UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________________________________________________________
Form 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 2016
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number: 001-37576
Surgery Partners, Inc.
(Exact name of registrant as specified in its charter)
Delaware | 47-3620923 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
40 Burton Hills Boulevard, Suite 500
Nashville, Tennessee 37215
(Address of principal executive offices and zip code)
(615) 234-5900
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o | Accelerated filer o | |
Non-accelerated filer x | Smaller reporting company o | |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of May 6, 2016, there were 48,497,665 shares of the registrant’s common stock outstanding.
SURGERY PARTNERS, INC.
FORM 10-Q
TABLE OF CONTENTS
Page | ||
Item 1. | ||
Condensed Consolidated Balance Sheets (Unaudited) | ||
Condensed Consolidated Statements of Operations (Unaudited) | ||
Condensed Consolidated Statements of Comprehensive Income (Loss) (Unaudited) | ||
Condensed Consolidated Statements of Stockholders' Equity (Unaudited) | ||
Condensed Consolidated Statements of Cash Flows (Unaudited) | ||
Notes to Condensed Consolidated Financial Statements (Unaudited) | ||
Item 2. | ||
Item 3. | Quantitative and Qualitative Disclosure About Market Risk | |
Item 4. | ||
Item 1. | ||
Item 1A. | Risk Factors | |
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | |
Item 3. | Defaults Upon Senior Securities | |
Item 4. | Mine Safety Disclosures | |
Item 5. | Other Information | |
Item 6. | Exhibits | |
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, amounts in thousands, except shares and per share amounts)
March 31, 2016 | December 31, 2015 | |||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 135,047 | $ | 57,933 | ||||
Accounts receivable, less allowance for doubtful accounts of $17,585 and $18,322, respectively | 185,885 | 177,757 | ||||||
Inventories | 26,552 | 25,591 | ||||||
Prepaid expenses and other current assets | 32,346 | 34,620 | ||||||
Acquisition escrow deposit | 13,984 | 13,984 | ||||||
Indemnification receivable due from seller | 1,072 | 1,072 | ||||||
Total current assets | 394,886 | 310,957 | ||||||
Property and equipment, net | 191,653 | 184,550 | ||||||
Intangible assets, net | 51,166 | 53,568 | ||||||
Goodwill | 1,417,991 | 1,407,927 | ||||||
Investments in and advances to affiliates | 34,475 | 34,103 | ||||||
Restricted invested assets | 315 | 316 | ||||||
Long-term deferred tax assets | 91,813 | 94,105 | ||||||
Long-term acquisition escrow deposit | 8,793 | 8,408 | ||||||
Other long-term assets | 11,248 | 10,509 | ||||||
Total assets | $ | 2,202,340 | $ | 2,104,443 | ||||
LIABILITIES AND STOCKHOLDERS' EQUITY | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 45,557 | $ | 45,341 | ||||
Accrued payroll and benefits | 26,361 | 26,307 | ||||||
Acquisition escrow liability | 13,984 | 13,984 | ||||||
Other current liabilities | 70,710 | 68,410 | ||||||
Current maturities of long-term debt | 27,169 | 27,247 | ||||||
Total current liabilities | 183,781 | 181,289 | ||||||
Long-term debt, less current maturities | 1,328,739 | 1,228,112 | ||||||
Long-term tax receivable agreement liability | 119,655 | 119,655 | ||||||
Long-term acquisition escrow liability | 8,793 | 8,408 | ||||||
Other long-term liabilities | 86,110 | 85,613 | ||||||
Non-controlling interests—redeemable | 183,028 | 183,439 | ||||||
Stockholders' equity: | ||||||||
Preferred stock, $0.01 par value, 20,000,000 shares authorized, no shares issued or outstanding | — | — | ||||||
Common stock, $0.01 par value, 300,000,000 shares authorized, 48,492,772 shares issued and outstanding at March 31, 2016; 48,156,990 shares issued and outstanding at December 31, 2015 | 485 | 482 | ||||||
Additional paid-in capital | 317,622 | 316,294 | ||||||
Retained deficit | (327,994 | ) | (320,804 | ) | ||||
Total Surgery Partners, Inc. stockholders' deficit | (9,887 | ) | (4,028 | ) | ||||
Non-controlling interests—non-redeemable | 302,121 | 301,955 | ||||||
Total stockholders' equity | 292,234 | 297,927 | ||||||
Total liabilities and stockholders' equity | $ | 2,202,340 | $ | 2,104,443 | ||||
See notes to unaudited condensed consolidated financial statements.
1
SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, amounts in thousands, except shares and per share amounts)
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Revenues | $ | 267,074 | $ | 224,143 | ||||
Operating expenses: | ||||||||
Salaries and benefits | 86,886 | 60,151 | ||||||
Supplies | 63,662 | 57,086 | ||||||
Professional and medical fees | 19,654 | 14,740 | ||||||
Lease expense | 12,434 | 10,960 | ||||||
Other operating expenses | 14,067 | 12,836 | ||||||
Cost of revenues | 196,703 | 155,773 | ||||||
General and administrative expenses | 12,197 | 11,862 | ||||||
Depreciation and amortization | 9,568 | 8,462 | ||||||
Provision for doubtful accounts | 3,873 | 5,186 | ||||||
Income from equity investments | (758 | ) | (707 | ) | ||||
(Gain) loss on disposal or impairment of long-lived assets, net | (206 | ) | 223 | |||||
Loss on debt refinancing | 8,281 | — | ||||||
Merger transaction and integration costs | 3,172 | 5,006 | ||||||
Electronic health records incentive income | (93 | ) | — | |||||
Other expense (income) | 57 | (13 | ) | |||||
Total operating expenses | 232,794 | 185,792 | ||||||
Operating income | 34,280 | 38,351 | ||||||
Interest expense, net | (22,153 | ) | (25,756 | ) | ||||
Income before income taxes | 12,127 | 12,595 | ||||||
Income tax expense | 1,770 | 2,107 | ||||||
Net income | 10,357 | 10,488 | ||||||
Less: Net income attributable to non-controlling interests | (17,547 | ) | (17,250 | ) | ||||
Net loss attributable to Surgery Partners, Inc. | $ | (7,190 | ) | $ | (6,762 | ) | ||
Net loss per share attributable to common stockholders | ||||||||
Basic | $ | (0.15 | ) | $ | (0.21 | ) | ||
Diluted (1) | $ | (0.15 | ) | $ | (0.21 | ) | ||
Weighted average common shares outstanding(2) | ||||||||
Basic | 48,017,226 | 32,054,089 | ||||||
Diluted (1) | 48,017,226 | 32,054,089 | ||||||
(1) The impact of potentially dilutive securities for the three months ended March 31, 2016 and 2015 was not considered because the effect would be anti-dilutive in each of those periods.
(2) Effect of the Reorganization, as defined in Note 1, has been retrospectively applied to the period ended March 31, 2015.
See notes to unaudited condensed consolidated financial statements.
2
SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited, amounts in thousands)
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Net income | $ | 10,357 | $ | 10,488 | ||||
Other comprehensive income | — | — | ||||||
Comprehensive income | $ | 10,357 | $ | 10,488 | ||||
Less: Comprehensive income attributable to non-controlling interests | (17,547 | ) | (17,250 | ) | ||||
Comprehensive loss attributable to Surgery Partners, Inc. | $ | (7,190 | ) | $ | (6,762 | ) | ||
See notes to unaudited condensed consolidated financial statements.
3
SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited, amounts in thousands, except shares)
Common Stock | Additional Paid-in Capital | Retained Deficit | Non-Controlling Interests— Non-Redeemable | Total | ||||||||||||||||||
Shares | Amount | |||||||||||||||||||||
Balance as of December 31, 2015 | 48,156,990 | $ | 482 | $ | 316,294 | $ | (320,804 | ) | $ | 301,955 | $ | 297,927 | ||||||||||
Net (loss) income | — | — | — | (7,190 | ) | 13,193 | 6,003 | |||||||||||||||
Issuance of restricted stock, net of forfeitures | 335,782 | 3 | (3 | ) | — | — | — | |||||||||||||||
Equity-based compensation | — | — | 133 | — | — | 133 | ||||||||||||||||
Acquisition and disposal of shares of non-controlling interests, net | — | — | 1,198 | — | 244 | 1,442 | ||||||||||||||||
Distributions to non-controlling interests—non-redeemable holders | — | — | — | — | (13,271 | ) | (13,271 | ) | ||||||||||||||
Balance as of March 31, 2016 | 48,492,772 | $ | 485 | $ | 317,622 | $ | (327,994 | ) | $ | 302,121 | $ | 292,234 | ||||||||||
See notes to unaudited condensed consolidated financial statements.
4
SURGERY PARTNERS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, amounts in thousands)
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Cash flows from operating activities: | ||||||||
Net income | $ | 10,357 | $ | 10,488 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 9,568 | 8,462 | ||||||
Amortization of debt issuance costs and discounts | 1,417 | 1,620 | ||||||
Amortization of unfavorable lease liability | (108 | ) | (108 | ) | ||||
Equity-based compensation | 133 | 426 | ||||||
(Gain) loss on disposal or impairment of long-lived assets, net | (206 | ) | 223 | |||||
Loss on debt refinancing | 8,281 | — | ||||||
Deferred income taxes | 1,485 | 1,717 | ||||||
Provision for doubtful accounts | 3,873 | 5,186 | ||||||
Income from equity investments, net of distributions received | (372 | ) | 257 | |||||
Changes in operating assets and liabilities, net of acquisitions and divestitures: | ||||||||
Accounts receivable | (12,546 | ) | (12,400 | ) | ||||
Other operating assets and liabilities | 3,362 | (6,357 | ) | |||||
Net cash provided by operating activities | 25,244 | 9,514 | ||||||
Cash flows from investing activities: | ||||||||
Purchases of property and equipment, net | (11,804 | ) | (5,461 | ) | ||||
Payments for acquisitions, net of cash acquired | (7,049 | ) | (8,102 | ) | ||||
Proceeds from divestitures | — | 8,367 | ||||||
Net cash used in investing activities | (18,853 | ) | (5,196 | ) | ||||
Cash flows from financing activities: | ||||||||
Principal payments on long-term debt | (396,146 | ) | (8,457 | ) | ||||
Borrowings of long-term debt | 501,268 | 4,124 | ||||||
Payments of debt issuance costs | (11,909 | ) | — | |||||
Penalty on prepayment of debt | (4,900 | ) | — | |||||
Distributions to non-controlling interest holders | (17,513 | ) | (16,059 | ) | ||||
Receipts (payments) related to ownership transactions with consolidated affiliates | 94 | (2,292 | ) | |||||
Financing lease obligation | (171 | ) | (110 | ) | ||||
Net cash provided by (used in) financing activities | 70,723 | (22,794 | ) | |||||
Net increase (decrease) in cash and cash equivalents | 77,114 | (18,476 | ) | |||||
Cash and cash equivalents at beginning of period | 57,933 | 74,920 | ||||||
Cash and cash equivalents at end of period | $ | 135,047 | $ | 56,444 | ||||
See notes to unaudited condensed consolidated financial statements.
5
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
1. Organization
Surgery Partners, Inc., a Delaware corporation (together with its subsidiaries, the “Company”), was formed April 2, 2015, as a holding company for the purpose of facilitating an initial public offering (the “IPO”) of shares of common stock. Prior to September 30, 2015, the Company conducted business through Surgery Center Holdings, Inc. and its subsidiaries. Surgery Center Holdings, LLC was and is the sole indirect owner of the equity interests of Surgery Center Holdings, Inc. and has no other material assets. On October 1, 2015, the Company completed its IPO of 14,285,000 shares of common stock at an offering price of $19.00 per share.
On September 30, 2015, Surgery Partners, Inc. became the direct parent and sole member of Surgery Center Holdings, LLC (the "Reorganization"). In the Reorganization, all of the equity interests held by the pre-IPO owners of Surgery Center Holdings, LLC were contributed to Surgery Partners, Inc. in exchange for 33,871,990 shares of common stock of Surgery Partners, Inc. and certain rights to additional payments under a tax receivable agreement. After giving effect to the Reorganization, Surgery Partners, Inc. is a holding company, and its sole material asset is an equity interest in Surgery Center Holdings, LLC. The Company's condensed consolidated financial statements for periods prior to the Reorganization represent the historical operating results and financial position of Surgery Center Holdings, Inc. and certain of its subsidiaries.
