-balance sheet financing that has, or is reasonably likely to have, a material current or future effect on our financial condition, cash flows, results of operations, liquidity, capital expenditures or capital resources.
Reimbursement, Legislative and Regulatory Changes
Legislative and regulatory action has resulted in continuing changes in reimbursement under the Medicare and Medicaid programs that will continue to limit payments we receive under these programs. Within the statutory framework of the Medicare and Medicaid programs, there are substantial areas subject to legislative and regulatory changes, administrative rulings, interpretations, and discretion which may further affect payments made under those programs, and the federal and state governments may, in the future, reduce the funds available under those programs or require more stringent utilization and quality reviews of our hospitals or require other changes in our operations. Additionally, there may be a continued rise in managed care programs and future restructuring of the financing and delivery of healthcare in the United States. These events could have an adverse effect on our future
financial results. See Item 1A: Risk Factors - Reductions or changes in reimbursement from government or third-party payors could adversely impact our operating results.
Inflation
The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages, such as the growing nationwide shortage of qualified nurses, occur in the marketplace. In addition, suppliers pass along rising costs to us in the form of higher prices. We have implemented cost control measures, including our case and resource management program, to curb increases in operating costs and expenses. We have, to date, offset increases in operating costs by increasing reimbursement for services and expanding services. However, we cannot predict our ability to cover, or offset, future cost increases.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
We maintain a policy for managing risk related to exposure to variability in interest rates, commodity prices, and other relevant market rates and prices which includes considering entering into derivative instruments (freestanding derivatives), or contracts or instruments containing features or terms that behave in a manner similar to derivative instruments (embedded derivatives) in order to mitigate our risks. In addition, we may be required to hedge some or all of our market risk exposure, especially to interest rates, by creditors who provide debt funding to us. To date, we have only entered into the fixed interest rate swaps as discussed below.
Three of our consolidated hospitals entered into fixed interest rate swaps during previous years. These fixed interest rate swaps effectively fixed the interest rate on the hedged portion of the related debt at 4.92% plus an applicable margin for two of the hospitals and at 4.6% plus an applicable margin for the other hospital. These interest rate swaps were accounted for as cash flow hedges prior to the repayment of the outstanding balances of the mortgage debt for these three hospitals as part of the July 2004 financing transaction. We did not terminate the interest rate swaps as part of the financing transaction, which resulted in the recognition of a loss of approximately $0.6 million during the fourth quarter of fiscal 2004. Since July 2004, the fixed interest rate swaps have not been utilized as a hedge of variable debt obligations, and accordingly, changes in the valuation of the interest rate swaps have been recorded directly to earnings as a component of interest expense. The fixed interest rate swaps expired during fiscal 2006 resulting in an unrealized gain for the fiscal year ended September 30, 2006 that was not significant to the consolidated financial position or results of operations.
Item 8.
Item 8.
Financial Statements and Supplementary Data
MEDCATH CORPORATION AND SUBSIDIARIES
HEART HOSPITAL OF SOUTH DAKOTA, LLC
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
MedCath Corporation
Charlotte, North Carolina
We have audited the accompanying consolidated balance sheets of MedCath Corporation and subsidiaries (the Company) as of September 30, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended September 30, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at September 30, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, effective October 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123-R, Share-Based Payment.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated December 14, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
Charlotte, North Carolina
December 14, 2007
MEDCATH CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
See notes to consolidated financial statements.
MEDCATH CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
See notes to consolidated financial statements.
MEDCATH CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands)
See notes to consolidated financial statements.
MEDCATH CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See notes to consolidated financial statements.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All tables in thousands, except per share amounts)
1.
Business and Organization
MedCath Corporation (the Company) primarily focuses on providing high acuity services, including the diagnosis and treatment of cardiovascular disease. The Company owns and operates hospitals in partnership with physicians, most of whom are cardiologists and cardiovascular surgeons. While each of the Company’s majority-owned hospitals (collectively, the hospital division) is licensed as a general acute care hospital, the Company focuses on serving the unique needs of patients suffering from cardiovascular disease. As of September 30, 2007, the Company owned and operated eleven hospitals, together with its physician partners, who own an equity interest in the hospitals where they practice. The Company’s existing hospitals had a total of 667 licensed beds, of which 646 were staffed and available, and were located in eight states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota and Texas. The Company is currently in the process of developing a new hospital located in Kingman, Arizona which it expects to open during September 2009.
See Note 3 - Discontinued Operations for details concerning the Company’s sale of its equity interest in Tucson Heart Hospital and the Company’s pending disposition of Heart Hospital of Lafayette. Unless specifically indicated otherwise, all amounts and percentages presented in these notes are exclusive of the Company’s discontinued operations.
The Company accounts for all but two of its owned and operated hospitals as consolidated subsidiaries. The Company owns a minority interest in Avera Heart Hospital of South Dakota and Harlingen Medical Center as of September 30, 2007 and is not the primary beneficiary under the revised version of Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (FIN No. 46-R). Therefore, the Company is unable to consolidate the hospitals’ results of operations and financial position, but rather is required to account for its minority ownership interest in the hospital as an equity investment. Harlingen Medical Center was a consolidated entity for the fiscal years ended September 30, 2005 and 2006 and for the first three quarters of fiscal 2007. In July 2007, the Company sold a portion of its equity interest in Harlingen Medical Center; therefore, the Company no longer is its primary beneficiary and accounts for its minority ownership interest in the hospital as an equity investment.
In addition to its hospitals, the Company provides cardiovascular care services in diagnostic and therapeutic facilities in various locations and through mobile cardiac catheterization laboratories (the MedCath Partners division). The Company also provides consulting and management services tailored primarily to cardiologists and cardiovascular surgeons, which is included in the corporate and other division.
2.
Summary of Significant Accounting Policies and Estimates
Basis of Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries that are wholly and majority owned and/or over which it exercises substantive control, including variable interest entities in which the Company is the primary beneficiary. All intercompany accounts and transactions have been eliminated in consolidation. The Company uses the equity method of accounting for entities, including variable interest entities, in which it holds less than a 50% interest and it is not the primary beneficiary.
Restatements and Reclassifications - In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144), hospitals sold or classified as held for sale are required to be reported as discontinued operations. During fiscal 2005, the Company completed the sale of the assets of The Heart Hospital of Milwaukee and during fiscal 2006, the Company completed the sale of its equity interest in Tucson Heart Hospital and decided to seek to dispose of its interest in Heart Hospital of Lafayette and entered into a confidentiality and exclusivity agreement with a potential buyer, therefore classifying the hospital as held for sale. Subsequent to September 30, 2007, the Company completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians. See Note 21 - Subsequent Events, to the Consolidated Financial Statements. In accordance with the provisions of SFAS No. 144, the results of operations of these hospitals for the years ended September 30, 2007, 2006 and 2005 are reported as discontinued operations for all periods presented. Many of the provisions of SFAS No. 144 involve judgment in determining whether a hospital will be reported as continuing or discontinued operations. Such judgments include whether a hospital will be sold, the period required to complete the disposition and the likelihood of changes to a plan for sale. If in future periods the Company determines that a hospital should be either reclassified from continuing operations to discontinued operations or from discontinued operations to continuing operations, previously reported consolidated statements of operations are reclassified in order to reflect the current classification.
The Company evaluated the carrying value of the long lived assets related to Heart Hospital of Lafayette at the end of each of the four quarters during fiscal 2007. At December 31, 2006 and September 30, 2007, it was determined that the carrying value was in excess of the fair value. Accordingly, an impairment charge of $4.1 million and $3.5 million was recorded in accordance with SFAS No. 144 during the first and fourth quarters of fiscal 2007, respectively, and is included in loss from discontinued operations in the consolidated statement of operations for the year ended September 30, 2007. As of March 31 and June 30, 2007 it was determined that the carrying value approximated fair value and no further impairment was necessary.
The Company has reclassified the prior year loss on early extinguishment of debt to be consistent with the current year presentation. The loss had previously been recorded as a component of interest expense. In addition, the Company reclassified proceeds from the sale of discontinued operations to net cash provided by investing activities of discontinued operations in the accompanying 2006 and 2005 consolidated statements of cash flows as the Company believes such presentation is more reflective of the concepts contained in FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. There is a reasonable possibility that actual results may vary significantly from those estimates.
Fair Value of Financial Instruments - The Company considers the carrying amounts of significant classes of financial instruments on the consolidated balance sheets, including cash and cash equivalents, accounts receivable, net, accounts payable, income taxes payable, accrued liabilities, variable rate long-term debt, obligations under capital leases, and other long-term obligations to be reasonable estimates of fair value due either to their length to maturity or the existence of variable interest rates underlying such financial instruments that approximate prevailing market rates at September 30, 2007 and 2006. The estimated fair value of long-term debt, including the current portion, at September 30, 2007 is approximately $177.0 million as compared to a carrying value of approximately $149.3 million. At September 30, 2006, the estimated fair value of long-term debt, including the current portion, was approximately $336.7 million as compared to a carrying value of approximately $322.4 million. Fair value of the Company’s fixed rate debt was estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of arrangements, and the fair value of the Company’s variable rate debt was determined to approximate its carrying value, due to the underlying variable interest rates.
Concentrations of Credit Risk - Financial instruments that potentially subject the Company to concentrations of credit risk are primarily cash and cash equivalents and accounts receivable. Cash and cash equivalents are maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally these deposits may be redeemed upon demand.
The Company grants credit without collateral to its patients, most of whom are insured under payment arrangements with third party payors, including Medicare, Medicaid and commercial insurance carriers. The
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Company has not experienced significant losses related to receivables from individual patients or groups of patients in any particular industry or geographic area.
Cash and Cash Equivalents - Cash consists of currency on hand and demand deposits with financial institutions. Cash equivalents include investments in highly liquid instruments with original maturities of three months or less.
Allowance for Doubtful Accounts - Accounts receivable primarily consist of amounts due from third-party payors and patients in the Company’s hospital division. The remainder of the Company’s accounts receivable principally consist of amounts due from billings to hospitals for various cardiovascular care services performed in its MedCath Partners division and amounts due under consulting and management contracts. To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The Company estimates this allowance based on such factors as payor mix, aging and the historical collection experience and write-offs of its respective hospitals and other business units.
Medical Supplies - Medical supplies consist primarily of supplies necessary for diagnostics, catheterization and surgical procedures and general patient care and are stated at the lower of first-in, first-out (FIFO) cost or market.
Property and Equipment - Property and equipment are recorded at cost and are depreciated principally on a straight-line basis over the estimated useful lives of the assets, which generally range from 25 to 40 years for buildings and improvements, 25 years for land improvements, and from 3 to 10 years for equipment, furniture and software. Repairs and maintenance costs are charged to operating expense while betterments are capitalized as additions to the related assets. Retirements, sales, and disposals are recorded by removing the related cost and accumulated depreciation with any resulting gain or loss reflected in income from operations. Amortization of property and equipment recorded under capital leases is included in depreciation expense. Interest expense incurred in connection with the construction of hospitals is capitalized as part of the cost of the building until the facility is operational, at which time depreciation begins using the straight-line method over the estimated useful life of the building. The Company capitalized approximately $0.2 million during the year ended September 30, 3007. The Company did not capitalize any interest during the years ended September 30, 2006 and 2005.
Goodwill and Intangible Assets - Goodwill represents acquisition costs in excess of the fair value of net identifiable tangible and intangible assets of businesses purchased. Other intangible assets primarily consist of the value of management contracts. With the exception of goodwill, intangible assets are being amortized over periods ranging from 11 to 29 years. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142), the Company evaluates goodwill annually on September 30 for impairment, or earlier if indicators of potential impairment exist. The determination of whether or not goodwill has become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the value of the Company’s reporting units. Changes in the Company’s strategy, assumptions and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of intangible assets. The Company recorded a goodwill impairment charge of approximately $2.8 million during the first quarter of fiscal 2007 related to Heart Hospital of Lafayette, which is reported as a discontinued operation. The impairment charge is included as a component of income (loss) from discontinued operations in the statement of operations for the fiscal year ended September 30, 2007.
