10-K 1 june302009_10k.htm VANGUARD HEALTH SYSTEMS, INC.

 

 
 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

_______________

FORM 10-K
_______________

(Mark One)

 

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

 

THE SECURITIES EXCHANGE ACT OF 1934

 

 

For the fiscal year ended June 30, 2009

 

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

 

THE SECURITIES EXCHANGE ACT OF 1934

 

 

For the transition period from ____________ to ____________

Commission File Number: 333-71934
_______________


VANGUARD HEALTH SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware

62-1698183

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)


20 Burton Hills Boulevard, Suite 100
Nashville, TN 37215
(Address and zip code of principal executive offices)

(615) 665-6000
(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act:   None
Securities Registered Pursuant to Section 12(g) of the Act:   None

     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.oYes ýNo

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ýYes oNo

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed under 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. ýYes oNo

     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 the Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)    Yeso   Noo

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. ý

     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 (Do not check if a smaller reporting company)

 

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). oYes ýNo

     There were 749,550 shares of registrant’s common stock outstanding as of September 1, 2009 (all of which are privately owned and not traded on a public market).

     Documents incorporated by reference:  None

 
 

VANGUARD HEALTH SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

PART I

 

Page

Item 1.

Business.....................................................................................................................................................

1

Item 1A.

Risk Factors...............................................................................................................................................

32

Item 1B.

Unresolved Staff Comments....................................................................................................................

50

Item 2.

Properties...................................................................................................................................................

51

Item 3.

Legal Proceedings.....................................................................................................................................

51

Item 4.

Submission of Matters to a Vote of Security Holders.........................................................................

52

 

 

PART II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities...................................................................................................

53

Item 6.

Selected Financial Data............................................................................................................................

53

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations.....

56

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk..........................................................

78

Item 8.

Financial Statements and Supplementary Data....................................................................................

80

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.....

130

Item 9A(T).

Controls and Procedures.........................................................................................................................

130

Item 9B.

Other Information......................................................................................................................................

131

 

 

PART III

 

Item 10.

Directors, Executive Officers and Corporate Governance..................................................................

132

Item 11.

Executive Compensation..........................................................................................................................

137

Item 12.

Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters...................................................................................................................

156

Item 13.

Certain Relationships and Related Transactions, and Director Independence...............................

158

Item 14.

Principal Accounting Fees and Services...............................................................................................

162

 

 

PART IV

 

Item 15.

Exhibits and Financial Statement Schedules.........................................................................................

163

 

 

SIGNATURES

.....................................................................................................................................................................

164

iii



VANGUARD HEALTH SYSTEMS, INC.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

        This annual report on Form 10-K contains “forward-looking statements” within the meaning of the federal securities laws that are intended to be covered by safe harbors created thereby.  Forward-looking statements are those statements that are based upon management’s plans, objectives, goals, strategies, future events, future revenue or performance, capital expenditures, financing needs, plans or intentions relating to acquisitions, business trends and other information that is not historical information.  These statements are based upon estimates and assumptions made by the Company’s management that, although believed to be reasonable, are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected.  When used in this annual report on Form 10-K, the words “estimates,” “expects,” ”anticipates,” “projects,” “plans,” “intends,” “believes,” “forecasts,” “continues,” or future or conditional verbs, such as “will,” “should,” “could” or “may,” and variations of such words or similar expressions are intended to identify forward-looking statements.

        These factors, risks and uncertainties include, among other things, statements relating to:

               •

 

Our high degree of leverage

               •

 

Our ability to incur substantially more debt

               •

 

Operating and financial restrictions in our debt agreements

               •

 

The impact of the tightened credit markets and economic recession on our ability to service or refinance our debt

               •

 

Our ability to successfully implement our business strategies

               •

 

Our ability to successfully integrate our recent and any future acquisitions

               •

 

The highly competitive nature of the healthcare industry

               •

 

Governmental regulation of the industry, including Medicare and Medicaid reimbursement levels

               •

 

Pressures to contain costs by managed care organizations and other insurers and our ability to negotiate acceptable terms with these third party payers

               •

 

Our ability to attract and retain qualified management and healthcare professionals, including physicians and nurses

               •

 

Potential federal or state reform of healthcare

               •

 

Future governmental investigations

               •

 

Potential management information systems failures and the significant costs of systems integrations

               •

 

The availability of capital to fund our corporate growth strategy

               •

 

Potential lawsuits or other claims asserted against us

               •

 

Our ability to maintain or increase patient membership and control costs of our managed healthcare plans

               •

 

Changes in general economic conditions, including the current U.S. economic recession, that could adversely impact our operating results, financial position and cash flows

               •

 

Our exposure to the increased amounts of and collection risks associated with uninsured accounts and the co-pay and deductible portions of insured accounts

               •

 

Cost of professional and general liability insurance and increases in the quantity and severity of professional liability claims

               •

 

Our ability to maintain and increase patient volumes and control the costs of providing services, including salaries and benefits, supplies and bad debts

               •

 

Our failure to comply, or allegations of our failure to comply, with applicable laws and regulations

               •

 

The geographic concentration of our operations

               •

 

Technological and pharmaceutical improvements that increase the cost of providing, or reduce the demand for, healthcare services

               •

 

Potential substantial liabilities arising from unfavorable retrospective reviews by governmental or other payers of the medical necessity of medical procedures performed at our hospitals

               •

 

Lost future revenues from payer contract terminations resulting from their unfavorable retrospective

reviews of the medical necessity of medical procedures performed at our hospitals

        See “Item 1A – Risk Factors” for further discussion.  We assume no obligation to update any forward-looking statements.

iv



PART I

Item 1.    Business.

Company Overview

        We own and operate acute care hospitals, complementary outpatient facilities and related health plans principally located in urban and suburban markets. We currently operate 15 acute care hospitals which, as of June 30, 2009, had a total of 4,135 beds in the following four locations:

                •  San Antonio, Texas

                •  metropolitan Phoenix, Arizona

                •  metropolitan Chicago, Illinois

                •  Massachusetts

        Historically, we have concentrated our operations in markets with high population growth and median income in excess of the national average. Our objective is to help communities achieve health for life by delivering an ideal patient-centered experience in a highly reliable environment of care. We must continue to strengthen our financial operations to fund further investment in these communities. During the year ended June 30, 2009, we generated revenues of $3,199.7 million. During this period 78.8% of our total revenues were derived from acute care hospitals and complementary outpatient facilities.

        Our general acute care hospitals offer a variety of medical and surgical services including emergency services, general surgery, internal medicine, cardiology, obstetrics, orthopedics and neurology. In addition, certain of our facilities provide on-campus and off-campus services including outpatient surgery, physical therapy, radiation therapy, diagnostic imaging and laboratory services. We also own three strategically important managed care health plans: a Medicaid managed health plan, Phoenix Health Plan, that served approximately 176,200 members as of June 30, 2009 in Arizona; Abrazo Advantage Health Plan, a managed Medicare and dual-eligible health plan that served approximately 2,800 members as of June 30, 2009 in Arizona; and MacNeal Health Providers a preferred provider network that served approximately 39,700 member lives in metropolitan Chicago as of June 30, 2009 under capitated contracts covering only outpatient and physician services.

        We are a Delaware corporation formed in July 1997. Our principal executive offices are located at 20 Burton Hills Boulevard, Suite 100, Nashville, Tennessee, 37215 and our telephone number at that address is (615) 665-6000.  Our corporate website address is www.vanguardhealth.com.  Information contained on our website does not constitute part of this Annual Report on Form 10-K.  The terms “we”, “our”, “the Company”, “us”, “registrant” and “Vanguard” as used in this report refer to Vanguard Health Systems, Inc. and its subsidiaries as a consolidated entity, except where it is clear from the context that such terms mean only Vanguard Health Systems, Inc.  “Subsidiaries” means direct and indirect corporate subsidiaries of Vanguard Health Systems, Inc. and partnerships, joint ventures and limited liability companies in which such subsidiaries are partners or members.

The Merger

        On July 23, 2004, Vanguard executed an agreement and plan of merger (the “Merger Agreement”) with VHS Holdings LLC (“Holdings”) and Health Systems Acquisition Corp., a newly formed Delaware corporation (“Acquisition Corp.”), pursuant to which on September 23, 2004 Acquisition Corp. merged with and into Vanguard, with Vanguard being the surviving corporation (the “Merger”). In the Merger, holders of the outstanding Vanguard capital stock, options to acquire Vanguard common stock and other securities convertible into Vanguard common stock received aggregate consideration of approximately $1,248.6 million.

        The Blackstone Group, together with its affiliates (collectively, “Blackstone”), funded the Merger in part by subscribing for and purchasing approximately $494.9 million aggregate amount of (1) Class A membership units in Holdings and (2) common stock of Acquisition Corp. (merged with and into Vanguard), in an amount equal to

1


$125.0 million of such common stock. In addition, Morgan Stanley Capital Partners, together with its affiliates (collectively, “MSCP”), subscribed for and purchased Class A membership units in Holdings by contributing to Holdings a number of shares of Vanguard common stock equal to (1) $130.0 million divided by (2) the per share consideration payable for each share of Vanguard common stock in connection with the Merger.  Certain senior members of management and certain other stockholders of Vanguard (the “Rollover Management Investors”) subscribed for and purchased Class A membership units in Holdings, having an aggregate purchase price of approximately $119.1 million, by (a) paying cash using the proceeds of consideration received in connection with the Merger and/or (b) contributing shares of Vanguard common stock in the same manner as MSCP. Baptist Health Services (“Baptist”), the former owner of our division, Baptist Health System of San Antonio, also purchased $5.0 million of Class A membership units in Holdings. Immediately after completion of the Merger in September 2004, Blackstone, MSCP (together with Baptist) and the Rollover Management Investors held approximately 66.1%, 18.0% and 15.9%, respectively, of the common equity of Vanguard (most of which is indirectly held through the ownership of the Class A membership units in Holdings). Certain members of senior management also purchased $5.7 million of the equity incentive units in Holdings.

Our Mission and Business Strategies

        Our mission is to help communities achieve health for life. We expect to change the way healthcare is delivered in our communities through our corporate and regional business strategies. We have established a corporate values framework that includes safety, excellence, respect, integrity and accountability to support both our mission and the corporate and regional business strategies that will define our future success. Some of the more key elements of our business strategy are outlined below.

        Delivery of an ideal patient-centered experience

        We expect all of our facilities to provide the best available experience for our patients.  To achieve this goal, we must create a highly reliable environment of care that yields superior safety and quality outcomes. We have implemented and will continue to implement various programs to improve the quality of care we provide including our patient safety initiative. We are working with an external consulting group to implement a company-wide patient safety model that will combine information technology advancement such as bedside medication barcoding with nursing process improvements to create a high reliability organization. Our commitment to quality of care starts at the top of our organization and spreads to all levels. Not only must our care be reliable, but our care must also be efficient and compassionate.

        Providing efficient and compassionate care requires collaboration and open communication lines between the patients, physicians, nurses and payers. We have implemented best practices to provide our patients quick access to key services they need to improve their health. We have rapid response teams and hourly nurse rounding in place at all of our hospitals to ensure that any patient health issues are communicated and addressed in a timely manner. We have invested and will continue to invest significant capital to strengthen information technology within our facilities that enable physicians, nurses and other clinicians to coordinate patient care from the time the patients arrive at our facilities to the time they leave.

        We have implemented a comprehensive patient satisfaction monitoring program to measure our success in providing an ideal patient-centered experience. The patient satisfaction results are shared with all of our leadership teams and are a component of incentive compensation plans for those leaders.

        Nurse leadership initiatives

        Our most valuable resource in improving the health of our patients is our nurse workforce. We are in the early stages of implementing a nursing professional practice model that will transform our delivery of patient care. This externally-validated model incorporates leadership, clinical practice, professional development and interdisciplinary collaboration to foster nursing practice that is evidence-based, innovative and patient-focused. The model will identify the most important goals to achieve clinical excellence and will incorporate best practices and process input from all levels within the nursing organization. The goals established as part of the model will be formally measured against nationally recognized sources for core measure benchmarking and will establish nursing peer reviews and detailed action plans to improve upon any areas where goals are not met.

2


        The success of this model depends upon our ability to gain the trust and loyalty of our nurse leadership teams and line staff. We will continue to invest in nurse recruiting and retention programs that provide our nurses clinical advancement opportunities, preceptor and training programs, work-life balance flexibility and competitive compensation necessary to engage our nurses in this professional practice model. We are currently considering initiatives such as talent evaluations, coaching programs, premier preceptor programs and hospital nurse advisory councils to incorporate into our professional practice model. We believe that an engaged nurse workforce that shares our values and commitment to exemplary nursing care will improve the care experience for our patients, inspire the confidence of physicians practicing in our hospitals and reduce our financial costs of replacing nursing professionals or utilizing costly temporary nursing resources. We will utilize comprehensive nurse satisfaction surveys to measure whether the model is being embraced by the nursing staff and if the initiatives included in the model result in a more engaged workforce.

        Physician collaboration and alignment

        In order to help our communities achieve health for life, we must work collaboratively with physicians to provide clinically superior healthcare services. The first step in this process is to ensure that physician resources are available to provide the necessary services to our patients. During fiscal 2009, we recruited approximately 150 physicians to the communities we serve through both employment and non-employment initiatives. During fiscal 2010, we expect to recruit approximately 200 additional physicians primarily through employment arrangements. Most of these recruiting initiatives relate to primary care or hospitalist physicians, but certain specialists will also be targeted such as:  cardiovascular, neurology, obstetrics/gynecology, orthopedics and urology. We will continue to provide significant corporate and regional resources to assist in the relocation and management of these new physician practices.

        Delivering an ideal patient-centered experience requires that we align the goals of the physicians who practice in our hospitals to the goals previously discussed in our nursing professional practice model while respecting physician care decisions and methods of practice. We have implemented multiple initiatives including physician leadership councils, physician training programs and information technology upgrades to ease the flow of on-site and off-site communication between physicians, nurses and patients in order to effectively align the interest of all patient caregivers. These initiatives are just some of those included in our clinical integration roadmap.

        Two significant initiatives that are currently underway to achieve physician alignment are our employed hospitalist strategy and our medical officer leadership strategy. We have currently implemented our new hospitalist model in most of our Arizona hospitals and are beginning implementation in a second market. We intend to commit significant resources during fiscal 2010 to grow our employed hospitalist program. We believe that hospitalists provide an effective means through which care can be coordinated between specialist physicians and our nursing staff. The existence of a strong, reputable group of hospitalists provides confidence to admitting physicians that their patients will receive high-quality, coordinated care on a 24-hour, 7-day basis while in our hospitals. The hospitalist model should improve patient satisfaction due to the increase in the number of specialized physician encounters the patients experience. To facilitate care standards for our physicians, we have established chief medical officers at each of our corporate, regional and hospital levels. These officers work with our physician leadership councils to drive our quality of core initiatives. We will continue to utilize physician satisfaction surveys and physician leadership council discussions to measure our physician integration success.

        Expansion of services and care efficiencies

        We continue to identify services that are in demand in the communities we serve that we do not provide or else only provide on a limited basis. Some of our more significant planned service additions during fiscal year 2010 include the following:  women’s and children’s services in Phoenix; radiology and urology services in Chicago; cardiology services in Massachusetts and orthopedics and women’s services in San Antonio. We also plan to launch standardization projects for our emergency and operating room departments across the company during fiscal 2010 that will result in process improvements, better patient throughput and more satisfied patients.

        One area where we plan to use technology to improve care efficiencies is in our intensive care units. Due to shortages in the availability of intensivists, we are working to implement electronic intensive care units (“EICUs”) at certain of our hospitals. EICUs will provide constant monitoring of intensive care patients even when an intensivist

3


is not available at the bedside and will enhance communications to both the hospitalist and the specialty physicians of patient conditions. We expect this initiative to improve lengths of stay by shortening the transition time between intensive care beds and general beds and to improve mortality rates.

        Strengthening our financial operations to fund continuing community investment

        In order to continue to invest in the capital, information and human resources necessary to improve health in our communities, we must continue to generate strong financial returns. We believe that payment mechanisms for hospital providers will continue to transition during the upcoming years, and hospitals will need to transform their delivery of care in order to be successful. We expect to combine a population health strategy with a complex clinical program strategy based on fee for episode as reimbursement transitions away from fee for service. Additionally, quality of care measures have become an increasingly important factor in governmental and managed care reimbursement. We monitor core measures and other quality of care indicators on a monthly basis and continuously implement process improvements to improve clinical quality.

        Many payers, including Medicare and several large managed care organizations, currently require providers to report certain quality measures in order to receive the full amount of payment increases that were awarded automatically in the past. For federal fiscal year 2010, Medicare expanded the number of quality measures to 47 from 43 during federal fiscal year 2009. These measures include risk-adjusted outcomes measures such as 30-day mortality measures for patients who suffered a heart attack, heart failure or pneumonia; additional measures related to patients who underwent surgical procedures such as hospital-acquired infections data; and several patient satisfaction indicators. Many large managed care organizations have developed quality measurement criteria that are similar to or even more stringent than the Medicare requirements. We believe that pay for performance reimbursement will continue to evolve, and that quality measure scores themselves will determine reimbursement. This is evidenced by the Center for Medicare Services’ (“CMS”) new reforms effective October 1, 2008 that took the first steps toward preventing Medicare from making additional payments to hospitals for treating patients that acquired one of eleven identified hospital-acquired conditions during a hospital stay.

        In addition to meeting the reporting or adherence requirements related to core measure scores, we must also continue to successfully negotiate favorable payment rates with our most significant managed care payers. Our service expansion initiatives and organic market growth gives us an expanded presence in the markets we serve and provides opportunities for us to negotiate better rates with these managed care organizations. During fiscal 2009, our San Antonio hospitals also were awarded participation in the CMS ACE demonstration project for cardiology and orthopedic services. We believe that this reimbursement program will be beneficial to us if we are able to efficiently manage the care of those patients.

Our Competitive Strengths

       Concentrated Local Market Positions in Attractive Markets

        We believe that our markets are attractive because of their favorable demographics, competitive landscape, payer mix and opportunities for expansion. Ten of our 15 hospitals are located in markets with long-term population growth rates in excess of the national average and all of our acute care hospitals are located in markets in which the median household income is above the national average. For the fiscal year ended June 30, 2009, we derived approximately 67% of our total revenues from the San Antonio and metropolitan Phoenix markets, which have high long-term growth projections. Our facilities in these markets primarily serve Bexar County, Texas, which encompasses most of the metropolitan San Antonio area and Maricopa County, Arizona, which encompasses most of the metropolitan Phoenix area. Our strong market positions provide us with opportunities to offer integrated services to patients, receive more favorable reimbursement terms from a broader range of third party payers and realize regional operating efficiencies. The U.S. Census Bureau projects that the number of individuals aged 65 and older will increase by an average of 3.0% each year during the years 2010 to 2020 so that those individuals aged 65 and older would represent approximately 18.6% of the total U.S. population by 2020. Our presence in high growth markets combined with the general aging of the United States population and expected longer life expectancies should result in higher demand for healthcare services and provide growth opportunities for us well into the future.

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       Strong Management Team with Significant Equity Investment

        Our senior management has an average of more than 20 years of experience in the healthcare industry at various organizations, including OrNda Healthcorp, HCA Inc. and HealthTrust, Inc. Many of our senior managers have been with Vanguard since its founding in 1997, and 11 of our 20 members of senior management have worked together managing healthcare companies for up to 30 years, either continuously or from time to time. In connection with consummation of the Merger, the Rollover Management Investors purchased Class A membership units in Holdings having an aggregate purchase price of approximately $119.1 million which then represented approximately 15.9% of our equity interests.

       Proven Ability to Complete and Integrate Acquisitions

        Including our first acquisition in 1998, we have selectively acquired 18 hospitals, 12 of which were formerly not-for-profit hospitals. We have subsequently sold 3 of these hospitals and ceased acute care operations in another. We believe our success in completing acquisitions is due in large part to our disciplined approach to making acquisitions. Prior to completing an acquisition, we carefully review the operations of the target facility and develop a strategic plan to improve performance. We have routinely rejected acquisition candidates that did not meet our financial and operational criteria.

        We believe our historical performance demonstrates our ability to identify underperforming facilities and improve the operations of acquired facilities. When we acquire a hospital, we generally implement a number of measures to lower costs, and we often make significant investments in the facility to expand existing services and introduce new services, strengthen the medical staff and improve our overall market position. We expect to continue to grow revenues and profitability in the markets in which we operate by improving quality of care, increasing the depth and breadth of services provided and through the implementation of additional operational enhancements.

The Markets We Serve

       San Antonio, Texas

        In the San Antonio market, as of June 30, 2009, we owned and operated 5 hospitals with a total of 1,741 licensed beds and related outpatient service locations complementary to the hospitals. We acquired these hospitals in January 2003 from the non-profit Baptist Health Services (formerly known as Baptist Health System) and continue to operate the hospitals as the Baptist Health System. The acquisition followed our strategy of acquiring a significant market share in a growing market, San Antonio, Texas. Our facilities primarily serve the residents of Bexar County which encompasses most of the metropolitan San Antonio area.

        During the years ended June 30, 2008 and 2009, we generated approximately 32.1% and 29.6% of our total revenues, respectively, in this market. We have invested approximately $461.0 million of capital in this market since we purchased these hospitals.

       Metropolitan Phoenix, Arizona

        In the Phoenix market, as of June 30, 2009, we owned and operated 5 hospitals with a total of 988 licensed beds and related outpatient service locations complementary to the hospitals, a prepaid Medicaid managed health plan, Phoenix Health Plan (“PHP”), and a managed Medicare and dual-eligible health plan, Abrazo Advantage Health Plan (“AAHP”). Phoenix is the fifth largest city in the U.S. and has been one of the fastest growing major metropolitan areas during the past ten years. Our facilities primarily serve the residents of Maricopa County, which encompasses most of the metropolitan Phoenix area.

        During the years ended June 30, 2008 and 2009, exclusive of PHP and AAHP, we generated approximately 18.8% and 17.9% of our total revenues, respectively, in this market. Three of our hospitals in this market were formerly not-for-profit hospitals. We believe that payers will choose to contract with us in order to give their enrollees a comprehensive choice of providers in the western and northern Phoenix areas. Recently, we have negotiated improvements in our payer rates at our Phoenix hospitals generally, and Arizona’s state Medicaid program remains a comprehensive provider of healthcare coverage to low income individuals and families. We

5


believe our network strategy will position us to continue to negotiate favorable rate increases with managed care payers and to build upon our network’s comprehensive range of integrated services. In addition, our ownership of PHP and AAHP will allow us to enroll eligible patients, who would not otherwise be able to pay for healthcare services, into our health plan or into other state-approved plans.

       Metropolitan Chicago, Illinois

        In the Chicago metropolitan area, as of June 30, 2009, we owned and operated 2 hospitals with 766 licensed beds, and related outpatient service locations complementary to the hospitals. Weiss Hospital is operated by us in a consolidated joint venture corporation in which we own 80.1% and the University of Chicago Hospitals owns 19.9% of the equity interests. During the years ended June 30, 2008 and 2009, we generated approximately 14.9% and 14.6%, respectively, of our total revenues in this market.

        We chose MacNeal Hospital and Weiss Hospital, both former not-for-profit facilities, as our first two entries into the largely not-for-profit metropolitan Chicago area. Both MacNeal and Weiss Hospitals are large, well-equipped, university-affiliated hospitals with strong reputations and medical staffs. We believe we have captured a large share of the patients in MacNeal Hospital’s immediate surrounding service area, which encompasses the cities of Berwyn and Cicero, Illinois. MacNeal offers tertiary services such as open heart surgery that patients would otherwise have to travel outside the local community to receive. We have also established fully-integrated healthcare systems at MacNeal and Weiss Hospitals by operating free-standing primary care and occupational medicine centers and a large commercial reference laboratory. As of June 30, 2009, these health systems employed 67 physicians including 32 primary care physicians. Our network of 21 primary care and occupational medicine centers allows us to draw patients to MacNeal and Weiss from around the metropolitan Chicago area. Both hospitals partner with various medical schools, the most significant being the University of Chicago Medical School and the University of Illinois Medical School, to provide medical training through residency programs in multiple specialties. In addition, MacNeal Hospital runs a successful free-standing program in family practice, one of the oldest such programs in the state of Illinois, and Weiss Hospital also runs a successful free-standing residency program in internal medicine. Our medical education programs help us to attract quality physicians to both the hospitals and our network of primary care and occupational medicine centers.

       Massachusetts

        In Massachusetts, as of June 30, 2009, we owned and operated 3 hospitals with a total of 640 licensed beds and related healthcare services complementary to the hospitals. These hospitals include Saint Vincent Hospital located in Worcester and MetroWest Medical Center, a two-campus hospital system comprised of Framingham Union Hospital in Framingham and Leonard Morse Hospital in Natick. These hospitals were acquired by us on December 31, 2004. We believe that opportunities for growth through increased market share exist in the Massachusetts area through the possible addition of new services, partnerships and the implementation of a strong primary care physician strategy. During the years ended June 30, 2008 and 2009, the Massachusetts facilities represented 19.7% and 18.3% of our total revenues, respectively.