As of March 31, 2016, the Company owned and operated a national network of surgical facilities and ancillary services in 29 states. The surgical facilities, which include ASCs and surgical hospitals, primarily provide non-emergency surgical procedures across many specialties, including, among others, otolaryngology ("ENT"), gastroenterology ("GI"), general surgery, ophthalmology, orthopedics, cardiology and pain management. The Company's surgical hospitals provide services such as diagnostic imaging, laboratory, obstetrics, oncology, pharmacy, physical therapy and wound care. Ancillary services are comprised of a diagnostic laboratory, multi-specialty physician practices, urgent care facilities, anesthesia services, optical services and specialty pharmacy services.
As of March 31, 2016, the Company owned or operated a portfolio of 101 surgical facilities, comprised of 96 ASCs and five surgical hospitals. The Company owns these facilities in partnership with physicians and, in some cases, healthcare systems in the markets and communities it serves. The Company owned a majority interest in 71 of the surgical facilities and consolidated 90 of these facilities for financial reporting purposes. In addition, the Company owned or operated a network of 48 physician practices.
2. Significant Accounting Policies
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, as well as interests in partnerships and limited liability companies controlled by the Company through its ownership of a majority voting interest or other rights granted to the Company by contract to manage and control the affiliate's business. All significant intercompany balances and transactions are eliminated in consolidation.
The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation of the Company's financial position and results of operations have been included. The Company’s fiscal year ends on December 31 and interim results are not necessarily indicative of results for a full year or any other interim period. The condensed consolidated balance sheet at December 31, 2015 has been derived from the audited financial statements as of that date. The information contained in these condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the fiscal year ended December 31, 2015. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Non-Controlling Interests
The physician limited partners and physician minority members of the entities that the Company controls are responsible for the supervision and delivery of medical services. The governance rights of limited partners and minority members are restricted to those that protect their financial interests. Under certain partnership and operating agreements governing these partnerships and limited liability companies, the Company could be removed as the sole general partner or managing member for certain events such as material breach of the partnership or operating agreement, gross negligence or bankruptcy. These protective rights do not preclude consolidation of the respective partnerships and limited liability companies.
Ownership interests in consolidated subsidiaries held by parties other than the Company are identified and generally presented in the condensed consolidated financial statements within the equity section but separate from the Company's equity. However, in instances in which certain redemption features that are not solely within the control of the Company are present, classification of non-controlling interests outside of permanent equity is required. Consolidated net income attributable to the Company and to the non-controlling interests are identified and presented on the condensed consolidated statements of operations; changes in ownership interests in which the Company retains a controlling interest are accounted for as equity transactions. Certain transactions with non-controlling interests are classified within financing activities in the condensed consolidated statements of cash flows.
The condensed consolidated financial statements of the Company include all assets, liabilities, revenues and expenses of surgical facilities in which the Company has sufficient ownership and rights to allow the Company to consolidate the surgical facilities. Similar to its investments
6
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
in non-consolidated affiliates, the Company regularly engages in the purchase and sale of ownership interests with respect to its consolidated subsidiaries that do not result in a change of control.
Non-Controlling Interests — Redeemable. Each of the partnerships and limited liability companies through which the Company owns and operates its surgical facilities is governed by a partnership or operating agreement. In certain circumstances, the partnership and operating agreements for the Company's surgical facilities provide that the facilities will purchase all of the physicians’ ownership if certain adverse regulatory events occur, such as it becoming illegal for the physicians to own an interest in a surgical facility, refer patients to a surgical facility or receive cash distributions from a surgical facility. The non-controlling interests - redeemable are reported outside of stockholders' equity in the condensed consolidated balance sheets.
A summary of activity related to the non-controlling interests—redeemable follows (in thousands):
Balance at December 31, 2015 | $ | 183,439 | ||
Net income attributable to non-controlling interests—redeemable | 4,354 | |||
Acquisition and disposal of shares of non-controlling interests, net—redeemable | (523 | ) | ||
Distributions to non-controlling interest —redeemable holders | (4,242 | ) | ||
Balance at March 31, 2016 | $ | 183,028 | ||
Variable Interest Entities
The condensed consolidated financial statements include the accounts of variable interest entities in which the Company is the primary beneficiary under the provisions of Accounting Standards Codification Topic ("ASC") 810, Consolidation. As of March 31, 2016 and December 31, 2015, the variable interest entities include five surgical facilities, three anesthesia practices and one physician practice. The Company has the power to direct the activities that most significantly impact the variable interest entity's economic performance. Additionally, the Company would absorb the majority of the expected losses of these entities should they occur. As of March 31, 2016 and December 31, 2015, the condensed consolidated balance sheets of the Company included total assets of $97.2 million and $104.2 million, respectively, and total liabilities of $13.2 million and $13.2 million, respectively, related to the Company's variable interest entities.
Equity Method Investments
The Company has non-consolidating investments in surgical facilities and management companies that own or manage surgical facilities. These investments are accounted for using the equity method of accounting. The total amount of these investments included in investments in and advances to affiliates in the condensed consolidated balance sheets was $34.5 million and $34.1 million as of March 31, 2016 and December 31, 2015, respectively.
Reclassifications
Certain reclassifications have been made to the comparative periods' financial statements to conform to the three months ended March 31, 2016 presentation.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and footnotes. Examples include, but are not limited to, estimates of accounts receivable allowances, professional and general liabilities and the estimate of deferred tax assets or liabilities. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All adjustments are of a normal, recurring nature. Actual results could differ from those estimates.
Fair Value of Financial Instruments
The fair value of a financial instrument is the amount at which the instrument could be exchanged in an orderly transaction between market participants to sell the asset or transfer the liability. The Company uses fair value measurements based on quoted prices in active markets for identical assets or liabilities (Level 1), inputs other than quoted prices in active markets that are either directly or indirectly observable (Level 2), or unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions (Level 3), depending on the nature of the item being valued.
The carrying amounts reported in the condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, restricted invested assets and accounts payable approximate their fair values.
7
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
A summary of the carrying amounts and fair values of the Company's long-term debt follows (in thousands):
Carrying Amount | Fair Value | |||||||||||||||
March 31, 2016 | December 31, 2015 | March 31, 2016 | December 31, 2015 | |||||||||||||
2014 First Lien Credit Agreement, net of debt issuance and discount | $ | 913,162 | $ | 839,701 | $ | 901,181 | $ | 828,816 | ||||||||
2014 Second Lien Credit Agreement, net of debt issuance and discount | $ | — | $ | 237,532 | $ | — | $ | 225,382 | ||||||||
Senior Unsecured Notes, net of debt issuance and discount | $ | 386,601 | $ | — | $ | 386,117 | $ | — | ||||||||
The fair values of the 2014 First Lien Credit Agreement, 2014 Second Lien Credit Agreement and Senior Unsecured Notes, as defined in Note 5 on Long-Term Debt, were based on a Level 2 computation using quoted prices for identical liabilities in inactive markets at March 31, 2016 and December 31, 2015, as applicable. The carrying amounts related to the Company's other long-term debt obligations approximate their fair values.
The Company maintains a supplemental executive retirement savings plan (the "SERP") for certain executive officers. The SERP is a non-qualified deferred compensation plan for eligible executive officers and other key employees of the Company that allows participants to defer portions of their compensation. The fair value of the SERP asset and liability was based on a quoted market price, or a Level 1 computation. As of both March 31, 2016 and December 31, 2015, the fair value of the assets in the SERP were $1.6 million and were included in other long-term assets in the condensed consolidated balance sheets. The Company had a liability related to the SERP of $1.6 million as of each of March 31, 2016 and December 31, 2015, which was included in other long-term liabilities in the condensed consolidated balance sheets.
Revenues
The Company recognizes revenues in the period in which the services are performed. Patient service revenues and receivables from third-party payors are recorded net of estimated contractual adjustments and allowances, which the Company estimates based on the historical trend of its cash collections and contractual write-offs, accounts receivable agings, established fee schedules, contracts with payors and procedure statistics.
A summary of revenues by service type as a percentage of total revenues follows:
Three Months Ended March 31, | ||||||
2016 | 2015 | |||||
Patient service revenues: | ||||||
Surgical facilities revenues | 91.3 | % | 92.1 | % | ||
Ancillary services revenues | 6.6 | % | 5.6 | % | ||
97.9 | % | 97.7 | % | |||
Other service revenues: | ||||||
Optical services revenues | 1.4 | % | 1.7 | % | ||
Other | 0.7 | % | 0.6 | % | ||
2.1 | % | 2.3 | % | |||
Total revenues | 100.0 | % | 100.0 | % | ||
Patient service revenues. The fee charged for healthcare procedures performed in surgical facilities varies depending on the type of service provided, but usually includes all charges for usage of an operating room, a recovery room, special equipment, medical supplies, nursing staff and medications. The fee does not normally include professional fees charged by the patient’s surgeon, anesthesiologist or other attending physician, which are billed directly by such physicians to the patient or third-party payor. However, in several surgical facilities, the Company charges for anesthesia services. Ancillary service revenues include fees for patient visits to the Company's physician practices, pharmacy services and diagnostic tests ordered by physicians. Patient service revenues are recognized on the date of service, net of estimated contractual adjustments and discounts from third-party payors, including Medicare and Medicaid. Changes in estimated contractual adjustments and discounts are recorded in the period of change. During the three months ended March 31, 2016, the Company recognized an increase to patient service revenues as a result of changes in estimates to third-party settlements related to prior years of approximately $940,000.
8
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
The following table sets forth patient service revenues by type of payor and as a percentage of total patient service revenues for the Company's consolidated surgical facilities (dollars in thousands):
Three Months Ended March 31, | ||||||||||||||
2016 | 2015 | |||||||||||||
Amount | % | Amount | % | |||||||||||
Patient service revenues: | ||||||||||||||
Private insurance | $ | 132,215 | 50.5 | % | $ | 122,481 | 55.9 | % | ||||||
Government | 105,803 | 40.5 | % | 79,433 | 36.2 | % | ||||||||
Self-pay | 3,713 | 1.4 | % | 5,104 | 2.3 | % | ||||||||
Other | 19,829 | 7.6 | % | 12,133 | 5.6 | % | ||||||||
Total patient service revenues | $ | 261,560 | 100.0 | % | $ | 219,151 | 100.0 | % | ||||||
Other service revenues: | ||||||||||||||
Optical service revenues | $ | 3,624 | $ | 3,740 | ||||||||||
Other revenues | 1,890 | 1,252 | ||||||||||||
Total net revenues | $ | 267,074 | $ | 224,143 | ||||||||||
Other service revenues. Optical service revenues consist of product sales from the Company's optical laboratories as well as handling charges billed to the members of the Company's optical products purchasing organization and sales from the Company's marketing products and services business. The Company's optical products purchasing organization negotiates volume buying discounts with optical products manufacturers. The buying discounts and any handling charges billed to the members of the buying group represent the revenue recognized for financial reporting purposes. Revenue is recognized as orders are shipped to members. The Company bases its estimates for sales returns and discounts on historical experience and has not experienced significant fluctuations between estimated and actual return activity and discounts given. The Company's optical laboratories manufacture and distribute corrective lenses and eyeglasses to ophthalmologists and optometrists. Revenue is recognized when product is shipped, net of allowance for discounts. The Company's marketing products and services businesses recognize revenue when product is shipped or services are rendered.
Other revenues include management and administrative service fees derived from the non-consolidated facilities that the Company accounts for under the equity method, management of surgical facilities in which it does not own an interest, and management services provided to physician practices for which the Company is not required to provide capital or additional assets. The fees derived from these management arrangements are based on a predetermined percentage of the revenues of each facility or practice and are recognized in the period in which services are rendered.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The Company maintains its cash and cash equivalent balances at high credit quality financial institutions.