Other Assets - Other assets primarily consist of loan acquisition costs and prepaid rent under a long-term operating lease for land at one of the Company’s hospitals. The loan acquisition costs are being amortized using the straight-line method over the life of the related debt, which approximates the effective interest method. The Company recognizes the amortization of the loan acquisition costs as a component of interest expense. The prepaid rent is being amortized using the straight-line method over the lease term, which extends through December 11, 2065. The Company recognizes the amortization of prepaid rent as a component of other operating expense. For the
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
years ended September 30, 2007, 2006 and 2005, amortization expense related to other assets was $1.2 million, $2.9 million and $1.6 million, respectively.
Long-Lived Assets - In accordance with SFAS No. 144 (SFAS No. 144), Accounting for the Impairment or Disposal of Long-Lived Assets, are evaluated for impairment when events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of an asset and its eventual disposition are less than its carrying amount. The determination of whether or not long-lived assets have become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the estimated future cash flows expected to result from the use of those assets. Changes in the Company’s strategy, assumptions and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of long-lived assets.
During the year ended September 30, 2006, the operating performance of one of the Company’s facilities, Heart Hospital of Lafayette, was significantly below expectations. The performance of the hospital as well as other strategic initiatives were considered when management made the decision to seek to dispose of the Heart Hospital of Lafayette, which is classified as a discontinued operation in the accompanying financial statements (see Note 3). At September 30, 2006, management believed the net carrying value of the discontinued assets as of September 30, 2007 would be realizable; however, ultimate realization of the discontinued assets could not be assured. During the year ended September 30, 2007, the Company re-evaluated the discontinued assets and $4.8 million in impairment charges in accordance with SFAS No. 144 (in addition to the $2.8 million goodwill impairment recorded in accordance with SFAS No. 142 discussed above) were recorded and are included in income (loss) from discontinued operations, net of taxes in the Company’s statement of operations for fiscal 2007.
Also during the year ended September 30, 2006, management decided to discontinue the implementation of certain nurse staffing software and as a result, a $0.5 million impairment charge was recognized to write-off the costs incurred to date on such software.
During the year ended September 30, 2005, the Company recorded a $2.7 million impairment charge, which was comprised of $1.7 million relating to license fees associated with the use of certain accounting software and $1.0 million relating to a management contract. The accounting software was installed in two hospitals and was intended to be installed in the remaining hospitals; however, due to a lack of additional benefits provided by the system and additional installation costs required, it was determined that the system would not be installed in any additional hospitals. Therefore, the impairment charge reflects the unused license fees associated with this system. The remaining $1.0 million impairment charge relates to the excess carrying value over the fair value of a management contract due to lack of volumes and other economic factors at one managed diagnostic venture.
Other Long-Term Obligations - Other long-term obligations consist of the Company’s liabilities for its interest rate swap derivatives, which are recognized at their fair market value as of the balance sheet date and the Company’s noncurrent obligations under certain deferred compensation arrangements.
Market Risk Policy - The Company’s policy for managing risk related to its exposure to variability in interest rates, commodity prices, and other relevant market rates and prices includes consideration of entering into derivative instruments (freestanding derivatives), or contracts or instruments containing features or terms that behave in a manner similar to derivative instruments (embedded derivatives) in order to mitigate its risks. In addition, the Company may be required to hedge some or all of its market risk exposure, especially to interest rates, by creditors who provide debt funding to the Company. The Company recognizes all derivatives as either assets or liabilities on the balance sheets and measures those instruments at fair value in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities (an Amendment of FASB Statement No. 133), and as amended by SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.
Revenue Recognition - Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as commercial insurers, health
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
maintenance organizations and preferred provider organizations are generally less than established billing rates. Payment arrangements with third-party payors may include prospectively determined rates per discharge or per visit, a discount from established charges, per diem payments, reimbursed costs (subject to limits) and/or other similar contractual arrangements. As a result, net revenue for services rendered to patients is reported at the estimated net realizable amounts as services are rendered. The Company accounts for the differences between the estimated realizable rates under the reimbursement program and the standard billing rates as contractual adjustments.
The majority of the Company’s contractual adjustments are system-generated at the time of billing based on either government fee schedules or fee schedules contained in managed care agreements with various insurance plans. Portions of the Company’s contractual adjustments are performed manually and these adjustments primarily relate to patients that have insurance plans with whom the Company’s hospitals do not have contracts containing discounted fee schedules, also referred to as non-contracted payors, and patients that have secondary insurance plans following adjudication by the primary payor. Estimates of contractual adjustments are made on a payor-specific basis and based on the best information available regarding the Company’s interpretation of the applicable laws, regulations and contract terms. While subsequent adjustments to the systematic contractual allowances can arise due to denials, short payments deemed immaterial for continued collection effort and a variety of other reasons, such amounts have not historically been significant.
The Company continually reviews the contractual estimation process to consider and incorporate updates to the laws and regulations and any changes in the contractual terms of its programs. Final settlements under some of these programs are subject to adjustment based on audit by third parties, which can take several years to determine. From a procedural standpoint, for governmental payors, primarily Medicare, the Company recognizes estimated settlements in its consolidated financial statements based on filed cost reports. The Company subsequently adjusts those settlements as new information is obtained from audits or reviews by the fiscal intermediary and, if the result of the fiscal intermediary audit or review impacts other unsettled and open cost reports, the Company recognizes the impact of those adjustments. As such, the Company recognized adjustments that increased/(decreased) net revenue by $1.5 million, ($0.5) million and $3.0 million in the years ended September 30, 2007, 2006 and 2005, respectively.
A significant portion of the Company’s net revenue is derived from federal and state governmental healthcare programs, including Medicare and Medicaid, which, combined, accounted for 46.3%, 49.4% and 53.0% of the Company’s net revenue during the years ended September 30, 2007, 2006 and 2005, respectively. Medicare payments for inpatient acute services and certain outpatient services are generally made pursuant to a prospective payment system. Under this system, hospitals are paid a prospectively-determined fixed amount for each hospital discharge based on the patient’s diagnosis. Specifically, each discharge is assigned to a diagnosis-related group (DRG). Based upon the patient’s condition and treatment during the relevant inpatient stay, each DRG is assigned a fixed payment rate that is prospectively set using national average costs per case for treating a patient for a particular diagnosis. The DRG rates are adjusted by an update factor each federal fiscal year, which begins on October 1. The update factor is determined, in part, by the projected increase in the cost of goods and services that are purchased by hospitals, referred to as the market basket index. DRG payments do not consider the actual costs incurred by a hospital in providing a particular inpatient service; however, DRG payments are adjusted by a predetermined adjustment factor assigned to the geographic area in which the hospital is located.
While hospitals generally do not receive direct payment in addition to a DRG payment, hospitals may qualify for additional capital-related cost reimbursement and outlier payments from Medicare under specific circumstances. Medicare payments for non-acute services, certain outpatient services, medical equipment, and education costs are made based on a cost reimbursement methodology and are under transition to various methodologies involving prospectively determined rates. The Company is reimbursed for cost-reimbursable items at a tentative rate with final settlement determined after submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Medicaid payments for inpatient and outpatient services are made at prospectively determined amounts and cost based reimbursement, respectively.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company’s managed diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories operate under various contracts where management fee revenue is recognized under fixed-rate and percentage-of-income arrangements as services are rendered. In addition, certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories recognize additional revenue under cost reimbursement and equipment lease arrangements. Net revenue from the Company’s owned diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories is reported at the estimated net realizable amounts due from patients, third-party payors, and others as services are rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors.
Advertising - Advertising costs are expensed as incurred. During the years ended September 30, 2007, 2006 and 2005, the Company incurred approximately $4.1 million, $4.5 million and $5.2 million of advertising expenses, respectively.
Pre-opening Expenses - Pre-opening expenses consist of operating expenses incurred during the development of a new venture and prior to its opening for business. Such costs specifically relate to ventures under development and are expensed as incurred. The Company incurred approximately $0.6 million of pre-opening expenses during the year ended September 30, 2007. The Company did not incur any pre-opening expenses during the years ended September 30, 2006 and 2005.
Income Taxes - Income taxes are computed on the pretax income based on current tax law. Deferred income taxes are recognized for the expected future tax consequences or benefits of differences between the tax bases of assets or liabilities and their carrying amounts in the consolidated financial statements. A valuation allowance is provided for deferred tax assets if it is more likely than not that these items will either expire before the Company is able to realize their benefit or that future deductibility is uncertain.
Members’ and Partners’ Share of Hospital’s Net Income and Loss - Each of the Company’s consolidated hospitals is organized as a limited liability company or limited partnership, with one of the Company’s wholly-owned subsidiaries serving as the manager or general partner and holding from 51.0% to 89.2% of the ownership interest in the entity. In most cases, physician partners or members own the remaining ownership interests as members or limited partners. In some instances, the Company may organize a hospital with a community hospital investing as an additional partner or member. In those instances, the Company may hold a minority interest in the hospital with the community hospital and physician partners owning the remaining interests also as minority partners. In such instances, the hospital is generally accounted for under the equity method of accounting. Profits and losses of hospitals accounted for under either the consolidated or equity methods are generally allocated to their owners based on their respective ownership percentages. If the cumulative losses of a hospital exceed its initial capitalization and committed capital obligations of the partners or members, the Company is required, due to at-risk capital position, by generally accepted accounting principles, to recognize a disproportionate share of the hospital’s losses that otherwise would be allocated to all of its owners on a pro rata basis. In such cases, the Company will recognize a disproportionate share of the hospital’s future profits to the extent the Company has previously recognized a disproportionate share of the hospital’s losses.
Share-Based Compensation - On October 1, 2005, the Company adopted SFAS No. 123-R (revised 2004), Share-Based Payment (SFAS No. 123-R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS No. 123-R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model and to expense the value of the portion of the award that is ultimately expected to vest over the requisite service period in the Company’s statement of operations. Prior to the adoption of SFAS No. 123-R, the Company accounted for stock options issued to employees and directors using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), as permitted under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), and provided pro forma net income and pro forma earnings per share disclosures for stock option grants made as if the fair value method of measuring compensation cost for stock options granted had been applied. Under the intrinsic
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
value method, no share-based compensation expense was recognized for options granted with an exercise price equal to the fair value of the underlying stock at the grant date.
In September 2005, the compensation committee of the board of directors approved a plan to accelerate the vesting of substantially all unvested stock options previously awarded to employees with the condition that the optionee enter into a sale restriction agreement which provides that if the optionee exercises a stock option prior to its originally scheduled vesting date while employed by the Company, the optionee will be prohibited from selling the share of stock acquired upon exercise of the option until the date the option would have become vested had it not been accelerated. All new stock options granted since September 30, 2005 have immediate vesting with the same sale restriction. As a result, share-based compensation is recorded on the option grant date.
The Company adopted SFAS No. 123-R using the modified prospective transition method, which requires the application of the accounting standard as of October 1, 2005, the first day of the Company’s fiscal year 2006. The Company’s financial statements as of and for the years ended September 30, 2007 and 2006 reflect the impact of SFAS No. 123-R.
On November 10, 2005, the FASB issued Staff Position No. 123-R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards (Staff Position No. 123-R-3), which provides a simplified alternative method to calculate the pool of excess income tax benefits upon the adoption of SFAS No. 123-R. The Company has elected to follow the provisions of Staff Position No. 123-R-3.