        Saint Vincent Hospital, located in Worcester, is a 321-bed teaching hospital with an extensive residency program. Worcester is located in central Massachusetts and is the second largest city in Massachusetts. The service area is characterized by a patient base that is older, more affluent and well-insured. Saint Vincent Hospital is focused on strengthening its payer relationships, developing its primary care physician base and expanding its offerings in cardiology, orthopedics, radiology and minimally-invasive surgery capabilities.

        MetroWest Medical Center’s two campus system has a combined total of 319 licensed beds with locations in Framingham and Natick, in the suburbs west of Boston. These facilities serve communities that are generally well-insured. We are seeking to develop strong ambulatory care capabilities in these service areas, as well as to expand our oncology, radiology, women’s services and cardiology services.

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Our Facilities

        We owned and operated 15 acute care hospitals as of June 30, 2009. The following table contains information concerning our hospitals:

Hospital

City

Licensed
Beds

 

Date Acquired




 


Texas

 

 

 

Baptist Medical Center

San Antonio

636

January 1, 2003

Northeast Baptist Hospital

San Antonio

367

January 1, 2003

North Central Baptist Hospital

San Antonio

268

January 1, 2003

Southeast Baptist Hospital

San Antonio

175

January 1, 2003

St. Luke’s Baptist Hospital

San Antonio

295

January 1, 2003

 

 

 

Arizona

 

 

Maryvale Hospital

Phoenix

232

June 1, 1998

Arrowhead Hospital

Glendale

220

June 1, 2000

Phoenix Baptist Hospital

Phoenix

236

June 1, 2000

Paradise Valley Hospital

Phoenix

136

November 1, 2001

West Valley Hospital (1)

Goodyear

164

September 4, 2003

 

 

 

 

 

Illinois

MacNeal Hospital

Berwyn

427

February 1, 2000

Louis A. Weiss Memorial Hospital (2)

Chicago

339

June 1, 2002

 

 

 

 

 

Massachusetts

MetroWest Medical Center – Leonard Morse Hospital

Natick

141

December 31, 2004

MetroWest Medical Center  - Framingham Union Hospital

Framingham

178

December 31, 2004

Saint Vincent Hospital at Worcester Medical Center

Worcester

321

December 31, 2004

 

 


 

 

Total Licensed Beds

4,135

 

 


 

____________________

(1)

This hospital was constructed, not acquired.

 

 

(2)

This hospital is operated by us in a consolidated joint venture corporation in which we own 80.1% of the equity interests and the University of Chicago Hospitals owns 19.9% of the equity interests.

        In addition to the hospitals listed in the table above, as of June 30, 2009, we owned certain outpatient service locations complementary to our hospitals and two surgery centers in Orange County, California. We also own and operate a limited number of medical office buildings in conjunction with our hospitals which are primarily occupied by physicians practicing at our hospitals.

Our Hospital Operations

       Acute Care Services

        Our hospitals typically provide the full range of services commonly available in acute care hospitals, such as internal medicine, general surgery, cardiology, oncology, neurosurgery, orthopedics, obstetrics, diagnostic and emergency services, as well as select tertiary services such as open-heart surgery and level II and III neonatal intensive care. Our hospitals also generally provide outpatient and ancillary healthcare services such as outpatient surgery, laboratory, radiology, respiratory therapy and physical therapy. We also provide outpatient services at our imaging centers and ambulatory surgery centers. Certain of our hospitals have a limited number of psychiatric, skilled nursing and rehabilitation beds.

7


       Management and Oversight

        Our senior management team has extensive experience in operating multi-facility hospital networks and plays a vital role in the strategic planning for our facilities. A hospital’s local management team is generally comprised of a chief executive officer, chief operating officer, chief financial officer and chief nursing officer. Local management teams, in consultation with our corporate staff, develop annual operating plans setting forth revenue growth strategies through the expansion of offered services and the recruitment of physicians in each community, as well as plans to improve operating efficiencies and reduce costs. We believe that the ability of each local management team to identify and meet the needs of our patients, medical staffs and the community as a whole is critical to the success of our hospitals. We base the compensation for each local management team in part on its ability to achieve the goals set forth in the annual operating plan, including quality of care, patient satisfaction and financial measures.

        Boards of trustees at each hospital, consisting of local community leaders, members of the medical staff and the hospital chief executive officer, advise the local management teams. Members of each board of trustees are identified and recommended by our local management teams and serve three-year staggered terms. The boards of trustees establish policies concerning medical, professional and ethical practices, monitor these practices and ensure that they conform to our high standards. We have recently formed Physician Advisory Councils at each of our hospitals that focus on quality of care, clinical integration and other issues important to physicians and make recommendations to the boards of trustees as necessary. We maintain company-wide compliance and quality assurance programs and use patient care evaluations and other assessment methods to support and monitor quality of care standards and to meet accreditation and regulatory requirements.

        We also provide support to the local management teams through our corporate resources in areas such as revenue cycle, business office, legal, managed care, clinical efficiency, physician services and other administrative functions. These resources also allow for sharing best practices and standardization of policies and processes among all of our hospitals.

       Attracting Patients

        We believe that the most important factors affecting a patient’s choice in hospitals are the reputation of the hospital’s nursing staff for delivering quality care, the availability and expertise of physicians caring for patients at the facility and the location and convenience of the hospital. Other factors that affect utilization include local demographics and population growth, local economic conditions and the hospital’s success in contracting with a wide range of local payers.

       Outpatient Services

        The healthcare industry has experienced a general shift during recent years from inpatient services to outpatient services as Medicare, Medicaid and managed care payers have sought to reduce costs by shifting lower-acuity cases to an outpatient setting. Advances in medical equipment technology and pharmacology have supported the shift to outpatient utilization, which has resulted in an increase in the acuity of inpatient admissions. However, we expect inpatient admissions to recover over the long-term as the baby boomer population reaches ages where inpatient admissions become more prevalent. We have responded to the shift to outpatient services through expanding service offerings and increasing the throughput and convenience of our emergency departments, outpatient surgery facilities and other ancillary units in our hospitals. We also own two ambulatory surgery centers in Orange County, California, interests in diagnostic imaging centers in San Antonio, Texas, outpatient diagnostic imaging centers in metropolitan Phoenix, Arizona and a network of primary care and occupational medicine centers in metropolitan Chicago, Illinois. We continually upgrade our resources, including procuring excellent physicians and nursing staff and utilizing technologically advanced equipment, to support our comprehensive service offerings to capture inpatient volumes from the baby boomers. We have focused on core services including cardiology, neurology, oncology, orthopedics and women’s services. We also operate sub-acute units such as rehabilitation, skilled nursing facilities and psychiatric services, where appropriate, to meet the needs of our patients while increasing volumes and increasing care management efficiencies.

8



       Operating Statistics

        The following table sets forth certain operating statistics from continuing operations for the periods indicated. Acute care hospital operations are subject to fluctuations due to seasonal cycles of illness and weather, including increased patient utilization during the cold weather months and decreases during holiday periods.

 

 

 

Year Ended June 30,

 

 

 


 

 

 

2005

 

 

2006

 

 

 

2007

 

 

2008

 

 

2009

 

 

 

 


 

 


 

 

 


 

 


 

 


 

Number of hospitals at end of period (a)

 

 

15

 

 

15

 

 

 

15

 

 

15

 

15

Number of licensed beds at end of period (b)               

 

 

3,907

 

 

3,937

 

 

 

4,143

 

 

4,181

 

4,135

Discharges (c)

 

 

147,798

 

 

162,446

 

 

 

166,873

 

 

169,668

 

167,880

Adjusted discharges - hospitals (d)

 

 

231,322

 

 

261,056

 

 

 

264,698

 

 

270,076

 

274,767

Average length of stay (days) (e)

 

 

4.2

 

 

4.3

 

 

 

4.3

 

 

4.3

 

4.2

Average daily census (f)

 

 

1,708

 

 

1,921

 

 

 

1,978

 

 

2,008

 

1,945

Net patient revenue per adjusted hospital discharge (g)

$

6,859

$

7,319

$

7,766

$

8,110

$

8,623

Total surgeries (h)

 

 

101,368

 

113,043

 

 

113,833

 

110,877

 

114,348

Member lives (i)

146,700

146,200

145,600

 

149,600

 

218,700

____________________

(a)

 

The number of hospitals at the end of each period represents hospitals included in continuing operations.

 

 

 

(b)

 

Licensed beds are those beds for which a facility has been granted approval to operate from the applicable state licensing agency.

 

 

 

(c)

 

Represents the total number of patients discharged (in the facility for an overnight stay) from our hospitals and is used by management and certain investors as a general measure of inpatient volumes.

 

 

 

(d)

 

Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined inpatient and outpatient volumes and is computed by multiplying discharges by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation enables management to assess hospital volumes by a combined measure of inpatient and outpatient volumes.

 

 

 

(e)

 

Average length of stay represents the average number of days admitted patients stay in our hospitals.

 

 

 

(f)

 

Average daily census represents the average number of patients in our hospitals each day during our ownership.

 

 

 

(g)

 

Net revenue per adjusted hospital discharge is calculated by dividing hospital net patient revenues by hospital adjusted discharges and measures the average net payment expected to be received for a patient’s hospital stay.

(h)

Total surgeries represent the sum of inpatient surgeries and outpatient surgeries performed at our hospitals or ambulatory surgery centers.

 

 

 

(i)

 

Member lives represents the total number of enrollees in our Arizona prepaid managed health plans and our Chicago capitated health plan as of the end of the respective period.

Our Health Plan Operations

       Phoenix Health Plan

        In addition to our hospital operations, we own three health plans. PHP is a prepaid Medicaid managed health plan that currently serves nine counties in the Phoenix, Arizona area. We acquired PHP in May 2001. We are able to enroll eligible patients in our hospitals into PHP or other approved Medicaid managed health plans who otherwise would not be able to pay for their hospital expenses. We believe the volume of patients generated through our health plans will help attract quality physicians to the communities our hospitals serve.

        For the year ended June 30, 2009, we derived approximately $577.7 million of our total revenues from PHP. PHP had approximately 176,200 enrollees as of June 30, 2009, and derives substantially all of its revenues through a contract with the Arizona Health Care Cost Containment System (“AHCCCS”), which is Arizona’s state Medicaid

9


program. The contract requires PHP to arrange for healthcare services for enrolled Medicaid patients in exchange for monthly capitation payments and supplemental payments from AHCCCS. PHP subcontracts with physicians, hospitals and other healthcare providers to provide services to its enrollees. These services are provided regardless of the actual costs incurred to provide these services. We receive reinsurance and other supplemental payments from AHCCCS to cover certain costs of healthcare services that exceed certain thresholds.

        As part of its contract with AHCCCS, PHP is required to maintain a performance guarantee in the amount of $40.0 million. Vanguard maintains this performance guarantee on behalf of PHP in the form of surety bonds totaling $40.0 million with independent third party insurers that expire on October 1, 2009. We were also required to arrange for $5.0 million in letters of credit to collateralize our $40.0 million in surety bonds with the third party insurers. The amount of the performance guaranty that AHCCCS requires is based upon the membership in the health plan and the related capitation amounts paid to us.

        Our current contract with AHCCCS commenced on October 1, 2008 and covers members in nine Arizona counties: Apache, Conconino, Gila, Maricopa, Mohave, Navajo, Pima, Pinal and Yavapai. This contract covers the three-year period beginning October 1, 2008 and ending September 30, 2011. Our previous contract with AHCCCS covered only Gila, Maricopa and Pinal counties. AHCCCS has the option to renew the new contract, in whole or in part, for two additional one-year periods commencing on October 1, 2011 and on October 1, 2012.

       Abrazo Advantage Health Plan

        Effective January 1, 2009, AAHP became a Medicare Advantage Prescription Drug Special Needs Plan provider under a contract with CMS. This allows AAHP to offer Medicare and Part D drug benefit coverage for Medicare members and dual-eligible members (those that are eligible for Medicare and Medicaid). PHP has historically served dual-eligible members through its AHCCCS contract. As of June 30, 2009, approximately 2,800 members were enrolled in AAHP, most of whom were previously enrolled in PHP. For the year ended June 30, 2009, we derived approximately $40.1 million of our total revenues from AAHP.

       MacNeal Health Providers

        The operations of MHP are somewhat integrated with our MacNeal Hospital in Berwyn, Illinois. For the year ended June 30, 2009, we derived approximately $60.2 million of our total revenues from MHP. MHP generates revenues from its contracts with health maintenance organizations from whom it took assignment of capitated member lives as well as third party administration services for other providers. As of June 30, 2009, MHP had contracts in effect covering approximately 39,700 capitated member lives. Such capitation is limited to physician services and outpatient ancillary services and does not cover inpatient hospital services. We try to utilize MacNeal Hospital and its medical staff as much as possible for the physician and outpatient ancillary services that are required by such capitation arrangements. Revenues of MHP are dependent upon health maintenance organizations in the metropolitan Chicago area continuing to assign capitated-member lives to health plans like MHP as opposed to entering into direct fee-for-service arrangements with healthcare providers.

Competition

        The hospital industry is highly competitive. We currently face competition from established, not-for-profit healthcare systems, investor-owned hospital companies, large tertiary care hospitals, specialty hospitals and outpatient service providers. In the future, we expect to encounter increased competition from companies, like ours, that consolidate hospitals and healthcare companies in specific geographic markets. Continued consolidation in the healthcare industry will be a leading factor contributing to increased competition in our current markets and markets we may enter in the future. Due to the shift to outpatient care and more stringent payer-imposed pre-authorization requirements during the past few years, most hospitals have significant unused capacity resulting in increased competition for patients. Many of our competitors are larger than us and have more financial resources available than we do. Other not-for-profit competitors have endowment and charitable contribution resources available to them and can purchase equipment and other assets on a tax-free basis.

        One of the most important factors in the competitive position of a hospital is its location, including its geographic coverage and access to patients. A location convenient to a large population of potential patients or a

10


wide geographic coverage area through hospital networks can make a hospital significantly more competitive. Another important factor is the scope and quality of services a hospital offers, whether at a single facility or a network of facilities, compared to the services offered by its competitors. A hospital or network of hospitals that offers a broad range of services and has a strong local market presence is more likely to obtain favorable managed care contracts. We intend to evaluate changing circumstances in the geographic areas in which we operate on an ongoing basis to ensure that we offer the services and have the access to patients necessary to compete in these managed care markets and, as appropriate, to form our own, or join with others to form, local hospital networks.

        A hospital’s competitive position also depends in large measure on the quality and specialties of physicians associated with the hospital. Physicians refer patients to a hospital primarily on the basis of the quality and breadth of services provided by the hospital, the quality of the nursing staff and other professionals affiliated with the hospital, the hospital’s location and the availability of modern equipment and facilities. Although physicians may terminate their affiliation with our hospitals, we seek to retain physicians of varied specialties on our medical staffs and to recruit other qualified physicians by maintaining or improving our level of services and providing quality facilities, equipment and nursing care for our patients.

        Another major factor in the competitive position of a hospital is the ability of its management to obtain contracts with managed care plans and other group payers. The importance of obtaining managed care contracts has increased in recent years due primarily to consolidations of health plans and is expected to continue to increase as private and government payers increasingly turn to managed care organizations to help control rising healthcare costs. Our markets have experienced significant managed care penetration. The revenues and operating results of our hospitals are significantly affected by our hospitals’ ability to negotiate favorable contracts with managed care plans. Health maintenance organizations and preferred provider organizations use managed care contracts to encourage patients to use certain hospitals in exchange for discounts from the hospitals’ established charges. Traditional health insurers and large employers also are interested in containing costs through similar contracts with hospitals.

        The hospital industry and our hospitals continue to have significant unused capacity. Inpatient utilization, average lengths of stay and average occupancy rates have historically been negatively affected by payer-required pre-admission authorization, utilization review and payer pressure to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Admissions constraints, payer pressures and increased competition are expected to continue. We expect to meet these challenges first and foremost by our continued focus on our previously discussed quality of care initiatives, which should increase patient, nursing and physician satisfaction. We also may expand our outpatient facilities, strengthen our managed care relationships, upgrade facilities and equipment and offer new or expanded programs and services.

Employees and Medical Staff

        As of June 30, 2009, we had approximately 19,200 employees, including approximately 2,100 part-time employees. Approximately 1,600 of our full-time employees at our three Massachusetts hospitals are unionized.  Overall, we consider our employee relations to be good. While some of our non-unionized hospitals experience union organizing activity from time to time, we do not currently expect these efforts to materially affect our future operations. Our hospitals, like most hospitals, have experienced labor costs rising faster than the general inflation rate.

        While the national nursing shortage has abated somewhat as a result of the weakended U.S. economy, certain pockets of the markets we serve continue to have limited available nursing resources. Nursing shortages often result in our using more contract labor resources to meet increased demand especially during the peak winter months. We expect our nurse leadership and recruiting initiatives to mitigate the impact of the nursing shortage. These initiatives include more involvement with nursing schools, participation in more job fairs, recruiting nurses from abroad, implementing preceptor programs, providing flexible work hours, improving performance leadership training, creating awareness of our quality of care and patient safety initiatives and providing competitive pay and benefits. We anticipate that demand for nurses will continue to exceed supply especially as the baby boomer population reaches the ages where inpatient stays become more frequent. We continue to implement best practices to reduce turnover and to stabilize our nursing workforce over time.

11


        One of our primary nurse recruiting strategies for our San Antonio hospitals is our continued investment in the Baptist Health System School of Health Professions (“SHP”), our nursing school in San Antonio. SHP offers seven different healthcare educational programs with its greatest enrollment in the professional nursing program. SHP trains approximately 450 students each year. The majority of these students have historically chosen permanent employment with our hospitals. We have changed SHP’s nursing program from a diploma program to a degree program and may improve other SHP programs in future periods. We completed the necessary steps during fiscal 2009 to make SHP students eligible for participation in the Pell Grant and other federal grant and loan programs. We expect these enhancements will make SHP more attractive to potential students.

        Our hospitals grant staff privileges to licensed physicians who may serve on the medical staffs of multiple hospitals, including hospitals not owned by us. A physician who is not an employee can terminate his or her affiliation with our hospital at any time. Although we employ a growing number of physicians, a physician does not have to be our employee to be a member of the medical staff of one of our hospitals. Any licensed physician may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by each hospital’s medical staff and board of trustees in accordance with established credentialing criteria. Under state laws and other licensing standards, hospital medical staffs are generally self-governing organizations subject to ultimate oversight by the hospital’s local governing board. Although we were generally successful in our physician recruiting efforts during fiscal 2009, we face continued challenges in some of our markets to recruit certain types of physician specialists who are in high demand. We expect that our previously described physician recruiting and alignment initiatives will make our hospitals more desirable environments in which more physicians will choose to practice.

Compliance Program

        We voluntarily maintain a company-wide compliance program designed to ensure that we maintain high standards of ethics and conduct in the operation of our business and implement policies and procedures so that all our employees act in compliance with all applicable laws, regulations and company policies. The organizational structure of our compliance program includes oversight by our board of directors and a high-level corporate management compliance committee. The board of directors and compliance committee are responsible for ensuring that the compliance program meets its stated goals and remains up-to-date to address the current regulatory environment and other issues affecting the healthcare industry. Our Senior Vice President of Compliance and Ethics reports jointly to our Chairman and Chief Executive Officer and to our board of directors, serves as our Chief Compliance Officer and is charged with direct responsibility for the day-to-day management of our compliance program. Other features of our compliance program include Regional Compliance Officers who report to our Chief Compliance Officer in all four of our operating regions, initial and periodic ethics and compliance training and effectiveness reviews, a toll-free hotline for employees to report, without fear of retaliation, any suspected legal or ethical violations, annual “fraud and abuse” audits to examine all of our payments to physicians and other referral sources and annual “coding audits” to make sure our hospitals bill the proper service codes for reimbursement from the Medicare program.

        Our compliance program also oversees the implementation and monitoring of the standards set forth by the Health Insurance Portability and Accountability Act (“HIPAA”) for privacy and security. To facilitate reporting of potential HIPAA compliance concerns by patients, family or employees, we established a second toll-free hotline dedicated to HIPAA and other privacy matters. Corporate HIPAA compliance staff monitors all reports to the privacy hotline and each phone call is responded to appropriately. Ongoing HIPAA compliance also includes self-monitoring of HIPAA policy and procedure implementation by each of our healthcare facilities and corporate compliance oversight.

Our Information Systems

        We believe that our information systems must cost-effectively meet the needs of our hospital management, medical staff and nurses in the following areas of our business operations:

                •  patient accounting, including billing and collection of revenues;
                •  accounting, financial reporting and payroll;
                •  coding and compliance;
                •  laboratory, radiology and pharmacy systems;

12


                •  medical records and document storage;
                •  remote physician access to patient data;
                •  quality indicators;
                •  materials and asset management; and
                •  negotiating, pricing and administering our managed care contracts.

        During fiscal 2009, we invested significantly in clinical information technology. We believe that the importance of and reliance upon clinical information technology will continue to increase in the future. Accordingly, we expect to make additional significant investments in clinical information technology during fiscal years 2010 and 2011 as part of our business strategy to increase the efficiency and quality of patient care.

        Although we map the financial information systems from each of our hospitals to one centralized database, we do not automatically standardize our financial information systems among all of our hospitals. We carefully review the existing systems at the hospitals we acquire. If a particular information system is unable to cost-effectively meet the operational needs of the hospital, we will convert or upgrade the information system at that hospital to one of several standardized information systems that can cost-effectively meet these needs.

Professional and General Liability Insurance

        As is typical in the healthcare industry, we are subject to claims and legal actions by patients and others in the ordinary course of business. For claims incurred on or after June 1, 2002 through May 31, 2006, our wholly owned captive insurance subsidiary insured our professional and general liability risks at a $10.0 million retention level. For professional and general liability claims incurred from June 1, 2006 to June 30, 2009, we self-insured the first $9.0 million of each claim, and the captive subsidiary insured the next $1.0 million. We maintain excess coverage from independent third-party carriers for individual claims exceeding $10.0 million per occurrence up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. The captive insurance subsidiary funds its portion of claims costs from proceeds of premium payments received from us.

        The malpractice insurance environment remains volatile. Some states in which we operate, including Texas and Illinois, have passed in recent years tort reform legislation to place limits on non-economic damages. However, in November 2007 a judge in the Illinois Cook County Circuit Court declared that these Illinois malpractice limits were unconstitutional under state law. While such ruling is being considered in an appeal to the Illinois Supreme Court, we understand that the trial courts are not enforcing the non-economic damages limits under that Illinois tort reform statute. Additionally, in Texas an action has been brought to declare its tort reform legislation unconstitutional under federal law. Thus, while we have taken multiple steps at our facilities to reduce our professional liability exposures, absent significant legislation (not later declared unconstitutional) to curb the size of malpractice judgments in the states in which we operate, our insurance costs may increase in the future.

Sources of Revenues

        Hospital revenues depend upon inpatient occupancy levels, the medical and ancillary services ordered by physicians and provided to patients, the volume of outpatient procedures and the charges or payment rates for such services. Charges and reimbursement rates for inpatient services vary significantly depending on the type of payer, the type of service (e.g., acute care, intensive care or subacute) and the geographic location of the hospital. Inpatient occupancy levels fluctuate for various reasons, many of which are beyond our control.

        We receive payment for patient services from:

        •  the federal government, primarily under the Medicare program;
        •  state Medicaid programs;
        •  health maintenance organizations, preferred provider organizations, managed Medicare providers,
           managed Medicaid providers and other private insurers; and
        •  individual patients

13



        The table below presents the approximate percentage of net patient revenues we received from the following sources for the periods indicated:

 

 

Year ended June 30,

 

 


Payer Source

 

2007

 

 

2008

 

 

2009

 

 

 


 

 


 

 


 

Medicare

 

26%

 

 

26%

 

 

25%

 

Medicaid

9   

8   

8   

Managed Medicare

13   

14   

14   

Managed Medicaid

7   

7   

9   

Other managed care plans

32   

35   

35   

Self-pay

 

10   

9   

8   

 

Commercial

3   

1   

1   

 


 

 


 

 


   Total 

 

100%

100%

100%

 


 

 


 

 


        The Medicare program, the nation’s largest health insurance program, is administered by CMS. Medicare provides certain hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease without regard to beneficiary income or assets. Medicaid is a federal-state program, administered by the states, which provides hospital and medical benefits to qualifying individuals who are unable to afford healthcare. All of our general, acute care hospitals located in the United States are certified as healthcare services providers for persons covered under the Medicare and the various state Medicaid programs. Amounts received under these programs are generally significantly less than established hospital gross charges for the services provided.