Accounts Receivable and Allowances for Contractual Adjustments and Doubtful Accounts
Accounts receivable are recorded net of contractual adjustments and allowances for doubtful accounts to reflect accounts receivable at net realizable value. Accounts receivable consists of receivables from federal and state agencies (under the Medicare and Medicaid programs), managed care health plans, commercial insurance companies, employers and patients. Management recognizes that revenues and receivables from government agencies are significant to the Company's operations, but it does not believe that there is significant credit risk associated with these government agencies. Concentration of credit risk with respect to other payors is limited because of the large number of such payors. As of March 31, 2016 and December 31, 2015, the Company had third-party Medicaid settlements of $5.1 million and $5.2 million, respectively, in other current liabilities in the condensed consolidated balance sheets.
The Company recognizes that final reimbursement of accounts receivable is subject to final approval by each third-party payor. However, because the Company has contracts with its third-party payors and also verifies insurance coverage of the patient before medical services are rendered, the amounts that are pending approval from third-party payors are not significant. The Company's policy is to collect co-payments and deductibles prior to providing medical services. It is also the Company's policy to verify a patient’s insurance 72 hours prior to the patient’s procedure. Patient services of the Company are primarily non-emergency, which allows the surgical facilities to control the procedures for which third-party reimbursement is sought and obtained. The Company does not require collateral from self-pay patients.
The Company analyzes accounts receivable at each of its facilities to ensure the proper aged category and collection assessment. At a consolidated level, the Company's policy is to review accounts receivable aging, by facility, to determine the appropriate allowance for doubtful accounts. Patient account balances are reviewed for delinquency based on contractual terms. This review is supported by an analysis of the actual revenues, contractual adjustments and cash collections received. An account balance is written off only after the Company has pursued collection with legal or collection agency assistance or otherwise has deemed an account to be uncollectible.
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SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
The receivables related to the Company's optical products purchasing organization are recognized separately from patient accounts receivable, as discussed above, and are included in other current assets in the condensed consolidated balance sheets. Such receivables were $8.6 million and $8.4 million at March 31, 2016 and December 31, 2015, respectively.
Inventories
Inventories, which consist primarily of medical and drug supplies, are stated at the lower of cost or market value. Cost is determined using the first-in, first-out method.
Prepaid Expenses and Other Current Assets
A summary of prepaid expenses and other current assets follows (in thousands):
March 31, 2016 | December 31, 2015 | |||||||
Prepaid expenses | $ | 10,920 | $ | 7,409 | ||||
Receivables - optical product purchasing organization | 8,636 | 8,434 | ||||||
Acquisition escrow receivable | — | 8,000 | ||||||
Other current assets | 12,790 | 10,777 | ||||||
Total | $ | 32,346 | $ | 34,620 | ||||
Property and Equipment
Property and equipment are stated at cost or, if obtained through acquisition, at fair value determined on the date of acquisition. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets, generally three to five years for computers and software and five to seven years for furniture and equipment. Leasehold improvements are depreciated on a straight-line basis over the shorter of the lease term or the estimated useful life of the assets. Routine maintenance and repairs are expensed as incurred, while expenditures that increase capacities or extend useful lives are capitalized.
A summary of property and equipment follows (in thousands):
March 31, 2016 | December 31, 2015 | |||||||
Land | $ | 8,082 | $ | 6,790 | ||||
Buildings and improvements | 106,045 | 104,971 | ||||||
Furniture and equipment | 16,125 | 14,520 | ||||||
Computer and software | 26,301 | 24,597 | ||||||
Medical equipment | 106,166 | 96,291 | ||||||
Construction in progress | 4,034 | 7,619 | ||||||
Property and equipment, at cost | 266,753 | 254,788 | ||||||
Less: Accumulated depreciation | (75,100 | ) | (70,238 | ) | ||||
Property and equipment, net | $ | 191,653 | $ | 184,550 | ||||
The Company also leases certain facilities and equipment under capital leases. Assets held under capital leases are stated at the present value of minimum lease payments at the inception of the related lease. Such assets are depreciated on a straight-line basis over the lesser of the lease term or the remaining useful life of the leased asset. The carrying values of assets under capital lease were $13.3 million and $12.3 million as of March 31, 2016 and December 31, 2015, respectively, net of accumulated depreciation of $10.6 million and $10.5 million, respectively.
Intangible Assets
The Company has indefinite-lived intangible assets related to the certificates of need held in jurisdictions where certain of its surgical facilities are located. The Company also has finite-lived intangible assets related to physician guarantee agreements, non-compete agreements, management agreements and customer relationships. Physician income guarantees are amortized into salaries and benefits costs in the condensed consolidated statements of operations over the commitment period of the contract, generally three to four years. Non-compete agreements and management rights agreements are amortized into depreciation and amortization expense in the condensed consolidated statements of operations over the service lives of the agreements, ranging from two to 20 years for non-compete agreements and 15 years for the management rights agreements. Customer relationships are amortized into depreciation and amortization expense in the condensed consolidated statements of operations over the estimated lives of the relationships, ranging from three to ten years.
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SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
A summary of the activity related to intangible assets for the three months ended March 31, 2016 follows (in thousands):
Physician Income Guarantees | Management Rights | Non-Compete Agreements | Certificates of Need | Customer Relationships | Other | Total Intangible Assets | ||||||||||||||||||||||
Balance at December 31, 2015 | $ | 1,212 | $ | 23,026 | $ | 18,571 | $ | 3,711 | $ | 4,936 | $ | 2,112 | $ | 53,568 | ||||||||||||||
Additions | — | — | — | — | — | — | — | |||||||||||||||||||||
Recruitment expense | (79 | ) | — | — | — | — | — | (79 | ) | |||||||||||||||||||
Amortization | — | (438 | ) | (1,461 | ) | — | (306 | ) | (118 | ) | (2,323 | ) | ||||||||||||||||
Balance at March 31, 2016 | $ | 1,133 | $ | 22,588 | $ | 17,110 | $ | 3,711 | $ | 4,630 | $ | 1,994 | $ | 51,166 | ||||||||||||||
Goodwill
Goodwill represents the fair value of the consideration provided in an acquisition over the fair value of net assets acquired and is not amortized. Additions to goodwill include amounts resulting from new business combinations and incremental ownership purchases in the Company's subsidiaries.
A summary of activity related to goodwill for the three months ended March 31, 2016 follows (in thousands):
Balance at December 31, 2015 | $ | 1,407,927 | ||
Acquisitions | 9,164 | |||
Divestitures | — | |||
Purchase price adjustments | 900 | |||
Balance at March 31, 2016 | $ | 1,417,991 | ||
Impairment of Long-Lived Assets, Goodwill and Intangible Assets
The Company evaluates the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist in accordance with ASC 350, Intangibles- Goodwill and Other. The Company performs an impairment test by preparing an expected undiscounted cash flow projection. If the projection indicates that the recorded amount of the long-lived asset is not expected to be recovered, the carrying value is reduced to estimated fair value. The cash flow projection and fair value represents management’s best estimate, using appropriate and customary assumptions, projections and methodologies, at the date of evaluation. The Company tests its goodwill and intangible assets for impairment at least annually, or more frequently if certain indicators arise.
Restricted Invested Assets
Restricted invested assets of $315,000 and $316,000 at March 31, 2016 and December 31, 2015, respectively, were related to a requirement under the operating lease agreement at the Company's Chesterfield, Missouri facility. In accordance with the provisions of the lease agreement, the Company has a deposit with the landlord that shall be held as security for performance under the Company's covenants and obligations within the agreement through January 2024.
Other Long-Term Assets
A summary of other long-term assets follows (in thousands):
March 31, 2016 | December 31, 2015 | |||||||
Notes receivable | $ | 199 | $ | 212 | ||||
Deposits | 2,526 | 2,475 | ||||||
Assets of SERP | 1,638 | 1,606 | ||||||
Debt issuance costs | 1,843 | 2,005 | ||||||
Other | 5,042 | 4,211 | ||||||
Total | $ | 11,248 | $ | 10,509 | ||||
11
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
Other Current Liabilities
A summary of other current liabilities follows (in thousands):
March 31, 2016 | December 31, 2015 | |||||||
Interest payable | $ | 3,717 | $ | 5,410 | ||||
Current taxes payable | 2,511 | 1,977 | ||||||
Insurance liabilities | 5,883 | 5,476 | ||||||
Third-party settlements | 5,092 | 5,222 | ||||||
Acquisition consideration payable | 16,768 | 16,768 | ||||||
Amounts due to patients and payors | 13,634 | 11,424 | ||||||
Other accrued expenses | 23,105 | 22,133 | ||||||
Total | $ | 70,710 | $ | 68,410 | ||||
The acquisition consideration payable is related to the acquisition of Symbion Holdings Corporation ("Symbion") and was funded to an escrow account on May 3, 2016.
Other Long-Term Liabilities
A summary of other long-term liabilities follows (in thousands):
March 31, 2016 | December 31, 2015 | |||||||
Facility lease obligations | $ | 53,641 | $ | 53,927 | ||||
Medical malpractice liability | 6,339 | 6,339 | ||||||
Liability of SERP | 1,638 | 1,608 | ||||||
Contingent consideration obligation | 14,330 | 14,049 | ||||||
Unfavorable lease liability | 1,915 | 1,996 | ||||||
Other long-term liabilities | 8,247 | 7,694 | ||||||
Total | $ | 86,110 | $ | 85,613 | ||||
The Company has facility lease obligations in connection with the surgical hospital located in Idaho Falls, Idaho and with a radiation oncology building at this facility. The obligation is payable to the lessor of this facility for the land, building and improvements. The current portion of the lease obligation was $867,000 and $797,000 at March 31, 2016 and December 31, 2015, respectively, and was included in other current liabilities in the condensed consolidated balance sheets. The total of the facility lease obligations related to the surgical hospital and radiation oncology building in Idaho Falls, Idaho was $50.6 million and $50.8 million at March 31, 2016 and December 31, 2015, respectively.
In addition, the Company has a facility lease obligation with a surgical facility in Ocala, Florida. The obligation is payable to the lessor of this facility for the building. The current portion of the lease obligation was $172,000 and $169,000 at March 31, 2016 and December 31, 2015, respectively, and was included in other current liabilities in the condensed consolidated balance sheets. The total of the facility lease obligations related to the surgical facility in Ocala, Florida was $4.1 million at March 31, 2016 and December 31, 2015.
Operating Leases
The Company leases office space and equipment for its surgical facilities, including surgical facilities under development. The lease agreements generally require the lessee, or the Company, to pay all maintenance, property taxes, utilities and insurance costs. The Company accounts for operating lease obligations and sublease income on a straight-line basis. Contingent obligations of the Company, as defined by each lease agreement, are recognized when specific contractual measures have been met, typically the result of an increase in the Consumer Price Index. Lease obligations paid in advance are recorded as prepaid rent and included in prepaid expenses and other current assets on the condensed consolidated balance sheets. The difference between actual lease payments and straight-line lease expense over the initial lease term, excluding optional renewal periods, is recorded as deferred rent and included in other current liabilities and other long-term liabilities on the condensed consolidated balance sheets.
Equity-Based Compensation
Transactions in which the Company receives employee and non-employee services in exchange for the Company’s equity instruments or liabilities that are based on the fair value of the Company’s equity securities or may be settled by the issuance of these securities are accounted for using a fair value method. Prior to the Reorganization, on the grant date, the Company employed a market approach to estimate the fair value of equity-based awards based on various considerations and assumptions, including implied earnings multiples and other metrics of relevant market participants, the Company’s operating results and forecasted cash flows and the Company’s capital structure. Such estimates require the input of highly subjective, complex assumptions. However, such assumptions are no longer required to determine fair value of
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SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
shares of the Company’s common stock as its underlying shares began trading publicly during the fourth quarter of 2015. The Company applies the Black-Scholes-Merton method of valuation in determining share-based compensation expense for option awards.