As required under SFAS No. 123-R in calculating the share-based compensation expense for the years ended September 30, 2007 and 2006 and as required under SFAS No. 123 and SFAS No. 148, Accounting for Stock Based Compensation, in calculating the share-based compensation expense for the year ended September 30, 2005, the fair value of each option grant was estimated on the date of grant. The Company used the Black-Scholes option pricing model with the range of weighted-average assumptions used for option grants noted in the following table. The expected life of the stock options represents the period of time that options granted are expected to be outstanding and the range given below results from certain groups of employees exhibiting different behavior with respect to the options granted to them and was determined based on an analysis of historical and expected exercise and cancellation behavior. This analysis is updated December 31 of each year and at December 31, 2006 the analysis illustrated a change in the range of expected life for subsequent grants, which is reflected in the table below. The risk-free interest rate is based on the US Treasury yield curve in effect on the date of the grant. The expected volatility is based on the historical volatilities of the Company’s common stock and the common stock of comparable publicly traded companies.
Accounting for Gains on Capital Transactions of Subsidiary. In accordance with SAB Topic 5H, the Company has adopted an accounting policy of recording non-operating gains in the Company’s consolidated statement of income upon the dilution of ownership interests that occurs when ownership interests of subsidiaries are issued to third party investors, if the gain recognition criteria of Topic 5H are met. If such criteria are not met, then such gains will be recorded directly to equity as a capital transaction. A gain on the issuance of units in one of the Company’s formerly consolidated subsidiaries, Harlingen Medical Center, LLC (the Partnership), is reflected in the Company’s consolidated balance sheets for fiscal 2007 as a capital transaction, in accordance with the provisions of Topic 5H. The gain resulted from the difference between the carrying amount of the Company’s investment in the Partnership prior to the issuance of units and the Company’s equity investment immediately following the issuance of units. Management determined that recognition of the gain as a capital transaction was appropriate because the Partnership has historically experienced net losses, and due to the uncertainty surrounding
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
future transactions that may involve further dilution of the Company’s equity interest in the Partnership. Future issuances of units to third parties will further dilute the Company’s ownership percentage and may give rise to additional gains or losses based on the offering price in comparison to the carrying value of the Company’s investment.
New Accounting Pronouncements - In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN No. 48). FIN No. 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes (FAS No. 109). Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN No. 48 and in subsequent periods. FIN No. 48 will be effective for fiscal years beginning after December 15, 2006 and the provisions of FIN No. 48 will be applied to all tax positions accounted for under FAS No. 109 upon initial adoption. The cumulative effect of applying the provisions of FIN No. 48 will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. The accounting provisions of FIN 48 will be effective for us as of the beginning of fiscal 2008. The Company has evaluated the potential impact of FIN No. 48 on the consolidated financial statements and has determined that the adoption will not have a significant impact on the consolidated financial position or results of operations.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS No. 157). SFAS No. 157 defines fair value, establishes a formal framework for measuring fair value and expands disclosures about fair value measurements. The Statement is effective beginning in fiscal 2009. The Company is in the process of determining the effect, if any, that the adoption of SFAS No. 157 will have on its consolidated financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS No. 159). SFAS No. 159 provides companies with an option to report selected financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007, the Company’s fiscal 2009. The Company is in the process of determining the effect, if any, that the adoption of SFAS No. 159 will have on its financial statements.
On June 29, 2005, the FASB ratified the Emerging Issues Task Force’s final consensus on Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights, (Issue No. 04-5). Issue No. 04-5 provides a framework for determining whether a general partner controls, and should consolidate, a limited partnership or a similar entity. The Issue No. 04-5 framework is based on the principal that a general partner in a limited partnership is presumed to control the limited partnership, regardless of the extent of its ownership interest, unless the limited partners have substantive kick-out rights or substantive participating rights. However, the consensus does not apply to entities that are variable interest entities, as defined under FIN No. 46-R, and various other situations. Issue No. 04-5 is effective after June 29, 2005 for all newly formed limited partnerships and for any pre-existing limited partnerships that modify their partnership agreements after that date. In addition, general partners of all other limited partnerships should apply the consensus no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005. The Company does not currently have any partnerships that meet the requirements of Issue No. 04-5.
3.
Discontinued Operations
During September 2006, the Company decided to seek to dispose of its interest in Heart Hospital of Lafayette (HHLf) and entered into a confidentiality and exclusivity agreement with a potential buyer. Subsequent to September 30, 2007, the Company completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
hospital and local physicians. See Note 21 - Subsequent Events. Pursuant to the provisions of SFAS No. 144, the consolidated financial statements for all periods presented have been restated to give effect to HHLf as a discontinued operation.
At September 30, 2007 and 2006, the Company was in violation of a financial covenant under an equipment loan to HHLf, which is guaranteed by MedCath. HHLf is classified as a discontinued operation. Accordingly, the total outstanding balance of this loan has been included in current liabilities of discontinued operations on the consolidated balance sheets as of September 30, 2007 and 2006.
On August 31, 2006, the Company completed the divestiture of its equity interest in Tucson Heart Hospital (THH) to Carondelet Health Network. Pursuant to the terms of the transaction, Carondelet Health Network acquired MedCath’s 59% ownership interest in THH and the hospital repaid all secured debt owed to MedCath. Total proceeds received by MedCath were $40.7 million. The consolidated financial statements for all periods presented have been restated to give effect to THH as a discontinued operation.
On November 5, 2004, the Company and local Milwaukee physicians, who jointly owned The Heart Hospital of Milwaukee (HHM), entered into an agreement with Columbia St. Mary’s, a Milwaukee-area hospital group, to close HHM and sell certain assets primarily comprised of real property and equipment to Columbia St. Mary’s for $42.5 million. The sale was completed on December 1, 2004. In connection with the agreement to sell the assets of HHM, the Company closed the facility prior to the completion of the sale. As a part of the closure, the company incurred termination benefits and contract termination costs of approximately $2.2 million. In addition, the Company wrote-off approximately $1.4 million related to the net book value of certain assets abandoned as a part of the closure of the facility. Transaction proceeds were used by HHM to pay intercompany secured debt, which totaled approximately $37.0 million on the date of the closing, as well as transaction costs and hospital operating expenses of approximately $2.0 million. The remaining proceeds from the divestiture, combined with proceeds from the liquidation of the assets not sold to Columbia St. Mary’s were used to satisfy certain liabilities of HHM and return a portion of the original capital contribution to the investors. The consolidated financial statements for all periods presented have been restated to give effect to HHM as a discontinued operation.
The results of operations of HHLf , THH and HHM excluding intercompany interest expense, are as follows:
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The principal balance sheet items of HHLf including allocated goodwill and excluding intercompany debt, are as follows:
4.
Goodwill and Other Intangible Assets
The results of the annual goodwill impairment testing performed in September 2007, 2006 and 2005 indicated that no impairment was required in fiscal 2007, 2006 and 2005, respectively for continuing operations.
As of September 30, 2007 and 2006, the Company’s other intangible assets, net, included the following:
Amortization expense recognized for the management contracts and other intangible assets totaled $0.6 million, $1.0 million and $1.2 million for the years ended September 30, 2007, 2006 and 2005, respectively.
The estimated aggregate amortization expense for each of the five fiscal years succeeding the Company’s most recent fiscal year ended September 30, 2007 is as follows:
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5.
Business Combinations and Hospital Development
New Hospital Development - In August 2007, the Company announced a venture to construct a new 105 inpatient bed capacity general acute care hospital, Hualapai Mountain Medical Center, which will be located in Kingman, Arizona. The hospital is accounted for as a consolidated subsidiary since the Company, through its wholly-owned subsidiary, owns 79.2% of the interest in the venture with physician partners owning the remaining 20.8%. Further, the Company exercises substantive control over the hospital. Construction of Hualapai Mountain Medical Center is expected to begin in early calendar 2008 and is anticipated to be completed in September 2009.
In May 2007, the Company and its physician partners announced a 120 bed general acute care expansion of its hospital located in St. Tammany Parish, Louisiana. Construction is expected to be completed in late fall of 2008, with 80 patient rooms being completed initially and capacity for 40 patient rooms being available for future growth. To recognize its expanded service capabilities, the hospital, which opened in February 2003, has been renamed the Louisiana Medical Center and Heart Hospital.
In April 2007, the Company and its physician partners announced the expansion of Arkansas Heart Hospital, located in Little Rock, Arkansas. The expansion will convert shelled space into 28 inpatient beds, add a 130 space parking garage to the campus and support the renovation of the hospital’s annex building to accommodate non-clinical services. The new beds are anticipated to be in service by January 2008, pending state regulatory approval.
Closure of Hospital and Sale of Related Assets - As further discussed in Note 3, the Company closed and sold certain assets of The Heart Hospital of Milwaukee on December 1, 2004.
Lease Transaction with HMC Realty. During July 2007, Harlingen Medical Center transferred real property with a net book value of approximately $34.3 million (fair value of $57.8 million) to a newly formed wholly-owned limited liability subsidiary, HMC Realty, LLC (HMC Realty), in exchange for HMC Realty’s assumption of related party and third party debt of approximately $57.8 million. Subsequently, Harlingen Medical Center entered into a lease agreement with HMC Realty whereby Harlingen Medical Center will lease the real property from HMC Realty for approximately $5.5 million annually for 25 years. Subsequent to the transfer of assets and debt, HMC Realty received capital contributions as described below, and Harlingen Medical Center canceled its membership in HMC Realty. The $57.8 million debt assumed by HMC Realty consisted of $2.9 million owed to Valley Baptist Health System (Valley Baptist), $11.3 million owed to the Company for working capital loans, and the assumption of $43.5 million in real estate debt with a third party. The Company converted $9.6 million of the working capital loan with HMC Realty into a 36% interest in HMC Realty.
Recapitalization of Harlingen Medical Center. During fiscal 2006, Harlingen Medical Center entered into two $10.0 million convertible notes with Valley Baptist. The first note could have been voluntarily converted by the health system into a 13.2% ownership interest in Harlingen Medical Center after the third anniversary date of issuance, or it could have been automatically converted into an ownership interest in Harlingen Medical Center upon the achievement of specified financial targets contained in the debt agreement, up until the third anniversary date of the agreement or the fourth anniversary date of the agreement, if extended by Harlingen Medical Center. The second note was convertible into the same ownership interest percentage as the first note at the discretion of the health system after the conversion of the first note. The potential ownership interest in Harlingen Medical Center by the health system was capped at 49%. The notes accrued interest at 5% per annum up until the third anniversary date, after which time the interest rate would have been increased to 8% if the notes had not been converted.
The noncash impact of accounting for Harlingen Medical Center as an equity investment and the recapitalization of Harlingen Medical Center during the fourth quarter of fiscal 2007 were taken into consideration in the accompanying consolidated statements of cash flows.
Interest payments were due quarterly. In accordance with the provisions of EITF 99-1, Accounting for Debt Convertible into the Stock of a Consolidated Subsidiary, EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and EITF 01-6, The Meaning of
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Indexed to a Company’s Own Stock, the convertible notes were accounted for as convertible debt in the accompanying consolidated balance sheets and the embedded conversion option in the convertible notes were not accounted for as a separate derivative.