        Our hospitals offer discounts from established charges to certain group purchasers of healthcare services, including private insurance companies, employers, health maintenance organizations, preferred provider organizations and other managed care plans. These discount programs limit our ability to increase net revenues in response to increasing costs. Patients generally are not responsible for any difference between established hospital charges and amounts reimbursed for such services under Medicare, Medicaid and managed care programs, but are generally responsible for exclusions, deductibles and coinsurance features of their coverages. Due to rising healthcare costs, many payers have increased the number of excluded services and the levels of deductibles and coinsurance resulting in a higher portion of the contracted rate due from the individual patients. Collecting amounts due from individual patients is typically more difficult than collecting from governmental or private managed care plans.

       Traditional Medicare

        One of the ways Medicare beneficiaries can elect to receive their medical benefits is through the traditional Medicare program, which provides reimbursement under a prospective payment fee-for-service system. A general description of the types of payments we receive for services provided to patients enrolled in the traditional Medicare program is provided below. The impact of recent changes to reimbursement for these types of services is included in the section entitled “Annual Medicare Regulatory Update.”

        Medicare Inpatient Acute Care Reimbursement

        Medicare Severity-Adjusted Diagnosis-Related Group Payments. Sections 1886(d) and 1886(g) of the Social Security Act (the “Act”) set forth a system of payments for the operating and capital costs of inpatient acute care hospital admissions based on a prospective payment system. Under the inpatient prospective payment system, Medicare payments for hospital inpatient operating services are made at predetermined rates for each hospital discharge. Discharges are classified according to a system of Medicare severity-adjusted diagnosis-related groups (“MS-DRGs”), which categorize patients with similar clinical characteristics that are expected to require similar amounts of hospital resources to treat. CMS assigns to each MS-DRG a relative weight that represents the average resources required to treat cases in that particular MS-DRG, relative to the average resources used to treat cases in all MS-DRGs.

14


        The base payment amount for the operating component of the MS-DRG payment is comprised of an average standardized amount that is divided into a labor-related share and a nonlabor-related share. Both the labor-related share of operating base payments and the base payment amount for capital costs are adjusted for geographic variations in labor and capital costs, respectively. These base payments are multiplied by the relative weight of the MS-DRG assigned to each case. The MS-DRG operating and capital base rates, relative weights and geographic adjustment factors are updated annually, with consideration given to: the increased cost of goods and services purchased by hospitals; the relative costs associated with each MS-DRG; and changes in labor data by geographic area. Although these payments are adjusted for area labor and capital cost differentials, the adjustments do not consider an individual hospital’s operating and capital costs. Historically, the average operating and capital costs for our hospitals have exceeded the Medicare rate increases. These annual adjustments are effective for the Medicare fiscal year beginning October 1 of each year and are indicated by the “market basket index” for that year.

        Outlier Payments. Outlier payments are additional payments made to hospitals for treating Medicare patients that are costlier to treat than the average patient in the same MS-DRG. To qualify as a cost outlier, a hospital’s billed charges, adjusted to cost, must exceed the payment rate for the MS-DRG by a fixed threshold established annually by CMS. The Medicare fiscal intermediary calculates the cost of a claim by multiplying the billed charges by a cost-to-charge ratio that is typically based upon the hospital’s most recently filed cost report. Generally, if the computed cost exceeds the sum of the MS-DRG payment plus the fixed threshold, the hospital receives 80% of the difference as an outlier payment.

        Under the Act, CMS must project aggregate annual outlier payments to all prospective payment system hospitals to be not less than 5% or more than 6% of total MS-DRG payments. CMS adjusts the fixed threshold on an annual basis to bring the outlier percentage within the 5% to 6% parameters. Changes to the outlier fixed threshold amount can impact a hospital’s number of cases that qualify for the additional payment and the amount of reimbursement the hospital receives for those cases that qualify. The most recently filed cost reports for our hospitals as of June 30, 2007, 2008 and 2009 reflected outlier payments of $5.8 million, $4.3 million and $4.2 million, respectively.

        Disproportionate Share Hospital Payments. Hospitals that treat a disproportionately large number of low-income patients currently receive additional payments from Medicare in the form of disproportionate share hospital (“DSH”) payments. DSH payments are determined annually based upon certain statistical information defined by CMS and are calculated as a percentage add-on to the MS-DRG payments. This percentage varies, depending on several factors that include the percentage of low-income patients served. CMS has recommended certain changes to the DSH formula, including a change that would give greater weight to the amount of uncompensated care provided by a hospital than it would to the number of low-income patients treated. During the years ended June 30, 2008 and 2009, we recognized $59.4 million and $53.4 million of Medicare DSH revenues, respectively.

        Direct Graduate and Indirect Medical Education. The Medicare program provides additional reimbursement to approved teaching hospitals for additional expenses incurred by such institutions. This additional reimbursement, which is subject to certain limits, including intern and resident full-time equivalent limits established in 1996, is made in the form of Direct Graduate Medical Education (“GME”) and Indirect Medical Education (“IME”) payments. During our fiscal year 2009, five of our hospitals were affiliated with academic institutions and received GME or IME payments.

        Medicare Outpatient Services Reimbursement

        CMS reimburses hospital outpatient services and certain Medicare Part B services furnished to hospital inpatients who have no Part A coverage on a prospective payment system basis. CMS utilizes existing fee schedules to pay for physical, occupational and speech therapies, durable medical equipment, clinical diagnostic laboratory services and nonimplantable orthotics and prosthetics. Freestanding surgery centers and independent diagnostic testing facilities also receive reimbursement from Medicare on a fee schedule basis.

        Those hospital outpatient services subject to prospective payment reimbursement are classified into groups called ambulatory payment classifications (“APCs”). Services in each APC are similar clinically and in terms of the resources they require. A payment rate is established for each APC. Depending upon the services provided, a hospital may be paid for more than one APC for a patient visit. CMS periodically updates the APCs and annually

15


adjusts the rates paid for each APC. As part of a final rule published in November 2007, CMS outlined the requirements for hospitals to submit quality data relating to outpatient care in order to receive the full market basket index increase starting in 2009. This rule required submission of seven quality measures in 2009 or else the market basket index increase would be reduced by two percentage points. We submitted the required quality data for 2009

        Rehabilitation Units

        CMS reimburses inpatient rehabilitation designated units pursuant to a prospective payment system. Under this prospective payment system, patients are classified into case mix groups based upon impairment, age, comorbidities and functional capability. Inpatient rehabilitation units are paid a predetermined amount per discharge that reflects the patient’s case mix group and is adjusted for area wage levels, low-income patients, rural areas and high-cost outliers. As of June 30, 2009, we operated three inpatient rehabilitation units within our acute care hospitals.

        Skilled Nursing Units

        From July 1998 to June 2002, Medicare phased in a prospective payment system for Medicare skilled nursing units, under which the units are paid a federal per diem rate for virtually all covered services. The effect of this new payment system generally has been to significantly reduce reimbursement for skilled nursing services, which has led many hospitals to close such units. We will monitor closely and evaluate the few remaining skilled nursing units in our hospitals and related facilities to determine whether it is feasible to continue to offer such services under this reimbursement system. As of June 30, 2009, we operated one skilled nursing unit within our acute care hospitals.

        Psychiatric Units

        Medicare utilizes a prospective payment system to pay inpatient psychiatric hospitals and units. This system is a per diem prospective payment system with adjustments to account for certain patient and facility characteristics. Additionally, this system includes a stop-loss provision, an “outlier” policy authorizing additional payments for extraordinarily costly cases and an adjustment to the base payment if the facility maintains a full-service emergency department which all of our units qualified for. As of June 30, 2009, we operated six even psychiatric units within our acute care hospitals.

        Annual Medicare Regulatory Update

        The annual Medicare regulatory update published by CMS on August 27, 2009 in the Federal Register provided for the following adjustments in Medicare reimbursement for the Medicare fiscal year 2010 (October 1, 2009 through September 30, 2010):

               •

 

A market basket index increase of 2.1% for MS-DRG operating payments for hospitals who reported the 43 patient quality care indicators from 2009 and 0.1% for those who did not (this compares to 3.6% for 2009 and 3.3% for 2008, both of which are subject to a 2.0% reduction for those hospitals who did not report the patient quality care indicators applicable to those years).

 

 

 

               •

 

No across-the-board reduction to the to the MS-DRG base payment rate to offset the effect of documentation and/or coding changes or the classification of discharges not related to case mix changes (2009 and 2008 included reductions of 0.9% and 0.6%, respectively). However, CMS will consider phasing in future adjustments over an extended period beginning in fiscal 2011.

 

 

 

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Continuation of the capital indirect medical adjustment to payment rates for teaching hospitals.

 

 

 

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Continuation of a provision of the Deficit Reduction Act of 2005 that precludes hospitals from receiving additional payments to treat costs associated with 10 specifically identified  patient hospital-acquired conditions including infections (the same 10 identified conditions as for 2009, but compares to 8 identified conditions for 2008).

 

 

 

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An increase in the inpatient cost outlier threshold to $23,140 from $20,045 in 2009 and $22,185 in 2008.

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An increase in the capital federal MS-DRG rate of 1.4% (compares to a 1.9% increase for federal fiscal year 2009).

 

 

 

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A market basket increase of 2.2% for hospital skilled nursing unit payment rates (this compares to 3.4% for 2009 and 3.3% for 2008).

 

 

 

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A market basket increase of 2.5% for hospital rehabilitation unit payment rates (this compares to 0% for both 2009 and 2008).

        We have submitted the required patient care quality indicators for our hospitals to receive the full market basket index increases for the both the inpatient and outpatient prospective payment systems for 2009. We intend to submit the necessary information to realize the full federal fiscal year 2010 inpatient and outpatient increases as well. However, as additional patient quality indicator reporting requirements are added, system limitations or other difficulties could result in CMS deeming our submissions not timely or not complete to qualify for the full market basket index increases. Additionally, Congress has given CMS the ability to continue to evaluate whether the 2008 and 2009 inpatient reductions for documentation and coding adjustments were sufficient to account for payment changes not related to case mix changes. This continuing evaluation could negatively impact MS-DRG payment rates for federal fiscal years 2011 and 2012. Further realignments in the MS-DRG system could also reduce the payments we receive for certain specialties, including cardiology and orthopedics. The more widespread development of specialty hospitals in recent years has caused CMS to focus on payment levels for these specialty services. Changes in the payments for specialty services could adversely impact our revenues. We do not believe that the final Medicare payment updates for federal fiscal year 2010 will have a significant impact on our future financial position, results of operations or cash flows.

        Contractor Reform

        CMS has a significant initiative underway that could affect the administration of the Medicare program and impact how hospitals bill and receive payment for covered Medicare services. In accordance with the Medicare Modernization Act (“MMA”), CMS has begun implementation of contractor reform whereby CMS will competitively bid the Medicare fiscal intermediary and Medicare carrier functions to 15 Medicare Administrative Contractors (“MACs”). Hospital management companies like Vanguard will have the option to work with the selected MAC in the jurisdiction where a given hospital is located or to use the MAC in the jurisdiction where our home office is located. For hospital management companies, either all hospitals in the system must choose to stay with the MAC chosen for their locality or all hospitals must opt to use the home office MAC. We have filed a request for our single home office MAC to serve all of our hospitals. CMS has now completed the process of awarding contracts for all 15 MAC jurisdictions. Individual MAC jurisdictions are in varying phases of transition. All of these changes could impact claims processing functions and the resulting cash flows; however, we are unable to predict the impact that these changes could have, if any, to our cash flows.

        Recovery Audit Contractors

        The MMA established the Recovery Audit Contractor (“RAC”) three-year demonstration program to detect Medicare overpayments not identified through existing claims review mechanisms. The RAC program relies on private auditing firms to examine Medicare claims filed by healthcare providers. Fees to the RACs are paid on a contingency basis. The RAC program began as a demonstration project in 2005 in three states (New York, California and Florida) which was expanded into the three additional states of Arizona, Massachusetts and South Carolina in July 2007. No RAC audits, however, were initiated at our Arizona or Massachusetts hospitals during the demonstration project. The program was made permanent by the Tax Relief and Health Care Act of 2006 enacted in December 2006. CMS ended the demonstration project in March 2008 and commenced the permanent RAC program in all states beginning in 2009 with plans to have RACs in full operation in all 50 states by 2010.

        In a report issued in July 2008, CMS reported that the RACs in the demonstration project corrected over $1 billion of Medicare improper payments from 2005 through March 2008. Roughly 96% of the improper payments ($992.7 million) were overpayments collected from providers, while the remaining 4% ($37.8 million) were underpayments repaid to providers. Of the overpayments, 85% were collected from inpatient hospital providers,

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while the other principal collections were 6% from inpatient rehabilitation facilities, and 4% from outpatient hospital providers.

        RACs utilize a post-payment targeted review process employing data analysis techniques in order to identify those Medicare claims most likely to contain overpayments, such as incorrectly coded services, incorrect payment amounts, non-covered services and duplicate payments. The RAC review is either “automated”, for which a decision can be made without reviewing a medical record, or “complex”, for which the RAC must contact the provider in order to procure and review the medical record to make a decision about the payment. CMS has given RACs the authority to look back at claims up to three years old, provided that the claim was paid on or after October 1, 2007. Claims identified as overpayments will be subject to the Medicare appeals process.

                As to “automated” reviews where a review of the medical record is not required, RACs make claim determinations using proprietary software designed to detect certain kinds of errors where both of the following conditions must apply. First, there must be certainty that the service is not covered or is coded incorrectly. Second, there must be a written Medicare policy, Medicare article or Medicare-sanctioned coding guideline supporting the determination. For example, an automated review could identify when a provider is billing for more units than allowed on one day. However, the RAC may also use automated review even if such written policies don’t exist on certain CMS-approved “clinically unbelievable issues” and when making certain other types of administrative determinations (e.g., duplicate claims, pricing mistakes) when there is certainty that an error exists.

        As to “complex” reviews where a review of the medical review is required, RACs make claim determinations when there is a high probability (but not certainty) that a service is not covered, or where no Medicare policy, guidance or Medicare-sanctioned coding guideline exists. It is expected that many complex reviews will be medical necessity audits that assess whether care provided was medically necessary and provided in the appropriate setting. It is currently expected that, while RACs will make complex reviews in calendar year 2009 related to DRG validation and coding, the RACs will not conduct complex reviews for medical necessity cases until calendar year 2010.

        RACs are paid a contingency fee based on the overpayments they identify and collect. Therefore, we expect that the RACs will look very closely at claims submitted by our facilities in an attempt to identify possible overpayments. We believe the claims for reimbursement submitted to the Medicare program by our facilities have been accurate. However, we cannot predict, once our facilities are subject to RAC reviews in all subject matters in the future, the results of such reviews. It is reasonably possible that the aggregate payments that our facilities will be required to return to the Medicare program pursuant to these RAC reviews may have a material adverse effect on our financial position, results of operations or cash flows.

       Managed Medicare

        Managed Medicare plans represent arrangements where a private company contracts with CMS to provide members with Medicare Part A, Part B and Part D benefits. Managed Medicare plans can be structured as health maintenance organizations, preferred provider organizations or private fee-for-service plans. The Medicare program allows beneficiaries to choose enrollment in certain managed Medicare care plans. MMA increased reimbursement to managed Medicare plans and included provisions limiting, to some extent, the financial risk to the companies offering the plans. Following these changes, the number of beneficiaries choosing to receive their Medicare benefits through such plans increased significantly. However, the Medicare Improvement for Patients and Providers Act of 2008 reduced payments to managed Medicare plans, and CMS has recently proposed additional payment cuts to managed Medicare plans. Future changes may result in reduced premium payments to managed Medicare plans and may lead to decreased enrollment in such plans.

        Medicaid

        Medicaid programs are funded jointly by the federal government and the states and are administered by states under approved plans. Most state Medicaid program payments are made under a prospective payment system or are based on negotiated payment levels with individual hospitals. Medicaid reimbursement is less than Medicare reimbursement for the same services and is often less than a hospital’s cost of services. The federal government and many states have recently reduced or are currently considering legislation to reduce the level of Medicaid funding

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(including upper payment limits) or program eligibility that could adversely affect future levels of Medicaid reimbursement received by our hospitals. As permitted by law, certain states in which we operate have adopted broad-based provider taxes to fund their Medicaid programs. Since states must operate with balanced budgets and since the Medicaid program is often the state’s largest program, states may consider further reductions in their Medicaid expenditures.

        As to recent federal action affecting Medicaid, the Deficit Reduction Act of 2005 (“DRA 2005”) included Medicaid cuts in federal funding of approximately $4.8 billion over five years. Additionally, on May 29, 2007, CMS published a final rule entitled “Medicaid Program; Cost Limit for Providers Operated by Units of Government and Provisions to Ensure the Integrity of Federal-State Financial Partnership” which was estimated to reduce federal Medicaid funding from $12 to $20 billion over five years. Congress enacted two moratoria in respect of this rule that delayed six of the seven proposed Medicaid regulations in this final CMS rule until July 1, 2009. On June 30, 2009, three more of the Medicaid regulations that had been under a congressional moratorium set to expire July 1, 2009 were officially rescinded all or in part by CMS, and CMS also delayed until June 30, 2010 the enforcement of the fourth of the six regulations. As a result of these changes in implementing the final CMS 2007 rule, the impact on us of the final rule can not be quantified.

        Disproportionate Share Payments

        Certain states in which we operate provide disproportionate share payments to hospitals that treat a disproportionately large number of low-income patients as part of their state Medicaid programs, similar to disproportionate share payments received from Medicare. During the years ended June 30, 2008 and 2009, we recognized revenues of approximately $20.2 million and $26.0 million, respectively, related to Medicaid disproportionate share reimbursement payments. These amounts do not include our revenues recognized from payments related to the Texas UPL program and the Illinois PTA program, which totaled $44.4 million during fiscal 2009, since these programs are separate from DSH. These states continually assess the level of expenditures for disproportionate share reimbursement and may reduce these payments or restructure this portion of their Medicaid programs.

        Given the recent budgetary challenges that most states faced (including those in which we operate) for their new fiscal years, it is reasonable to believe that Medicaid payment rates, coverage levels or patient eligibility could be reduced in future periods as new tax collections data is received. Such legislation could also include taxes assessed on hospitals to help fund or expand the states’ Medicaid programs or else to balance their general budgets. Future federal or state legislation or other changes in the administration or interpretation of government health programs by the federal government or by the states in which we operate could have a material, adverse effect on our financial position, results of operations and cash flows.

       Managed Medicaid

        Managed Medicaid programs represent arrangements where states contract with one or more entities for patient enrollment, care management and claims adjudication for enrollees in their state Medicaid programs. The states usually do not give up program responsibilities for financing, eligibility criteria and core benefit plan design. We generally contract directly with one of the designated entities, usually a managed care organization. The provisions of these programs are state-specific.

        Annual Cost Reports

        All hospitals participating in the Medicare and Medicaid programs are required to meet specific financial reporting requirements. Federal and, where applicable, state regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients. Moreover, annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. The audit process takes several years to reach the final determination of allowable amounts under the programs. Providers also have the right of appeal, and it is common to contest issues raised in audits of prior years’ reports.

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        Many prior year cost reports of our facilities are still open. If any of our facilities are found to have been in violation of federal or state laws relating to preparing and filing of Medicare or Medicaid cost reports, whether prior to or after our ownership of these facilities, we and our facilities could be subject to substantial monetary fines, civil and criminal penalties and exclusion from participation in the Medicare and Medicaid programs. If an allegation is lodged against one of our facilities for a violation occurring during the time period before we acquired the facility, we may have indemnification rights against the seller of the facility to us. In each of our acquisitions, we have negotiated customary indemnification and hold harmless provisions for any damages we may incur in these areas.

        Managed Care and Other Private Insurers

        Managed care providers, including health maintenance organizations, preferred provider organizations, other private insurance companies and employers, are organizations that provide insurance coverage and a network of healthcare providers to members for a fixed monthly premium. To attract additional volume, most of our hospitals offer discounts from established charges or prospective payment systems to these large group purchasers of healthcare services. These discount programs often limit our ability to increase charges in response to increasing costs. However, as part of our business strategy, we have been able to renegotiate payment rates on many of our managed care contracts to improve our operating margin. While we generally received annual average payment rate increases of 5 to 11 percent from non-governmental managed care payers during fiscal year 2009, there can be no assurance that we will continue to receive increases in the future and that patient volumes from these payers will not be adversely affected by rate negotiations. These contracts often contain exclusions, carve-outs, performance criteria and other provisions and guidelines that require our constant focus and attention. Patients who are members of managed care plans are not required to pay us for their healthcare services except for coinsurance and deductible portions of their plan coverage calculated after managed care discounts have been applied. While the majority of our admissions and revenues are generated from patients covered by managed care plans, the percentage may decrease in the future due to increased Medicare utilization associated with the aging U.S. population. We experienced a slight decrease in managed care utilization of inpatient days as a percentage of total inpatient days during the year ended June 30, 2009 compared to the year ended June 30, 2008.

       Self-Pay Patients

        Self-pay patients are patients who do not qualify for government programs payments, such as Medicare and Medicaid, who do not qualify for charity care under our guidelines and who do not have some form of private insurance. These patients are responsible for their own medical bills. We also include in our self-pay accounts those unpaid coinsurance and deductible amounts for which payment has been received from the primary payer.

        Effective for service dates on or after April 1, 2009, as a result of a state mandate, we implemented a new uninsured discount policy for those patients receiving services in our Illinois hospitals who had no insurance coverage and who did not otherwise qualify for charity care under our guidelines. Under this policy, we apply an uninsured discount (calculated as a standard percentage of gross charges) at the time of patient billing and include this discount as a reduction to patient service revenues. These discounts were approximately $11.7 million for the year ended June 30, 2009. We implemented this policy for most of our remaining facilities effective July 1, 2009 and expect to implement it at all of our facilities by the end of our fiscal year 2010.

        A significant portion of our self-pay patients are admitted through our hospitals' emergency departments and often require high-acuity treatment. High-acuity treatment is more costly to provide and, therefore, results in higher billings, which are the least collectible of all accounts. We believe self-pay patient volumes and revenues have been impacted during the last two years due to a combination of broad economic factors, including reductions in state Medicaid budgets, increasing numbers of individuals and employers who choose not to purchase insurance and an increased burden of coinsurance and deductibles to be made by patients instead of insurers.

        Self-pay accounts pose significant collectibility problems. At June 30, 2009, approximately 24.5% of our accounts receivable, prior to the allowance for doubtful accounts, contractual allowances and the charity care allowance, was comprised of self-pay accounts. The majority of our provision for doubtful accounts relates to self-pay patients. While our combined allowances for doubtful accounts, uninsured discounts and charity care cover over 96% of our self-pay receivables, we remain vulnerable to further increased self-pay utilization. We are taking multiple actions in an effort to mitigate the effect on us of the high number of uninsured patients and the related

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economic impact. These initiatives include conducting detailed reviews of intake procedures in hospitals facing the greatest pressures and applying these intake best practices to all of our hospitals. We developed hospital-specific reports detailing collection rates by type of patient to help the hospital management teams better identify areas of vulnerability and opportunities for improvement. Also, we completely redesigned our self-pay collection workflows, enhanced technology and improved staff training in an effort to increase collections.

        We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We exclude charity care accounts from revenues when we determine that the account meets our charity care guidelines.  We provide expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. During our fiscal years ended June 30, 2007, 2008 and 2009, we deducted $86.1 million, $86.1 million and $91.8 million of charity care from gross charges, respectively.

        Other Reimbursement Regulatory and Legislative Changes

        Other regulatory and legislative actions that impact or may have a future impact on Medicare or Medicaid reimbursement are set forth below.

       •

 

CMS Medicare Value-Based Purchasing Program Report – Congress, through DRA 2005, authorized the Secretary of Health and Human Services to develop a plan to implement value-based purchasing (“VBP”). In November 2007, CMS issued a report to Congress with its plan to implement a VBP program that would transform Medicare from a passive payer of claims to an active purchaser of care. Under this proposal, its VBP program would make a portion of hospital payments contingent on actual performance under specified standards rather than simply on the hospital’s reporting data for those measures. We can not predict what action Congress will ultimately take regarding implementation of a VBP program at this time.

 

 

 

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Medicare regulation of serious medical errors – In an effort to encourage hospitals to improve quality of care, the Medicare program and certain state Medicaid programs have taken steps to withhold payments to hospitals for treatment provided to patients whose conditions were caused by serious medical error. Effective October 1, 2008, Medicare will no longer pay hospitals for the additional costs of care resulting from eight medical events such as patient falls, objects left inside patients during surgery, pressure ulcers, and certain types of infections. Certain states have established policies or proposed legislation to prohibit hospitals from charging or receiving payments from their Medicaid programs for highly preventable adverse medical events (often called “never events”), which were developed by the National Quality Forum. Never events include wrong-site surgery, serious medication errors, discharging a baby to the wrong mother, etc.

 

 

 

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SCHIP Extension Act of 2007 – The State Children’s Health Insurance Program (“SCHIP”) provides health insurance coverage for poor children. SCHIP is jointly funded by the federal government and state governments but is administered and designed by the states. SCHIP provided a capped amount of funds to states on a matching basis through September 30, 2007, when it expired. SCHIP funding was extended through March 31, 2009 by a law signed in December 2007. President Obama signed the State Children’s Insurance Program bill in February 2009, which extends SCHIP by 4.5 years and expands the program to an additional 4.5 million children.