The Company’s policy is to recognize compensation expense using the straight line method over the relevant vesting period for units that vest based on time. Prior to the Reorganization, employees held membership units in Surgery Center Holdings, LLC, and the associated expense was referred to as unit-based compensation. In connection with the Reorganization, the Company’s board of directors and stockholders adopted the Surgery Partners, Inc. 2015 Omnibus Incentive Plan from which the Company’s future equity-based awards will be granted. Following the Reorganization, such expense is referred to as equity-based compensation.
Professional, General and Workers' Compensation Insurance
The Company maintains general liability and professional liability insurance in excess of self-insured retentions through third party commercial insurance carriers in amounts that management believes is sufficient for the Company's operations, although, potentially, some claims may exceed the scope of coverage in effect. The professional and general insurance coverage is on a claims-made basis. Workers' compensation insurance is on an occurrence basis.
The Company expenses the costs under the self-insured retention exposure for general and professional liability and workers compensation claims which relate to (i) claims made during the policy period, which are offset by insurance recoveries and (ii) an estimate of claims incurred but not yet reported that are expected to be reported after the policy period expires. Reserves and provisions are based upon actuarially determined estimates. The reserves are estimated using individual case-basis valuations and actuarial analysis. Reserves for professional, general and workers' compensation claim liabilities are determined with no regard for expected insurance recoveries and are presented gross on the condensed consolidated balance sheets. Total professional, general and workers' compensation claim liabilities as of March 31, 2016 and December 31, 2015 are $9.7 million and $9.5 million, respectively. The balance includes expected insurance recoveries of $6.5 million and $6.3 million as of March 31, 2016 and December 31, 2015, respectively.
Electronic Health Record Incentives
The American Recovery and Reinvestment Act of 2009 provides for Medicare and Medicaid incentive payments beginning in calendar year 2011 for eligible hospitals and professionals that implement and achieve meaningful use of certified Electronic Health Records ("EHR") technology. Several of the Company's surgical hospitals have implemented plans to comply with the EHR meaningful use requirements of the Health Information Technology for Economic and Clinical Health Act ("HITECH") in time to qualify for the maximum available incentive payments.
Compliance with the meaningful use requirements has and will continue to result in significant costs including business process changes, professional services focused on successfully designing and implementing the Company's EHR solutions, along with costs associated with the hardware and software components of the project. The Company currently estimates that total costs incurred to comply will be recovered through the total EHR incentive payments over the projected life cycle of this initiative. The Company incurs both capital expenditures and operating expenses in connection with the implementation of its various EHR initiatives. The amount and timing of these expenditures do not directly correlate with the timing of the Company's cash receipts or recognition of the EHR incentives as other income. The Company expects to receive incentive payments and recognize corresponding revenue upon the completion of the EHR meaningful use requirements. The Company recorded electronic health records incentives income of $93,000 during the three months ended March 31, 2016. No electronic health records incentives were recorded during the three months ended March 31, 2015.
Income Taxes and Tax Receivable Agreement
The Company uses the asset and liability method to account for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If a net operating loss carryforward exists, the Company makes a determination as to whether that net operating loss carryforward will be utilized in the future. A valuation allowance is established for certain net operating loss carryforwards when their recoverability is deemed to be uncertain. The carrying value of the net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to adjust its deferred tax valuation allowances.
The Company, or one or more of its subsidiaries, files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal or state income tax examinations for years prior to 2011.
As part of the Reorganization that was effective September 30, 2015, the Company entered into a Tax Receivable Agreement (“TRA”) under which generally the Company will be required to pay to its stockholders as of immediately prior to the IPO 85% of the cash savings, if any, in U.S. federal, state or local tax that the Company actually realizes (or is deemed to realize in certain circumstances) as a result of (i) certain tax attributes, including NOLs, capital losses, charitable deductions, alternative minimum tax credit carryforwards and federal and state tax credits of Surgery Partners, Inc. and its affiliates relating to taxable years ending on or before the date of the Reorganization (calculated by assuming the taxable year of the relevant entity closes on the date of the Reorganization) that are or become available to the Company and its wholly-owned subsidiaries as a result of the Reorganization, and (ii) tax benefits attributable to payments made under the TRA, together with interest accrued at a rate of LIBOR plus 300 basis points from the date the applicable tax return is due (without extension) until paid.
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SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
The amounts payable under the TRA will vary depending upon a number of factors, including the amount, character and timing of the taxable income of Surgery Partners, Inc. in the future. The Company estimates the total amounts payable to be approximately $119.9 million, if the tax benefits of related deferred tax assets are ultimately realized. The amounts payable were recognized during 2015 in conjunction with the release of the Company's valuation allowance recorded against the deferred tax assets.
The Company and its subsidiaries file a consolidated federal income tax return. The partnerships, limited liability companies, and certain non-consolidated physician practice corporations file separate income tax returns. The Company's allocable portion of each partnership's and limited liability company's income or loss is included in taxable income of the Company. The remaining income or loss of each partnership and limited liability company is allocated to the other owners.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09, "Revenue from Contracts with Customers," which outlines a single comprehensive model for recognizing revenue and supersedes most existing revenue recognition guidance, including guidance specific to the healthcare industry. This ASU provides companies the option of applying a full or modified retrospective approach upon adoption. This ASU was originally set to be effective for fiscal years beginning after December 15, 2016, and early adoption was not permitted. In July 2015, the FASB deferred the effective date for the standard to be effective for fiscal years beginning after December 15, 2017. The FASB will now permit companies to early adopt within one year of the new effective date. The Company will adopt this ASU on January 1, 2018 and is currently evaluating its plan for adoption and the impact on the Company's revenue recognition policies, procedures and the resulting impact on the Company's condensed consolidated financial position, results of operations and cash flows.
In February 2015, the FASB issued ASU 2015-02 “Amendments to the Consolidation Analysis,” which amends the current consolidation guidance, including introducing a separate consolidation analysis specific to limited partnerships and other similar entities. Under this analysis, limited partnerships and other similar entities will be considered a variable-interest entity unless the limited partners hold substantive kick-out rights or participating rights. The provisions of ASU 2015-02 are effective for annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company adopted this ASU on January 1, 2016. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial position, results of operations, cash flows and financial disclosures.
In April 2015, the FASB issued ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs," which simplifies the presentation of debt issuance costs by requiring debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. ASU 2015-03 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2015. Early adoption is permitted, and the new guidance should be applied retrospectively. The Company adopted this ASU on January 1, 2016 retrospectively for all periods presented. As a result of the adoption of this ASU, the Company reclassified approximately $2.2 million at December 31, 2015, respectively, from deferred loan costs to long-term debt. The adoption of this ASU did not have a material impact on the Company's condensed consolidated results of operations, cash flows and financial disclosures.
In August 2015, the FASB issued ASU 2015-15, “Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements” which clarifies the Securities and Exchange Commission (“SEC”) staff’s position on presenting and measuring debt issuance costs incurred in connection with line-of-credit arrangements given the lack of guidance on this topic in ASU 2015-03. The SEC staff has announced that it would “not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement.” The Company adopted this ASU on January 1, 2016 retrospectively for all periods presented. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial position, results of operations, cash flows and financial disclosures.
In September 2015, the FASB issued ASU 2015-16, “Business Combinations: Simplifying the Accounting for Measurement-Period Adjustments” which eliminates the requirement for an acquirer to retrospectively adjust its financial statements for changes to provisional amounts that are identified during the measurement-period following the consummation of a business combination. Instead, ASU 2015-16 requires these types of adjustments to be made during the reporting period in which they are identified and would require additional disclosure or separate presentation of the portion of the adjustment that would have been recorded in the previously reported periods as if the adjustment to the provisional amounts had been recognized as of the acquisition date. ASU 2015-16 is effective prospectively for fiscal years beginning after December 15, 2015, including interim periods within those years. The Company adopted this ASU on January 1, 2016. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial position, results of operations, cash flows and financial disclosures.
In February 2016, the FASB issued ASU 2016-02, “Leases,” which will require, among other items, lessees to recognize most leases as assets and liabilities on the balance sheet. Qualitative and quantitative disclosures will be enhanced to better understand the amount, timing and uncertainty of cash flows arising from leases. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The Company is currently evaluating the impact this new guidance may have on the condensed consolidated financial position, results of operations and cash flows.
In March 2016, the FASB issued ASU 2016-07, “Investments- Equity Method and Joint Ventures,” which allows investments that now meet equity method treatment that were previously accounted for under a different method to apply the equity method prospectively from the date the investment qualifies for equity method treatment. ASU 2016-07 is effective prospectively for fiscal years beginning after December
14
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
15, 2016, including interim periods within those years. Early adoption is permitted. The Company is currently evaluating the impact this new guidance may have on the condensed consolidated financial position, results of operations and cash flows.
In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting,” which simplifies the accounting for share-based payments including the income tax consequences, classification of certain awards and treatment of forfeitures. ASU 2016-09 is effective prospectively for fiscal years beginning after December 15, 2016, including interim periods within those years. Early adoption is permitted. The Company early adopted this ASU during the first quarter of 2016. The adoption of this ASU did not have a material impact on the Company's condensed consolidated financial position, results of operation, cash flows and financial disclosures.
3. Acquisitions and Developments
The Company accounts for its business combinations in accordance with the fundamental requirements of the acquisition method of accounting and under the premise that an acquirer can be identified for each business combination. The acquirer is the entity that obtains control of one or more businesses in the business combination and the acquisition date is the date the acquirer achieves control. The assets acquired, liabilities assumed and any non-controlling interests in the acquired business at the acquisition date are recognized at their fair values as of that date, and the direct costs incurred in connection with the business combination are recorded and expensed separately from the business combination. Acquisitions in which the Company is able to exert significant influence but does not have control are accounted for using the equity method.
2016 Transactions
Surgical Facility Acquisitions
During the three months ended March 31, 2016, the Company acquired a controlling interest in one surgical facility located in an existing market for a purchase price of $4.0 million. The Company merged the operations of this surgical facility into an existing surgical facility in the same market which the Company consolidates for financial reporting purposes. The acquisition was funded through cash from operations.
Ancillary Services
During the three months ended March 31, 2016, through its recruiting efforts and capital-efficient acquisitions, the Company completed two in-market physician practice transactions through an aggregate investment of $3.7 million. These transactions added a total of two physicians to the Company’s physician network and were funded with a combination of cash from operations and facility ownership.
4. Long-Term Debt
A summary of long-term debt follows (in thousands):
March 31, 2016 | December 31, 2015 | |||||||
2014 Revolver Loan | $ | — | $ | 125,250 | ||||
2014 First Lien Credit Agreement | 939,125 | 861,300 | ||||||
2014 Second Lien Credit Agreement | — | 246,500 | ||||||
Senior Unsecured Notes | 400,000 | — | ||||||
Subordinated Notes | 1,000 | 1,000 | ||||||
Notes payable and secured loans | 42,669 | 40,615 | ||||||
Capital lease obligations | 12,477 | 11,316 | ||||||
Less: unamortized debt issuance costs and discount | (39,363 | ) | (30,622 | ) | ||||
Total debt | 1,355,908 | 1,255,359 | ||||||
Less: Current maturities | 27,169 | 27,247 | ||||||
Total long-term debt | $ | 1,328,739 | $ | 1,228,112 | ||||
2014 Revolver Loan
The 2014 Revolver Loan (“Revolver”), entered into on November 3, 2014, is a revolving credit facility used for working capital, acquisitions and development activities and general corporate purposes and matures on November 3, 2019. On October 7, 2015, the Company entered into an amendment to the 2014 First Lien Credit Agreement to increase certain lenders’ commitments under the Revolver from $80.0 million to an aggregate principal amount at any time outstanding not to exceed $150.0 million.