During July 2007, the Company elected, along with the original physician investors and Valley Baptist, to allow early conversion of the Valley Baptist notes into an equity interest in Harlingen Medical Center (the “Recapitalization”). Valley Baptist converted $17.1 million of the convertible notes into a 32.1% equity interest in Harlingen Medical Center. The remaining $2.9 million was converted into a membership interest in HMC Realty. Prior to the Recapitalization, Harlingen Medical Center had approximately $12.5 million in working capital debt outstanding with the Company. As a result of the Recapitalization, the Company converted $1.2 million of the debt into additional capital in Harlingen Medical Center, converted $9.6 million into a membership interest of HMC Realty, and was repaid the remaining balance of the working capital note. As a result of the transactions described above, the Company now owns a 36% interest in Harlingen Medical Center, and a 36% interest in HMC Realty. In addition, Valley Baptist holds a 32% interest in Harlingen Medical Center and a 19% interest in HMC Realty, and the remaining ownership interests in both entities are held by unrelated physician investor groups.
Prior to the Recapitalization, the Company consolidated Harlingen Medical Center. As a result of the Recapitalization, the Company’s interest in Harlingen Medical Center was diluted from 51.0% to 36.0% effective for the fourth quarter of fiscal year 2007. The Company recorded the gain resulting from the change in ownership interest in accordance with SAB Topic 5H. The gain resulted from the difference between the carrying amount of the Company’s investment in Harlingen Medical Center prior to the issuance of units and the Company’s equity investment immediately following the issuance of units. The Company determined that recognition of the gain as a capital transaction was appropriate because Harlingen Medical Center had historically experienced net losses, and because of uncertainty regarding the possible future occurrence of transactions that may involve further dilution of the Company’s equity interest in Harlingen Medical Center. Future issuances of units to third parties, if any, will further dilute the Company’s ownership percentage and may give rise to additional gains or losses based on the offering price in comparison to the carrying value of the Company’s investment.
Sale of Equity Interest in Hospital - As further discussed in Note 3, the Company sold its equity interest in Tucson Heart Hospital on August 31, 2006.
Assets Held For Sale - As further discussed in Note 3, the Company decided to seek to dispose of its interest in Heart Hospital of Lafayette and has entered into a confidentiality and exclusivity agreement with a potential buyer. Subsequent to September 30, 2007, the Company completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians. See Note 21 - Subsequent Events.
Diagnostic and Therapeutic Facilities Development - During fiscal 2007, the Company entered into three non-consolidating joint ventures of which the Company owns between 9.2% and 15%.
During fiscal 2006, the Company entered into a business alliance with a medical center in Illinois. Under this agreement, the Company receives fees related to the management of the hospital’s existing cardiovascular program.
Also throughout fiscal 2006, the Company opened five managed ventures throughout the United States. The Company owns 100% of these centers.
During fiscal 2005, the Company entered into a development agreement and service line management agreement with a third party hospital in Montana. Under these agreements, the Company receives fees related to the management of the hospital’s cardiovascular service line. During fiscal 2006, the Company announced its plans to end this strategic alliance. The alliance terminated in December 2006.
Also throughout fiscal 2005, the Company opened four different sleep centers throughout the United States. The Company owns 51% to 100% of these centers.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6.
Accounts Receivable
Accounts receivable, net,consist of the following:
Activity for the allowance for doubtful accounts is as follows:
7.
Property and Equipment
Property and equipment, net, consists of the following:
Substantially all of the Company’s property and equipment is either pledged as collateral for various long-term obligations or assigned to lenders under the senior secured credit facility as intercompany collateral liens.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
8.
Investments in Affiliates
The Company’s determination of the appropriate consolidation method to follow with respect to investments in affiliates is based on the amount of control it has and the ownership level in the underlying entity. Investments in entities that the Company does not control, but over whose operations the Company has the ability to exercise significant influence (including investments where we have less than 20% ownership), are accounted for under the equity method. The Company also considers FAS Interpretation No. 46, Consolidation of Variable Interest Entities (as amended) (FIN 46R) to determine if the Company is the primary beneficiary of (and therefore should consolidate) any entity whose operations the Company does not control. At September 30, 2007, all of the Company’s investments in unconsolidated affiliates are accounted for using the equity method.
Variable Interest Entities
During the fourth quarter of fiscal 2007 the Company’s interest in Harlingen Medical Center was diluted from 51.0% to 36.0% (see Note 5). Prior to the fourth quarter of fiscal 2007 the Company consolidated the results of Harlingen Medical Center. Upon dilution, the Company began accounting for Harlingen Medical Center as an equity investment as the Company determined that Harlingen Medical Center was a variable interest entity as defined by FIN 46(R) and was not the primary beneficiary. Harlingen Medical Center is an acute care hospital facility. The nature of the Company’s involvement with Harlingen Medical Center is to act as manager of the facility and provide support services as necessary. The Company’s initial involvement with Harlingen Medical Center began in fiscal year 2001. The Company’s share of the maximum loss exposure relating to the hospital is not anticipated to be material to the Company’s financial position, results of operations, or cash flows.
Investments in unconsolidated affiliates accounted for under the equity method consist of the following:
At September 30, 2007, accumulated deficit includes $7.6 million related to undistributed earnings of Avera Heart Hospital of South Dakota. Distributions received from Avera Heart Hospital of South Dakota were $3.3 million during the year ended September 30, 2007 and $2.7 million in each year ended September 30, 2006 and 2005. No distributions were received from Harlingen Medical Center during the year ended September 30, 2007.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
9.
Long-Term Debt
Long-term debt consists of the following:
Senior Notes - During fiscal 2004, the Company’s wholly-owned subsidiary, MedCath Holdings Corp. (the Issuer), completed an offering of $150.0 million in aggregate principal amount of 97/8% senior notes (the Senior Notes). The proceeds, net of fees, of $145.5 million were used to repay a significant portion of the Company’s then outstanding debt and obligations under capital leases. The Senior Notes, which mature on July 15, 2012, pay interest semi-annually, in arrears, on January 15 and July 15 of each year. The Senior Notes are redeemable, in whole or in part, at any time on or after July 15, 2008 at a designated redemption amount, plus accrued and unpaid interest and liquidated damages, if any, to the applicable redemption date. The Company could redeem up to 35% of the aggregate principal amount of the Senior Notes on or before July 15, 2007 with the net cash proceeds from certain equity offerings. In event of a change in control in the Company or the Issuer, the Company must offer to purchase the Senior Notes at a purchase price of 101% of the aggregate principal amount, plus accrued and unpaid interest and liquidated damages, if any, to the date of redemption.
The Senior Notes are general unsecured unsubordinated obligations of the Issuer and are fully and unconditionally guaranteed, jointly and severally, by MedCath Corporation (the Parent) and all 95% or greater owned existing and future domestic subsidiaries of the Issuer (the Guarantors). The guarantees are general unsecured unsubordinated obligations of the Guarantors.
The Senior Notes include covenants that restrict, among other things, the Company’s and its subsidiaries’ ability to make restricted payments, declare or pay dividends, incur additional indebtedness or issue preferred stock, incur liens, merge, consolidate or sell all or substantially all of the assets, engage in certain transactions with affiliates, enter into various transactions with affiliates, enter into sale and leaseback transactions or engage in any business other than a related business.
In connection with the sale of the assets of The Heart Hospital of Milwaukee and as stipulated by the indenture governing the Senior Notes, during fiscal 2006, the Company offered to repurchase up to $30.3 million of Senior Notes. The tender offer for the notes expired during the fiscal year and the Company accepted for purchase and paid for $11.9 million principal amount of Senior Notes tendered prior to the expiration of the tender offer. Accordingly, the Company expensed $0.4 million of deferred loan acquisition costs related to this prepayment. This expense is reported as a loss on early extinguishment of debt in the Company’s statement of operations for the year ended September 30, 2006.
During fiscal 2007, the Company repurchased $36.2 million of its outstanding Senior Notes using the proceeds from the Company’s secondary public offering which was declared effective by the Securities and Exchange Commission on November 6, 2006. The Company incurred a repurchase premium of $3.5 million and approximately $1.0 million of deferred loan acquisition costs were written off in connection with the repurchase. These costs are reported as a loss on early extinguishment of debt in the Company’s statement of operations for the year ended September 30, 2007.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Senior Secured Credit Facility - Concurrent with the offering of the Senior Notes, the Issuer entered into a $200.0 million senior secured credit facility (the Senior Secured Credit Facility) with a syndicate of banks and other institutional lenders. The Senior Secured Credit Facility provides for a seven-year term loan facility (the Term Loan) in the amount of $100.0 million and a five-year senior secured revolving credit facility (Revolving Facility) in the amount of $100.0 million, which includes a $25.0 million sub-limit for the issuance of stand-by and commercial letters of credit and a $10.0 million sub-limit for swing-line loans, and is collateralized by patient accounts receivable and certain other assets of the Company. There were no borrowings under the Revolving Facility at September 30, 2007; however, the Company has letters of credit outstanding of $1.7 million, which reduces availability under the Revolving Facility to $98.3 million.
Borrowings under the Senior Secured Credit Facility, excluding swing-line loans, bear interest per annum at a rate equal to the sum of LIBOR plus the applicable margin or the alternate base rate plus the applicable margin. The applicable margin is different for the Revolving Facility and the Term Loan and varies for the Revolving Facility depending on the Company’s financial performance. Swing-line borrowings under the Revolving Facility bear interest at the alternate base rate which is defined as the greater of the Bank of America, N.A. prime rate or the federal funds rate plus 0.5%. The Issuer is required to pay quarterly, in arrears, a 0.5% per annum commitment fee equal to the unused commitments under the Senior Secured Credit Facility. The Issuer is also required to pay quarterly, in arrears, a fee on the stated amount of each issued and outstanding letter of credit ranging from 200 to 300 basis points depending upon the Company’s financial performance.
The Senior Secured Credit Facility is guaranteed, jointly and severally, by the Parent and all 95% or greater owned existing and future direct and indirect domestic subsidiaries of the Issuer and is secured by a first priority perfected security interest in all of the capital stock or other ownership interests owned by the Issuer in each of its subsidiaries, all other present and future assets and properties of the Parent, the Issuer and the subsidiary guarantors and all the intercompany notes.
The Senior Secured Credit Facility requires compliance with certain financial covenants including a senior secured leverage ratio test, a fixed charge coverage ratio test, a tangible net worth test and a total leverage ratio test. The Senior Secured Credit Facility also contains customary restrictions on, among other things, the Company’s ability and its subsidiaries’ ability to incur liens; engage in mergers, consolidations and sales of assets; incur debt; declare dividends, redeem stock and repurchase, redeem and/or repay other debt; make loans, advances and investments and acquisitions; make capital expenditures; and transactions with affiliates.
The Issuer is required to make mandatory prepayments of principal in specified amounts upon the occurrence of excess cash flows and other certain events, as defined by the Senior Secured Credit Facility, and is permitted to make voluntary prepayments of principal under the Senior Secured Credit Facility. The Term Loan is subject to amortization of principal in quarterly installments of $250,000 for each of the first five years, with the remaining balance payable in the final two years.
During fiscal 2006, the Company made a voluntary prepayment of $58.0 million on the outstanding balance of the Term Loan. Accordingly, the Company expensed approximately $1.0 million of deferred loan acquisition costs related to this prepayment. This expense is reported as a loss on early extinguishment of debt in the Company’s statement of operations for the year ended September 30, 2006. Further, the amortization of principal was revised to quarterly installments of $102,000 for the remaining first five years, with the remaining balance payable in the final two years.
During January 2007, the Company paid off its outstanding $39.9 million Term Loan under the Senior Secured Credit Facility. In connection with the early repayment, the Company wrote off approximately $0.5 million in deferred loan acquisition costs. These costs are reported as a loss on early extinguishment of debt in the Company’s statement of operations for the year ended June 30, 2007.