 

 

 

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The American Recovery and Reinvestment Act of 2009 – In February 2009, President Obama signed the American Recovery and Reinvestment Act of 2009 into law. The $787 billion economic stimulus plan includes certain measures affecting medical providers including: $21 billion in health insurance assistance that includes COBRA continuation coverage for unemployed workers; a freeze until September 30, 2009 of the final rule phasing out Medicare IME capital payments; $86.7 billion for a temporary (27-month) increase in the rate at which the federal government matches states’ Medicaid expenditures and a 2.5% increase in the states’ fiscal year 2009 and 2010 DSH payments (with 2010’s 2.5% increase being above the new 2009 payment), but will revert to 100% of the annual DSH allotments under current law after 2010; and $31 billion in new spending on health information technology, most of which is for incentive

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payments to physicians and hospitals and $2 billion for health information technology grants.

        We can not predict what impact these measures will have on our future results of operations or cash flows at this time.

Government Regulation and Other Factors

        Overview

        All participants in the healthcare industry are required to comply with extensive government regulation at the federal, state and local levels. In addition, these laws, rules and regulations are extremely complex and the healthcare industry has had the benefit of little or no regulatory or judicial interpretation of many of them. Although we believe we are in compliance in all material respects with such laws, rules and regulations, if a determination is made that we were in material violation of such laws, rules or regulations, our business, financial condition or results of operations could be materially adversely affected. If we fail to comply with applicable laws and regulations, we can be subject to criminal penalties and civil sanctions, our hospitals can lose their licenses and their ability to participate in the Medicare and Medicaid programs.

       Licensing, Certification and Accreditation

        Healthcare facility construction and operation is subject to federal, state and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, rate-setting and compliance with building codes and environmental protection laws. Our facilities also are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation. We believe that all of our operating healthcare facilities are properly licensed under appropriate state healthcare laws.

        All of our operating hospitals are certified under the Medicare program and are accredited by The Joint Commission (formerly, known as The Joint Commission on Accreditation of Healthcare Organizations), the effect of which is to permit the facilities to participate in the Medicare and Medicaid programs. If any facility loses its accreditation by The Joint Commission, or otherwise loses its certification under the Medicare program, then the facility will be unable to receive reimbursement from the Medicare and Medicaid programs. We intend to conduct our operations in compliance with current applicable federal, state, local and independent review body regulations and standards. The requirements for licensure, certification and accreditation are subject to change and, in order to remain qualified, we may need to make changes in our facilities, equipment, personnel and services.

       Certificates of Need

        In some states, the construction of new facilities, acquisition of existing facilities or addition of new beds or services may be subject to review by state regulatory agencies under a Certificate of Need program. Illinois and Massachusetts are the only states in which we currently operate that require approval under a Certificate of Need program. These laws generally require appropriate state agency determination of public need and approval prior to the addition of beds or services or other capital expenditures. Failure to obtain necessary state approval can result in the inability to expand facilities, add services, acquire a facility or change ownership. Further, violation of such laws may result in the imposition of civil sanctions or the revocation of a facility’s license.

       Utilization Review

        Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of diagnosis related group classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department of Health and Human Services that a provider not in substantial compliance with the standards of the quality improvement

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organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.

       Federal Healthcare Program Statutes and Regulations

        Participation in any federal healthcare program, such as the Medicare and Medicaid programs, is regulated heavily by statute and regulation. If a hospital provider fails to substantially comply with the numerous conditions of participation in the Medicare or Medicaid program or performs specific prohibited acts, the hospital’s participation in the Medicare program may be terminated or civil or criminal penalties may be imposed upon it under provisions of the Social Security Act and other statutes.

        Anti-Kickback Statute

        A section of the Social Security Act known as the federal Anti-Kickback Statute prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent of generating referrals or orders for services or items covered by a federal healthcare program. Violation of this statute is a felony, including criminal penalties of imprisonment or criminal fines up to $25,000 for each violation, but it also includes civil money penalties of up to $50,000 per violation, damages up to three times the total amount of the improper payment to the referral source and exclusion from participation in Medicare, Medicaid or other federal healthcare programs.

        The Office of the Inspector General of the Department of Health and Human Services (the “OIG”) has published final safe harbor regulations that outline categories of activities that are deemed protected from prosecution under the Anti-Kickback Statute. Currently there are safe harbors for various activities, including the following: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, ambulatory surgery centers and referral agreements for specialty services.

        The fact that conduct or a business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the Anti-Kickback Statute. The conduct or business arrangement, however, does increase the risk of scrutiny by government enforcement authorities. We may be less willing than some of our competitors to take actions or enter into business arrangements that do not clearly satisfy the safe harbors. As a result, this unwillingness may put us at a competitive disadvantage.

        The OIG, among other regulatory agencies, is responsible for identifying and eliminating fraud, abuse and waste. The OIG carries out this mission through a nationwide program of audits, investigations and inspections. In order to provide guidance to healthcare providers, the OIG has from time to time issued “fraud alerts” that, although they do not have the force of law, identify features of a transaction that may indicate that the transaction could violate the Anti-Kickback Statute or other federal healthcare laws. The OIG has identified several incentive arrangements as potential violations, including:

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payment of any incentive by the hospital when a physician refers a patient to the hospital;

 

 

 

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use of free or significantly discounted office space or equipment for physicians in facilities usually located close to the hospital;

 

 

 

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provision of free or significantly discounted billing, nursing or other staff services;

 

 

 

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free training for a physician’s office staff, including management and laboratory techniques;

 

 

 

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guarantees that provide that, if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder;

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low-interest or interest-free loans, or loans which may be forgiven if a physician refers patients to the hospital;

 

 

 

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payment of the costs of a physician’s travel and expenses for conferences or a physician’s continuing education courses;

 

 

 

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coverage on the hospital’s group health insurance plans at an inappropriately low cost to the physician;

 

 

 

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rental of space in physician offices, at other than fair market value terms, by persons or entities to which physicians refer;

 

 

 

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payment of services which require few, if any, substantive duties by the physician, or payment for services in excess of the fair market value of the services rendered; or

 

 

 

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“gain sharing,” the practice of giving physicians a share of any reduction in a hospital’s costs for patient care attributable in part to the physician’s efforts.

Also, the OIG has encouraged persons having information about hospitals who offer the above types of incentives to physicians to report such information to the OIG.

        The OIG also issues “Special Advisory Bulletins” as a means of providing guidance to healthcare providers. These bulletins, along with other “fraud alerts”, have focused on certain arrangements between physicians and providers that could be subject to heightened scrutiny by government enforcement authorities, including, “suspect” joint ventures where physicians may become investors with the provider in a newly formed joint venture entity where the investors refer their  patients to this new entity, and are paid by the entity in the form of “profit distributions.” These subject joint ventures may be intended not so much to raise investment capital legitimately to start a  business, but to lock up a stream of referrals from the physician  investors and to compensate them indirectly for these referrals.  Because physician investors can benefit financially from their referrals, unnecessary procedures and tests may be ordered or performed, resulting in unnecessary Medicare expenditures.

        Similarly, in a Special Advisory Bulletin issued in April 2003, the OIG focused on “questionable” contractual arrangements where a healthcare provider in one line of business (the “Owner”) expands into a related healthcare business by contracting with an existing provider of a related item or service (the “Manager/Supplier”) to provide the new item or service to the Owner’s existing patient population, including federal healthcare program patients (so called “suspect Contractual Joint Ventures”). The Manager/Supplier not only manages the new line of business, but may also supply it with inventory, employees, space, billing, and other services. In other words, the Owner contracts out substantially the entire operation of the related line of business to the Manager/Supplier – otherwise a potential competitor – receiving in return the profits of the business as remuneration for its federal program referrals. The Bulletin lists the following features of these “questionable” contractual relationships. First, the Owner expands into a related line of business, which is dependent on referrals from, or other business generated by, the Owner’s existing business. Second, the Owner neither operates the new business itself nor commits substantial financial, capital or human resources to the venture. Instead, it contracts out substantially all the operations of the new business. The Manager/Supplier typically agrees to provide not only management services, but also a range of other services, such as the inventory necessary to run the business, office and healthcare personnel, billing support, and space. Third, the Manager/Supplier is an established provider of the same services as the Owner’s new line of business. In other words, absent the contractual arrangement, the Manager/Supplier would be a competitor of the new line of business, providing items and services in its own right, billing insurers and patients in its own name, and collecting reimbursement. Fourth, the Owner and the Manager/Supplier share in the economic benefit of the Owner’s new business. The Manager/Supplier takes its share in the form of payments under the various contracts with the Owner; the Owner receives its share in the form of the residual profit from the new business. Fifth, aggregate payments to the Manager/Supplier typically vary with the value or volume of business generated for the new business by the Owner. We monitor carefully our contracts with other healthcare providers and attempt to not allow our facilities to enter into these suspect Contractual Joint Ventures.

        In addition to issuing fraud alerts and Special Advisory Bulletins, the OIG from time to time issues compliance program guidance for certain types of healthcare providers. In January 2005, the OIG published a Supplemental

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Compliance Guidance for Hospitals, supplementing its 1998 guidance for the hospital industry. In the supplemental guidance, the OIG identifies a number of risk areas under federal fraud and abuse statutes and regulations. These areas of risk include compensation arrangements with physicians, recruitment arrangements with physicians and joint venture relationships with physicians.

        We have a variety of financial relationships with physicians who refer patients to our hospitals. As of June 30, 2009, physicians owned interests in two of our free-standing surgery centers in California and seven of our diagnostic imaging centers in Texas. We may sell ownership interests in certain other of our facilities to physicians and other qualified investors in the future. We also have contracts with physicians providing for a variety of financial arrangements, including employment contracts, leases and professional service agreements. We have provided financial incentives to recruit physicians to relocate to communities served by our hospitals, including income and collection guarantees and reimbursement of relocation costs, and will continue to provide recruitment packages in the future. Although we have established policies and procedures to ensure that our arrangements with physicians comply with current law and applicable regulations, we cannot assure you that regulatory authorities that enforce these laws will not determine that some of these arrangements violate the Anti-Kickback Statute or other applicable laws. An adverse determination could subject us to liabilities under the Social Security Act, including criminal penalties, civil monetary penalties and exclusion from participation in Medicare, Medicaid or other federal healthcare programs, any of which could have a material adverse effect in our business, financial condition or results of operations.

        Other Fraud and Abuse Provisions

        The Social Security Act also imposes criminal and civil penalties for submitting false claims to Medicare and Medicaid. False claims include, but are not limited to, billing for services not rendered, misrepresenting actual services rendered in order to obtain higher reimbursement and cost report fraud. Like the Anti-Kickback Statute, these provisions are very broad. Further, the Social Security Act contains civil penalties for conduct including improper coding and billing for unnecessary goods and services. Careful and accurate preparation and submission of claims for reimbursement must be performed in order to avoid liability.

        The Health Insurance Portability and Accountability Act of 1996 broadened the scope of the fraud and abuse laws by adding several criminal provisions for healthcare fraud offenses that apply to all health benefit programs. This Act also created new enforcement mechanisms to combat fraud and abuse, including the Medicaid Integrity Program and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. In addition, federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers and managing employees associated with business entities that have committed healthcare fraud. Additionally, this Act establishes a violation for the payment of inducements to Medicare or Medicaid beneficiaries in order to influence those beneficiaries to order or receive services from a particular provider or practitioner.

        Some of these provisions, including the federal Civil Monetary Penalty Law, require a lower burden of proof than other fraud and abuse laws, including the Anti-kickback Statute. Civil monetary penalties that may be imposed under the federal Civil Monetary Penalty Law range from $10,000 to $50,000 per act, and in some cases may result in penalties of up to three times the remuneration offered, paid, solicited or received. In addition, a violator may be subject to exclusion from federal and state healthcare programs. Federal and state governments increasingly use the federal Civil Monetary Penalty Law, especially where they believe they cannot meet the higher burden of proof requirements under the Anti-kickback Statute.

        The Stark Law

        The Social Security Act also includes a provision commonly known as the “Stark Law.” This law prohibits physicians from referring Medicare and (to an extent) Medicaid patients to entities with which they or any of their immediate family members have a financial relationship for the provision of certain designated health services that are reimbursable by Medicare or Medicaid, including inpatient and outpatient hospital services. The law also prohibits the entity from billing the Medicare program for any items or services that stem from a prohibited referral. Sanctions for violating the Stark Law include denial of payment, refunding amounts received for services provided pursuant to prohibited referrals, civil money penalties up to $15,000 per item or service improperly billed and

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exclusion from the federal healthcare programs. The statute also provides for a penalty of up to $100,000 for a circumvention scheme. There are a number of exceptions to the self-referral prohibition, including an exception for a physician’s ownership interest in an entire hospital as opposed to an ownership interest in a hospital department although pending legislation in Congress would substantially restrict this “entire hospital” exception. There are also exceptions for many of the customary financial arrangements between physicians and providers, including employment contracts, leases, professional services agreements, non-cash gifts having an annual value of no more than $355 in calendar 2009 and recruitment agreements. Unlike safe harbors under the Anti-kickback Statute with which compliance is voluntary, an arrangement must comply with every requirement of a Stark Law exception or the arrangement is in violation of the Stark Law.

        CMS has issued three phases of final regulations implementing the Stark Law, which became effective on January 4, 2002, July 26, 2004 and December 4, 2007, respectively, and which created several additional exceptions and many technical changes and nuanced details. Also, as part of its annual physician fee schedule update, on July 2, 2007, CMS released a number of proposed and potentially far-reaching changes to the Stark Law regulations apparently resulting from CMS’s frustration with what it perceived as a growing number of hospital/physician joint venture arrangements that permitted physicians to profit from their referrals of ancillary services, while side-stepping or working around existing Stark Law restrictions. On July 31, 2008, CMS issued the final hospital inpatient prospective payment system rule for federal fiscal year 2009 which, in part, finalized and responded to public comments regarding some of its July 2007 proposed major changes to the Stark Law regulations to undermine many common hospital/physician joint venture models. The most far-reaching of the changes made in this final July 2008 rule will effectively prohibit, as of a delayed effective date of October 1, 2009, both "under arrangements" ventures between a hospital and any of its physicians and unit-of-service-based "per click" compensation and percentage-based compensation in office space and equipment leases between a hospital and its physicians. We have examined all of our “under arrangements” ventures and space and equipment leases with physicians to identify those arrangements which potentially violate these new Stark regulations, and we are in the process of restructuring or terminating non-conforming arrangements so identified prior to October 1, 2009.

        Because the Stark Law and its implementing regulations are relatively new, we do not always have the benefit of significant regulatory or judicial interpretation of this law and its regulations. We attempt to structure our relationships to meet an exception to the Stark Law, but the regulations implementing the exceptions are detailed and complex, and we cannot assure that every relationship complies fully with the Stark Law. In addition, in the July 2008 final Stark rule CMS indicated that it will continue to enact further regulations tightening aspects of the Stark Law that it perceives allow for Medicare program abuse, especially those regulations that still permit physicians to profit from their referrals of ancillary services. There can be no assurance that the arrangements entered into by us and our facilities with physicians will be found to be in compliance with the Stark Law, as it ultimately may be implemented or interpreted.

        Similar State Laws, etc.

        Many of the states in which we operate also have adopted laws that prohibit payments to physicians in exchange for referrals similar to the federal Anti-Kickback Statute or that otherwise prohibit fraud and abuse activities. Many states also have passed self-referral legislation, similar to the Stark Law, prohibiting the referral of patients to entities with which the physician has a financial relationship. Often these state laws are broad in scope and they may apply regardless of the source of payment for care. These statutes typically provide criminal and civil penalties, as well as loss of licensure. Little precedent exists for the interpretation or enforcement of these state laws.

        Certain Implications of these Fraud and Abuse Laws or New Laws

        Our operations could be adversely affected by the failure of our arrangements to comply with the Anti-Kickback Statute, the Stark Law, billing laws and regulations, current state laws or other legislation or regulations in these areas adopted in the future. We are unable to predict whether other legislation or regulations at the federal or state level in any of these areas will be adopted, what form such legislation or regulations may take or how they may impact our operations. We are continuing to enter into new financial arrangements with physicians and other providers in a manner structured to comply in all material respects with these laws. We cannot assure you, however, that governmental officials responsible for enforcing these laws will not assert that we are in violation of them or

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that such statutes or regulations ultimately will be interpreted by the courts in a manner consistent with our interpretation.

       The Federal False Claims Act and Similar Laws

        Another trend affecting the healthcare industry today is the increased use of the federal False Claims Act, and, in particular, actions being brought by individuals on the government’s behalf under the False Claims Act’s “qui tam” or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. If the government intervenes in the action and prevails, the party filing the initial complaint may share in any settlement or judgment. If the government does not intervene in the action, the whistleblower plaintiff may pursue the action independently, and may receive a larger share of any settlement or judgment. When a private party brings a qui tam action under the False Claims Act, the defendant generally will not be made aware of the lawsuit until the government makes a determination whether it will intervene.

        When a defendant is determined by a court of law to be liable under the False Claims Act, the defendant must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 to $11,000 for each separate false claim. Settlements entered into prior to litigation usually involve a less severe calculation of damages. There are many potential bases for liability under the False Claims Act. Although liability often arises when an entity knowingly submits a false claim for reimbursement to the federal government, the False Claims Act defines the term “knowingly” broadly. Thus, simple negligence will not give rise to liability under the False Claims Act, but submitting a claim with reckless disregard to its truth or falsity can constitute “knowingly” submitting a false claim and result in liability. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the Anti-Kickback Statute or the Stark Law, have thereby submitted false claims under the False Claims Act.

        A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. From time to time, companies in the healthcare industry, including ours, may be subject to actions under the False Claims Act or similar state laws.

        Provisions in the Deficit Reduction Act of 2005 (“DRA”) that went into effect on January 1, 2007 give states significant financial incentives to enact false claims laws modeled on the federal False Claims Act. Additionally, the DRA requires every entity that receives annual payments of at least $5 million from a state Medicaid plan to establish written policies for its employees that provide detailed information about federal and state false claims statutes and the whistleblower protections that exist under those laws. Both provisions of the DRA are expected to result in increased false claims litigation against health care providers. We have complied with the written policy requirements.

       Corporate Practice of Medicine and Fee Splitting

        The states in which we operate have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians or laws that prohibit certain direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements that may violate these restrictions. These statutes vary from state to state, are often vague and seldom have been interpreted by the courts or regulatory agencies. Although we exercise care to structure our arrangements with healthcare providers to comply with the relevant state law, and believe these arrangements comply with applicable laws in all material respects, we cannot assure you that governmental officials responsible for enforcing these laws will not assert that we, or transactions in which we are involved, are in violation of such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretations.

       The Health Insurance Portability and Accountability Act of 1996

        The Administrative Simplification Provisions of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) require the use of uniform electronic data transmission standards for healthcare claims and

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payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce in the healthcare industry. The Department of Health and Human Services (“HHS”) has issued regulations implementing the HIPAA Administrative Simplification Provisions and compliance with these regulations is mandatory for our facilities. In January 2009, CMS published a final rule regarding updated standard code sets for certain diagnoses and procedures known as ICD-10 code sets and related changes to the formats used for certain electronic transactions. While use of the ICD-10 code sets is not mandatory until October 1, 2013, we will be modifying our payment systems and processes to prepare for the implementation. In addition, HIPAA requires that each provider use a National Provider Identifier. While use of the ICD-10 code sets will require significant administrative changes, we believe that the cost of compliance with these regulations has not had and is not expected to have a material, adverse effect on our business, financial position or results of operations.

        The privacy and security regulations promulgated pursuant to HIPAA extensively regulate the use and disclosure of individually identifiable health information and require covered entities, including our hospitals and health plans, to implement administrative, physical and technical safeguards to protect the security of such information. Recently, the American Recovery and Reinvestment Act of 2009 (“ARRA”) broadened the scope of the HIPAA privacy and security regulations. Among other things, the ARRA provides that HHS must issue regulations requiring covered entities to report certain security breaches to individuals affected by the breach and, in some cases, to HHS or to the public via a website. This reporting obligation will apply broadly to breaches involving unsecured protected health information and will become effective 30 days from the date HHS issues these regulations. In addition, the ARRA extends the application of certain provisions of the security and privacy regulations to business associates (entities that handle identifiable health information on behalf of covered entities) and subjects business associates to civil and criminal penalties for violation of the regulations.

        Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties, and the ARRA has strengthened the enforcement provisions of HIPAA, which may result in increased enforcement activity. Under the ARRA, HHS is required to conduct periodic compliance audits of covered entities and their business associates. The ARRA broadens the applicability of the criminal penalty provisions to employees of covered entities and requires HHS to impose penalties for violations resulting from willful neglect. The ARRA also significantly increases the amount of the civil penalties, with penalties of up to $50,000 per violation for a maximum civil penalty of $1,500,000 in a calendar year for violations of the same requirement. In addition, the ARRA authorizes state attorneys general to bring civil actions seeking either injunction or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.

        In addition, we remain subject to any state laws that relate to privacy or the reporting of security breaches that are more restrictive than the regulations issued under HIPAA and the requirements of the ARRA. For example, various state laws and regulations may require us to notify affected individuals in the event of a data breach involving certain individually identifiable health or financial information. In addition, the Federal Trade Commission has issued regulations requiring health providers and health plans to implement by May 1, 2009 written identity theft prevention programs to detect, prevent, and mitigate identity theft in connection with certain accounts.  We have complied with these new Federal Trade Commission regulations requiring identity theft prevention programs in all of our hospitals and health plans.

        Compliance with these standards has and will continue to require significant commitment and action by us and significant costs. We have appointed members of our management team to direct our compliance with these standards. Implementation has and will continue to require us to engage in extensive preparation and make significant expenditures. At this time we have appointed a corporate privacy officer and a privacy officer at each of our facilities, prepared privacy policies, trained our workforce on these policies and entered into business associate agreements with the appropriate vendors. However, failure by us or third parties on which we rely, including payers, to resolve HIPAA-related implementation or operational issues could have a material adverse effect on our results of operations and our ability to provide healthcare services. Consequently, we can give you no assurance that issues related to the full implementation of, or our operations under, HIPAA will not have a material adverse effect on our financial condition or future results of operations.

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       Conversion Legislation

        Many states have enacted laws affecting the conversion or sale of not-for-profit hospitals. These laws generally include provisions relating to attorney general approval, advance notification and community involvement. In addition, attorneys general in states without specific conversion legislation may exercise authority over these transactions based upon existing law. In many states, there has been an increased interest in the oversight of not-for-profit conversions. The adoption of conversion legislation and the increased review of not-for-profit hospital conversions may increase the cost and difficulty or prevent the completion of transactions with or acquisitions of not-for-profit organizations in various states.

       The Emergency Medical Treatment and Active Labor Act

        The Federal Emergency Medical Treatment and Active Labor Act (“EMTALA”) was adopted by Congress in response to reports of a widespread hospital emergency room practice of “patient dumping.” At the time of the enactment, patient dumping was considered to have occurred when a hospital capable of providing the needed care sent a patient to another facility or simply turned the patient away based on such patient’s inability to pay for his or her care. The law imposes requirements upon physicians, hospitals and other facilities that provide emergency medical services. Such requirements pertain to what care must be provided to anyone who comes to such facilities seeking care before they may be transferred to another facility or otherwise denied care. The government broadly interprets the law to cover situations in which patients do not actually present to a hospital’s emergency department, but present to a hospital-based clinic that treats emergency medical conditions on an urgent basis or are transported in a hospital-owned ambulance, subject to certain exceptions. EMTALA does not generally apply to patients admitted for inpatient services. Sanctions for violations of this statute include termination of a hospital’s Medicare provider agreement, exclusion of a physician from participation in Medicare and Medicaid programs and civil monetary penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law, and a medical facility that suffers a financial loss as a direct result of another participating hospital’s violation of the law, to sue the offending hospital for damages and equitable relief. Although we believe that our practices are in substantial compliance with the law, we cannot assure you that governmental officials responsible for enforcing the law will not assert from time to time that our facilities are in violation of this statute.

       Antitrust Laws

        The federal government and most states have enacted antitrust laws that prohibit certain types of conduct deemed to be anti-competitive. These laws prohibit price fixing, agreements to fix wages, concerted refusal to deal, market monopolization, price discrimination, tying arrangements, acquisitions of competitors and other practices that have, or may have, an adverse effect on competition. Violations of federal or state antitrust laws can result in various sanctions, including criminal and civil penalties. Antitrust enforcement in the healthcare industry is currently a priority of the Federal Trade Commission. We believe we are in compliance with such federal and state laws, but there can be no assurance that a review of our practices by courts or regulatory authorities will not result in a determination that could adversely affect our operations.