The Company has the option of classifying borrowings under the Revolver as either Alternate Base Rate ("ABR") loans or Eurodollar ("ED") loans. The interest base rate on an ABR loan is equal to the greatest of (a) the Prime Rate in effect on such day, (b) the Federal Funds Effective Rate in effect on such day plus 0.50% and (c) the adjusted LIBO Rate for a Eurodollar Borrowing with a one-month
15
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
interest period plus 1.00%. In addition to the base rate, the Company is required to pay a 3.25% margin for ABR loans. The interest base rate on an ED loan is equal to (x) the LIBO Rate for such Eurodollar borrowing in effect for such Interest Period divided by (y) One minus the Statutory Reserves (if any) for such Eurodollar Borrowing for such interest period. In addition to the base rate, the Company is required to pay a 4.25% margin for ED loans. The Company must also pay quarterly commitment fees of 0.50% per annum of the average daily unused amount of the Revolver. On March 31, 2016, the Company prepaid $126.5 million on the Revolver with proceeds from the issuance of the Senior Unsecured Notes described below. As of March 31, 2016, the Company availability on the Revolver was $146.8 million (including outstanding letters of credit of $3.2 million).
The 2014 First Lien Credit Agreement governs the Revolver and contains various covenants that include limitations on the Company's indebtedness, liens, acquisitions and investments. It additionally includes the requirement that, if triggered, the Company maintain a net leverage ratio within a specified range. As of March 31, 2016, the Company was in compliance with the covenants contained in the 2014 First Lien Credit Agreement.
2014 First Lien Credit Agreement
The 2014 First Lien Credit Agreement (“2014 First Lien”), entered into on November 3, 2014, is a senior secured obligation of Surgery Center Holdings, Inc. and is guaranteed on a senior secured basis by certain subsidiaries of the Company. The 2014 First Lien matures on November 3, 2020. On March 24, 2016, Surgery Center Holdings, Inc. and certain subsidiaries of the Company entered into an amendment to the 2014 First Lien to obtain an incremental term loan in an aggregate principal amount of $80.0 million, which increased the total term loan obligation under the 2014 First Lien to $950.0 million. As of March 31, 2016, the Company plans to use the proceeds of the incremental term loan to fund certain proposed acquisitions and for other corporate purposes.
The Company has the option of classifying the 2014 First Lien as either an ABR loan or an ED loan. The interest base rate on an ABR loan is equal to the greatest of (a) the Prime Rate in effect on such day, (b) the Federal Funds Effective Rate in effect on such day plus 0.50%, and (c) the Adjusted LIBO Rate for a Eurodollar Borrowing with a one-month interest period plus 1.00%; provided that the base rate shall not be less than 2.00% per annum. In addition to the base rate, the Company is required to pay a 3.25% margin for ABR loans. The interest base rate on an ED loan is equal to (x) the LIBO Rate for such Eurodollar borrowing in effect for such Interest Period divided by (y) One minus the Statutory Reserves (if any) for such Eurodollar Borrowing for such interest period; provided that the rate shall not be less than 1.00% per annum. In addition to the base rate, the Company is required to pay a 4.25% margin for ED loans. In 2015, the Company classified the 2014 First Lien as an ED loan with an interest rate of 5.25% (1.00% base rate plus a 4.25% margin). Accrued interest is payable in arrears on a quarterly basis. Within five business days after the earlier of (i) 90 days after the end of each fiscal year or (ii) the date on which financial statements have been delivered, the Company is required to make mandatory prepayments in amounts calculated in accordance with the excess cash flow provisions of the 2014 First Lien Credit Agreement. There were no excess cash flow payments required as of March 31, 2016.
In connection with the incremental loan of $80.0 million in March 2016, the Company recorded an additional $1.6 million and $3.5 million as original issue discount and amounts paid to lender for debt related issuance costs, respectively.
The 2014 First Lien Credit Agreement governs the 2014 First Lien and contains various covenants that include limitations on the Company's indebtedness, liens, acquisitions and investments. As of March 31, 2016, the Company was in compliance with the covenants contained in the 2014 First Lien Credit Agreement. The 2014 First Lien is collateralized by substantially all of the assets of the Company.
2014 Second Lien Credit Agreement
The 2014 Second Lien Credit Agreement (“2014 Second Lien”), entered into on November 3, 2014, was prepaid in full on March 31, 2016 as described below. The 2014 Second Lien was a senior secured obligation of Surgery Center Holdings, Inc. and was guaranteed on a senior secured basis by the Company and certain of its subsidiaries. On March 31, 2016, the Company repaid the remaining principal of the 2014 Second Lien of $252.8 million with the proceeds of the issuance of the Senior Unsecured Notes, defined below, of which $1.3 million was accrued interest. In connection with the prepayment, the Company incurred a loss on the extinguishment of debt of $8.3 million which included the write-off of loan costs and the original issue discount and a prepayment penalty.
Senior Unsecured Notes
Effective March 31, 2016, one of the Company's subsidiaries, Surgery Center Holdings, Inc., issued $400.0 million in gross proceeds of senior unsecured notes due April 15, 2021 (the "Senior Unsecured Notes"). The Senior Unsecured Notes bear interest at the rate of 8.875% per year, payable semi-annually on April 15 and October 15 of each year. The Senior Unsecured Notes are a senior unsecured obligation of Surgery Center Holdings, Inc. and are guaranteed on a senior unsecured basis by each of Surgery Center Holdings, Inc.'s existing and future domestic wholly owned restricted subsidiaries that guarantees the Revolver and the 2014 First Lien.
The Company may redeem up to 35% of the aggregate principal amount of the Senior Unsecured Notes, at any time before April 15, 2018, with the net cash proceeds of certain equity offerings at a redemption price equal to 108.875% of the principal amount to be redeemed, plus accrued and unpaid interest to, but excluding, the date of redemption, provided that at least 50% of the aggregate principal amount of the Senior Unsecured Notes remain outstanding immediately after the occurrence of such redemption and such redemption occurs within 180 days of the date of the closing of any such qualified equity offering.
The Company may redeem the Senior Unsecured Notes, in whole or in part, at any time prior to April 15, 2018 at a price equal to 100.000% of the principal amount of the notes redeemed plus an applicable make-whole premium, plus accrued and unpaid interest, if any, to, but excluding, the date of redemption. The Company may redeem the Senior Unsecured Notes, in whole or in part, at any time on or
16
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
after April 15, 2018, plus accrued and unpaid interest, if any, to the date of redemption plus a redemption price equal to a percentage of the principal amount of the notes redeemed based on the following redemption schedule:
April 15, 2018 to April 14, 2019 | 106.656 | % |
April 15, 2019 to April 14, 2020 | 104.438 | % |
April 15, 2020 and thereafter | 100.000 | % |
If one of the Company's subsidiaries, Surgery Center Holdings, Inc., experiences a change in control under certain circumstances, it must offer to purchase the notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest to, but excluding, the date of repurchase.
The Senior Unsecured Notes contain customary affirmative and negative covenants, which among other things, limit the Company’s ability to incur additional debt, pay dividends, create or assume liens, effect transactions with its affiliates, guarantee payment of certain debt securities, sell assets, merge, consolidate, enter into acquisitions and effect sale and leaseback transactions.
In connection with the offering of the Senior Unsecured Notes, the Company incurred debt issuance costs of $8.4 million.
Subordinated Notes
Effective April 11, 2013, the Company amended and reduced the size of its subordinated debt facility ("Subordinated Notes") to $1.0 million from $53.8 million. The Subordinated Notes, owed to H.I.G. Surgery Centers, LLC, mature on August 4, 2017. Effective January 1, 2014, the Subordinated Notes bear interest of 17.00% per annum.
Notes Payable and Secured Loans
Certain of the Company’s subsidiaries have outstanding bank indebtedness, which is collateralized by the real estate and equipment owned by the surgical facilities to which the loans were made. The various bank indebtedness agreements contain covenants to maintain certain financial ratios and also restrict encumbrance of assets, creation of indebtedness, investing activities and payment of distributions. At March 31, 2016, the Company was in compliance with its covenants contained in the credit agreement. The Company and its subsidiaries had notes payable to financial institutions of $42.7 million and $40.6 million as of March 31, 2016 and December 31, 2015, respectively. The Company and its subsidiaries also provide a corporate guarantee of certain indebtedness of the Company’s subsidiaries.
Letters of Credit
As of March 31, 2016 and December 31, 2015, the Company had two outstanding letters of credit at its optical purchasing group of $500,000 and $730,000. The Company had two outstanding letters of credit issued to the landlords for two of its surgical facilities in Orlando, Florida in the amount of $100,000 and in Lubbock, Texas for $1.0 million. In addition, the Company had one outstanding letter of credit related to the Symbion, Inc. workers compensation self-insured plan for $835,000.
Capital Lease Obligations
The Company is liable to various vendors for several equipment leases classified as capital leases. The carrying value of the leased assets was $13.3 million and $12.3 million as of March 31, 2016 and December 31, 2015, respectively.
5. Earnings Per Share
Basic and diluted earnings per share are calculated in accordance with ASC 260, Earnings Per Share, based on the weighted-average number of shares outstanding in each period and dilutive stock options, unvested shares and warrants, to the extent such securities exist and have a dilutive effect on earnings per share. The following is a reconciliation of the numerator and denominator of basic and diluted earnings per share for the three months ended March 31, 2016 and 2015 (in thousands except share and per share amounts):
17
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Numerator: | ||||||||
Net loss attributable to Surgery Partners, Inc. | $ | (7,190 | ) | $ | (6,762 | ) | ||
Denominator: | ||||||||
Weighted average shares outstanding- basic (1) | 48,017,226 | 32,054,089 | ||||||
Effect of dilutive securities (2) | — | — | ||||||
Weighted average shares outstanding- diluted | 48,017,226 | 32,054,089 | ||||||
Earnings (loss) per share: | ||||||||
Basic | $ | (0.15 | ) | $ | (0.21 | ) | ||
Diluted (2) | $ | (0.15 | ) | $ | (0.21 | ) | ||
Dilutive securities outstanding not included in the computation of loss per share as their effect is antidilutive: | ||||||||
Stock options | 8,488 | — | ||||||
Restricted shares | 484,017 | 1,817,901 | ||||||
(1) Effect of the Reorganization has been retrospectively applied to three months ended March 31, 2015.
(2) The impact of potentially dilutive securities for the three months ended March 31, 2016 and 2015 was not considered because the effect would be anti-dilutive in each of those periods.
6. Related Party Transactions
On December 24, 2009, the Company and Bayside Capital, Inc. (or "Bayside"), an affiliate of H.I.G. Capital, LLC (or "H.I.G."), entered into a Management and Investment Advisory Services Agreement ("Management Agreement") pursuant to which the Company will receive certain management, consulting and financial advisory services. Effective November 3, 2014, the Management Agreement was amended pursuant to the Symbion acquisition and the management fee was increased to $3.0 million annually. Fees related to the Management Agreement for the three months ended March 31, 2015 are recognized as general and administrative expense in the accompanying condensed consolidated statements of operations. Bayside was paid a transaction fee pursuant to the Management Agreement of $5.4 million as a result of the IPO and the Management Agreement was terminated upon the completion of the IPO.
7. Commitments and Contingencies
Lease and Debt Guarantees of Non-Consolidated Facilities
As of March 31, 2016 and December 31, 2015, the Company had guaranteed approximately $123,000 and $539,000, respectively, of operating lease payments for a non-consolidated surgical facility. These operating leases typically have ten-year terms, with optional renewal periods.
Professional, General and Workers' Compensation Liability Risks
The Company is subject to claims and legal actions in the ordinary course of business, including claims relating to patient treatment, employment practices and personal injuries. To cover these claims, the Company maintains general liability and professional liability insurance in excess of self-insured retentions through third party commercial insurance carriers in amounts that management believes is sufficient for the Company's operations, although, potentially, some claims may exceed the scope of coverage in effect. The professional and general insurance coverage is on a claims-made basis. Workers' compensation insurance is on an occurrence basis. Plaintiffs in these matters may request punitive or other damages that may not be covered by insurance. The Company is not aware of any such proceedings that would have a material adverse effect on the Company's business, financial condition or results of operations.