Real Estate Investment Trust (REIT) Loans - As of September 30, 2006, the Company’s REIT Loan balance included the outstanding indebtedness of two hospitals. The interest rates on the outstanding REIT Loans were
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
based on a rate index tied to U.S. Treasury Notes plus a margin that was determined on the completion date of the hospital, and subsequently increased per year by 20 basis points. The principal and interest on the REIT Loans were payable monthly over seven-year terms from the completion date of the hospital using extended period amortization schedules and included balloon payments at the end of the terms. One of the REIT Loans was due in full in October 2006 and therefore, the outstanding balance was included in the current portion of long-term debt and obligations under capital leases as of September 30, 2006. Borrowings under this REIT Loan were collateralized by a pledge of the Company’s interest in the related hospital’s property, equipment and certain other assets. During the first quarter of fiscal 2007, this loan, in the amount of $21.2 million, was repaid in full. The other REIT Loan, which was previously scheduled to mature during the second quarter of fiscal 2006, was refinanced in February 2006. Under the terms of the new financing, the loan requires monthly, interest-only payments for ten years, at which time the loan is due in full. The interest rate on this loan is 81/2%. Borrowings under this REIT Loan are collateralized by a pledge of the Company’s interest in the related hospital’s property, equipment and certain other assets.
As of September 30, 2006, in accordance with the hospital’s operating agreement and as required by the lender, the Company guaranteed 100% of the obligation of one of its subsidiary hospitals for the bank mortgage loan made under its REIT Loan. As of September 30, 2007, the outstanding REIT Loan was not guaranteed by the Company. The Company received a fee during fiscal 2006 from the minority partners in the subsidiary hospital as consideration for providing a guarantee in excess of the Company’s ownership percentage in the subsidiary hospital. The guarantee expired concurrent with the terms of the related real estate loan and required the Company to perform under the guarantee in the event of the subsidiary hospitals’ failing to perform under the related loan. The total amount of the real estate debt was secured by the subsidiary hospital’s underlying real estate, which was financed with the proceeds from the debt.
At September 30, 2007, the total amount of the REIT loan was approximately $35.3 million. Because the Company consolidates the subsidiary hospitals’ results of operations and financial position, both the assets and the accompanying liabilities are included in the assets and long-term debt on the Company’s consolidated balance sheets.
Convertible Notes - During fiscal 2006, Harlingen Medical Center entered into two $10.0 million convertible notes with a third-party health system, Valley Baptist Health System (Valley Baptist). The first note could be voluntarily converted by the health system into a 13.2% ownership interest in Harlingen Medical Center after the third anniversary date or it will automatically be converted into an ownership interest in Harlingen Medical Center upon the achievement of specified financial targets of the agreement, up until the third anniversary date of the agreement or the fourth anniversary date of the agreement, if extended by Harlingen Medical Center. The second note was convertible into the same ownership interest percentage as the first note at the discretion of the health system after the conversion of the first note. The potential ownership interest in Harlingen Medical Center by the health system was capped at 49%. The notes accrued interest at 5% up until the third anniversary date, after which time the interest rate increased to 8% if the notes have not been converted. Interest payments were due quarterly. In accordance with the provisions of EITF 99-1, Accounting for Debt Convertible into the Stock of a Consolidated Subsidiary, EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and EITF 01-6, The Meaning of Indexed to a Company’s Own Stock, at September 30, 2006, the convertible notes were accounted for as convertible debt in the accompanying consolidated balance sheet and the embedded conversion option in the convertible notes had not been accounted for as a separate derivative as of September 30, 2006.
During July 2007, the Company elected, along with the original physician investors and Valley Baptist, to allow early conversion of the notes into an equity interest in Harlingen Medical Center (the “Recapitalization”). Valley Baptist converted $17.1 million of the convertible loans into a 32.1% equity interest in Harlingen Medical Center. The remaining $2.9 million was conveyed to HMC Realty as payment of the real property as a result of the sales-leaseback transaction discussed above. See Note 5 for further discussion of the Recapitalization transaction.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Mortgage Loan - Concurrent with the issuance of the convertible notes, Harlingen Medical Center also entered into a $40.0 million, ten year mortgage loan with a third-party lender. The loan required quarterly, interest-only payments until the maturity date. The interest rate on the loan was 83/4%. The loan was secured by substantially all the assets of Harlingen Medical Center and was subject to certain financial and other restrictive covenants. In addition, the Company guaranteed $10.0 million of the loan balance. The Company received a fee from the minority partners at Harlingen Medical Center as consideration for providing a guarantee in excess of the Company’s ownership percentage in Harlingen Medical Center. The guarantee expired concurrent with the terms of the related loan and required the Company to perform under the guarantee in the event of Harlingen Medical Center’s failure to perform under the related loan.
During July 2007, the Company completed a recapitalization of Harlingen Medical Center, which included the repayment of this mortgage loan. See Note 5 for further discussion of the Recapitalization transaction.
Notes Payable to Various Lenders - The Company acquired substantially all of the medical and other equipment for its hospitals and certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories under installment notes payable to equipment lenders collateralized by the related equipment. In addition, two facilities in the MedCath Partners division financed leasehold improvements through notes payable collateralized by the leasehold improvements. Amounts borrowed under these notes are payable in monthly installments of principal and interest over 3 to 7 year terms. Interest is at fixed and variable rates ranging from 7.15% - 8.08%. The Company has guaranteed certain of its subsidiary hospitals’ equipment loans. The Company receives a fee from the minority partners in the subsidiary hospitals as consideration for providing guarantees in excess of the Company’s ownership percentage in the subsidiary hospitals. These guarantees expire concurrent with the terms of the related equipment loans and would require the Company to perform under the guarantee in the event of the subsidiaries’ failure to perform under the related loan.
During March 2007, the Company paid off $11.1 million of equipment debt outstanding at one of its hospitals. Due to the early prepayment, the Company wrote off approximately $0.1 million of deferred loan acquisition costs and incurred approximately $0.1 million in early prepayment fees. These costs are reported as a loss on early extinguishment of debt in the consolidated statement of operations for the year ended September 30, 2007.
At September 30, 2007, the total amount of notes payable to various lenders was approximately $12.0 million, of which $7.2 million was guaranteed by the Company. Because the Company consolidates the subsidiary hospitals’ results of operations and financial position, both the assets and the accompanying liabilities are included in the assets and long-term debt on the Company’s consolidated balance sheets. These notes payable contain various covenants and restrictions including the maintenance of specific financial ratios and amounts and payment of dividends.
Debt Covenants - At September 30, 2007, the Company was in violation of a financial covenant under an equipment loan to Heart Hospital of Lafayette, which is guaranteed by MedCath. Heart Hospital of Lafayette is classified as a discontinued operation. Accordingly, the total outstanding balance of this loan has been included in current liabilities of discontinued operations on the Company’s consolidated balance sheet as of September 30, 2007. The Company was in compliance with all other covenants in the instruments governing its outstanding debt as of September 30, 2007.
Guarantees of Unconsolidated Affiliate’s Debt - The Company has guaranteed approximately 30% of the equipment debt of one of the affiliate hospitals in which the Company has a minority ownership interest and therefore does not consolidate the hospital’s results of operations and financial position. The Company provides this guarantee in exchange for a fee from that affiliate hospital. At September 30, 2007, the affiliate hospital was in compliance with all covenants in the instruments governing its debt. The total amount of the affiliate hospital’s equipment debt was approximately $1.1 million at September 30, 2007. Accordingly, the equipment debt guaranteed by the Company was approximately $0.3 million at September 30, 2007. This guarantee expires concurrent with the terms of the related equipment loans and would require the Company to perform under the
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
guarantee in the event of the affiliate hospital’s failure to perform under the related loans. The total amount of this affiliate hospital’s debt is secured by the hospital’s underlying equipment, which was financed with the proceeds from the debt. Because the Company does not consolidate the affiliate hospital’s results of operations or financial position, neither the assets nor the accompanying liabilities are included in the assets or liabilities on the Company’s consolidated balance sheets.
Interest Rate Swaps - As required by their existing bank mortgage loans at the time, three of the Company’s consolidated hospitals entered into fixed interest rate swaps during fiscal 2001. These fixed interest rate swaps effectively fixed the interest rate on the hedged portion of the related debt at 4.92% plus an applicable margin for two of the hospitals and at 4.60% plus an applicable margin for the other hospital. These interest rate swaps were accounted for as cash flow hedges prior to the repayment of the outstanding balances of the bank mortgage debt for these three hospitals as part of the financing transaction in fiscal 2004. The Company did not terminate the interest rate swaps as part of the financing transaction, which resulted in the recognition of a loss of approximately $0.6 million during the fourth quarter of fiscal 2004. The fixed interest rate swaps have not been utilized as a hedge of variable rate debt obligations since the financing transaction, and accordingly, changes in the valuation of the interest rate swaps have been recorded directly to earnings as a component of interest expense. During fiscal 2006, all interest rate swaps expired resulting in an unrealized gain that was not significant to the consolidated results of operations or financial position.
Future Maturities - Future maturities of long-term debt at September 30, 2007 are as follows:
10.
Obligations Under Capital Leases
The Company currently leases several diagnostic and therapeutic facilities, mobile catheterization laboratories, office space, computer software and hardware, equipment and certain vehicles under capital leases expiring through fiscal year 2012. Some of these leases contain provisions for annual rental adjustments based on increases in the consumer price index, renewal options, and options to purchase during the lease terms. Amortization of the capitalized amounts is included in depreciation expense. Total assets under capital leases (net of accumulated depreciation of approximately $7.3 million and $7.2 million) at September 30, 2007 and 2006, respectively, are approximately $3.6 million and $4.5 million, respectively, and are included in property and equipment on the consolidated balance sheets. Lease payments during the years ended September 30, 2007, 2006, and 2005 were $1.8 million, $2.7 million and $3.1 million, respectively, and include interest of approximately $0.2 million, $0.4 million, and $0.8 million, respectively.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Future minimum lease payments at September 30, 2007 are as follows:
11.
Liability Insurance Coverage
During June 2004, the Company entered into a new one-year claims-made policy providing coverage for medical malpractice claim amounts in excess of $3.0 million of retained liability per claim, subject to an additional amount of retained liability of $2.0 million per claim and $4.0 million in the aggregate for claims reported during the policy year at one of its hospitals. During June 2005, the Company entered into a new one-year claims-made policy providing coverage for medical malpractice claim amounts in excess of $3.0 million of retained liability per claim. At that time, the Company also purchased additional insurance to reduce the retained liability per claim to $250,000 for the MedCath Partners division. During June 2006, the Company entered into a new one-year claims-made policy providing coverage for medical malpractice claim amounts in excess of $2.0 million of retained liability per claim. The Company also purchased additional insurance to reduce the retained liability per claim to $250,000 for the MedCath Partners division. During June 2007, the Company entered into a new one-year claims-made policy providing coverage for medical malpractice claim amounts in excess of $3.0 million of retained liability per claim. The Company also purchased additional insurance to reduce the retained liability per claim to $250,000 for the MedCath Partners division.
Because of the Company’s self-insured retention levels, the Company is required to recognize an estimated expense/liability for the amount of retained liability applicable to each malpractice claim. As of September 30, 2007 and September 30, 2006, the total estimated liability for the Company’s self-insured retention on medical malpractice claims, including an estimated amount for incurred but not reported claims, was approximately $4.2 million and $5.9 million, respectively, which is included in other accrued liabilities on the consolidated balance sheets. The Company maintains this reserve based on actuarial estimates prepared by an independent third party, who bases the estimates on the Company’s historical experience with claims and assumptions about future events. Due to the considerable variability that is inherent in such estimates, including such factors as changes in medical costs and changes in actual experience, there is a reasonable possibility that the recorded estimates will change by a material amount in the near term. Also, there can be no assurance that the ultimate liability will not exceed the Company’s estimates.
12.