       Healthcare Reform

        The healthcare industry, as one of the largest industries in the United States, continues to attract much legislative interest and public attention. The Obama administration has stated as its top domestic priority its desire to reform the U.S. healthcare system with the goal of providing affordable, accessible healthcare for all Americans while slowing the growth of healthcare costs. This priority was demonstrated in February 2009, when President Obama released a federal budget proposal to Congress that includes plans to expand coverage to more Americans, but also to reduce Medicare and Medicaid spending over ten years by $316.0 billion in the form of reduced subsidies to Medicare Advantage health plans, cuts in payments to hospitals with high readmission rates and bundled payments for post-acute services during the 30 days following inpatient stays and value-based purchasing savings by linking a portion of Medicare payments to hospitals to performance on specific quality measures. To implement their version of President Obama’s reform plans, in July 2009 four of the five Congressional committees working on healthcare reform approved some version of reform legislation. In the House of Representatives, all three committees working on the legislation (the Committees on Ways and Means, Energy and Commerce and Education

29


and Labor) passed different versions of the same bill under which the principal provisions were as follows: (1) for individuals not currently covered, a new healthcare exchange will be established where they can select from a menu of healthcare options: either a new “public health insurance option” or a plan offered by private insurers; (2) the legislation will provide for  portable, secure health care plans, with standardized and comprehensive healthcare benefits, ending denials of care based on pre-existing conditions and capping out-of-pocket expenses; (3) the federal government will provide affordability credits, available on a sliding scale for low- and middle-income individuals and families, to make premiums affordable and reduce cost-sharing;  and (4) the legislation imposes both an individual and employer mandate: individuals would be required to obtain and maintain health insurance coverage or be subject to a penalty of 2.5% of modified adjusted gross income above certain specified levels; employers may choose to fund 72.5% of an individual employee's premium cost (65% for families) or contribute an amount ranging from 2% to 8% of the employer's payroll, with small businesses (payroll below $250,000) being exempt from the employer mandate. In the House Energy and Commerce Committee several key provisions of the legislation were changed to reduce its costs, to increase to $500,000 in payroll (from $250,000) the threshold at which small businesses would be required to offer health insurance and to permit providers to negotiate payment rates for the federally-administered “public option” health insurance plan rather than linking payments to Medicare rates. During the Congressional recess in August 2009, the three House committees worked to meld the bills into one final version for consideration by the entire House of Representatives as early as September 2009. In the Senate, its Committee on Health, Education, Labor and Pensions approved its version of healthcare reform legislation on July 15, 2009 which is similar to, but less extensive in benefits than, the House version. Meanwhile, during August 2009 the Senate Committee on Finance continued its efforts to negotiate a bipartisan agreement on healthcare reform legislation and that committee is not expected to vote upon its healthcare reform bill until at least September 2009, when Congress returns from its August recess. One of the most significant differences in the legislation produced by the Senate Finance Committee is likely to be the establishment of state and/or regional health insurance cooperatives in lieu of a federally-administered “public option” to compete with private health insurance plans. The health cooperatives would be privately-administered, non-profit entities managed by a board of directors comprised of cooperative members. The Senate Finance Committee is also developing additional tax proposals such as taxing healthcare benefits under the most generous plans, as well as Medicare and Medicaid reductions, to offset the cost of the legislation. Furthermore, unlike the proposals passed by the four other House and Senate committees, it is anticipated that the Senate Finance Committee package will likely not include a requirement that employers must offer health insurance coverage to employees and their families. Once passed by the Senate Finance Committee, the two Senate committees will need to merge the two bills into one final version for consideration by the entire Senate, potentially in September or October 2009.

        Also, many states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures. States have also adopted, or are considering, legislation designed to reduce coverage and program eligibility and/or impose additional taxes on hospitals to help finance or expand states’ Medicaid systems. Also, many states, including the states in which we operate, have applied for and been granted federal waivers from current Medicaid regulations to allow them to serve some or all of their Medicaid participants through managed care providers.

        We are unable to predict the future course of federal or state healthcare legislation. Further changes in the law or regulatory framework that reduce our revenues or increase our costs could have a material adverse effect on our business, financial condition or results of operations.

       Healthcare Industry Investigations

        Significant media and public attention has focused in recent years on the hospital industry. In recent years, increased attention has been paid to hospitals with high Medicare outlier payments and to recruitment arrangements with physicians. Further, there are numerous ongoing federal and state investigations regarding multiple issues. These investigations have targeted hospital companies as well as their executives and managers. Like other hospital companies, we have substantial Medicare, Medicaid and other governmental billings and we engage in various arrangements with physicians, which could result in scrutiny of our operations. We continue to monitor these and all other aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices are consistent with both legal principles and current industry standards. However, because the law in this area is complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations that are inconsistent with industry practices, including ours. In public statements surrounding

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current investigations, governmental authorities have taken positions on a number of issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some instances, government investigations that have in the past been conducted under the civil provisions of federal law may now be conducted as criminal investigations.

        Many current healthcare investigations are national initiatives in which federal agencies target an entire segment of the healthcare industry. One example is the federal government’s initiative regarding hospital providers’ improper requests for separate payments for services rendered to a patient on an outpatient basis within three days prior to the patient’s admission to the hospital, where reimbursement for such services is included as part of the reimbursement for services furnished during an inpatient stay. In particular, the government has targeted all hospital providers to ensure conformity with this reimbursement rule. The federal government also has undertaken a national investigative initiative targeting the billing of claims for inpatient services related to bacterial pneumonia, as the government has found that many hospital providers have attempted to bill for pneumonia cases under more complex and higher reimbursed diagnosis related groups codes. Further, the federal government continues to investigate Medicare overpayments to prospective payment hospitals that incorrectly report transfers of patients to other prospective payment system hospitals as discharges. We are aware that prior to our acquisition of them, several of our hospitals were contacted in relation to certain government investigations relating to their operations. Although we take the position that, under the terms of the acquisition agreements, the prior owners of these hospitals retained any liability resulting from these government investigations, we cannot assure you that the prior owners’ resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, will not have a material adverse effect on our operations. Further, under the federal False Claims Act, private parties have the right to bring “qui tam” whistleblower lawsuits against companies that submit false claims for payments to the government. Some states have adopted similar state whistleblower and false claims provisions.

        In addition to national enforcement initiatives, federal and state investigations commonly relate to a wide variety of routine healthcare operations such as: cost reporting and billing practices; financial arrangements with referral sources; physician recruitment activities; physician joint ventures; and hospital charges and collection practices for self-pay patients. We engage in many of these routine healthcare operations and other activities that could be the subject of governmental investigations or inquiries from time to time. For example, we have significant Medicare and Medicaid billings, we have numerous financial arrangements with physicians who are referral sources to our hospitals and we have joint venture arrangements involving physician investors.

        While we are not currently aware of any material investigation of us under federal or state health care laws or regulations, it is possible that governmental entities may conduct investigations at facilities operated by us and that such investigations could result in significant penalties to us, as well as adverse publicity. It is also possible that our executives and managers, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. The positions taken by authorities in any future investigations of us, our executives or managers or other healthcare providers and the liabilities or penalties that may be imposed could have a material adverse effect on our business, financial condition and results of operations.

       Health Plan Regulatory Matters

        Our health plans are subject to state and federal laws and regulations. CMS has the right to audit our health plans to determine the plans’ compliance with such standards. In addition, AHCCCS has the right to audit PHP to determine PHP’s compliance with such standards. Also, PHP is required to file periodic reports with AHCCCS, meet certain financial viability standards, provide its enrollees with certain mandated benefits and meet certain quality assurance and improvement requirements. Our health plans also have to comply with the standardized formats for electronic transmissions and privacy and security standards set forth in the Administrative Simplifications Provisions of HIPAA. Our health plans have implemented the necessary policies and procedures to comply with the final federal regulations on these matters and were in compliance with them by their deadlines.

        The Anti-Kickback Statute has been interpreted to prohibit the payment, solicitation, offering or receipt of any form of remuneration in return for the referral of federal health program patients or any item or service that is reimbursed, in whole or in part, by any federal healthcare program. Similar statutes have been adopted in Illinois and

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Arizona that apply regardless of the source of reimbursement. The Department of Health and Human Services has adopted safe harbor regulations specifying certain relationships and activities that are deemed not to violate the Anti-Kickback Statute which specifically relate to managed care including:

               •

 

waivers by health maintenance organizations of Medicare and Medicaid beneficiaries’ obligations to pay cost-sharing amounts or to provide other incentives in order to attract Medicare and Medicaid enrollees;

               •

 

certain discounts offered to prepaid health plans by contracting providers;

               •

 

certain price reductions offered to eligible managed care organizations; and

               •

 

certain price reductions offered by contractors with substantial financial risk to managed care organizations.

        We believe that the incentives offered by our health plans to their enrollees and the discounts they receive contracting with healthcare providers satisfy the requirements of the safe harbor regulations. However, the failure to satisfy each criterion of the applicable safe harbor does not mean that the arrangement constitutes a violation of the law; rather, the safe harbor regulations provide that an arrangement which does not fit within a safe harbor must be analyzed on the basis of its specific facts and circumstances. We believe that our health plans’ arrangements comply in all material respects with the federal Anti-Kickback Statute and similar state statutes.

       Environmental Matters

        We are subject to various federal, state and local laws and regulations relating to environmental protection. Our hospitals are not highly regulated under environmental laws because we do not engage in any industrial activities at those locations. The principal environmental requirements and concerns applicable to our operations relate to:

               •

 

the proper handling and disposal of hazardous and low level medical radioactive waste;

               •

 

ownership or historical use of underground and above-ground storage tanks;

               •

 

management of impacts from leaks of hydraulic fluid or oil associated with elevators, chiller units or incinerators;

               •

 

appropriate management of asbestos-containing materials present or likely to be present at some locations; and

               •

 

the potential acquisition of, or maintenance of air emission permits for, boilers or other equipment.

        We do not expect our compliance with environmental laws and regulations to have a material effect on us. We may also be subject to requirements related to the remediation of substances that have been released into the environment at properties owned or operated by us or at properties where substances were sent for off-site treatment or disposal. These remediation requirements may be imposed without regard to fault and whether or not we owned or operated the property at the time that the relevant releases or discharges occurred. Liability for environmental remediation can be substantial.

Item 1A. Risk Factors.

        If any of the following events discussed in the following risks were to occur, our business, results of operations, financial condition, cash flows or prospects could be materially adversely affected.  Additional risks and uncertainties not presently known, or currently deemed immaterial by us, may also constrain our business and operations.

Risks Relating to our Capital Structure

        Our high level of debt and significant leverage may adversely affect our operations and our ability to grow and otherwise execute our business strategy.

        We have a substantial amount of debt. As of June 30, 2009, we had $1,551.6 million of outstanding debt, excluding letters of credit and guarantees. This represented 72.5% of our total capitalization as of June 30, 2009. The amount of our outstanding indebtedness is large compared to the net book value of our assets, and we have significant repayment obligations under our outstanding indebtedness.

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        Our substantial indebtedness could:

               •

 

limit our ability to obtain additional financing to fund future capital expenditures, working capital, acquisitions or other needs;

 

 

 

               •

increase our vulnerability to general adverse economic, market and industry conditions and limit our flexibility in planning for, or reacting to, these conditions;

 

 

 

               •

make us vulnerable to increases in interest rates since $316.4 million (as of September 1, 2009) and an additional $450.0 million (after the expiration of our interest rate swap agreement on March 31, 2010) of our borrowings under our senior credit facilities are, and additional borrowings may be, at variable interest rates;

 

 

 

               •

our flexibility to adjust to changing market conditions and ability to withstand competitive pressures could be limited, and we may be more vulnerable to a downturn in general economic or industry conditions or be unable to carry out capital spending that is necessary or important to our growth strategy and our efforts to improve operating margins;

 

 

 

               •

 

limit our ability to use operating cash in other areas of our business because we must use a substantial portion of these funds to make principal and interest payments; and

 

 

 

               •

limit our ability to compete with others who are not as highly-leveraged.

        Our ability to make scheduled payments of principal and interest or to satisfy our other debt obligations, to refinance our indebtedness or to fund capital expenditures will depend on our future operating performance. Prevailing economic conditions (including interest rates) and financial, business and other factors, many of which are beyond our control, will also affect our ability to meet these needs. We may not be able to generate sufficient cash flows from operations or realize anticipated revenue growth or operating improvements, or obtain future borrowings in an amount sufficient to enable us to pay our debt, or to fund our other liquidity needs. We may need to refinance all or a portion of our debt on or before maturity. We may not be able to refinance any of our debt when needed on commercially reasonable terms or at all.

        Despite our current significant leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks that we and our subsidiaries face.

        We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indentures and the senior credit facilities do not fully prohibit us or our subsidiaries from doing so. Our revolving credit facility provides commitments of up to $250.0 million (not giving effect to any outstanding letters of credit, which would reduce the amount available under our revolving credit facility), of which $218.8 million was available for future borrowings as of September 1, 2009.  In addition, upon the occurrence of certain events, we may request an incremental term loan facility or facilities be added to our current senior credit facilities in an amount not to exceed $300.0 million in the aggregate, subject to receipt of commitments by existing lenders or other financing institutions and to the satisfaction of certain other conditions. We may in the future borrow all available amounts under the revolving credit facility, under the incremental term loan facility and in addition, we may borrow substantial additional indebtedness in the future under new debt agreements. If new debt is added to our current debt levels, the related risks that we and our subsidiaries now face could intensify.

        Operating and financial restrictions in our debt agreements limit our operational and financial flexibility.

        The senior credit facilities and the indentures under which $575.0 million aggregate principal amount of our 9.0% senior subordinated notes due 2014 and $216.0 million aggregate principal amount of our 11.25% senior discount notes due 2015 were issued (collectively, the “Public Notes”) contain a number of significant covenants that, among other things, restrict our ability to:

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               •

incur additional indebtedness or issue preferred stock;

 

 

 

               •

 

pay dividends on or make other distributions or repurchase our capital stock or make other restricted payments;

 

 

 

               •

make investments;

 

 

 

               •

 

enter into certain transactions with affiliates;

 

 

 

               •

limit dividends or other payments by restricted subsidiaries to our restricted subsidiaries;

 

 

 

               •

create liens on pari passu or subordinated indebtedness without securing the Public Notes;

 

 

 

               •

designate our subsidiaries as unrestricted subsidiaries; and

 

 

 

               •

sell certain assets or merge with or into other companies or otherwise dispose of all or substantially all of our assets.

        In addition, under the senior credit facilities, we are required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect our ability to comply with those provisions, and we may not be able to meet those ratios and tests. The breach of any of these covenants would result in a default under the senior credit facilities. In the event of default, the lenders could elect to declare all amounts borrowed under the senior credit facilities, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior credit facilities are senior in right of payment to the Public Notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the Public Notes.

        Our capital expenditure and acquisition strategies require substantial capital resources. The building of new hospitals and the operations of our existing hospitals and newly acquired hospitals require ongoing capital expenditures for construction, renovation, expansion and the addition of medical equipment and technology. More specifically, we may in the future be contractually obligated to make significant capital expenditures relating to the facilities we acquire. Also, construction costs to build new hospitals are substantial and continue to increase. Our debt agreements may restrict our ability to incur additional indebtedness to fund these expenditures.

        A breach of any of the restrictions or covenants in our debt agreements could cause a cross-default under other debt agreements. A significant portion of our indebtedness then may become immediately due and payable. We are not certain whether we would have, or be able to obtain, sufficient funds to make these accelerated payments. If any senior debt is accelerated, our assets may not be sufficient to repay in full such indebtedness and our other indebtedness.

        We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

        Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness. In addition, the indentures governing the Public Notes allow us to make significant dividend payments, investments and other restricted payments. Our making these payments could decrease available cash and adversely affect our ability to make principal and interest payments on our indebtedness.

        If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. The

34


senior credit facilities and the indentures restrict our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair and proceeds that we do receive may not be adequate to meet any debt service obligations then due.

        Tightened credit markets and continued economic deterioration may prevent us from servicing our current debt or refinancing, replacing or otherwise obtaining a new revolving loan facility to replace our facility expiring in September 2010 or obtaining the necessary funds to repay a  significant portion of our debt that will mature during September 2011.

        We are a highly leveraged company. As of June 30, 2009, we had $1,551.6 million of outstanding indebtedness. Of this amount, $766.4 million of term loans mature in September 2011. Additionally, we have a $250.0 million ($218.8 million net of borrowing capacity reductions for our outstanding letters of credit) revolving loan facility that expires in September 2010. The tightened credit markets have especially impacted the ability of highly leveraged companies, like us, to access sources of liquidity on similar terms or pricing as currently in place, or at all. Our inability to replace our revolving credit facility in September 2010 may limit our ability to competitively manage our current operations, make capital expenditures, make required principal and interest repayments under our debt agreements or complete acquisitions to grow our business. If prevailing instability in the credit and financial markets continues, we may be unable to refinance or repay our outstanding $766.4 million term debt due in September 2011. We also make significant cash interest payments on our outstanding $575.0 million 9.0% senior subordinated notes and will be required to make cash interest payments on our $216.0 million 11.25% senior discount notes beginning in April 2010. Should current economic conditions worsen, our operating cash flows may be materially adversely impacted, which could make it more difficult for us to make these cash interest payments. If we were unable to make scheduled interest or principal payments on our debt, we would be in default and, as a result:

        •

 

Our debt holders could declare all outstanding principal and interest to be due and payable;

 

 

 

        •

Our secured debt lenders could terminate their commitments and commence foreclosure proceedings against our assets; and

 

 

 

        •

We could be forced into bankruptcy or liquidation.

        We also face the risk of non-compliance with the debt covenants under our senior secured credit agreement, including the total leverage ratio limit, which decreased to 4.50x from 5.00x for the test period ending March 31, 2009. While we are currently in compliance with all of our debt covenants, future violations of any of these covenants without cure would result in a debt default as described above.

        An increase in interest rates would increase the cost of servicing our debt and could reduce our profitability.

        A significant portion of the borrowings under our Senior Credit Facilities bear interest at variable rates. As a result, an increase in interest rates, whether because of an increase in market interest rates or an increase in our own cost of borrowing, would increase the cost of servicing our debt and could materially reduce our profitability. The impact of such an increase would be more significant than it would be for some other companies because of our substantial debt. For a discussion of how we manage our exposure to changes in interest rates through the use of interest rate swap agreements on certain portions of our outstanding debt, see “Item 7A. – Quantitave and Qualitative Disclosure About Market Risks.”

        We are controlled by a small number of stockholders and they may have conflicts of interest with us in the future.

        We are controlled by our principal equity sponsors, and they have the ability to control our policies and operations. The interests of our principal equity sponsors may not in all cases be aligned with our interests. For example, our principal equity sponsors could cause us to make acquisitions, divestitures and other transactions that, in their judgment, could enhance their equity investment in us, even though such transactions might reduce cash flows or capital reserves available to fund our debt service obligations. Additionally, our controlling shareholders are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Accordingly, our principal equity sponsors may also pursue

35


acquisitions that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. So long as our principal equity sponsors continue to own a significant amount of our equity interests, even if such amount is less than 50%, they will continue to be able to strongly influence or effectively control our decisions.

Risks Related to our Business

        If we are unable to enter into favorable contracts with managed care plans, our operating revenues may be reduced.

        Our ability to negotiate favorable contracts with health maintenance organizations, insurers offering preferred provider arrangements and other managed care plans significantly affects the revenues and operating results of our hospitals. Revenues derived from health maintenance organizations, insurers offering preferred provider arrangements and other managed care plans, including managed Medicare and managed Medicaid plans, accounted for approximately 58% of our net patient revenues for the year ended June 30, 2009. Managed care organizations offering prepaid and discounted medical services packages represent an increasing portion of our admissions, a general trend in the industry which has limited hospital revenue growth nationwide and a trend that may continue. In addition, private payers are increasingly attempting to control healthcare costs through direct contracting with hospitals to provide services on a discounted basis, increased utilization review and greater enrollment in managed care programs such as health maintenance organizations and preferred provider organizations. Additionally, the trend towards consolidation among private managed care payers tends to increase their bargaining prices over fee structures. In most cases, we negotiate our managed care contracts annually as they come up for renewal at various times during the year. Our future success will depend, in part, on our ability to renew existing managed care contracts and enter into new managed care contracts on terms favorable to us. Other healthcare companies, including some with greater financial resources, greater geographic coverage or a wider range of services, may compete with us for these opportunities. If we are unable to contain costs through increased operational efficiencies or to obtain higher reimbursements and payments from managed care payers, our results of operations and cash flows will be materially adversely affected.

        Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies reduce our reimbursements.

        Approximately 56% of our net patient revenues for the year ended June 30, 2009 came from the Medicare and Medicaid programs, including Medicare and Medicaid managed plans. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. Some of those changes adversely affect the reimbursement we receive for certain services. In addition, due to budget deficits in many states, significant decreases in state funding for Medicaid programs have occurred or are being proposed.

        On August 22, 2007, CMS issued a final rule for federal fiscal year 2008 for the hospital inpatient prospective payment system. This rule adopted a two-year implementation of MS-DRGs, a severity-adjusted DRG system. This change represented a refinement to the DRG system, and its impact on our revenues has not been significant. Realignments in the DRG system could impact the margins we receive for certain services.

        DRG rates are updated and MS-DRG weights are recalibrated each federal fiscal year. The index used to update the market basket gives consideration to the inflation experienced by hospitals and entities outside the healthcare industry in purchasing goods and services. The annual Medicare regulatory update for federal fiscal year 2010 provides for a 2.1% market basket update for hospitals that submit certain quality patient care indicators and a 0.1% update for hospitals that do not submit this data. While we will endeavor to comply with all quality data submission requirements, our submissions may not be deemed timely or sufficient to entitle us to the full market basket adjustment for all our hospitals. Medicare payments to hospitals in federal fiscal year 2009 were reduced by 0.9% to eliminate what CMS estimates will be the effect of coding or classification changes as a result of hospitals implementing the MS-DRG system. After earlier proposing an increase in the “documentation and coding adjustment” to 1.9% for federal fiscal year 2010, on July 31, 2009 CMS announced that it had decided not to make any adjustment in federal fiscal year 2010 since it did not know whether federal fiscal year 2009 spending from documentation and coding is more or less than earlier projected. However, Congress has given CMS the ability to continue to retrospectively determine if the documentation and coding adjustment levels for federal fiscal years 2008

36


and 2009 were adequate to account for changes in payments not related to changes in case mix. If the levels are found to have been inadequate, CMS could impose an adjustment to payments for federal fiscal years 2011 and 2012. This evaluation of changes in case-mix based on actual claims data may yield a higher documentation and coding adjustment thereby potentially reducing our revenues and impacting our results of operations in ways that cannot be quantified at this time. Additionally, Medicare payments to hospitals are subject to a number of other adjustments, and the actual impact on payments to specific hospitals may vary. In some cases, commercial third-party payers and other payers such as some state Medicaid programs rely on all or portions of the Medicare DRG system to determine payment rates. The change from traditional Medicare DRGs to MS-DRGs could adversely impact those payment rates if any other payers adopt MS-DRGs.

        The federal government and many states have recently adopted or are currently considering reducing the level of Medicaid funding (including upper payment limits) or program eligibility that could adversely affect future levels of Medicaid reimbursement received by our hospitals. Since states must operate with balanced budgets and since the Medicaid program is often a state’s largest program, a number of states have adopted, or are considering adopting, legislation designed to reduce their Medicaid expenditures. DRA 2005 includes federal Medicaid cuts of approximately $4.8 billion over five years. Additionally, on May 29, 2007, CMS published a final rule entitled “Medicaid Program; Cost Limit for Providers Operated by Units of Government and Provisions to Ensure the Integrity of Federal-State Financial Partnership” which is estimated to reduce federal Medicaid funding from $12 to $20 billion over five years. Congress enacted two moratoria in respect of this rule that delayed six of seven proposed Medicaid regulations in this final CMS rule until July 1, 2009. On June 30, 2009, three more of the Medicaid regulations that had been under a congressional moratorium set to expire July 1, 2009 were officially rescinded all or in part by CMS, and CMS also delayed until June 30, 2010 the enforcement of the fourth of the six regulations. As a result of these changes in implementing the final rule, the impact on us of the final rule can not be quantified. States have also adopted, or are considering adopting, legislation designed to reduce coverage and program eligibility, enroll Medicaid recipients in managed care programs and/or impose additional taxes on hospitals to help finance or expand the states’ Medicaid systems. Future legislation or other changes in the administration or interpretation of government health programs could have a material adverse effect on our financial position and results of operations.

        Our ability to negotiate favorable contracts with managed care plans significantly affects the revenues and operating results of most of our hospitals. Managed care payers increasingly are demanding discounted fee structures, and the trend toward consolidation among managed care plans tends to increase their bargaining power over fee structures. Reductions in price increases or the amounts received from managed care plans could have a material adverse effect on our financial position and results of operations.

        In recent years, both the Medicare program and several large managed care companies have changed our reimbursement to link some of their payments, especially their annual increases in payments, to performance of quality of care measures. We expect this trend to “pay-for-performance” to increase in the future. If we are unable to meet these performance measures, our results of operations and cash flow will be materially adversely affected.