18
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
Laws and Regulations
Laws and regulations governing the Company's business, including those relating to the Medicare and Medicaid programs, are complex and subject to interpretation. These laws and regulations govern every aspect of how the Company's surgical facilities conduct their operations, from licensing requirements to how and whether the Company's facilities may receive payments pursuant to the Medicare and Medicaid programs. Compliance with such laws and regulations can be subject to future government agency review and interpretation as well as legislative changes to such laws. Noncompliance with such laws and regulations may subject the Company to significant regulatory action including fines, penalties, and exclusion from the Medicare, Medicaid and other federal healthcare programs. From time to time, governmental regulatory agencies will conduct inquiries of the Company's practices, including, but not limited to, the Company's compliance with federal and state fraud and abuse laws, billing practices and relationships with physicians. It is the Company's current practice and future intent to cooperate fully with such inquiries. The Company is not aware of any such inquiry that would have a material adverse effect on the Company's business, results of operations or financial condition.
Acquired Facilities
The Company, through its wholly-owned subsidiaries or controlled partnerships and limited liability companies, has acquired and will continue to acquire surgical facilities with prior operating histories. Such facilities may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-referral laws. Although the Company attempts to assure that no such liabilities exist, obtain indemnification from prospective sellers covering such matters and institute policies designed to conform centers to its standards following completion of acquisitions, there can be no assurance that the Company will not become liable for past activities that may later be asserted to be improper by private plaintiffs or government agencies. There can be no assurance that any such matter will be covered by indemnification or, if covered, that the liability sustained will not exceed contractual limits or the financial capacity of the indemnifying party.
The Company cannot predict whether federal or state statutory or regulatory provisions will be enacted that would prohibit or otherwise regulate relationships which the Company has established or may establish with other healthcare providers or have materially adverse effects on its business or revenues arising from such future actions. Management believes, however, that it will be able to adjust the Company's operations so as to be in compliance with any statutory or regulatory provision as may be applicable.
Potential Physician Investor Liability
A majority of the physician investors in the partnerships and limited liability companies which operate the Company's surgical facilities carry general and professional liability insurance on a claims-made basis. Each partnership or limited liability company may, however, be liable for damages to persons or property arising from occurrences at the surgical facilities. Although the various physician investors and other surgeons generally are required to obtain general and professional liability insurance with tail coverage that extends beyond the period of any claims-made policies, such individuals may not be able to obtain coverage in amounts sufficient to cover all potential liability. Since most insurance policies contain exclusions, the physician investors will not be insured against all possible occurrences. In the event of an uninsured or underinsured loss, the value of an investment in the partnership interests or limited liability company membership units and the amount of distributions could be adversely affected.
Contingent Consideration
Pursuant to a purchase agreement dated December 24, 2009 (“the Purchase Agreement”), the Company acquired controlling interests in 36 business entities in various Florida locations which operate freestanding ASCs and provided anesthesia and pain management services (“the 2009 Acquisition”). The Purchase Agreement provided for maximum potential contingent consideration of up to $10.0 million based on operating results subsequent to the acquisition for the period from January 1, 2010 to December 31, 2010. Pursuant to the Purchase Agreement, the contingent consideration is payable as principal under a Subordinated Promissory Note that bears interest at 8%, the form of which was delivered concurrent with the Purchase Agreement. The balance is still outstanding due to ongoing litigation as a result of the civil claim. The Company has made indemnification claims against the Seller exceeding the amount of the contingent consideration liability which the Company has a contractual right of offset against the contingent consideration. The fair value of the contingent consideration liability, including accrued interest, as of March 31, 2016 and December 31, 2015 was $14.3 million and $14.0 million, respectively.
Acquisition of Symbion
The Company completed the acquisition of Symbion effective November 3, 2014. At closing, the Company funded $16.2 million of the purchase price to an escrow account. During 2015, $2.1 million of the escrow account was distributed based on a working capital settlement reducing the total amount funded on the escrow account to $14.0 million as of March 31, 2016. On May 3, 2016 the Company paid $16.6 million to fully fund the required balance in the escrow account. The amounts funded were materially consistent with the amounts stated within the purchase agreement. Subsequent to this funding, the escrow balance was fully distributed to the prior owners of Symbion.
19
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
8. Segment Reporting
A public company is required to report annual and interim financial and descriptive information about its reportable operating segments. Operating segments, as defined, are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or "CODM," in deciding how to allocate resources and in assessing performance.
The Company operates in three major lines of business that are also the Company's reportable operating segments - the operation of surgical facilities, the operation of optical services and the operation of ancillary services, which includes physician practices, a diagnostic laboratory and a specialty pharmacy.
During 2015, the Company made changes to its internal reports issued to and reviewed by the CODM. The primary effect of these changes was to remove the allocation of general and administrative expense and assets to the reportable operating segments. The Company has revised the segment disclosures below to present corporate overhead and corporate assets as a reconciling item back to the reported condensed consolidated financial information.
The following tables present financial information for each reportable segment (in thousands):
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Revenues: | ||||||||
Surgical facility services | $ | 245,670 | $ | 207,684 | ||||
Ancillary services | 17,780 | 12,719 | ||||||
Optical services | 3,624 | 3,740 | ||||||
Total revenues | $ | 267,074 | $ | 224,143 | ||||
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Operating Income: | ||||||||
Surgical facility services | $ | 56,201 | $ | 52,253 | ||||
Ancillary services | 2,458 | 3,442 | ||||||
Optical services | 506 | 610 | ||||||
Total | $ | 59,165 | $ | 56,305 | ||||
General and administrative | $ | (13,638 | ) | $ | (12,725 | ) | ||
Gain (loss) on disposal or impairment of long-lived assets, net | 206 | (223 | ) | |||||
Loss on debt extinguishment | (8,281 | ) | — | |||||
Merger transaction and integration costs | (3,172 | ) | (5,006 | ) | ||||
Total operating income | $ | 34,280 | $ | 38,351 | ||||
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Supplemental Information: | ||||||||
Depreciation and amortization: | ||||||||
Surgical facility services | $ | 6,868 | $ | 6,820 | ||||
Ancillary services | 886 | 372 | ||||||
Optical services | 373 | 407 | ||||||
Total | $ | 8,127 | $ | 7,599 | ||||
General and administrative | $ | 1,441 | $ | 863 | ||||
Total depreciation and amortization | $ | 9,568 | $ | 8,462 | ||||
20
SURGERY PARTNERS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2016
(Unaudited)
March 31, 2016 | December 31, 2015 | |||||||
Assets: | ||||||||
Surgical facility services | $ | 1,770,226 | $ | 1,762,396 | ||||
Ancillary services | 120,631 | 118,198 | ||||||
Optical services | 25,497 | 25,537 | ||||||
Total | 1,916,354 | 1,906,131 | ||||||
General and administrative | $ | 285,986 | $ | 198,312 | ||||
Total assets | $ | 2,202,340 | $ | 2,104,443 | ||||
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Supplemental Information: | ||||||||
Cash purchases of property and equipment, net: | ||||||||
Surgical facility services | $ | 9,815 | $ | 3,112 | ||||
Ancillary services | 560 | 93 | ||||||
Optical services | 77 | 38 | ||||||
Total | $ | 10,452 | $ | 3,243 | ||||
General and administrative | $ | 1,352 | $ | 2,218 | ||||
Total cash purchases of property and equipment, net | $ | 11,804 | $ | 5,461 | ||||
9. Subsequent Events
On April 6, 2016, the Company acquired an integrated physician practice, anesthesia company, laboratory and billing company and an 80% ownership in a surgical facility located in Jacksonville, Florida for a cash purchase price of $57.4 million and compensatory contingent future payments of $16.6 million. The Company used proceeds from the incremental borrowing to fund the purchase price. The acquisition added nine physicians to the Company's network. The pro forma impact of this acquisition is not considered material for disclosure.
On April 22, 2016, the Company acquired a physician practice in Sarasota, Florida for a cash purchase price of $3.6 million. The Company used cash from operations to fund the purchase price.
On May 3, 2016, the Company paid $16.6 million to fully fund the required balance in the escrow account. The amounts funded were materially consistent with the amounts stated within the purchase agreement. Subsequent to this funding, the escrow balance was fully distributed to the prior owners of Symbion.
21
SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
Item 2. 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 condensed consolidated financial statements and related notes included elsewhere in this report and included in the Annual Report on Form 10-K for the year ended December 31, 2015. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those estimated or projected in any of these forward-looking statements. Unless otherwise indicated or the context otherwise requires, references herein to the “Company”, “Surgery Partners”, “we”, “us” and “our” refer to, (i) Surgery Center Holdings, LLC and its consolidated subsidiaries, including Surgery Center Holdings, Inc., immediately prior to the Reorganization and (ii) Surgery Partners, Inc. and its consolidated subsidiaries, including Surgery Center Holdings, LLC and Surgery Center Holdings, Inc., immediately following the Reorganization. Unless the context implies otherwise, the term “affiliates” means direct and indirect subsidiaries of Surgery Center Holdings, LLC and Surgery Partners, Inc., as applicable, and partnerships and joint ventures in which such subsidiaries are partners. The terms “facilities” or “hospitals” refer to entities owned and operated by affiliates of Surgery Partners, and the term “employees” refers to employees of affiliates of Surgery Partners.
Cautionary Note Regarding Forward-Looking Statements
This report contains forward-looking statements, which are based on our current expectations, estimates and assumptions about future events. All statements other than statements of current or historical fact contained in this report, including statements regarding our future financial position, business strategy, budgets, effective tax rate, projected costs and plans and objectives of management for future operations, are forward-looking statements. The words “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “plan,” “will,” and similar expressions are generally intended to identify forward-looking statements. These statements involve risks, uncertainties and other factors that may cause actual results to differ from the expectations expressed in the statements. Many of these factors are beyond our ability to control or predict. These factors include, without limitation: (i) reductions in payments from government healthcare programs and managed care organizations; (ii) inability to contract with private third-party payors; (iii) failure to fully integrate the operations of Surgery Partners and legacy Symbion; (iv) changes in our payor mix or surgical case mix; (v) failure to maintain relationships with our physicians; (vi) payor controls designed to reduce the number of surgical procedures; (vii) inability to integrate operations of acquired surgical facilities, attract new physician partners, or acquire additional surgical facilities; (viii) shortages or quality control issues with surgery-related products, equipment and medical supplies; (ix) competition for physicians, nurses, strategic relationships, acquisitions and managed care contracts; (x) inability to enforce non-compete restrictions against our physicians; (xi) material liabilities incurred as a result of acquiring surgical facilities; (xii) litigation or medical malpractice claims; (xiii) changes in the regulatory, economic and other conditions of the states where our surgical facilities are located; (xiv) substantial payments we expect to be required to make under the tax receivable agreement; and (xv) other risks and uncertainties described in this report and set forth under the heading “Risk Factors” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 11, 2016.
In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur, and actual results could differ materially from those anticipated or implied in the forward-looking statements. When you consider these forward-looking statements, you should keep in mind these risk factors and other cautionary statements in this report.
These forward-looking statements speak only as of the date made. Other than as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Executive Overview
As of May 6, 2016, we owned and operated a national network of surgical facilities and physician practices in 29 states. Our surgical facilities, which include ASCs and surgical hospitals, primarily provide non-emergency surgical procedures across many specialties, including, among others, otolaryngology ("ENT"), gastroenterology ("GI"), general surgery, ophthalmology, orthopedics, cardiology and pain management. Our surgical hospitals provide services, such as diagnostic imaging, laboratory, obstetrics, oncology, pharmacy, physical therapy and wound care. Our portfolio of outpatient surgical facilities is complemented by our suite of ancillary services, which support our physicians in providing high quality and cost-efficient patient care. These ancillary services are comprised of a diagnostic laboratory, multi-specialty physician practices, urgent care facilities, anesthesia services, optical services and specialty pharmacy services. As a result, we believe we are well positioned to benefit from rising consumerism and payors’ and patients’ focus on the delivery of high quality care and superior clinical outcomes in the lowest cost and care setting.
As of May 6, 2016, we owned or operated, primarily in partnership with physicians, a portfolio of 102 surgical facilities comprised of 97 ASCs and five surgical hospitals across 29 states. We owned a majority interest in 72 of the surgical facilities and consolidated 91 of these facilities for financial reporting purposes. In addition to surgical facilities, we owned or operated a network of 50 physician practices as of May 6, 2016. For the three months ended March 31, 2016, approximately 101,000 surgical procedures were performed in our surgical facilities, generating approximately $245.7 million in revenue.