Commitments and Contingencies
Operating Leases - The Company currently leases several cardiac diagnostic and therapeutic facilities, mobile catheterization laboratories, office space, computer software and hardware equipment, certain vehicles and land under noncancelable operating leases expiring through fiscal year 2064. Total rent expense under noncancelable rental commitments was approximately $2.6 million, $3.1 million and $2.8 million for the years ended
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
September 30, 2007, 2006 and 2005, respectively, and is included in other operating expenses in the accompanying consolidated statements of operations.
The approximate future minimum rental commitments under noncancelable operating leases as of September 30, 2007 are as follows:
Contingencies - Laws and regulations governing the Medicare and Medicaid programs are complex, subject to interpretation and may be modified. The Company believes that it is in compliance with such laws and regulations. However, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including substantial fines and criminal penalties, as well as repayment of previously billed and collected revenue from patient services and exclusion from the Medicare and Medicaid programs.
The Company is involved in various claims and legal actions in the ordinary course of business, including malpractice claims arising from services provided to patients that have been asserted by various claimants and additional claims that may be asserted for known incidents through September 30, 2007. These claims and legal actions are in various stages, and some may ultimately be brought to trial. Moreover, additional claims arising from services provided to patients in the past and other legal actions may be asserted in the future. The Company is protecting its interests in all such claims and actions and does not expect the ultimate resolution of these matters to have a material adverse impact on the Company’s consolidated financial position, results of operations or cash flows.
The U.S. Department of Justice, or DOJ, conducted an investigation of a clinical trial conducted at one of our hospitals. The investigation concerns alleged improper federal healthcare program billings from 1998-2002 because certain endoluminal graft devices were implanted either without an approved investigational device exception or outside of the approved protocol. The DOJ has reached a settlement under the False Claims Act with the medical practice whose physicians conducted the clinical trial. The hospital has entered into an agreement with the DOJ under which it will pay $5.8 million to the United States to settle, and obtain a release from any federal civil false claims related to DOJ’s investigation. As part of the settlement, the hospital is finalizing negotiations with the Department of Health and Human Services, Office of the Inspector General, or OIG, on additional provisions to the hospital’s existing compliance program relating to certain disclosures and internal claims reviews, and to maintain that program for five years in order to obtain a permissive exclusion release from the OIG. The settlement and release cover both the hospital and the physician who conducted the clinical trial, and does not include any finding of wrong doing or any admission of liability. The Company recorded a $5.8 million reduction in net revenue for the year ended September 30, 2007, to establish a reserve for repayment of a portion of Medicare reimbursement related to hospital inpatient services provided to patients from 1998-2002 in accordance with SFAS No. 5, Accounting for Contingences. As a result of the agreement to settle, no additional reserve will be recorded. The settlement was paid to the United States in full in November 2007.
Commitments - On November 10, 2005, the FASB issued Interpretation No. 45-3, Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners (FIN No. 45-3).
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
FIN No. 45-3 amends FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others , to expand the scope to include guarantees granted to a business, such as a physician’s practice, or its owner(s), that the revenue of the business for a specified period will be at least a specified amount. Under FIN No. 45-3, the accounting requirements of FIN No. 45 are effective for any new revenue guarantees issued or modified on or after January 1, 2006 and the disclosure of all revenue guarantees, regardless of whether they were recognized under FIN No. 45, is required for all interim and annual periods beginning after January 1, 2006.
Some of the Company’s hospitals provide guarantees to certain physician groups for funds required to operate and maintain services for the benefit of the hospital’s patients including emergency care services and anesthesiology services, among others. These guarantees extend for the duration of the underlying service agreements and the maximum potential future payments that the Company could be required to make under these guarantees was approximately $2.6 million through October 2008 as of September 30, 2007. The Company would only be required to pay this maximum amount if none of the physician groups collected fees for services performed during the guarantee period.
13.
Income Taxes
The components of income tax expense (benefit) are as follows:
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The components of net deferred taxes are as follows:
As of September 30, 2007 and 2006, the Company had recorded a valuation allowance of $2.8 million and $1.7 million, respectively, primarily related to state net operating loss carryforwards. The valuation allowance increased by $1.1 million during the year ended September 30, 2007 due to current year losses incurred in certain states.
The Company has state net operating loss carryforwards of approximately $111.0 million that began to expire in 2007.
The differences between the U.S. federal statutory tax rate and the effective rate are as follows.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
14.
Per Share Data and Share Repurchase Plan
The calculation of diluted earnings (loss) per share considers the potential dilutive effect of options to purchase 1,727,112, 2,070,472, and 2,409,618 shares of common stock at prices ranging from $4.75 to $33.05, which were outstanding at September 30, 2007, 2006 and 2005, respectively, as well as 193,982 and 216,835 shares of restricted stock which were outstanding at September 30, 2007 and 2006, respectively. Of the outstanding stock options, 135,000, 208,500, and 170,000 options have not been included in the calculation of diluted earnings (loss) per share at September 30, 2007, 2006 and 2005, respectively, because the options were anti-dilutive.
15.
Stock Compensation Plans
On July 28, 1998, the Company’s board of directors adopted a stock option plan (the 1998 Stock Option Plan) under which it may grant incentive stock options and nonqualified stock options to officers and other key employees. Under the 1998 Stock Option Plan, the board of directors may grant option awards and determine the option exercise period, the option exercise price, and other such conditions and restrictions on the grant or exercise of the option as it deems appropriate. The 1998 Stock Option Plan provides that the option exercise price may not be less than the fair value of the common stock as of the date of grant and that the options may not be exercised more than ten years after the date of grant. Options that have been granted during the years ended September 30, 2007, 2006 and 2005 were granted at an option exercise price equal to or greater than fair market value of the underlying stock at the date of the grant and become exercisable on grading and fixed vesting schedules ranging from 4 to 8 years subject to certain performance acceleration features. As further discussed in Note 2, effective September 30, 2005, the compensation committee of the board of directors approved a plan to accelerate the vesting of substantially all unvested stock options previously awarded to employees, subject to a Restriction Agreement. At September 30, 2007, the maximum number of shares of common stock, which can be issued through awards granted under the 1998 Option Plan is 3,000,000, of which 825,365 are outstanding as of September 30, 2007.
On July 23, 2000, the Company adopted an outside director’s stock option plan (the Director’s Plan) under which nonqualified stock options may be granted to non-employee directors. Under the Director’s Plan, grants of 2,000 options were granted to each new director upon becoming a member of the board of directors and grants of 2,000 options were made to each continuing director on October 1, 1999 (the first day of the fiscal year ended September 30, 2000). Effective September 15, 2000, the Director’s Plan was amended to increase the number of options granted for future awards from 2,000 to 3,500. Further, effective September 30, 2007, the Director’s Plan was amended to increase the number of options granted for future awards from 3,500 to 8,000. All options granted under the Director’s Plan through September 30, 2007 have been granted at an exercise price equal to or greater than the fair market value of the underlying stock at the date of the grant. Options are exercisable immediately upon the date of grant and expire ten years from the date of grant. The maximum number of shares of common stock which can be issued through awards granted under the Director’s Plan is 250,000, of which 57,000 are outstanding as of September 30, 2007.
Effective October 1, 2005, the Company adopted the MedCath Corporation 2006 Stock Option and Award Plan (the Stock Plan), which provides for the issuance of stock options, restricted stock and restricted stock units to employees of the Company. The Stock Plan is administered by the compensation committee of the board of directors, who has the authority to select the employees eligible to receive awards. This committee also has the authority under the Stock Plan to determine the types of awards, select the terms and conditions attached to all awards, and, subject to the limitation on individual awards in the Stock Plan, determine the number of shares to be awarded. At September 30, 2007, the maximum number of shares of common stock which can be issued through awards granted under the Stock Plan is 1,750,000 of which 717,018 are outstanding as of September 30, 2007.
Stock options granted to employees and directors under the Stock Plan have an exercise price per share that represents the fair market value of the common stock of the Company on the respective dates that the options are granted. The options expire ten years from the grant date, are fully vested and are exercisable at any time. Subsequent to the exercise of stock options, the shares of stock acquired upon exercise may be subject to certain sale
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
restrictions depending on the optionee’s employment status and length of time the options were held prior to exercise.
Activity for the Company’s stock compensation plans during the years ended September 30, 2007, 2006 and 2005 was as follows:
The following table summarizes information for options outstanding and exercisable at September 30, 2007:
Under SFAS No. 123-R, share-based compensation expense recognized for the fiscal years ended September 30, 2007 and 2006 was $4.3 million and $13.2 million, respectively, which had the effect of decreasing net income by $2.5 million or $0.12 per basic and diluted share and $7.8 million or $0.42 per basic share and $0.40 per diluted share for the respective periods. The compensation expense recognized represents the compensation related to restricted stock awards over the vesting period, as well as the value of all stock options issued during the period as all such options vest immediately. The total intrinsic value of options exercised during fiscal 2007 and
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2006 was $5.5 million and $7.0 million, respectively and the total intrinsic value of options outstanding at September 30, 2007 was $11.2 million. Since all options granted during the year ended September 30, 2005 had an exercise price equal to the market value of the underlying shares of common stock at the date of grant, no compensation expense was recorded for the year ended September 30, 2005.
The following table illustrates the effect on reported net income and earnings per share as if the Company had applied SFAS No. 123-R during the periods indicated.
During the fiscal year ended September 30, 2006, the Company granted to employees 270,836 shares of restricted stock, which vest at various dates through March 2009. The compensation expense, which represents the fair value of the stock measured at the market price at the date of grant, less estimated forfeitures, is recognized on a straight-line basis over the vesting period. Unamortized compensation expense related to restricted stock amounted to $1.8 million at September 30, 2007.
16.
Employee Benefit Plan
The Company has a defined contribution retirement savings plan (the 401(k) Plan) which covers all employees. The 401(k) Plan allows employees to contribute from 1% to 25% of their annual compensation on a pre-tax basis.. The Company, at its discretion, may make an annual contribution of up to 30% of an employee’s pretax contribution, up to a maximum of 6% of compensation. This annual contribution percentage was increased to 30% for fiscal 2007 from 25% for fiscal 2006. The Company’s contributions to the 401(k) Plan for the years ended September 30, 2007, 2006 and 2005 were approximately $1.9 million, $1.5 million and $1.5 million, respectively.
17.
Related Party Transactions
During each of the years ended September 2007, 2006 and 2005 the Company incurred $0.1 million in insurance and related risk management fees to its principal stockholders and their affiliates. In addition, $0.1 million and $0.2 million were paid to a director in consulting fees in the years ended September 30, 2006 and 2005, respectively. No consulting fees were paid to a director during the year ended September 30, 2007.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18.
Summary of Quarterly Financial Data (Unaudited)
Summarized quarterly financial results were as follows:
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
19.
Reportable Segment Information
The Company’s reportable segments consist of the hospital division and the MedCath Partners division.
Financial information concerning the Company’s operations by each of the reportable segments as of and for the years ended September 30 are as follows:
Substantially all of the Company’s net revenue in its hospital division and MedCath Partners division is derived directly or indirectly from patient services. The amounts presented for corporate and other primarily include management and consulting fees, general overhead and administrative expenses, financing activities, certain cash and cash equivalents, prepaid expenses, other assets and operations of the business not subject to segment reporting.
All of the Company’s goodwill is recorded at the Corporate and other segment.
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
20.
Guarantor/Non-Guarantor Financial Statements
The following tables present the condensed consolidated financial information for each of the Parent, the Issuer, the Guarantors and the subsidiaries of the Issuer that are not Guarantors (the Non-Guarantors), together with consolidating eliminations, as of and for the periods indicated.