        We conduct business in a heavily regulated industry, and changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce our revenues and profitability.

        The healthcare industry is subject to extensive federal, state and local laws and regulations relating to licensing, the conduct of operations, the ownership of facilities, the addition of facilities and services, financial arrangements with physicians and other referral sources, confidentiality, maintenance and security issues associated with medical records, billing for services and prices for services. If a determination were made that we were in material violation of such laws or regulations, our operations and financial results could be materially adversely affected.

        In many instances, the industry does not have the benefit of significant regulatory or judicial interpretations of these laws and regulations. This is particularly true in the case of Medicare and Medicaid statute codified under section 1128B(b) of the Social Security Act and known as the “Anti-Kickback Statute.” This law prohibits providers and other person or entities from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent to generate referrals of orders for services or items reimbursable under Medicare, Medicaid and other federal healthcare programs. As authorized by Congress, the United States Department of Health and Human Services has issued regulations which describe some of the conduct and business relationships immune from prosecution under the Anti-Kickback Statute. The fact that a given business arrangement does not fall within one of

37


these “safe harbor” provisions does not render the arrangement illegal, but business arrangements of healthcare service providers that fail to satisfy the applicable safe harbor criteria risk increased scrutiny by enforcement authorities.

        Some of the financial arrangements that our facilities maintain with physicians do not meet all of the requirements for safe harbor protection. The regulatory authorities that enforce the Anti-Kickback Statute may in the future determine that one or more of these arrangements violate the Anti-Kickback Statute or other federal or state laws. A determination that a facility has violated the Anti-Kickback Statute or other federal laws could subject us to liability under the Social Security Act, including criminal and civil penalties, as well as exclusion of the facility from participation in government programs such as Medicare and Medicaid or other federal healthcare programs.

        In addition, the portion of the Social Security Act commonly known as the “Stark Law” prohibits physicians from referring Medicare and (to an extent) Medicaid patients to providers of certain “designated health services” if the physician or a member of his or her immediate family has an ownership or investment interest in, or compensation arrangement with, that provider. In addition, the provider in such arrangements is prohibited from billing for all of the designated health services referred by the physician. Many of the services furnished by our facilities are “designated health services” for Stark Law purposes. There are multiple exceptions to the Stark Law, among others, for physicians maintaining an ownership interest in an entire hospital or having a compensation relationship with the facility as a result of employment agreements, leases, physician recruitment and certain other arrangements. However, each of these exceptions applies only if detailed conditions are met. An arrangement subject to the Stark Law must qualify for an exception in order for the services to be lawfully referred by the physician and billed by the provider.

        CMS has issued three phases of final regulations implementing the Stark Law. Phases I and II became effective in January 2002 and July 2004, respectively, and Phase III became effective in December 2007. While these regulations help clarify the requirements of the exceptions to the Stark Law, it is unclear how the government will interpret many of these exceptions for enforcement purposes. In addition, in July 2007 CMS proposed far-reaching changes to the regulations implementing the Stark Law that would further restrict the types of arrangements that hospitals and physicians may enter, including additional restrictions on certain leases, percentage compensation arrangements, and agreements under which a hospital purchases services under arrangements. On July 31, 2008, CMS issued a final rule which, in part, finalized and responded to public comments regarding some of its July 2007 proposed major changes to the Stark Law regulations to undermine many common hospital/physician joint venture models. The most far-reaching of the changes made in this final July 2008 rule will effectively prohibit, as of a delayed effective date of October 1, 2009, both “under arrangements” ventures between a hospital and any of its physicians and unit-of-service-based "per click" compensation and percentage-based compensation in office space and equipment leases between a hospital and its physicians. We have examined all of our “under arrangements” ventures and space and equipment leases with physicians to identify those arrangements which potentially violate these new Stark regulations, and we are in the process of restructuring or terminating non-conforming arrangements so identified prior to October 1, 2009. Because the Stark Law and its implementing regulations are relatively new, we do not always have the benefit of significant regulatory or judicial interpretation of this law and its regulations. We attempt to structure our relationships to meet an exception to the Stark Law, but the regulations implementing the exceptions are detailed and complex, and we cannot assure that every relationship complies fully with the Stark Law. In addition, in the July 2008 final Stark rule CMS indicated that it will continue to enact further regulations tightening aspects of the Stark Law that it perceives allow for Medicare program abuse, especially those regulations that still permit physicians to profit from their referrals of ancillary services. We cannot assure you that the arrangements entered into by our hospitals with physicians will be found to be in compliance with the Stark Law, as it ultimately may be implemented or interpreted.

        Additionally, if we violate the Anti-kickback Statute or Stark Law, or if we improperly bill for our services, we may be found to violate the False Claims Act, either under a suit brought by the government or by a private person under a qui tam, or “whistleblower,” suit.

        If we fail to comply with the Anti-kickback Statute, the Stark Law, the False Claims Act or other applicable laws and regulations, or if we fail to maintain an effective corporate compliance program, we could be subjected to liabilities, including civil penalties (including the loss of our licenses to operate one or more facilities), exclusion of one or more facilities from participation in the Medicare, Medicaid and other federal and state health care programs

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and, for violations of certain laws and regulations, criminal penalties. See Item 1, “Business — Governmental Regulation and Other Factors.”

        All of the states in which we operate have adopted or have considered adopting similar anti-kickback and physician self-referral legislation, some of which extends beyond the scope of the federal law to prohibit the payment or receipt of remuneration for the referral of patients and physician self-referrals, regardless of the source of payment for the care. Little precedent exists for the interpretation or enforcement of these laws. Both federal and state government agencies have announced heightened and coordinated civil and criminal enforcement efforts.

        Government officials responsible for enforcing healthcare laws could assert that one or more of our facilities, or any of the transactions in which we are involved, are in violation of the Anti-Kickback Statute or the Stark Law and related state law exceptions. It is also possible that the courts could ultimately interpret these laws in a manner that is different from our interpretations. Moreover, other healthcare companies, alleged to have violated these laws, have paid significant sums to settle such allegations and entered into “corporate integrity agreements” because of concern that the government might exercise its authority to exclude those providers from governmental payment programs (Medicare, Medicaid, TRICARE). A determination that one or more of our facilities has violated these laws, or the public announcement that we are being investigated for possible violations of these laws, could have a material adverse effect on our business, financial condition, results of operations or prospects, and our business reputation could suffer significantly.

        Illinois and Massachusetts require governmental determinations of need (“Certificates of Need”) prior to the purchase of major medical equipment or the construction, expansion, closure, sale or change of control of healthcare facilities. We believe our facilities have obtained appropriate certificates wherever applicable. However, if a determination were made that we were in material violation of such laws, our operations and financial results could be materially adversely affected. The governmental determinations, embodied in Certificates of Need, can also affect our facilities’ ability to add bed capacity or important services. We cannot predict whether we will be able to obtain required Certificates of Need in the future. A failure to obtain any required Certificates of Need may impair our ability to operate the affected facility profitably.

        The laws, rules and regulations described above are complex and subject to interpretation. If we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed. For a more detailed discussion of the laws, rules and regulations described above, see Item 1, “Business – Government Regulation and Other Factors.”

        Some of our hospitals will be required to submit to CMS information on their relationships with physicians and this submission could subject such hospitals and us to liability.

        CMS announced in 2007 that it intends to collect information on ownership, investment and compensation arrangements with physicians from 500 (pre-selected) hospitals by requiring these hospitals to submit to CMS Disclosure of Financial Relationship Reports (“DFRR”) from each selected hospital. CMS also indicated that at least 10 of our hospitals will be among these 500 hospitals required to submit a DFRR because these 10 hospitals did not respond to CMS’ voluntary survey instrument on this topic purportedly submitted to these hospitals via email by CMS in 2006. CMS intends to use this data to determine whether these hospitals were in compliance with the Stark Law and implementing regulations during the reporting period (currently expected to be the cost reporting periods of these hospitals ending in 2006), and CMS has indicated it may share this information with other government agencies and with Congressional committees.  Many of these agencies have not previously analyzed this information and have the authority to bring enforcement actions against the hospitals. However, in July 2008 CMS announced that, based on its further review and expected further public comments on this matter, CMS may decide in the future to decrease (but not increase) the number of hospitals to which it will send the DFRR below the 500 hospitals originally designated.

        Once a hospital receives this request for a DFRR, the hospital will have 60 days to compile a significant amount of information relating to its financial relationships with physicians. The hospital may be subject to civil monetary penalties of up to $10,000 per day if it is unable to assemble and report this information within the required timeframe or if CMS or any other government agency determines that the submission is inaccurate or incomplete.

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The hospital may be the subject of investigations or enforcement actions if a government agency determines that any of the information indicates a potential violation of law.

        Also, while in 2007 CMS had announced that it was contemplating proposing a regular financial disclosure process that would apply in the future to all Medicare participating hospitals, in July 2008 CMS announced that, based upon public comments previously received, it was not adopting a regular reporting or disclosure process at that time, and, thus, CMS said the DFRR will initially be used as a one-time collection effort. However, CMS also said in July 2008 that, depending on the information received from the initial DFRR process and other factors, it may propose future rulemaking to use the DFRR or some other instrument as a periodic or regular collection instrument. Thus, even if one of our hospitals does not receive the DFRR survey as part of the initial up to 500 selected hospitals, we expect that all of our hospitals will possibly have to report similar information to CMS in the future.

        The DFRR and its supporting documentation are currently under review by the Office of Management and Budget and have not yet been released. Depending on the final format of the DFRR, responding hospitals may be subject to substantial penalties as a result of enforcement actions brought by government agencies and whistleblowers acting pursuant to the False Claims Act and similar state laws, based on such allegations like failure to respond within required deadlines, that the response is inaccurate or contains incomplete information or that the response indicates a potential violation of the Stark Law or other requirements.

        Any governmental investigation or enforcement action which results from the DFRR process could materially adversely affect the results of our operations.

        Providers in the healthcare industry have been the subject of federal and state investigations, whistleblower lawsuits and class action litigation, and we may become subject to investigations, whistleblower lawsuits or class action litigation in the future.

        Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies, as well as their executives and managers. These investigations relate to a wide variety of topics, including:

        •

 

cost reporting and billing practices;                                                                                                               

        •

 

laboratory and home healthcare services;

        •

 

physician ownership of, and joint ventures with, hospitals;

        •

 

physician recruitment activities; and

        •

 

other financial arrangements with referral sources

        In addition, the federal False Claims Act permits private parties to bring qui tam, or whistleblower, lawsuits against companies. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under false claims may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes and have submitted claims to a governmental payer during the time period they allegedly violated these other statutes, have thereby submitted false claims under the False Claims Act. Some states have adopted similar whistleblower and false claims provisions.

        The Office of the Inspector General of the Department of Health and Human Services and the Department of Justice have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Initiatives include a focus on hospital billing for outpatient charges associated with inpatient services, as well as hospital laboratory billing practices.  As a result of these regulations and initiatives, some of our activities could become the subject of governmental investigations or inquiries. For example, we have significant Medicare and Medicaid billings, we provide some durable medical equipment and home healthcare

40


services, and we have joint venture arrangements involving physician investors. We also have a variety of other financial arrangements with physicians and other potential referral sources including recruitment arrangements and leases. In addition, our executives and managers, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. We are aware that several of our hospitals or their related healthcare operations were and may still be under investigation in connection with activities conducted prior to our acquisition of them. Under the terms of our various acquisition agreements, the prior owners of our hospitals are responsible for any liabilities arising from pre-closing violations. The prior owners’ resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, may have a material adverse effect on our business, financial condition or results of operations. Any investigations of us, our executives, managers, facilities or operations could result in significant liabilities or penalties to us, as well as adverse publicity.

        We maintain a voluntary compliance program to address health regulatory and other compliance requirements. This program includes initial and periodic ethics and compliance training and effectiveness reviews, a toll-free hotline for employees to report, without fear of retaliation, any suspected legal or ethical violations, annual “fraud and abuse” audits to look at all of our financial relationships with physicians and other referral sources and annual “coding audits” to make sure our hospitals bill the proper service codes in respect of obtaining payment from the Medicare and Medicaid programs.

        As an element of our corporate compliance program and our internal compliance audits, from time to time we make voluntary disclosures and repayments to the Medicare and Medicaid programs and/or to the federal and/or state regulators for these programs in the ordinary course of business. At the current time, we know of no active investigations by any of these programs or regulators in respect of our disclosures or repayments. All of these voluntary actions on our part could lead to an investigation by the regulators to determine whether any of our facilities have violated the Stark Law, the Anti-Kickback Statute, the False Claims Act or similar state law. Either an investigation or initiation of administrative or judicial actions could result in a public announcement of possible violations of the Stark Law, the Anti-Kickback Statute or the False Claims Act or similar state law. Such determination or announcements could have a material adverse effect on our business, financial condition, results of operations or prospects, and our business reputation could suffer significantly.

        Additionally, several hospital companies have in recent years been named defendants in class action litigation alleging, among other things, that their charge structures are fraudulent and, under state law, unfair or deceptive practices, insofar as those hospitals charge insurers lower rates than those charged to uninsured patients. We cannot assure you that we will not be named as a defendant in litigation of this type. Furthermore, the outcome of these suits may affect the industry standard for charity care policies and any response we take may have a material adverse effect on our financial results.

        In June 2006 we and two other hospital systems operating in San Antonio, Texas had a putative class action lawsuit brought against all of us alleging that we and the other defendants has conspired with each other and with other unidentified San Antonio area hospitals to depress the compensation levels of registered nurses employed at the competing hospitals within the San Antonio area by engaging in certain activities that violated the federal antitrust laws.  See  “Item 3- Legal Proceedings” for further discussion of this litigation. On the same day that this litigation was brought against us and two other hospital systems in San Antonio, substantially similar class action litigation was brought against multiple hospitals in three other cities.

        Competition from other hospitals or healthcare providers (especially specialty hospitals) may reduce our patient volumes and profitability.

        The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years. Generally, other hospitals in the local communities served by most of our hospitals provide services similar to those offered by our hospitals. In addition, we believe the number of freestanding specialty hospitals and surgery and diagnostic centers in the geographic areas in which we operate has increased significantly in recent years. As a result, most of our hospitals operate in an increasingly competitive environment. Some of the hospitals that compete with our hospitals are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and

41


operations on a tax-exempt basis. Increasingly, we are facing competition from physician-owned specialty hospitals and freestanding surgery centers that compete for market share in high margin services and for quality physicians and personnel. If ambulatory surgery centers are better able to compete in this environment than our hospitals, our hospitals may experience a decline in patient volume, and we may experience a decrease in margin, even if those patients use our ambulatory surgery centers. Further, if our competitors are better able to attract patients, recruit physicians, expand services or obtain favorable managed care contracts at their facilities than our hospitals and ambulatory surgery centers, we may experience an overall decline in patient volume. See Item 1, “Business - Competition.”

        In 2005, CMS began making public performance data related to 10 quality measures that hospitals submit in connection with their Medicare reimbursement. In February 2006, federal legislation was enacted to expand and provide for the future expansion of the number of quality measures that must be reported. During federal fiscal year 2008, CMS required hospitals to report 30 measures of inpatient quality of care to avoid a 2% point reduction in their market basket update. During federal fiscal year 2009, CMS requires hospitals to report 43 inpatient quality measures to avoid a 2% point reduction in their market basket update. For federal fiscal year 2010, CMS will require hospitals to report 47 inpatient quality measures to avoid a 2% reduction in their market basket update. If any of our hospitals achieve poor results (or results that are lower than our competitors) on these quality measures, patient volumes could decline. Also, the additional quality measures and future trends toward clinical transparency may have an unanticipated impact on our competitive position and patient volumes.

        PHP also faces competition within the Arizona markets that it serves. As in the case of our hospitals, some of our competitors in these markets are owned by governmental agencies or not-for-profit corporations that have greater financial resources than we do. The revenues we derive from PHP could significantly decrease if new plans operating under AHCCCS enter these markets or other existing AHCCCS plans increase their number of enrollees. Moreover, a failure to attract future enrollees may negatively impact our ability to maintain our profitability in these markets.

        We may be subject to liabilities from claims brought against our facilities.

        We operate in a highly regulated and litigious industry. As a result, various lawsuits, claims and legal and regulatory proceedings have been instituted or asserted against us, including those outside of the ordinary course of business like class actions and those in the ordinary course of business like malpractice lawsuits. Some of these actions may involve large claims as well as significant defense costs. (See “Item 3, “Legal Proceedings.”)

        We maintain professional and general liability insurance in amounts we believe are sufficient to cover claims arising out of the operations of our facilities. Some of the claims could exceed the scope of the coverage in effect or coverage of particular claims or damages could be denied.

        The relatively high cost of professional liability insurance and, in some cases, the lack of availability of such insurance coverage, for physicians with privileges at our hospitals increases our risk of vicarious liability in cases where both our hospital and the uninsured or underinsured physician are named as co-defendants. As a result, we are subject to greater self-insured risk and may be required to fund claims out of our operating cash flows to a greater extent than during fiscal year 2009. We cannot assure you that we will be able to continue to obtain insurance coverage in the future or that such insurance coverage, if it is available, will be available on acceptable terms.

        While we cannot predict the likelihood of future claims or inquiries, we expect that new matters may be initiated against us from time to time. Moreover, the results of current claims, lawsuits and investigations cannot be predicted, and it is possible that the ultimate resolution of these matters, individually or in the aggregate, may have a material adverse effect on our business (both in the near and long term), financial position, results of operations or cash flows.

        Our hospitals face a growth in uncompensated care as the result of the inability of uninsured patients to pay for healthcare services and difficulties in collecting patient portions of insured accounts. 

        Like others in the hospital industry, we have experienced an increase in uncompensated care. Our combined provision for doubtful accounts and charity care deductions as a percentage of patient service revenues increased

42


from 12.0% during fiscal 2007 to 12.5% during fiscal 2008 and decreased to 12.0% during fiscal 2009. Our self pay discharges as a percentage of total discharges have not fluctuated significantly during our past three fiscal years. Our hospitals remain at risk for increases in uncompensated care as a result of price increases, the continuing trend of increases in coinsurance and deductible portions of managed care accounts and increases in uninsured patients as a result of potential state Medicaid funding cuts or general economic weakness. Although we continue to seek ways of improving point of service collection efforts and implementing appropriate payment plans with our patients, if we continue to experience growth in self-pay volumes and revenues, our results of operations could be materially adversely affected. Further, our ability to improve collections for self-pay patients may be limited by regulatory and investigatory initiatives, including private lawsuits directed at hospital charges and collection practices for uninsured and underinsured patients.

        Our performance depends on our ability to recruit and retain quality physicians.

        Physicians generally direct the majority of hospital admissions. Thus, the success of our hospitals depends in part on the following factors:

        •

 

the number and quality of the physicians on the medical staffs of our hospitals;                                         

        •

the admitting practices of those physicians; and

        •

the maintenance of good relations with those physicians.

        Most physicians at our hospitals also have admitting privileges at other hospitals. Our efforts to attract and retain physicians are affected by our managed care contracting relationships, national shortages in some specialties, such as anesthesiology and radiology, the adequacy of our support personnel, the condition of our facilities and medical equipment, the availability of suitable medical office space and federal and state laws and regulations prohibiting financial relationships that may have the effect of inducing patient referrals. If facilities are not staffed with adequate support personnel or technologically advanced equipment that meets the needs of patients, physicians may be discouraged from referring patients to our facilities, which could adversely affect our profitability.

        In an effort to meet community needs in the markets in which we operate, we have implemented a strategy to employ physicians both in primary care and in certain specialties. As of June 30, 2009, we employed approximately 290 practicing  physicians, excluding residents.  The deployment of a physician employment strategy includes increased salary costs, physician integration risks and difficulties associated with physician practice management. While we believe this strategy is consistent with industry trends, we cannot be assured of the long-term success of such a strategy.

        We may be unable to achieve our acquisition and growth strategies and we may have difficulty acquiring not-for-profit hospitals due to regulatory scrutiny.

        An important element of our business strategy is expansion by acquiring hospitals in our existing and in new urban and suburban markets and by entering into partnerships or affiliations with other healthcare service providers. The competition to acquire hospitals is significant, including competition from healthcare companies with greater financial resources than ours. We may not be able to make suitable acquisitions on favorable terms. We may have difficulty obtaining financing, if necessary, for such acquisitions on satisfactory terms. We sometimes agree not to sell an acquired hospital for some period of time (currently no longer than 10 years) after purchasing it and/or grant the seller a right of first refusal to purchase the hospital if we agree to sell it to a third party. In addition, we may not be able to effectively integrate any acquired facilities with our operations. Even if we continue to acquire additional facilities and/or enter into partnerships or affiliations with other healthcare service providers, federal and state regulatory agencies may constrain our ability to grow.

        Additionally, many states, including some where we have hospitals and others where we may in the future attempt to acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the sale proceeds by the not-for-profit seller. These review and approval processes can add time to the consummation of an acquisition of a not-for profit hospital, and future actions on the state level could seriously

43


delay or even prevent future acquisitions of not-for-profit hospitals. Furthermore, as a condition to approving an acquisition, the attorney general of the state in which the hospital is located may require us to maintain specific services, such as emergency departments, or to continue to provide specific levels of charity care, which may affect our decision to acquire or the terms upon which we acquire one of these hospitals.

        Difficulties with integrating our acquisitions may disrupt our ongoing operations.

        We may not be able to profitably or effectively integrate the operations of, or otherwise achieve the intended benefits from, any acquisitions we make or partnerships or affiliations we may form. The process of integrating acquired hospitals may require a disproportionate amount of management’s time and attention, potentially distracting management from its day-to-day responsibilities. This process may be even more difficult in the case of hospitals we may acquire out of bankruptcy or otherwise in financial distress. In addition, poor integration of acquired facilities could cause interruptions to our business activities, including those of the acquired facilities. As a result, we may incur significant costs related to acquiring or integrating these facilities and may not realize the anticipated benefits.

        Moreover, acquired businesses may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations. We could in the future become liable for past activities of acquired businesses and these liabilities could be material.

        The cost of our malpractice insurance and the malpractice insurance of physicians who practice at our facilities remains volatile. Successful malpractice or tort claims asserted against us, our physicians or our employees could materially adversely affect our financial condition and profitability.

        Physicians, hospitals and other healthcare providers are subject to legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large monetary claims and significant defense costs. Hospitals and physicians have typically maintained a special type of insurance (commonly called malpractice or professional liability insurance) to protect against the costs of these types of legal actions. We created a captive insurance subsidiary on June 1, 2002, to assume a substantial portion of the professional and general liability risks of our facilities. For claims incurred during the period June 1, 2002 to May 31, 2006, we maintained all of our professional and general liability insurance through this captive insurance subsidiary in respect of losses up to $10.0 million per occurrence. For claims incurred from June 1, 2006 to June 30, 2009, we self-insured the first $9.0 million per occurrence, and our captive subsidiary insured the next $1.0 million per occurrence. We have also purchased an umbrella excess policy for professional and general liability insurance for the period July 1, 2009 to June 30, 2010 with unrelated commercial carriers. This policy covers losses in excess of $10.0 million per occurrence up to $75.0 million, but is limited to total annual payments of $65.0 million in the aggregate. While our premium prices have declined during the past few years, the total cost of professional and general liability insurance remains sensitive to the volume and severity of cases reported.  There is no guarantee that excess insurance coverage will continue to be available in the future at a cost allowing us to maintain adequate levels of such insurance. Moreover, due to the increased retention limits insured by us and our captive subsidiary, if actual payments of claims materially exceed our projected estimates of malpractice claims, our financial condition could be materially adversely affected.

        Physicians’ professional liability insurance costs in certain markets have dramatically increased to the point where some physicians are either choosing to retire early or leave those markets. If physician professional liability insurance costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volumes and revenues. Our hospitals may also incur a greater percentage of the amounts paid to claimants if physicians are unable to obtain adequate malpractice coverage since we are often sued in the same malpractice suits brought against physicians on our medical staffs who are not employed by us.

        We anticipate employing over 160 additional physicians during our fiscal year 2010. Such a significant increase in employed physicians could significantly increase our professional and general liability risks and related costs in future periods since for employed physicians there is no insurance coverage from unaffiliated insurance companies.

44


        We are subject to uncertainties regarding healthcare reform that could materially and adversely affect our business.