We continue to focus on improving our same-facility performance, selectively acquiring established facilities and developing new facilities. During the three months ended March 31, 2016, we completed one in-market surgical facility transaction that was merged with an existing surgical facility and two in-market physician practice transactions for an aggregate investment of $7.7 million adding a total of two physicians to our physician network.
22
SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
Revenues
Our revenues consist of patient service revenues and other service revenues. Patient service revenues consist of revenue from our surgical facility services and ancillary services segments. Specifically, patient service revenues include fees for surgical or diagnostic procedures performed at surgical facilities that we consolidate for financial reporting purposes, as well as for patient visits to our physician practices, anesthesia services, pharmacy services and diagnostic screens ordered by our physicians. Other service revenues consist of product sales from our optical laboratories, as well as the discounts and handling charges billed to the members of our optical products purchasing organization. Other service revenues also include management and administrative service fees derived from our non-consolidated facilities that we account for under the equity method, management of surgical facilities and physician practices in which we do not own an interest and management services we provide to physician practices for which we are not required to provide capital or additional assets.
The following table summarizes our revenues by service type as a percentage of total revenues for the periods indicated:
Three Months Ended March 31, | ||||||
2016 | 2015 | |||||
Patient service revenues: | ||||||
Surgical facilities revenues | 91.3 | % | 92.1 | % | ||
Ancillary services revenues | 6.6 | % | 5.6 | % | ||
97.9 | % | 97.7 | % | |||
Other service revenues: | ||||||
Optical services revenues | 1.4 | % | 1.7 | % | ||
Other | 0.7 | % | 0.6 | % | ||
2.1 | % | 2.3 | % | |||
Total revenues | 100.0 | % | 100.0 | % | ||
Payor Mix
The following table sets forth by type of payor the percentage of our patient service revenues generated at the surgical facilities which we consolidate for financial reporting purposes in the periods indicated:
Three Months Ended March 31, | ||||||
2016 | 2015 | |||||
Private insurance payors | 50.5 | % | 55.9 | % | ||
Government payors | 40.5 | % | 36.2 | % | ||
Self-pay payors | 1.4 | % | 2.3 | % | ||
Other payors(1) | 7.6 | % | 5.6 | % | ||
Total | 100.0 | % | 100.0 | % | ||
(1) Other is comprised of anesthesia service agreements, auto liability, letters of protection and other payor types.
Surgical Case Mix
We primarily operate multi-specialty surgical facilities where physicians perform a variety of procedures in various specialties, including ENT, GI, general surgery, ophthalmology, orthopedics, cardiology and pain management, among others. We believe this diversification helps to protect us from adverse pricing and utilization trends in any individual procedure type and results in greater consistency in our case volume.
The following table sets forth the percentage of cases in each specialty performed at the surgical facilities which we consolidate for financial reporting purposes for the periods indicated:
23
SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
Three Months Ended March 31, | ||||||
2016 | 2015 | |||||
Gastrointestinal | 21.5 | % | 22.4 | % | ||
General surgery | 2.5 | % | 2.9 | % | ||
Ophthalmology | 29.7 | % | 29.7 | % | ||
Orthopedic and pain management | 31.8 | % | 30.3 | % | ||
Other | 14.5 | % | 14.7 | % | ||
Total | 100.0 | % | 100.0 | % | ||
Case Growth
Same-facility Information
Same-facility revenue includes revenues from our consolidated and non-consolidated surgical facilities (excluding facilities acquired in new markets or divested during the current and prior year) along with the revenues from our ancillary services comprised of a diagnostic laboratory, multi-specialty physician practices, urgent care facilities, anesthesia services, optical services and specialty pharmacy services that complement our surgical facilities in our existing markets.
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Cases | $ | 103,296 | $ | 92,574 | ||||
Case growth | 11.6 | % | N/A | |||||
Revenue per case | $ | 2,514 | $ | 2,476 | ||||
Revenue per case growth | 1.5 | % | N/A | |||||
Number of facilities | 93 | N/A | ||||||
Operating Income Margin
Our operating income margin for the three months ended March 31, 2016 decreased to 12.8% from 17.1% during the three months ended March 31, 2015. During the three months ended March 31, 2016, we recorded a loss on debt extinguishment of $8.3 million, $3.2 million of merger transaction and integration costs related to the acquisition of Symbion Holdings Corporation (“Symbion”) (the “Merger”) and a gain on disposal of long-lived assets of $206,000. Excluding the impact of these items, our operating income margin was 17.0% for the three months ended March 31, 2016.
During the three months ended March 31, 2015, we recorded $5.0 million of merger transaction and integration costs related to the Merger and a loss on disposal of long-lived assets of $223,000. Excluding the impact of these items, our operating income margin was 19.4% for the three months ended March 31, 2015. The decrease in the operating income margin period over period is primarily related to the effects of the laboratory rate reductions from CMS which comprised approximately 1.4% of the decline. The remaining decline is largely the result of our expansion of anesthesia services, a line of business that typically has lower first quarter margins due to higher fixed costs related to physician salary and benefits. As we continue to integrate ancillary services into our existing surgical facilities, we expect continued revenue enhancements and cost savings.
Segment Information
A public company is required to report annual and interim financial and descriptive information about its reportable operating segments. Operating segments, as defined, are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or “CODM,” in deciding how to allocate resources and in assessing performance. Aggregation of similar operating segments into a single reportable operating segment is permitted if the businesses have similar economic characteristics and meet the criteria established by GAAP.
Our business is comprised of the following three reportable segments:
Surgical Facility Services Segment: Our surgical facility services segment consists of the operation of ASCs and surgical hospitals, and includes our anesthesia services. Our surgical facilities primarily provide non-emergency surgical procedures across many specialties, including, among others, ENT, GI, general surgery, ophthalmology, orthopedics, cardiology and pain management.
Ancillary Services Segment: Our ancillary services segment consists of a diagnostic laboratory, a specialty pharmacy and multi-specialty physician practices. These physician practices include our owned and operated physician practices pursuant to long-term management service agreements.
Optical Services Segment: Our optical services segment consists of an optical laboratory, an optical products group purchasing organization and a marketing business. Our optical laboratory manufactures eyewear, while our optical products purchasing organization negotiates volume buying discounts with optical product manufacturers.
24
SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
Our financial information by reportable segment is prepared on an internal management reporting basis that the chief operating decision maker uses to allocate resources and assess the performance of the operating segments. Our operating segments have been defined based on the separate financial information that is regularly produced and reviewed by our CODM, which is its Chief Executive Officer.
During 2015, we made changes to our internal reports issued to and reviewed by the CODM. The primary effect of these changes was to remove the allocation of general and administrative expense and assets to the reportable segments. We have revised the segment disclosures below to present corporate overhead and corporate assets as a reconciling item back to the reported condensed consolidated financial information.
The following tables present financial information for each reportable segment (in thousands):
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Revenues: | ||||||||
Surgical facility services | $ | 245,670 | $ | 207,684 | ||||
Ancillary services | 17,780 | 12,719 | ||||||
Optical services | 3,624 | 3,740 | ||||||
Total revenues | $ | 267,074 | $ | 224,143 | ||||
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Operating Income: | ||||||||
Surgical facility services | $ | 56,201 | $ | 52,253 | ||||
Ancillary services | 2,458 | 3,442 | ||||||
Optical services | 506 | 610 | ||||||
Total | $ | 59,165 | $ | 56,305 | ||||
General and administrative | $ | (13,638 | ) | $ | (12,725 | ) | ||
Gain (loss) on disposal or impairment of long-lived assets, net | 206 | (223 | ) | |||||
Loss on debt extinguishment | (8,281 | ) | — | |||||
Merger transaction and integration costs | (3,172 | ) | (5,006 | ) | ||||
Total operating income | $ | 34,280 | $ | 38,351 | ||||
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Supplemental Information: | ||||||||
Depreciation and amortization: | ||||||||
Surgical facility services | $ | 6,868 | $ | 6,820 | ||||
Ancillary services | 886 | 372 | ||||||
Optical services | 373 | 407 | ||||||
Total | $ | 8,127 | $ | 7,599 | ||||
General and administrative | $ | 1,441 | $ | 863 | ||||
Total depreciation and amortization | $ | 9,568 | $ | 8,462 | ||||
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SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
March 31, 2016 | December 31, 2015 | |||||
Assets: | ||||||
Surgical facility services | 1,770,226 | 1,762,396 | ||||
Ancillary services | 120,631 | 118,198 | ||||
Optical services | 25,497 | 25,537 | ||||
Total | 1,916,354 | 1,906,131 | ||||
General and administrative | 285,986 | 198,312 | ||||
Total assets | 2,202,340 | 2,104,443 | ||||
Three Months Ended March 31, | ||||||||
2016 | 2015 | |||||||
Supplemental Information: | ||||||||
Cash purchases of property and equipment, net: | ||||||||
Surgical facility services | $ | 9,815 | $ | 3,112 | ||||
Ancillary services | 560 | 93 | ||||||
Optical services | 77 | 38 | ||||||
Total | $ | 10,452 | $ | 3,243 | ||||
General and administrative | $ | 1,352 | $ | 2,218 | ||||
Total cash purchases of property and equipment, net | $ | 11,804 | $ | 5,461 | ||||
Critical Accounting Policies
Our significant accounting policies and practices are described in Note 2 of our condensed consolidated financial statements included previously in this report. In preparing our condensed consolidated financial statements in conformity with Generally Accepted Accounting Principles ("GAAP"), our management must make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Certain accounting estimates are particularly sensitive because of their complexity and the possibility that future events affecting them may differ materially from our current judgments and estimates. Our actual results could differ from those estimates. We believe that the following critical accounting policies are important to the portrayal of our financial condition and results of operations and require our management’s subjective or complex judgment because of the sensitivity of the methods, assumptions and estimates used. This listing of critical accounting policies is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for management’s judgment regarding accounting policy.
Consolidation and Control
Our condensed consolidated financial statements include the accounts of our Company, wholly-owned or controlled subsidiaries and variable interest entities in which we are the primary beneficiary. Our controlled subsidiaries consist of wholly-owned subsidiaries and other subsidiaries that we control through our ownership of a majority voting interest or other rights granted to us by contract to function as the sole general partner or managing member of the surgical facility. The rights of limited partners or minority members at our controlled subsidiaries are generally limited to those that protect their ownership interests, including the right to approve the issuance of new ownership interests, and those that protect their financial interests, including the right to approve the acquisition or divestiture of significant assets or the incurrence of debt that either physician limited partners or minority members are required to guarantee on a pro-rata basis based upon their respective ownership, or that exceeds 20.0% of the fair market value of the related surgical facility’s assets. All significant intercompany balances and transactions, including management fees from consolidated surgical facilities, are eliminated in consolidation.
We hold non-controlling interests in five surgical facilities, three anesthesia practices and one physician practice over which we exercise significant influence. Significant influence includes financial interests, duties, rights and responsibilities for the day-to-day management of the entity. We also consider the relevant sections of the Accounting Standard Codification ("ASC") 810, Consolidation, to determine if we have the power to direct the activities and are the primary beneficiary of (and therefore should consolidate) any entity whose operations we do not control with voting rights. As we were the primary beneficiary, we consolidated the above nine entities at March 31, 2016.
Revenue Recognition
Our patient service revenues are derived from surgical procedures performed at our ASCs, patient visits to physician practices, anesthesia services provided to patients, pharmacy services and diagnostic screens ordered by our physicians. The fees for such services are
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SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
billed either to the patient or a third-party payor, including Medicare and Medicaid. We recognize patient service revenues, net of contractual allowances, which we estimate based on the historical trend of our cash collections and contractual write-offs.
Our optical products purchasing organization negotiates volume buying discounts with optical product manufacturers. The buying discounts and any handling charges billed to the members of the purchasing organization represent the revenues recognized for financial reporting purposes. Revenue is recognized as orders are shipped to members. Product sale revenues from our optical laboratories and marketing products and services businesses, net of an allowance for returns and discounts, is recognized when the product is shipped or service is provided to the customer. We base our estimates for sales returns and discounts on historical experience and have not experienced significant fluctuations between estimated and actual return activity and discounts given.