MEDCATH CORPORATION
CONDENSED CONSOLIDATING BALANCE SHEET
September 30,
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
MEDCATH CORPORATION
CONDENSED CONSOLIDATING BALANCE SHEET
September 30,
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
MEDCATH CORPORATION
CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
MEDCATH CORPORATION
CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
MEDCATH CORPORATION
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
MEDCATH CORPORATION
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
21.
Subsequent Events
The Company completed the disposition of Heart Hospital of Lafayette to the Heart Hospital of Acadiana on November 30, 2007. The Company had previously announced that it had entered into a letter of intent to sell its interest in Heart Hospital of Lafayette to certain of the hospital’s physician partners. Heart Hospital of Acadiana is co-owned by Our Lady of Lourdes, a Lafayette, Louisiana community hospital and local physicians.
The aggregate purchase price and other settlement amounts related to the transaction, which was structured as an asset sale, totaled $25 million, subject to customary post-closing adjustments. Since September 30, 2006, the Company has reported the operations of Heart Hospital of Lafayette as an asset held for sale.
The Board of Directors approved a stock repurchase program of up to $59.0 million in August 2007. Stock purchases can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable federal and state securities laws and regulations. The repurchase program may be discontinued at any time. Subsequent to the approval of the stock repurchase program, the Company purchased 523,263 shares of common stock at a total cost of $12.3 million.
INDEPENDENT AUDITORS’ REPORT
To Heart Hospital of South Dakota, LLC:
We have audited the accompanying balance sheets of Heart Hospital of South Dakota, LLC (the Company) as of September 30, 2007 and 2006 and the related statements of operations, members’ capital, and cash flows for each of the three years in the period ended September 30, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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, such financial statements present fairly, in all material respects, the financial position of the Company as of September 30, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 2007 in conformity with accounting principles generally accepted in the United States of America.
/s/ Deloitte & Touche LLP
December 14, 2007
Charlotte,North Carolina
HEART HOSPITAL OF SOUTH DAKOTA, LLC
BALANCE SHEETS
(In thousands)
See notes to financial statements.
HEART HOSPITAL OF SOUTH DAKOTA, LLC
STATEMENTS OF OPERATIONS
(In thousands)
See notes to financial statements.
HEART HOSPITAL OF SOUTH DAKOTA, LLC
STATEMENTS OF MEMBERS’ CAPITAL
(In thousands)
See notes to financial statements.
HEART HOSPITAL OF SOUTH DAKOTA, LLC
STATEMENTS OF CASH FLOWS
(In thousands)
See notes to financial statements.
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS
(All tables in thousands)
1.
Organization
Heart Hospital of South Dakota, LLC, doing business as Avera Heart Hospital of South Dakota, (the Company) is a North Carolina limited liability company that was formed on June 18, 1999 to develop, own, and operate an acute-care hospital located in South Dakota, specializing in all aspects of cardiology and cardiovascular surgery. The hospital commenced operations on March 20, 2001. At September 30, 2007 and 2006, Sioux Falls Hospital Management, Inc., North Central Heart Institute Holdings, PLLC, and Avera McKennan each held a 331/3% interest in the Company.
Sioux Falls Hospital Management, Inc., an indirectly wholly owned subsidiary of MedCath Corporation (MedCath), acts as the managing member in accordance with the Company’s operating agreement. The Company will cease to exist on December 31, 2060, unless the members elect earlier dissolution. The termination date may be extended for up to an additional 40 years in five-year increments at the election of the Company’s board of directors.
2.
Summary of Significant Accounting Policies
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the financial statements and accompanying notes. There is a reasonable possibility that actual results may vary significantly from those estimates.
Fair Value of Financial Instruments - The Company considers the carrying amounts of significant classes of financial instruments on the balance sheets, including cash, accounts receivable, net, accounts payable, accrued liabilities and long-term debt to be reasonable estimates of fair value due either to their length to maturity or the existence of variable interest rates underlying such financial instruments that approximate prevailing market rates at September 30, 2007 and 2006. The Company has no financial instruments on the balance sheets for which the carrying amounts and estimated fair values differed significantly at September 30, 2007 and 2006.
Cash - Cash consists of currency on hand and demand deposits with financial institutions.
Concentrations of Credit Risk - The Company grants credit without collateral to its patients, most of whom are insured under payment arrangements with third-party payors, including Medicare, Medicaid, and commercial insurance carriers. The following table summarizes the percentage of gross accounts receivable from all payors at September 30:
Allowance for Doubtful Accounts - Accounts receivable primarily consist of amounts due from third-party payors and patients. To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The Company estimates this allowance based on such factors as payor mix, aging and its historical collection experience and write-offs.
Medical Supplies - Medical supplies consist primarily of supplies necessary for diagnostics, catheterization and surgical procedures and general patient care and are stated at the lower of first-in, first-out (FIFO) cost or market.
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS - (Continued)
Property and Equipment - Property and equipment are recorded at cost and depreciated principally on a straight-line basis over the estimated useful lives of the assets, which generally range from 25 to 40 years for buildings and improvements, 25 years for land improvements, and from 3 to 10 years for equipment and software. Repairs and maintenance costs are charged to operating expense while betterments are capitalized as additions to the related assets. Retirements, sales and disposals of assets are recorded by removing the related cost and accumulated depreciation with any resulting gain or loss reflected in income from operations.
Long-Lived Assets - Long-lived assets are evaluated for impairment when events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of these assets and their eventual disposition are less than their carrying amount. The determination of whether or not long-lived assets have become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the estimated future cash flows expected to result from the use of those assets. Changes in the Company’s strategy, assumptions and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of long-lived assets. No impairment charges of long-lived assets were necessary for the years ended September 30, 2007, 2006 and 2005.
Other Assets - Other assets primarily consist of loan acquisition costs, which are costs associated with obtaining long-term financing (Loan Costs). The Loan Costs are being amortized using the straight-line method, over the life of the related debt, which approximates the effective interest method. The Company recognizes the amortization of Loan Costs as a component of interest expense. Amortization expense recognized for Loan Costs totaled approximately $38,000, $66,000 and $119,000 for the years ended September 30, 2007, 2006 and 2005, respectively.
Revenue Recognition - Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as commercial insurers, health maintenance organizations and preferred provider organizations are generally less than established billing rates. Payment arrangements with third-party payors may include prospectively determined rates per discharge or per visit, a discount from established charges, per diem payments, reimbursed costs (subject to limits) and/or other similar contractual arrangements. As a result, net revenue for services rendered to patients is reported at the estimated net realizable amounts as services are rendered. The Company accounts for the differences between the estimated realizable rates under the reimbursement program and the standard billing rates as contractual adjustments.
The majority of the Company’s contractual adjustments are system-generated at the time of billing based on either government fee schedules or fee schedules contained in managed care agreements with various insurance plans. Portions of the Company’s contractual adjustments are performed manually and these adjustments primarily relate to patients that have insurance plans with whom the Company does not have contracts containing discounted fee schedules, also referred to as non-contracted payors, patients that have secondary insurance plans following adjudication by the primary payor, uninsured self-pay patients and charity care patients. Estimates of contractual adjustments are made on a payor-specific basis and based on the best information available regarding the Company’s interpretation of the applicable laws, regulations and contract terms. While subsequent adjustments to the systematic contractual allowances can arise due to denials, short payments deemed immaterial for continued collection effort and a variety of other reasons, such amounts have not historically been significant.
The Company continually reviews the contractual estimation process to consider and incorporate updates to the laws and regulations and any changes in the contractual terms of its programs. Final settlements under some of these programs are subject to adjustment based on audit by third parties, which can take several years to determine. From a procedural standpoint, the Company subsequently adjusts those settlements as new information is obtained from audits or review by the fiscal intermediary, and, if the result of the of the fiscal intermediary audit or review impacts other unsettled and open costs reports, then the Company recognizes the impact of those adjustments.
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS - (Continued)
A significant portion of the Company’s net revenue is derived from federal and state governmental healthcare programs, including Medicare and Medicaid, which, combined, accounted for 53% , 53% and 55% of the Company’s net revenue during the years ended September 30, 2007, 2006 and 2005, respectively. Medicare payments for inpatient acute services and certain outpatient services are generally made pursuant to a prospective payment system. Under this system, a hospital is paid a prospectively-determined fixed amount for each hospital discharge based on the patient’s diagnosis. Specifically, each discharge is assigned to a diagnosis-related group (DRG). Based upon the patient’s condition and treatment during the relevant inpatient stay, each DRG is assigned a fixed payment rate that is prospectively set using national average costs per case for treating a patient for a particular diagnosis. The DRG rates are adjusted by an update factor each federal fiscal year, which begins on October 1. The update factor is determined, in part, by the projected increase in the cost of goods and services that are purchased by hospitals, referred to as the market basket index. DRG payments do not consider the actual costs incurred by a hospital in providing a particular inpatient service; however, DRG payments are adjusted by a predetermined adjustment factor assigned to the geographic area in which the hospital is located.
While hospitals generally do not receive direct payment in addition to a DRG payment, hospitals may qualify for additional capital-related cost reimbursement and outlier payments from Medicare under specific circumstances. Medicare payments for non-acute services, certain outpatient services, medical equipment, and education costs are made based on a cost reimbursement methodology and are under transition to various methodologies involving prospectively determined rates. The Company is reimbursed for cost-reimbursable items at a tentative rate with final settlement determined after submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Medicaid payments for inpatient and outpatient services are made at prospectively determined amounts and cost based reimbursement, respectively.
The Company provides care to patients who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amounts determined to qualify as charity care, they are not reported as net revenue.
Advertising - Advertising costs are expensed as incurred. During the years ended September 30, 2007, 2006 and 2005, the Company incurred approximately $597,000, $544,000 and $348,000, respectively, of advertising expenses.
Income Taxes - The Company has elected to be treated as a limited liability company for federal and state income tax purposes. As such, all taxable income or loss of the Company is included in the income tax returns of the respective members. Accordingly, no provision has been made for federal or state income taxes in the accompanying financial statements.
Members’ Share of Net Income and Loss - In accordance with the membership agreement, net income and loss are first allocated to the members based on their respective ownership percentages. If the cumulative losses of the Company exceed its initial capitalization and committed capital obligations of its members, Sioux Falls Hospital Management, Inc., the Company’s managing member, is required, due to at-risk capital position, by accounting principles generally accepted in the United States of America, to recognize a disproportionate share of the Company’s losses that otherwise would be allocated to all of its members on a pro rata basis. In such cases, Sioux Falls Hospital Management, Inc. will recognize a disproportionate share of the Company’s future profits to the extent it has previously recognized a disproportionate share of the Company’s losses.
Market Risk - The Company’s policy for managing risk related to its exposure to variability in interest rates, commodity prices, and other relevant market rates and prices includes consideration of entering into derivative instruments (freestanding derivatives), or contracts or instruments containing features or terms that behave in a manner similar to derivative instruments (embedded derivatives) in order to mitigate its risks. In addition, the Company may be required to hedge some or all of its market risk exposure, especially to interest rates, by creditors who provide debt funding to the Company. The Company recognizes all derivatives as either assets or liabilities in the balance sheets and measures those instruments at fair value in accordance with Statement of Financial
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS - (Continued)
Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities (an Amendment of FASB Statement No. 133) and as amended by SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.
3.
Accounts Receivable
Accounts receivable, net, at September 30 is as follows:
Activity for the allowance for doubtful accounts for the years ended September 30 is as follows:
4.
Property and Equipment
Property and equipment, net, at September 30 is as follows:
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS - (Continued)
5.