        In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would result in major changes in the healthcare system, either nationally or at the state level. Among the proposals that have been introduced in recent years are price controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of a government health insurance plan or plans that would cover all citizens and increase payments by beneficiaries. Also, theObama administration has stated as its top domestic priority its desire to reform the U.S. healthcare system with the goal of providing affordable, accessible healthcare for all Americans. In July 2009 four of the five Congressional committees working on healthcare reform approved some version of reform legislation.  In the House of Representatives, all three committees working on the legislation (the Committees on Ways and Means, Energy and Commerce and Education and Labor) passed different versions of the same extensive reform bill under which, for individuals not currently covered, a new healthcare exchange will be established where they can select either a new “public health insurance option” or a plan offered by private insurers. During the Congressional recess in August 2009, the three House committees worked to meld the bills into one final version for consideration by the entire House of Representatives as early as September 2009. In the Senate, its Committee on Health, Education, Labor and Pensions approved its version of healthcare reform legislation on July 15, 2009 which is similar to, but less extensive in benefits than, the House version. Meanwhile, during August 2009 the Senate Committee on Finance continued its efforts to negotiate a bipartisan agreement on healthcare reform legislation and that committee is not expected to vote upon its healthcare reform bill until at least September 2009. One of the most significant differences in the legislation produced by the Senate Finance Committee is likely to be the establishment of state and/or regional health insurance cooperatives in lieu of a federally-administered “public option” to compete with private health insurance plans.  Once passed by the Senate Finance Committee, the two Senate committees will need to merge the two bills into one final version for consideration by the entire Senate, potentially in September or October 2009. Also, many states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures. States have also adopted, or are considering, legislation designed to reduce coverage and program eligibility, enroll Medicaid recipients in managed care programs and/or impose additional taxes on hospitals to help finance or expand states’ Medicaid systems. We cannot predict whether any of the above proposals or any other proposals will be adopted, and if adopted, we cannot assure you that the implementation of these reforms will not have a material adverse effect on our business, financial position or results of operations.

        Our facilities are concentrated in a small number of regions. If any one of the regions in which we operate experiences a regulatory change, economic downturn or other material change, our overall business results may suffer.

        Among our operations as of June 30, 2009, five hospitals and various related healthcare businesses were located in San Antonio, Texas; five hospitals and related healthcare businesses were located in metropolitan Phoenix, Arizona; two hospitals and related healthcare businesses were located in metropolitan Chicago, Illinois; and three hospitals and related healthcare businesses were located in Massachusetts.

For the year ended June 30, 2009, our total revenues were generated as follows:

 

 

Year Ended
June 30, 2009

 

 

 


 

San Antonio

 

29.6

%

 

Phoenix Health Plan and Abrazo Advantage Health Plan

 

19.3

Massachusetts

 

18.3

Metropolitan Phoenix, excluding Phoenix Health Plan and Abrazo
   Advantage Health Plan

 

17.9

 

 

Metropolitan Chicago (1)

 

14.6

Other

 

0.3

 

 


  

____________________

 

100.0

%

 

(1)   Includes MacNeal Health Providers.

 

 

 

 

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        Any material change in the current demographic, economic, competitive or regulatory conditions in any of these regions could adversely affect our overall business results because of the significance of our operations in each of these regions to our overall operating performance. Moreover, due to the concentration of our revenues in only four regions, our business is less diversified and, accordingly, is subject to greater regional risk than that of some of our larger competitors.

        If we are unable to control our healthcare costs at Phoenix Health Plan and Abrazo Advantage Health Plan, if the health plans should lose their governmental contracts or if budgetary cuts reduce the scope of Medicaid or dual-eligibility coverage, our profitability may be adversely affected.

        For the year ended June 30, 2009, PHP generated approximately 18.1% of our total revenues. PHP derives substantially all of its revenues through a contract with AHCCCS. AHCCCS pays capitated rates to PHP, and PHP subcontracts with physicians, hospitals and other healthcare providers to provide services to its enrollees. If we fail to effectively manage our healthcare costs, these costs may exceed the payments we receive. Many factors can cause actual healthcare costs to exceed the capitated rates paid by AHCCCS, including:

        •

 

our ability to contract with cost-effective healthcare providers;                                                                   

        •

 

the increased cost of individual healthcare services;

        •

the type and number of individual healthcare services delivered; and

        •

the occurrence of catastrophes, epidemics or other unforeseen occurrences

        Our current contract with AHCCCS began October 1, 2008 and expires September 30, 2011. This contract is terminable without cause on 90 days’ written notice from AHCCCS or for cause upon written notice from AHCCCS if we fail to comply with any term or condition of the contract or fail to take corrective action as required to comply with the terms of the contract. AHCCCS may also terminate the contract with PHP in the event of unavailability of state or federal funding. If our AHCCCS contract is terminated, our profitability would be adversely affected by the loss of these revenues and cash flows. Also, should the scope of the Medicaid program be reduced as a result of state budgetary cuts or other political factors, our results of operations could be adversely affected.

        For the year ended June 30, 2009, AAHP generated 1.2% of our total revenues. AAHP began providing healthcare coverage to Medicare and Medicaid dual-eligible enrollees on January 1, 2006. Most of AAHP’s members were formerly enrolled in PHP. AAHP’s contract with CMS went into effect on January 1, 2006, for a term of one year, with a provision for successive one year renewals, and has currently been renewed through December 31, 2009. If we fail to effectively manage AAHP’s healthcare costs, these costs may exceed the payments we receive.

        We are dependent on our senior management team and local management personnel, and the loss of the services of one or more of our senior management team or key local management personnel could have a material adverse effect on our business.

        The success of our business is largely dependent upon the services and management experience of our senior management team, which includes Charles N. Martin, Jr., our Chairman and Chief Executive Officer; Kent H. Wallace, our President and Chief Operating Officer; Keith B. Pitts, our Vice Chairman, Phillip W. Roe, our Executive Vice President, Chief Financial Officer and Treasurer; and Joseph D. Moore, Executive Vice President. In addition, we depend on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our senior officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. We do not maintain key man life insurance policies on any of our officers. If we were to lose any of our senior management team or members of our local management teams, or if we are unable to attract other necessary personnel in the future, it could have a material adverse effect on our business, financial condition and results of operations. If we were to lose the services of one or more members of our senior management team or a significant portion of our hospital management staff at one or more of our hospitals, we would likely experience a significant disruption in our operations and failure of the affected hospitals to adhere to their respective business plans.

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        Controls designed to reduce inpatient services may reduce our revenues.

        Controls imposed by Medicare and commercial third-party payers designed to reduce admissions and lengths of stay, commonly referred to as “utilization review,” have affected and are expected to continue to affect our facilities. Utilization review entails the review of the admission and course of treatment of a patient by managed care plans. Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payer-required preadmission authorization and utilization review and by payer pressures to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Efforts to impose more stringent cost controls are expected to continue. Although we are unable to predict the effect these changes will have on our operations, significant limits on the scope of services reimbursed and on reimbursement rates and fees could have a material, adverse effect on our business, financial position and results of operations.

        If we fail to continually enhance our hospitals with the most recent technological advances in diagnostic and surgical equipment, our ability to maintain and expand our markets will be adversely affected.

        Technological advances with respect to computed axial tomography (CT), magnetic resonance imaging (MRI) and positron emission tomography (PET) equipment, as well as other equipment used in our facilities, are continually evolving. In an effort to compete with other healthcare providers, we must constantly evaluate our equipment needs and upgrade equipment as a result of technological improvements. Such equipment costs typically range from $1.0 million to $3.0 million, exclusive of construction or build-out costs.

        Our hospitals face competition for staffing especially as a result of the national shortage of nurses and the increased imposition on us of nurse-staffing ratios, which has in the past and may in the future increase our labor costs and materially reduce our profitability.

        We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including most significantly nurses and other non-physician healthcare professionals. In the healthcare industry generally, including in our markets, the national shortage of nurses and other medical support personnel has become a significant operating issue. This shortage has caused us in the past and may require us in the future to increase wages and benefits to recruit and retain nurses and other medical support personnel or to hire more expensive temporary personnel. We have voluntarily raised on several occasions in the past, and expect to raise in the future, wages for our nurses and other medical support personnel.

        In addition, union-mandated or state-mandated nurse-staffing ratios significantly affect not only labor costs, but may also cause us to limit patient admissions with a corresponding adverse effect on revenues if we are unable to hire the appropriate number of nurses to meet the required ratios. While we do not currently operate in any states with mandated nurse-staffing ratios, the states in which we operate could adopt mandatory nurse-staffing ratios at any time. In those instances where our nurses are unionized, it is our experience that new union contracts often impose significant new additional staffing ratios by contract on our hospitals. This was the case with the increased staffing ratios imposed on us in our union contract with our nurses at Saint Vincent Hospital in Worcester, Massachusetts negotiated in 2007.

        Congress is currently considering a bill called the Employee Free Choice Act of 2009 (“EFCA”) which organized labor, a major supporter of the Obama administration, has called its number one legislative objective. EFCA would amend the National Labor Relations Act to establish a procedure whereby the National Labor Relations Board would certify a union as the bargaining representative of employees, without a NLRB-supervised secret ballot election, if a majority of unit employees signs valid union authorization cards (the “card-check provision”). Additionally, under EFCA, parties that are unable to reach a first contract within 90 days of collective bargaining could refer the dispute to mediation by the Federal Mediation and Conciliation Service. If the Service is unable to bring the parties to agreement within 30 days, the dispute then would be referred to binding arbitration. Also, the bill would provide for increased penalties for labor law violations by employers. In July 2009, due to intense opposition from the business community, alternative draft legislation became public dropping the card-check provision, but putting in its place new provisions making it easier for employees to organize including provisions to require shorter unionization campaigns, faster elections and limitations on employer-sponsored anti-unionization

47


meetings which employees are required to attend. This legislation, if passed, would make it easier for our nurses or other groups of hospital employees to unionize, which could materially increase our labor costs.

        If our labor costs continue to increase, we may not be able to raise our payer reimbursement levels to offset these increased costs, including the significantly increased costs that we will incur for wage increases and nurse-staffing ratios under our new union contract with our nurses at Saint Vincent Hospital.  Because substantially all of our net patient revenues consist of payments based on fixed or negotiated rates, our ability to pass along increased labor costs is materially constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have a material adverse effect on our profitability.

        The current economic recession, along with difficult and volatile conditions in the capital and credit markets, could materially adversely affect our financial position, results of operations or cash flows, and we are unsure whether these conditions will improve in the near future.

        The United States economy is currently in a period of recession and global credit markets remain volatile. Declining consumer confidence and increased unemployment have increased concerns of prolonged economic weakness. While certain healthcare spending is considered non-discretionary and may not be significantly impacted by economic downturns, other types of healthcare spending may be significantly adversely impacted by such conditions. When patients are experiencing personal financial difficulties or have concerns about general economic conditions, they may choose to defer or forego elective surgeries and other non-emergent procedures, which are generally more profitable lines of business for hospitals. We are unable to determine the specific impact of the current economic conditions on our business at this time, but we believe that further deterioration or a prolonged period of recession will have an adverse impact on our operations. Other risk factors discussed in this report describe some significant risks that may be magnified by the current economic conditions such as the following:

        •

  

Our concentration of operations in a small number of regions, and the impact of economic downturns in those communities. To the extent the communities in and around San Antonio, Texas; Phoenix, Arizona; Chicago, Illinois or certain communities in Massachusetts experience a greater degree of economic weakness than average, the adverse impact on our operations could be magnified.

 

 

 

        •

Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies (including managed Medicare and managed Medicaid payers) reduce our reimbursement. Current economic conditions have accelerated and increased the budget deficits for most states, including those in which we operate. These budgetary pressures may result in healthcare payment reductions under state Medicaid plans or reduced benefits to participants in those plans. Also, governmental, managed Medicare or managed Medicaid payers may defer payments to us to conserve cash. Managed care companies may also seek to reduce payment rates or limit payment rate increases to hospitals in response to reductions in enrolled participants.

 

 

 

        •

Our hospitals face a growth in uncompensated care as the result of the inability of uninsured patients to pay for healthcare services and difficulties in collecting patient portions of insured accounts. Higher unemployment, Medicaid benefit reductions and employer efforts to reduce employee healthcare costs may increase our exposure to uncollectible accounts for uninsured patients or those patients with higher co-pay and deductible limits.

 

 

 

        •

We believe our operating cash and remaining borrowing capacity is sufficient to run our business and fund our growth initiatives. However, under extreme market conditions, there can be no assurance that such funds will be available to us on favorable terms or at all. Most of our cash and borrowing capacity under our revolving credit facility is held with a limited number of financial institutions, which could increase our liquidity risk if one or more of those institutions become financially strained or are no longer able to operate.

        We are unable to predict if the condition of the United States economy, the local economies in the communities we serve or global credit conditions will improve in the near future or when such improvements may occur.

48


        Compliance with section 404 of the Sarbanes-Oxley Act may negatively impact our results of operations and failure to comply may subject us to regulatory scrutiny and a loss of investors’ confidence in our internal control over financial reporting.

        Section 404 of the Sarbanes-Oxley Act of 2002 (the “404 Act”) requires us to perform an evaluation of our internal control over financial reporting and file management’s attestation with our annual report. The 404 Act also requires our independent auditors to opine on our internal control over financial reporting beginning with our fiscal year ending June 30, 2010. We have evaluated, tested and implemented internal controls over financial reporting to enable management to report on such internal controls under the 404 Act. However, we can not assure you that the conclusions reached in our June 30, 2010 management report will be the same as those reached by our independent auditors in its report. Failure on our part to comply with the 404 Act may subject us to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting.

        A failure of our information systems would adversely affect our ability to properly manage our operations.

        We rely on our advanced information systems and our ability to successfully use these systems in our operations. These systems are essential to the following areas of our business operations, among others:

               •

patient accounting, including billing and collection of patient service revenues;

               •

financial, accounting, reporting and payroll;

               •

coding and compliance;

               •

laboratory, radiology and pharmacy systems;

               •

remote physician access to patient data;

               •

negotiating, pricing and administering managed care contracts; and

               •

monitoring quality of care.

        If we are unable to use these systems effectively, we may experience delays in collection of patient service revenues and may not be able to properly manage our operations or oversee the compliance with laws or regulations.

        Difficulties with current construction projects or new construction projects such as additional hospitals or major expansion projects may involve significant capital expenditures that could have an adverse impact on our liquidity.

        We may decide to construct an additional hospital or hospitals in the future or construct additional major expansion projects to existing hospitals in order to achieve our growth objectives. Our ability to complete construction of new hospitals or new expansion projects on budget and on schedule would depend on a number of factors, including, but not limited to:

               •

our ability to control construction costs;                                                                                                       

               •

the failure of general contractors or subcontractors to perform under their contracts;

               •

adverse weather conditions;

               •

shortages of labor or materials;

               •

our ability to obtain necessary licensing and other required governmental authorizations; and

               •

other unforeseen problems and delays.

        As a result of these and other factors, we cannot assure you that we will not experience increased construction costs on our construction projects or that we will be able to construct our current or any future construction projects as originally planned. In addition, our current and any future major construction projects would involve a significant commitment of capital with no revenues associated with the projects during construction, which also could have a future adverse impact on our liquidity.

        If the costs for construction materials and labor continue to rise, such increased costs could have an adverse impact on the return on investment relating to our expansion projects.

        The cost of construction materials and labor has significantly increased over the past years as a result of global and domestic events. We have experienced significant increases in the cost of steel due to the demand in China for

49


such materials and an increase in the cost of lumber due to multiple factors. Increases in oil and gas prices have increased costs for oil-based products and for transporting materials to job sites. As we continue to invest in modern technologies, emergency rooms and operating room expansions, we expend large sums of cash generated from operating activities. We evaluate the financial viability of such projects based on whether the projected cash flow return on investment exceeds our cost of capital. Such returns may not be achieved if the cost of construction continues to rise significantly or anticipated volumes do not materialize.

        State efforts to regulate the construction or expansion of hospitals could impair our ability to operate and expand our operations.

        Some states require healthcare providers to obtain prior approval, known as certificates of need, for:

               •

the purchase, construction or expansion of healthcare facilities;                                                                  

               •

capital expenditures exceeding a prescribed amount; or

               •

changes in services or bed capacity.

        In giving approval, these states consider the need for additional or expanded healthcare facilities or services. Illinois and Massachusetts are the only states in which we currently own hospitals that have certificate of need laws. The failure to obtain any required certificate of need could impair our ability to operate or expand operations in these states.

        If the fair value of our reporting units declines, a material non-cash charge to earnings from impairment of our goodwill could result.

        Blackstone acquired our predecessor company during fiscal 2005. We recorded a significant portion of the purchase price as goodwill. At June 30, 2009, we had approximately $692.1 million of goodwill recorded on our financial statements. We expect to recover the carrying value of this goodwill through our future cash flows. On an ongoing basis, we evaluate, based on the fair value of our reporting units, whether the carrying value of our goodwill is impaired. During fiscal 2007, we recorded a $123.8 million ($110.5 million, net of tax benefit) impairment charge to goodwill to reduce the carrying values of our Chicago hospitals to their fair values. If the carrying value of our goodwill is further impaired, we may incur an additional material non-cash charge to earnings.

Additional Risk Factors

        See the additional risks related to our business in “Item 7 – Management’s Discussion and Analysis of Financial Conditions and Results of Operations – General Trends” which are incorporated by reference in this Item 1A as if fully set forth herein.

Available Information

        We currently voluntarily file certain reports with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K and quarterly reports on Form 10-Q. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We are an electronic filer and the SEC maintains an Internet site at http://www.sec.gov that contains the reports and other information we file electronically. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports are also available free of charge on our internet website at www.vanguardhealth.com under “Investor Relations-SEC Filings-SEC Filings on the Edgar Database” as soon as reasonably practicable after such reports are electronically filed with or furnished to the SEC. Please note that our website address is provided as an inactive textual reference only. Also, the information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is specifically referenced elsewhere in this report.

Item 1B. Unresolved Staff Comments.

        Not applicable.

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Item 2.    Properties.

        A listing of our owned acute hospitals is included in Item 1 of this report under the caption “Business-Our Facilities”. We also own or lease space for outpatient service facilities complementary to our hospitals and own and operate a limited number of medical office buildings (some of which are joint ventures) associated with our hospitals that are occupied primarily by physicians who practice at our hospitals. The most significant of these complementary outpatient healthcare facilities are two surgery centers in Orange County, California, five diagnostic imaging centers in metropolitan Phoenix, Arizona and a 50% interest in seven diagnostic imaging centers in San Antonio, Texas. Most of these outpatient facilities are in leased facilities, and the diagnostic imaging centers in San Antonio are owned and operated in joint ventures where we have minority partners.

        As of June 30, 2009, we leased approximately 53,200 square feet of office space at 20 Burton Hills Boulevard, Nashville, Tennessee, for our corporate headquarters.

        Our headquarters, hospitals and other facilities are suitable for their respective uses and are, in general, adequate for our present needs. Our obligations under our senior credit facilities are secured by a pledge of substantially all of our assets, including first priority mortgages on each of our hospitals. Also, our properties are subject to various federal, state and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our financial position or results from operations.

Item 3.    Legal Proceedings.

        We operate in a highly regulated and litigious industry. As a result, various lawsuits, claims and legal and regulatory proceedings have been instituted or asserted against us.  While we cannot predict the likelihood of future claims or inquiries, we expect that new matters may be initiated against us from time to time. The results of claims, lawsuits and investigations cannot be predicted, and it is possible that the ultimate resolution of these matters, individually or in the aggregate, may have a material adverse effect on our business (both in the near and long term), financial position, results of operations or cash flows. We recognize that, where appropriate, our interests may be best served by resolving certain matters without litigation. If non-litigated resolution is not possible or appropriate with respect to a particular matter, we will continue to defend ourselves vigorously.

        Currently pending and recently settled legal proceedings and investigations that are not in the ordinary course of business are set forth below. Where specific amounts are sought in any pending legal proceeding, those amounts are disclosed. For all other matters, where the possible loss or range of loss is reasonably estimable, an estimate is provided. Where no estimate is provided, the possible amount of loss is not reasonably estimable at this time. We record reserves for claims and lawsuits when they are probable and reasonably estimable. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, we have not recognized in our consolidated financial statements all potential liabilities that may result. We undertake no obligation to update the following disclosures for any new developments.

        Sherman Act Antitrust Class Action Litigation – Maderazo, et al v. VHS San Antonio Partners, L.P. d/b/a Baptist Health Systems, et al, Case No. 5:06cv00535 (United States District Court, Western District of Texas, San Antonio Division, filed June 20, 2006 and amended August 29, 2006)

        On June 20, 2006, a federal antitrust class action suit was filed in San Antonio, Texas against our Baptist Health System subsidiary in San Antonio, Texas and two other large hospital systems in San Antonio. In the complaint, plaintiffs allege that the three hospital system defendants conspired with each other and with other unidentified San Antonio area hospitals to depress the compensation levels of registered nurses employed at the conspiring hospitals within the San Antonio area by engaging in certain activities that violated the federal antitrust laws. The complaint alleges two separate claims. The first count asserts that the defendant hospitals violated Section 1 of the federal Sherman Act, which prohibits agreements that unreasonably restrain competition, by conspiring to depress nurses’ compensation. The second count alleges that the defendant hospital systems also violated Section 1 of the Sherman Act by participating in wage, salary and benefits surveys for the purpose, and having the effect, of depressing registered nurses’ compensation or limiting competition for nurses based on their compensation. The class on whose behalf the plaintiffs filed the complaint is alleged to comprise all registered nurses employed by the defendant hospitals since June 20, 2002. The suit seeks unspecified damages, trebling of this damage amount pursuant to

51


federal law, interest, costs and attorneys fees. From 2006 through April 2008 we and the plaintiffs worked on producing documents to each other relating to, and supplying legal briefs to the court in respect of, the issue of whether the court will certify a class in this suit. In April 2008 the case was stayed by the judge pending his ruling on plaintiffs’ motion for class certification. We believe that the allegations contained within this putative class action suit are without merit, and we have vigorously worked to defeat class certification. If a class is certified, we will continue to defend vigorously against the litigation.

        On the same date that this suit was filed against us in federal district court in San Antonio, the same attorneys filed three other substantially similar putative class action lawsuits in federal district courts in Chicago, Illinois, Albany, New York and Memphis, Tennessee against some of the hospitals in those cities (none of such hospitals being owned by us). The attorneys representing the plaintiffs in all four of these cases said in June 2006 that they may file similar complaints in other jurisdictions and in December 2006 they brought a substantially similar class action lawsuit against various hospitals in the Detroit, Michigan metropolitan area. Since representatives of the Service Employees International Union joined plaintiffs’ attorneys in announcing the filing of all four complaints on June 20, 2006, and as has been reported in the media, we believe that SEIU’s involvement in these actions appears to be part of a corporate campaign to attempt to organize nurses in these cities, including San Antonio. The nurses in our hospitals in San Antonio are currently not members of any union.

        Claims in the ordinary course of business.

        We are also subject to claims and lawsuits arising in the ordinary course of business, including potential claims related to care and treatment provided at our hospitals and outpatient services facilities.  Although the results of these claims and lawsuits cannot be predicted with certainty, we believe that the ultimate resolution of these ordinary course claims and lawsuits will not have a material adverse effect on our business, financial condition or results of operations.

Item 4.    Submission of Matters to a Vote of Security Holders.

        No matters were submitted to a vote of stockholders during the fourth quarter ended June 30, 2009, except that the holders of 100% of our outstanding common stock approved Amendment 6 to our 2004 Stock Incentive Plan pursuant to a written consent dated May 5, 2009. This Amendment increased the total number of our shares which may be issued under the Plan from 101,117 to 105,611.

52



PART II

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

        There is no established public trading market for our common stock.  At September 1, 2009, there were five holders of record of our common stock.  These holders are VHS Holdings LLC and four investment funds affiliated with Blackstone.

        We have not declared or paid any dividends on our common stock in our two most recent fiscal years.  We intend to retain all current and foreseeable future earnings to support operations and finance expansion.  Our senior secured credit facility and the indentures governing our long-term indebtedness restrict our ability to pay cash dividends on our common stock.

        There were no unregistered sales of our equity securities during the quarter ended June 30, 2009.

        Information regarding our equity compensation plans is set forth in this report under “Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters – Equity Compensation Plan Information”, which information is incorporated herein by reference.

Item 6.    Selected Financial Data.

        The following table sets forth our selected historical financial and operating data for, or as of the end of, each of the five years ended June 30, 2009 (including the predecessor and successor periods). The selected historical financial data as of and for the combined predecessor and successor year ended June 30, 2005 and the years ended June 30, 2006, 2007, 2008 and 2009 were derived from our audited consolidated financial statements that have been audited by Ernst & Young LLP, an independent registered public accounting firm. Dispositions completed during fiscal 2007 have been excluded from all periods presented. See “Executive Overview” included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” This table should be read in conjunction with the consolidated financial statements and notes thereto.