Other service revenues consist of management and administrative service fees derived from non-consolidated surgical facilities that we account for under the equity method, management of surgical facilities in which we do not own an interest and management services we provide to physician networks for which we are not required to provide capital or additional assets. The fees we derive from these management arrangements are based on a predetermined percentage of the revenues of each surgical facility and physician network. We recognize other service revenues in the period in which services are rendered.
Allowance for Contractual Adjustments and Doubtful Accounts
Our patient service revenues and other receivables from third-party payors are recorded net of estimated contractual adjustments and allowances from third-party payors, which we estimate based on the historical trend of our surgical facilities’ cash collections and contractual write-offs, accounts receivable agings, established fee schedules, relationships with payors and procedure statistics. While changes in estimated reimbursement from third-party payors remain a possibility, we expect that any such changes would be minimal and, therefore, would not have a material effect on our financial condition or results of operations.
We estimate our allowances for doubtful accounts using similar information and analysis. While we believe that our allowances for contractual adjustments and doubtful accounts are adequate, if the actual write-offs are significantly different from our estimates, it could have a material adverse effect on our financial condition and results of operations. Because in most cases we have the ability to verify a patient’s insurance coverage before services are rendered, and because we have entered into contracts with third-party payors which account for a majority of our total revenues, the out-of-period contractual adjustments have been minimal. Our net accounts receivable reflected allowances for doubtful accounts of $17.6 million and $18.3 million at March 31, 2016 and December 31, 2015, respectively.
Our collection policies and procedures are based on the type of payor, size of claim and estimated collection percentage for each patient account. The operating systems used to manage our patient accounts provide for an aging schedule in 30-day increments, by payor, physician and patient. We analyze accounts receivable at each of our surgical facilities to ensure the proper collection and aged category. The operating systems generate reports that assist in the collection efforts by prioritizing patient accounts. Collection efforts include direct contact with insurance carriers or patients, written correspondence and the use of legal or collection agency assistance, as required. Our days sales outstanding were 63 days for the three months ended March 31, 2016 and 60 days for the year ended December 31, 2015.
At a consolidated level, we review the standard aging schedule, by facility, to determine the appropriate provision for doubtful accounts by monitoring changes in our consolidated accounts receivable by aged schedule, days sales outstanding and bad debt expense as a percentage of revenues. At a consolidated level, we do not review a consolidated aging by payor. Regional and local employees review each surgical facility’s aged accounts receivable by payor schedule. These employees have a closer relationship with the payors and have a more thorough understanding of the collection process for that particular surgical facility. Furthermore, this review is supported by an analysis of the actual revenues, contractual adjustments and cash collections received. If our internal collection efforts are unsuccessful, we further review patient accounts with balances of $25 or more. We then classify the accounts based on any external collection efforts we deem appropriate. An account is written-off only after we have pursued collection with legal or collection agency assistance or otherwise deemed an account to be uncollectible. Typically, accounts will be outstanding a minimum of 120 days before being written-off.
We recognize that final reimbursement of outstanding accounts receivable is subject to final approval by each third-party payor. However, because we have contracts with our third-party payors and we verify the insurance coverage of the patient before services are rendered, the amounts that are pending approval from third-party payors are minimal. Amounts are classified outside of self-pay if we have an agreement with the third-party payor or we have verified a patient’s coverage prior to services rendered. It is our policy to collect co-payments and deductibles prior to providing services. It is also our policy to verify a patient’s insurance 72 hours prior to the patient’s procedure. Because our services are primarily non-emergency, our surgical facilities have the ability to control these procedures. Our patient service revenues from self-pay payors as a percentage of total revenues were approximately 1.4% and 2.3% for the three months ended March 31, 2016 and 2015, respectively.
Income Taxes and Tax Receivable Agreement
We use the asset and liability method to account for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. If a net operating loss carryforward exists, we make a determination as to whether that net operating loss carryforward will be utilized in the future. A valuation allowance will be established for certain net operating loss carryforwards and other deferred tax assets where their recoverability is deemed to be uncertain. The carrying value of the net deferred tax assets is based upon estimates and assumptions related to our ability to generate
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SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
sufficient future taxable income in certain tax jurisdictions. If these estimates and related assumptions change in the future, we will be required to adjust our deferred tax valuation allowances.
As of March 31, 2016, we maintained a valuation allowance against certain state NOLs and capital losses for which we believe it is more likely than not that they will not be realized. On a quarterly basis, we continue to monitor results. If our expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to adjust the valuation allowance, for all or a portion of our deferred tax assets. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings.
As of March 31, 2016, we recorded income tax expense at a rate of approximately 14.6% of income before income taxes. As a percentage of income before income taxes, we expect the tax rate to remain relatively constant throughout the year. As a percentage of net income after income attributable to noncontrolling interests, we expect the tax rate for the year to be between 41% and 42%. Based upon the application of interim accounting guidance, however, the tax rate as a percentage of net income after income attributable to noncontrolling interests will vary based upon the relative net income from period to period.
Section 382 (“Section 382”) of the Internal Revenue Code of 1986, as amended (the “Code”) imposes an annual limit on the ability of a corporation that undergoes an “ownership change” to use its NOLs to reduce its tax liability. An “ownership change” is generally defined as any change in ownership of more than 50.0% of a corporation’s “stock” by its “5-percent shareholders” (as defined in Section 382) over a rolling three-year period based upon each of those shareholder’s lowest percentage of stock owned during such period. As a result of the Symbion acquisition, approximately $179 million in NOL carryforwards are subject to an annual Section 382 base limitation of $4.9 million, and, as a result of the Novamed acquisition, approximately $17 million in NOL carryforwards are subject to an annual Section 382 base limitation of $4.9 million. It is possible that future transactions, not all of which would be within our control (including a possible sale by the investment funds affiliated with H.I.G. of some or all of their shares of our common stock), could cause us to undergo an ownership change as defined in Section 382. In that event, we would not be able to use our pre-ownership-change NOLs in excess of the limitation imposed by Section 382. At this time, we do not believe these limitations, when combined with amounts allowable due to net unrecognized built in gains, will affect our ability to use any NOLs before they expire. However, no such assurances can be provided. If our ability to utilize our NOLs to offset taxable income generated in the future is subject to this limitation, it could have an adverse effect on our business, prospects, results of operations and financial condition.
As part of the Reorganization that was effective September 30, 2015, we entered into a Tax Receivable Agreement (“TRA”) under which generally we will be required to pay to our stockholders as of immediately prior to the IPO 85% of the cash savings, if any, in U.S. federal, state or local tax that we actually realize (or are deemed to realize in certain circumstances) as a result of (i) certain tax attributes, including NOLs, capital losses, charitable deductions, alternative minimum tax credit carryforwards and federal and state tax credits of Surgery Partners, Inc. and its affiliates relating to taxable years ending on or before the date of the Reorganization (calculated by assuming the taxable year of the relevant entity closes on the date of the Reorganization) that are or become available to us and our wholly-owned subsidiaries as a result of the Reorganization, and (ii) tax benefits attributable to payments made under the TRA, together with interest accrued at a rate of LIBOR plus 300 from the date the applicable tax return is due (without extension) until paid.
The amounts payable under the TRA will vary depending upon a number of factors, including the amount, character and timing of the taxable income of Surgery Partners, Inc. in the future. We estimate the total amounts payable under the TRA to be approximately $119.9 million, if the tax benefits of related deferred tax assets are ultimately realized. The amounts payable were recognized during 2015 in conjunction with the release of our valuation allowance recorded against the deferred tax assets.
Long-Lived Assets, Goodwill and Intangible Assets
We evaluate the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist in accordance with ASC 350, Intangibles- Goodwill and Other. We perform an impairment test by preparing an expected undiscounted cash flow projection. If the projection indicates that the recorded amount of the long-lived asset is not expected to be recovered, the carrying value is reduced to estimated fair value. The cash flow projection and fair value represents management’s best estimate, using appropriate and customary assumptions, projections and methodologies, at the date of evaluation. We test our goodwill and intangible assets for impairment at least annually, or more frequently if certain indicators arise.
Off-Balance Sheet Arrangements
We guarantee our pro-rata share of the third-party debts and other obligations of many of the non-consolidated partnerships and limited liability companies in which we own an interest. In most instances of these guarantees, the physicians and/or physician groups have also guaranteed their pro-rata share of the indebtedness to secure the financing. At March 31, 2016, we did not guarantee any debt of our non-consolidated surgical facilities.
JOBS Act Accounting Election
We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 ("the JOBS Act"). Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have irrevocably elected not to avail ourselves of this
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SURGERY PARTNERS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS (UNAUDITED)
MARCH 31, 2016
exemption from new or revised accounting standards and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.
Equity-Based Compensation
We recognize in the financial statements the cost of employee services received in exchange for awards of equity instruments based on the fair value of those awards. Prior to the Reorganization, on the grant date, we employed a market approach to estimate the fair value of equity-based awards based on various considerations and assumptions, including implied earnings multiples and other metrics of relevant market participants, our operating results and forecasted cash flows and our capital structure. Such estimates require the input of highly subjective, complex assumptions. However, such assumptions are not required to determine fair value of shares of our common stock as our underlying shares are now publicly traded. The fair value of future stock options awarded will be based on the quoted market price of our common stock upon grant, as well as assumptions including expected stock price volatility, risk-free interest rate, expected dividends, and expected term.
Our policy is to recognize compensation expense using the straight line method over the relevant vesting period for units that vest based on time. Our equity-based compensation expense can vary in the future depending on many factors, including levels of forfeitures and whether performance targets are met and whether a liquidity event occurs. Prior to the Reorganization, employees held membership units in Surgery Center Holdings, LLC, and the associated expense was referred to as unit-based compensation. In connection with the Reorganization, our board of directors and stockholders adopted the Surgery Partners, Inc. 2015 Omnibus Incentive Plan from which our future equity-based awards will be granted. Following the Reorganization, such expense is referred to as equity-based compensation.
Results of Operations
The following tables summarize certain results from the statements of operations for the three months ended March 31, 2016 and 2015. The tables also show the percentage relationship to revenues for the periods indicated (dollars in thousands):
Three Months Ended March 31, | ||||||||||||||
2016 | 2015 | |||||||||||||
Amount | % of Revenues | Amount | % of Revenues | |||||||||||
Revenues | $ | 267,074 | 100.0 | % | $ | 224,143 | 100.0 | % | ||||||
Operating expenses: | ||||||||||||||
Cost of revenues | 196,703 | 73.7 | % | 155,773 | 69.5 | % | ||||||||
General and administrative expenses | 12,197 | 4.6 | % | 11,862 | 5.3 | % | ||||||||
Depreciation and amortization | 9,568 | 3.6 | % | 8,462 | 3.8 | % | ||||||||
Provision for doubtful accounts | 3,873 | 1.5 | % | 5,186 | 2.3 | % | ||||||||
Income from equity investments | (758 | ) | (0.3 | )% | (707 | ) | (0.3 | )% | ||||||
(Gain) loss on disposal or impairment of long-lived assets, net | (206 | ) | (0.1 | )% | 223 | 0.1 | % | |||||||
Loss on debt refinancing | 8,281 | 3.1 | % | — | — | % | ||||||||
Merger transaction and integration costs | 3,172 | 1.2 | % | 5,006 | 2.2 | % | ||||||||
Electronic health records incentive income | (93 | ) | — | % | — | — | % | |||||||
Other expense (income) | 57 | — | % | (13 | ) | — | % | |||||||
Total operating expenses | 232,794 | 87.2 | % | 185,792 | 82.9 | % | ||||||||
Operating income | 34,280 | 12.8 | % | 38,351 | 17.1 | % | ||||||||
Interest expense, net | (22,153 | ) | (8.3 | )% | (25,756 | ) | (11.5 | )% | ||||||
Income before income taxes | 12,127 | 4.5 | % | 12,595 | ||||||||||