Long-Term Debt
Long-term debt at September 30 is as follows:
Bank Mortgage Loan - The Company financed its building and land through a bank mortgage loan dated June 29, 2000. Under the terms of the loan, interest-only payments were due through June 2002, which represented the first 24 months following the closing of the loan. Thereupon, the loan converted to a term loan with principal and interest payments due monthly, based on a 240-month amortization schedule with interest determined using the LIBOR rate plus an applicable margin of 2.75%. The loan was originally scheduled to mature on July 10, 2003 but was amended to extend the maturity date to September 30, 2008. During February 2006, this loan was refinanced and extended through December 2015 with an interest rate of the LIBOR rate plus an applicable margin of 1.25%. At September 30, 2007 and 2006, the interest rate on this loan is 6.97% and 6.58%, respectively. Until the date of refinancing, MedCath and Avera McKennan guaranteed 50% of the outstanding balance of the bank mortgage loan.
At September 30, 2005, the Company had four interest rate swaps, which qualified as cash flow hedges, outstanding for a total notional amount of approximately 80% of the bank mortgage loan’s outstanding balance. Two of the swaps effectively fixed LIBOR at 4.18% (4.18% Swaps) for approximately 60% of the bank mortgage loan’s outstanding balance. The remaining two swaps effectively fixed LIBOR at 3.46% (3.46% Swaps) for approximately 20% of the bank mortgage loan’s outstanding balance. The Company terminated the 4.18% Swaps and the 3.46% Swaps during the year ended September 30, 2006 and entered into a new interest rate swap (the Swap), which qualifies as a cash flow hedge and which effectively fixes LIBOR at 5.21% for approximately 80% of the bank mortgage loan’s outstanding balance. At both September 30, 2007 and 2006, the Company’s effective interest rate on the notional amount of the Swap is 6.46%. During fiscal 2007 and 2006, the Company recognized interest expense based upon the fixed interest rates provided under the swaps, while the change in the fair value of the swaps is recorded as other comprehensive income (loss) and as an adjustment to the derivative liability in the balance sheets. The derivative liability is $282,000 and $224,000 at September 30, 2007 and 2006, respectively, and is included in other long-term obligations on the balance sheets. Future changes in the fair value of the Swap will be recorded based upon the variability in the market interest rates until maturity in December 2015.
The bank mortgage loan agreement contains certain restrictive covenants, which require the maintenance of specific financial ratios and amounts. The Company is in compliance with these restrictive covenants at September 30, 2007.
Notes Payable to Equipment Lenders - The Company acquired substantially all of its equipment under installment notes payable to equipment lenders collateralized by the related equipment, which has a net book value of approximately $1.3 million and $1.9 million at September 30, 2007 and 2006, respectively. Amounts borrowed under these notes are payable in monthly installments of principal and interest over five-year and seven-year terms. The notes have annual fixed rates of interest ranging from 6.4% to 9.3%. MedCath and Avera McKennan have each guaranteed 30% of $731,000 of the installment notes payable to equipment lenders as of September 30, 2007.
The Company also had a $2.5 million working capital line of credit that was provided by the real estate lender, and was subject to the interest rate, covenants, guarantee and collateral of the real estate loan which was scheduled
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS - (Continued)
to expire in June 2006 but during fiscal 2006 was extended to December 2008. No amounts were outstanding under this line of credit at September 30, 2007 or 2006.
Future maturities of long-term debt, as of September 30, 2007, are as follows:
6.
Commitments and Contingencies
Operating Leases - The Company leases certain equipment under noncancelable operating leases. The total rent expense under operating leases was approximately $100,000 during the years ended September 30, 2007, 2006 and 2005 and is included in other operating expenses. The future approximate minimum payments on noncancelable operating leases as of September 30, 2007 were $50,000 for fiscal 2008.
Commitments - The Company provides guarantees to certain non-investor physician groups for funds required to operate and maintain services for the benefit of the hospital’s patients requiring radiology services. These guarantees extend for the duration of the underlying service agreements and the maximum potential future payments that the Company could be required to make under these guarantees was approximately $150,000 through March 2008 as of September 30, 2007. The Company would only be required to pay this maximum amount if none of the physician groups collected fees for services performed during the guarantee period.
Contingencies - Laws and regulations governing the Medicare and Medicaid programs are complex, subject to interpretation and may be modified. The Company believes that it is in compliance with such laws and regulations and it is not aware of any investigations involving allegations of potential wrongdoing. However, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action, including substantial fines and criminal penalties, as well as repayment of previously billed and collected revenue from patient services and exclusion from the Medicare and Medicaid programs. Medicare and Medicaid cost reports have been audited by the fiscal intermediary through September 30, 2005 and September 30, 2004, respectively.
The Company is involved in various claims and legal actions in the ordinary course of business. Moreover, claims arising from services provided to patients in the past and other legal actions may be asserted in the future. The Company is protecting its interests in all such claims and actions.
Management does not believe, taking into account the applicable liability insurance coverage and the expectations of counsel with respect to the amount of potential liability, the outcome of any such claims and litigation, individually or in the aggregate, will have a materially adverse effect on the Company’s financial position or results of operations.
7.
Related-Party Transactions
MedCath provides working capital to the Company under a revolving credit note with a maximum borrowing limit of $12.0 million. The loan is collateralized by the Company’s accounts receivable from patient services. There
HEART HOSPITAL OF SOUTH DAKOTA, LLC
NOTES TO FINANCIAL STATEMENTS - (Continued)
are no amounts outstanding under the working capital loan as of September 30, 2007 and 2006. No interest was paid in fiscal 2007, 2006 or 2005 because the working capital loan was paid off monthly.
MedCath and Avera McKennan received debt guarantee fees for their guarantee of 50% of the Company’s outstanding bank mortgage loan until the loan was refinanced in February 2006. In addition, at September 30, 2007, 2006 and 2005 MedCath and Avera McKennan each guarantee 30% of $731,000, $2.3 million and $5.5 million, respectively, of the Company’s outstanding equipment debt. The total amount of such debt guarantee fees are approximately $2,000 each, for the year ended September 30, 2007, $23,000 each, for the year ended September 30, 2006 and $63,000 each, for the year ended September 30, 2005. No amounts are due as of September 30, 2007 or 2006.
MedCath allocated corporate expenses to the Company for costs in the following categories, which are included in operating expenses in the statements of operations, during the years ended September 30:
The other category above consists primarily of support services provided by MedCath and consolidated purchased services paid for by MedCath for which it receives reimbursement at cost in lieu of the Company’s incurring these services directly. Support services include but are not limited to training, treasury, and development. Consolidated purchased services include, but are not limited to insurance coverage, professional services, software maintenance and licenses purchased by MedCath under its consolidated purchasing programs and agreements with third-party vendors for the direct benefit of the Company.
The Company pays Avera McKennan and North Central Heart Institute Holdings, PLLC for various services, including labor, supplies and equipment purchases. The amounts paid during the years ended September 30, were as follows:
8.
Employee Benefit Plan
The Company participates in MedCath’s defined contribution retirement savings plan (the 401(k) Plan), which covers all employees. The 401(k) Plan allows eligible employees to contribute from 1% to 25% of their annual compensation on a pretax basis. The Company, at its discretion, may make an annual contribution of up to 30% of an employee’s pretax contribution, up to a maximum of 6% of compensation. This annual contribution percentage was increased to 30% for fiscal 2007 from 25% for fiscal 2006. The Company’s contributions to the 401(k) Plan were approximately $231,000, $176,000 and $167,000 during the years ended September 30, 2007, 2006 and 2005, respectively.
Item 9.
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures.
The President and Chief Executive Officer and the Executive Vice President and Chief Financial Officer of the Company (its principal executive officer and principal financial officer, respectively) have concluded, based on their evaluation of the Company’s disclosure controls and procedures as of the end of the fiscal year covered by this Annual Report on Form 10-K, that the Company’s disclosure controls and procedures were effective as of the end of the fiscal year covered by this report to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
No change in the Company’s internal control over financial reporting was made during the most recent fiscal quarter covered by this report that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company (as defined in Securities Exchange Act Rule 13a-15(f)). The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation and the reliability of financial reporting. Moreover, 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.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2007. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, the Company’s internal control over financial reporting was effective as of September 30, 2007 based on those criteria.
Deloitte & Touche LLP, an independent registered public accounting firm, which audited the consolidated financial statements included in this Annual Report on Form 10-K, has issued an attestation report on management’s assessment of internal control over financial reporting, which is included below.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
MedCath Corporation
Charlotte, North Carolina
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that MedCath Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of September 30, 2007, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of the company’s principal executive and principal financial officers, or persons performing similar functions and effected by the company’s board of directors, management, and other personnel 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. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting 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.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of September 30, 2007, is fairly stated, in all material respects, based on the criteria established in Internal Control - Integrated Framework issued by COSO. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2007, based on the criteria established in Internal Control - Integrated Framework issued by COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of September 30, 2007 and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended and our report dated December 14, 2007 expressed an unqualified opinion on those financial statements, and contained an explanatory paragraph regarding the Company’s adoption of the provisions of Statement of Financial Accounting Standards No. 123-R, Share-Based Payment, effective October 1, 2005.
/s/ Deloitte & Touche LLP
Charlotte, North Carolina
December 14, 2007
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
The information required by this Item with respect to directors is incorporated by reference to information provided under the headings “Election of Directors,” “Corporate Governance,” “Other Matters-Section 16(a) Beneficial Ownership Compliance” and “Accounting and Audit Matters-Audit Committee Financial Expert” and elsewhere in the Company’s proxy statement to be filed with the Commission on or before January 28, 2008 in connection with the Annual Meeting of Stockholders of the Company scheduled to be held on March 5, 2008 (the 2008 Proxy Statement). Some of the information required by this Item with respect to executive officers is provided under the heading “Executive Officers” in Part I of this report.
Item 11.
Item 11.
Executive Compensation.
The information required by this Item is incorporated by reference to information provided under the headings “Executive Compensation” and “Corporate Governance-Compensation of Directors” and elsewhere in the 2008 Proxy Statement.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this Item is incorporated by reference to information provided under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Executive Compensation-Equity Compensation Plan Information” and elsewhere in the 2008 Proxy Statement.
Item 13.
Item 13.
Certain Relationships and Related Transactions.
The information required by this Item is incorporated by reference to information provided under the heading “Certain Transactions” and elsewhere in the 2008 Proxy Statement.
Item 14.
Item 14.
Principal Accounting Fees and Services.
The information required by this Item is incorporated by reference to information provided under the heading “Accounting and Audit Matters” and elsewhere in the 2008 Proxy Statement.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules.
(a)(1) The financial statements as listed in the Index under Part II, Item 8, are filed as part of this report.
(2) Financial Statement Schedules. All schedules have been omitted because they are not required, are not applicable or the information is included in the selected consolidated financial data or notes to consolidated financial statements appearing elsewhere in this report.
(3) The following list of exhibits includes both exhibits submitted with this report and those incorporated by reference to other filings:
(1)
Incorporated by reference from the Company’s Registration Statement on Form S-1 (File no. 333-60278).
(2)
Incorporated by reference from the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2001.
(3)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2001.
(4)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002.
(5)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002.
(6)
Certain portions of these exhibits have been omitted pursuant to a request for confidential treatment filed with the Commission.
(7)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2002.
(8)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003.
(9)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003.
(10)
Incorporated by reference from the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003.
(11)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2003.
(12)
Incorporated by reference from the Company’s Registration Statement on Form S-4 (File No. 333-119170).
(13)
Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended September 30, 2004.
(14)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2004.
(15)
Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended September 30, 2005.
(16)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2005.
(17)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006.
(18)
Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.
(19)
Incorporated by reference from the Company’s Current Report on Form 8-K filed September 7, 2006.
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.
Medcath Corporation
By:
/s/ O. Edwin French
O. Edwin French
President, Chief Executive Officer
(principal executive officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.