53



 

Combined
Basis
Year
Ended
June 30,
2005

Year
Ended
June 30,
2006

Year
Ended
June 30,
2007

Year
ended
June 30,
2008

Year
ended
June 30,
2009

Predecessor
July 1, 2004
through
September
22,
2004

Successor
September 23,
2004
through
June 30,
2005

 








(Dollars in millions, except Operating Data)

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Total revenues

 

$

2,037.3

 

 

$

2,418.6

 

 

$

2,580.7

 

$

2,790.7

 

$

3,199.7

 

$

397.9

 

 

$

1,639.4

 

   Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

      Salaries and benefits (includes stock compensation
         of $97.4, $1.7, $1.2, $2.5, $4.4, $96.7 and
         $0.7, respectively)

909.2

991.4

1,067.9

1,152.7

1,240.1

248.2

661.0

      Supplies

336.8

394.1

421.8

434.5

456.3

63.7

273.1

      Health plan claims expense

237.2

270.3

297.0

328.2

525.6

55.0

182.2

      Provision for doubtful accounts

133.0

156.8

175.2

205.6

210.8

27.8

105.2

      Other operating expenses

288.8

353.0

375.0

405.8

468.9

57.3

231.5

      Depreciation and amortization

75.7

100.3

118.6

131.0

130.6

16.0

59.7

      Interest, net

82.3

103.8

123.8

122.1

111.6

9.0

73.3

      Debt extinguishment costs

62.2

0.1

62.2

      Minority interests

(0.3

)

2.6

2.6

3.0

3.2

(0.5

)

0.2

      Merger expenses

23.3

23.1

0.2

      Impairment loss

123.8

6.2

      Other expenses

3.6

6.5

0.2

6.5

2.7

0.4

3.2

 

 

 


 

 

 


 

 

 


 

 


 

 


 

 


 

 

 


 

      Subtotal

2,151.8

2,378.9

2,705.9

2,789.4

3,156.0

562.2

1,589.6

 


 

 

 


 

 

 


 

 


 

 


 

 


 

 

 


 

   Income (loss) from continuing operations
      before income taxes

(114.5

)

39.7

(125.2

)

1.3

43.7

(164.3

)

49.8

   Income tax expense (benefit)

(34.7

)

17.8

(11.6

)

1.7

16.0

(52.2

)

17.5

 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

   Income (loss) from continuing operations

(79.8

)

21.9

(113.6

)

(0.4

)

27.7

(112.1

)

32.3

   Income (loss) from discontinued operations,
      net of taxes

1.7

(9.0

)

(19.1

)

(0.3

)

0.9

1.4

0.3

 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

   Net income (loss)

(78.1

)

12.9

(132.7

)

(0.7

)

28.6

(110.7

)

32.6

   Preferred dividends

(1.0

)

(1.0

)

 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

 

 


 

   Net income (loss) attributable to common
      stockholders

$

(79.1

)

$

12.9

$

(132.7

)

$

(0.7

)

$

28.6

$

(111.7

)

$

32.6

 








Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Assets

$

2,471.7

$

2,650.5

$

2,538.1

$

2,582.3

$

2,731.1

$

2,471.7

   Long-term debt, including current portion

1,357.1

1,519.2

1,528.7

1,537.5

1,551.6

1,357.1

   Working capital

77.7

193.0

156.4

217.8

251.6

77.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Financial Data:

   Capital expenditures

$

224.2

$

275.5

$

164.3

$

121.6

$

132.1

$

27.1

$

197.1

   Cash provided by operating activities

201.8

149.3

123.3

173.1

308.2

78.8

123.0

   Cash used in investing activities

(324.3

)

(245.4

)

(118.5

)

(143.8

)

(133.6

)

(50.0

)

(274.3

)

   Cash provided by (used in) financing activities

151.6

140.5

(8.3

)

(7.8

)

(8.0

)

(20.0

)

171.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Data-continuing operations: (unaudited)

   Number of hospitals at end of period

15

15

15

15

15

   Number of licensed beds at end of period (a)

3,907

3,937

4,143

4,181

4,135

   Discharges (b)

147,798

162,446

166,873

169,668

167,880

   Adjusted discharges - hospitals (c)

231,322

261,056

264,698

270,076

274,767

   Adjusted discharges (d)

278,255

303,696

278,820

284,680

289,997

   Net revenue per adjusted discharge – hospitals (e)

$

6,859

$

7,319

$

7,766

$

8,110

$

8,623

   Net revenue per adjusted discharge (f)

$

6,817

$

7,353

$

7,690

$

8,059

$

8,517

   Patient days (g)

623,333

701,307

721,832

734,838

709,952

   Average length of stay (days) (h)

4.2

4.3

4.3

4.3

4.2

   Inpatient surgeries (i)

33,424

36,606

37,227

37,538

37,970

   Outpatient surgeries (j)

67,944

76,437

76,606

73,339

76,378

   Emergency room visits (k)

504,172

554,250

572,946

588,246

605,729

   Occupancy rate (l)

48.5%

49.2%

48.2%

48.0%

47.0%

   Average daily census (m)

 

 

1,708

 

 

 

1,921

 

 

 

1,978

 

 

 

2,008

 

 

 

1,945

 

 

 

 

 

 

 

 

 

   Member lives (n)

146,700

146,200

145,600

149,600

218,700

   Health plan claims expense percentage (o)

71.1%

72.1%

74.0%

72.9%

77.5%

54



____________________

(a)

 

Licensed beds are those beds for which a facility has been granted approval to operate from the applicable state licensing agency.

 

 

 

(b)

 

Discharges represent the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatient volumes.

 

 

 

(c)

 

Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined hospital inpatient and outpatient volumes. Adjusted discharges-hospitals is computed by multiplying discharges by the sum of gross hospital inpatient and gross hospital outpatient revenues and then dividing the result by gross hospital inpatient revenues. This computation enables management to assess hospital volumes by a combined measure of hospital inpatient and outpatient utilization.

 

 

 

(d)

 

Adjusted discharges is used by management and certain investors as a general measure of consolidated inpatient and outpatient volumes. Adjusted discharges is computed by multiplying discharges by the sum of gross inpatient revenues and gross outpatient revenues and then dividing the result by gross inpatient revenues.

 

 

 

(e)

 

Net revenue per adjusted discharge-hospitals is calculated by dividing hospital net patient revenues by adjusted discharges-hospitals and measures the average net payment expected to be received for a patient’s stay in the hospital.

 

 

 

(f)

 

Net revenue per adjusted discharge is calculated by dividing net patient revenues by adjusted discharges and measures the average net payment expected to be received for an episode of service provided to a patient.

 

 

 

(g)

 

Patient days represent the number of days (calculated as overnight stays) our beds were occupied by patients during the periods.

 

 

 

(h)

 

Average length of stay represents the average number of days an admitted patient stays in our hospitals.

 

 

 

(i)

 

Inpatient surgeries represent the number of surgeries performed in our hospitals where overnight stays are necessary.

 

 

 

(j)

 

Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stay not necessary).

 

 

 

(k)

 

Emergency room visits represent the number of patient visits to a hospital or freestanding emergency room where treatment is received, regardless of whether an overnight stay is subsequently required.

 

 

 

(l)

 

Occupancy rate represents the percentage of hospital licensed beds occupied by patients. Occupancy rate provides a measure of the utilization of inpatient rooms.

 

 

 

(m)

 

Average daily census represents the average number of patients in our hospitals each day during our ownership.

 

 

 

(n)

 

Member lives represent the total number of enrollees in PHP, AAHP and MHP as of the end of the respective period.

 

 

 

(o)

 

Health plan claims expense percentage is calculated by dividing health plan claims expense by premium revenues.

55



Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

        You should read the following discussion together with our historical financial statements and related notes included elsewhere herein and the information set forth under “Item 6. Selected Financial Data.” The discussion contains forward-looking statements that involve risks and uncertainties. For additional information regarding some of the risks and uncertainties that affect our business and the industry in which we operate, please read “Item 1A. - Risk Factors” included elsewhere herein. Our actual results may differ materially from those estimated or projected in any of these forward-looking statements.

Executive Overview

        As of June 30, 2009, we owned and operated 15 hospitals with a total of 4,135 licensed beds, and related outpatient service facilities complementary to the hospitals in San Antonio, Texas; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; and Massachusetts, and two surgery centers in Orange County, California. As of June 30, 2009, we also owned three health plans as set forth in the following table.

Health Plan

    

 

   Location   

      

Membership



 


Phoenix Health Plan (“PHP”) – managed Medicaid

 

Arizona

 

176,200

Abrazo Advantage Health Plan (“AAHP”) – managed Medicare and Dual Eligible

 

Arizona

 

    2,800

MacNeal Health Providers (“MHP”) – capitated outpatient and physician services

 

Illinois

 

  39,700

 

 

 


 

 

 

 

218,700

 

 

 

 


        Our objective is to help communities achieve health for life by delivering an ideal patient-centered experience in a highly reliable environment of care. We plan to grow our business by improving quality of care, expanding services and strengthening the financial performance of our existing operations and selectively acquiring other hospitals where we see an opportunity to improve operating performance and profitability.

Operating Environment

        We believe that the operating environment for hospital operators continues to evolve, which presents both challenges and opportunities for us.  In order to remain competitive in the markets we serve, we must transform our operating strategies to not only accommodate changing environmental factors but to make them operating advantages for us relative to our peers.  These factors will require continued focus on quality of care initiatives. As consumers become more involved in their healthcare decisions, we believe perceived quality of care will become an even greater factor in determining where physicians choose to practice and where patients choose to receive care. In the following paragraphs we discuss both current challenges and future challenges that we face and our strategies to proactively address them.

        Pay for Performance Reimbursement

        Many payers, including Medicare and several large managed care organizations, currently require hospital providers to report certain quality measures in order to receive the full amount of payment increases that were awarded automatically in the past.  For federal fiscal year 2010, Medicare expanded the number of quality measures to be reported to 47 compared to 43 during federal fiscal year 2009. Many large managed care organizations have developed quality measurement criteria that are similar to or even more stringent than these Medicare requirements.  While current Medicare guidelines and contracts with most managed care payers provide for reimbursement based upon the reporting of quality measures, we believe it is only a matter of time until all significant payers utilize the quality measures themselves to determine reimbursement rates for hospital services. In order to meet these requirements, we must deliver an ideal patient-centered experience. This will require us to engage our nurses and partner with physicians to drive our quality of care strategies, invest in and to upgrade our information technology systems to monitor clinical quality indicators and to make all of our processes more efficient.

56


        Physician Alignment

        Our ability to attract skilled physicians to our hospitals is critical to our success. Coordination of care and alignment of care strategies between hospitals and physicians will become more critical as reimbursement becomes more episode-based. We have adopted several significant physician recruitment goals with primary emphasis on recruiting physicians specializing in family practice, internal medicine, obstetrics and gynecology, cardiology, neurology, orthopedics and inpatient hospital care (hospitalists). To provide our patients access to the appropriate physician resources, we recruited approximately 150 physicians to the communities served by our hospitals during the year ended June 30, 2009 through employment agreements, relocation agreements or physician practice acquisitions. We have invested heavily in the infrastructure necessary to coordinate our physician alignment strategies and manage our physician operations. Our hospitalist strategy is a key element in coordination of patient-centered care. The costs associated with recruiting, integrating and managing such a large number of new physicians will have a negative impact on our operating results and cash flows in the short term. However, we expect to realize improved clinical quality and service expansion capabilities from this initiative that will positively impact our operating results over the long-term.

        Cost pressures

        In order to demonstrate a highly reliable environment of care, we must hire and retain nurses who share our ideals and beliefs and who have access to the training necessary to implement our clinical quality initiatives. While the national nursing shortage has abated somewhat during the past year, the nursing workforce remains volatile. As a result, we expect continuing pressures on nursing salaries and benefits. These pressures include higher than normal base wage increases, demands for flexible working hours and other increased benefits and higher nurse to patient ratios necessary to improve quality of care. Inflationary pressures and technological advancements continue to drive supplies costs higher. We have implemented multiple supply chain initiatives including consolidation of low-priced vendors, establishment of value analysis teams and coordination of care efforts with physicians to reduce physician preference items.

        Potential Healthcare Reform

        The increase in the number of individuals and families without healthcare coverage has heightened debate about whether and how to implement comprehensive reform of the United States healthcare system. The Obama administration has made healthcare reform its primary domestic agenda item, and Congress is currently considering multiple plans on how to change the healthcare system and how to fund those changes. Generally, President Obama and most members of Congress believe that the current healthcare system is too inefficient and leaves too many individuals without healthcare coverage. Much of the current healthcare reform debate includes the following considerations: whether a public insurance option should be established; the impact to private insurance companies; the impact to consumer choice of healthcare services; the impact to small businesses; and the impact of funding alternatives including personal tax rate increases, business surcharges, service provider assessments and increasing the federal deficit. We are not able to predict whether healthcare reform will be implemented, what provisions a potential reform plan may include or what impact these developments may have on our future operating results or cash flows at this time.

        Implementation of our Clinical Quality Initiatives

The integral component of each of the challenge areas previously discussed is quality of care. We have implemented many of our expanded clinical quality initiatives and are in the process of implementing several others. These initiatives include monthly review of the current 43 CMS quality indicators, rapid response teams, mock Joint Commission surveys, hourly nursing rounds, our nurse leadership professional practice model, alignment of hospital management incentive compensation with quality performance indicators and the formation of Physician Advisory Councils at our hospitals to align the quality goals of our hospitals with those of the physicians who practice in our hospitals.

57



Revenue/Volume Trends

        Our revenues depend upon inpatient occupancy levels, outpatient procedures performed at our facilities, the ancillary services and therapy programs ordered by physicians and provided to patients and our ability to successfully negotiate appropriate payment rates for these services with third party payers.

        Sources of Revenues

        The primary sources of our revenues include various managed care payers including managed Medicare and managed Medicaid programs, the traditional Medicare program, various state Medicaid programs, commercial health plans and the patients themselves. We are typically paid much less than our gross charges regardless of the payer source. Refer to “Item 1. Business – “Sources of Revenues” section of this report for a comprehensive discussion of these payers, how they reimburse us for our services provided and the risks we face with regard to potential reimbursement changes.

        The following table sets forth the percentages of net patient revenues by payer for the years ended June 30, 2007, 2008 and 2009.

 

 

Year ended June 30,

 

 


 

 

2007

 

2008

 

2009

 

 


 


 


Medicare

26.4%

26.2%

25.3%

Medicaid

8.6%

7.6%

7.8%

Managed Medicare

12.8%

14.0%

14.1%

Managed Medicaid

7.5%

7.5%

8.9%

Managed care

32.0%

35.0%

34.8%

Self pay

9.7%

8.6%

8.2%

Other

3.0%

1.1%

0.9%

 

 


 


 


Total

100.0%

100.0%

100.0%

 

 


 


 


        Volumes by Payer

        During the year ended June 30, 2009, we experienced a 1.1% decrease in discharges compared to the prior year. During the year ended June 30, 2009, we experienced a 1.7% increase in hospital adjusted discharges compared to the prior year. The following table provides details of discharges by payer for the years ended June 30, 2007, 2008 and 2009.

 

 

Year  ended June 30,

 

 


 

 

2007

 

2008

 

2009

 

 


 


 


Medicare

 

46,452

 

27.8%

 

47,040

 

27.7%

  

45,516

 

27.1%

Medicaid

 

22,518

 

13.5%

 

20,195

 

11.9%

 

17,068

 

10.2%

Managed Medicare

23,339

14.0%

26,040

15.3%

26,925

16.0%

Managed Medicaid

18,579

11.1%

19,893

11.7%

23,185

13.8%

Managed care

 

48,481

 

29.1%

 

50,040

 

29.5%

 

48,977

 

29.2%

Self pay

 

6,181

 

3.7%

 

5,854

 

3.5%

 

5,650

 

3.4%

Other

1,323

0.8%

606

0.4%

 

559

0.3%

 

 


 


 


 


 


 


Total

 

166,873

 

100.0%

 

169,668

 

100.0%

 

167,880

 

100.0%

 

 


 


 


 


 


 


58


        Impact of Current Economic Environment

        We continue to experience limited volume growth due to stagnant demand for inpatient healthcare services and increased competition for available patients. The current economic recession has negatively impacted many industries. While many healthcare services are considered non-discretionary in nature, certain services including elective procedures and other non-emergent services may be deferred or canceled by patients when they are suffering personal financial hardship or have a negative outlook on the general economy. Increases in unemployment often result in a higher number of uninsured patients, and employer cost reduction programs may result in a higher level of co-pays and deductible limits for patients.  Governmental payers and managed care payers may reduce reimbursement paid to hospitals and other healthcare providers to address budget shortfalls or enrollment declines. We are unable to determine the specific impact of the economic recession on our results of operations and cash flows, but we believe a prolonged or more severe economic recession during the remainder of 2009 and into 2010 will have an adverse impact on our revenues whether in the form of payer mix shifts from managed care to uninsured or Medicaid, additional charity care, lower patient volumes, lower collection rates of patient co-pay and deductible balances or a combination of such factors.  We expect our volumes to improve more significantly over the long-term as a result of our quality of care and service expansion initiatives and other market-specific strategies, especially as more individuals in the markets we serve reach ages where hospital services become more prevalent. However, we have no way to estimate when the economy may improve or when we will realize the benefits of our long-term strategies.

        Payer Reimbursement Trends

        In addition to the volume factors described above, patient mix, acuity factors and pricing trends affect our patient service revenues. Net patient revenue per adjusted hospital discharge was $8,110 and $8,623 for the years ended June 30, 2008 and 2009, respectively. This increase reflects improved reimbursement for services provided under negotiated managed care contracts and increased revenues earned from the Texas upper payment limit (“UPL”) program and the Illinois provider tax assessment (“PTA”) program further described below. However, due to consolidation of managed care plans and federal and state efforts to decrease Medicare and Medicaid spending, our ability to recognize improved reimbursement above or equal to rates recognized in previous periods is becoming more difficult. We cannot assure you that future reimbursement rates, even if improved, will sufficiently cover potential increases in the cost of providing healthcare services to our patients.

        During fiscal 2007 we were approved to receive payments under the Bexar County, Texas UPL Medicaid program. UPL programs allow private hospitals to enter into indigent care affiliation agreements with governmental entities. Within the parameters of these programs, private hospitals expand charity care services to indigent patients and alleviate expenses for the governmental entity. The governmental entity is then able to utilize its tax revenue to fund the Medicaid program for private hospitals. CMS began reviewing the operations of this private hospital UPL program after the State of Texas made the first payments in April 2007. It is customary for CMS to review Medicaid UPL payment programs. In October 2007, the State of Texas halted all funding of its private hospital UPL programs due to the deferral by CMS of certain federal Medicaid payments to the State of Texas. In August 2008, CMS completed its review and the state lifted its moratorium on payments under this UPL program. Payments received under the Texas UPL program increased income before taxes by $0.2 million and $19.5 million during the years ended June 30, 2008 and 2009, respectively.

        During our third quarter of fiscal 2009, the federal government approved federal matching funds for the Illinois PTA program. This program enables the state of Illinois to increase funding for its state Medicaid plan. Hospitals providing services to Medicaid enrollees receive funds directly from the state and then repay a portion of these proceeds to the state in the form of a provider tax assessment. We received $24.9 million of cash from this program during the year ended June 30, 2009, all of which increased revenues and $13.4 million of which was subsequently paid to the state in the form of a provider tax assessment and is included in non-income taxes in our consolidated statement of operations for the year ended June 30, 2009. The PTA program increased income before taxes by $11.5 million during the year ended June 30, 2009.

59



        Accounts Receivable Collection Risks Leading to Increased Bad Debts

        Similar to others in the hospital industry, we have a significant amount of self-pay receivables (including self-pay after primary), and collecting these receivables is difficult and may become more difficult if economic conditions worsen. The following table provides a summary of our accounts receivable payer class mix as of June 30, 2007, 2008 and 2009.

June 30, 2007

0-90 days

91-180 days

Over 180 days

Total






Medicare

 

 

15.0%

 

 

 

0.6%

 

 

0.6%

 

 

16.2%

Medicaid

7.5%

2.0%

1.0%

10.5%

Managed Medicare

7.6%

0.7%

0.6%

8.9%

Managed Medicaid

5.3%

0.6%

0.7%

6.6%

Managed Care

25.1%

2.7%

1.6%

29.4%

Self-Pay(1)

10.2%

8.0%

1.7%

19.9%

Self-Pay after primary(2)

1.8%

2.8%

1.1%

5.7%

Other

1.8%

0.6%

0.4%

2.8%

    Total

 





 

 

 

74.3%

 

18.0%

 

7.7%

 

100.0%

 





 

 

 

 

 

 

 

 

 

 

June 30, 2008

0-90 days

91-180 days

Over 180 days

Total






Medicare

 

 

15.3%

 

 

 

0.6%

 

 

0.4%

 

 

16.3%

Medicaid

8.0%

2.2%

1.3%

11.5%

Managed Medicare

8.5%

0.6%

0.5%

9.6%

Managed Medicaid

5.6%

0.4%

0.3%

6.3%

Managed Care

25.8%

2.6%

1.9%

30.3%

Self-Pay(1)

9.3%

7.6%

1.1%

18.0%

Self-Pay after primary(2)

1.9%

2.6%

1.0%

5.5%

Other

1.6%

0.5%

0.4%

2.5%

 





    Total

 

76.0%

 

17.1%

 

6.9%

 

100.0%

 





 

 

 

 

 

 

 

 

 

 

June 30, 2009

0-90 days

91-180 days

Over 180 days

Total






Medicare

 

 

15.6%

 

 

 

0.3%

 

 

0.3%

 

 

16.2%

Medicaid

6.7%

0.9%

1.0%

8.6%

Managed Medicare

10.0%

0.5%

0.3%

10.8%

Managed Medicaid

7.1%

0.5%

0.5%

8.1%

Managed Care

25.1%

2.3%

1.5%

28.9%

Self-Pay(1)

9.7%

8.1%

0.8%

18.6%

Self-Pay after primary(2)

2.1%

2.9%

0.9%

5.9%

Other

1.8%

0.6%

0.5%

2.9%

 





    Total

 

78.1%

 

16.1%

 

5.8%

 

100.0%

 





____________________
(1)  Includes uninsured only.
(2)  Includes patient co-insurance and deductible amounts after payment has been received from the primary payer.

60


        Our combined allowances for doubtful accounts, self-pay discounts and charity care covered 96.3% and 96.5% of combined self-pay and self-pay after primary accounts receivable as of June 30, 2008 and 2009, respectively.

        The volume of self-pay accounts receivable remains sensitive to a combination of factors including price increases, acuity of services, higher levels of patient deductibles and co-insurance under managed care plans, economic factors and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay for escalating healthcare costs. We have implemented policies and procedures designed to expedite upfront cash collections and promote repayment plans from our patients. However, we believe bad debts will remain a significant risk for us and the rest of the hospital industry in the near term.

        Governmental and Managed Care Payer Reimbursement

        Healthcare spending comprises a significant portion of total spending in the United States and has been growing at annual rates that exceed inflation, wage growth and gross national product. There is considerable pressure on governmental payers, managed Medicare/Medicaid payers and commercial managed care payers to control costs by either reducing or limiting increases in reimbursement to healthcare providers or limiting benefits to enrollees. The current economic recession has magnified these pressures. Lower than expected tax collections due to higher unemployment and depressed consumer spending have resulted in budget shortfalls for most states, including those in which we operate. Additionally, the demand for Medicaid coverage has increased due to job losses that have left many individuals without health insurance. To balance their budgets, many states, either directly or through their managed Medicaid programs, may enact healthcare spending cuts or defer cash payments to healthcare providers, since raising taxes is not a popular option during recessionary cycles. Further, the tightened credit markets have complicated the states’ efforts to issue additional bonds to raise cash. During the year ended June 30, 2009, Medicaid and managed Medicaid programs accounted for approximately 17% of our net patient revenues. Managed care payers also face economic pressures during periods of economic weakness due to lower enrollment resulting from higher unemployment rates and the inability of individuals to afford private insurance coverage. These payers may respond to these challenges by reducing or limiting increases to healthcare provider reimbursement rates or reducing benefits to enrollees. During the year ended June 30, 2009, we recognized approximately 35% of our net patient revenues from managed care payers. If we do not receive increased payer reimbursement rates from governmental or managed care payers that cover the increasing cost of providing healthcare services to our patients or if governmental payers defer payments to our hospitals, our financial position, results of operations and cash flows could be materially adversely impacted.

        Increased Costs of Compliance in a Heavily Regulated Industry

        We conduct business in a heavily regulated industry. Accordingly, we maintain a comprehensive, company-wide compliance program to address healthcare regulatory and other compliance requirements. This compliance program includes, among other things, initial and periodic ethics and compliance training, a toll-free reporting hotline for employees, annual fraud and abuse audits and annual coding audits. The organizational structure of our compliance program includes oversight by our board of directors and a high-level corporate management compliance committee. Our Senior Vice President of Compliance and Ethics reports jointly to our Chairman and Chief Executive Officer and to our board of directors, serves as our Chief Compliance Officer and is charged with direct responsibility for the day-to-day management of our compliance program. We also have regional compliance officers in our markets that are 100% dedicated to compliance duties. The financial resources necessary for program oversight, internal enforcement and periodic improvements to our program continue to grow, especially when we add new features to our program or engage external resources to assist with these highly complex matters.

        Premium Revenues

        We recognize premium revenues from our three health plans, PHP, AAHP and MHP. PHP’s membership increased to approximately 176,200 at June 30, 2009 compared to approximately 103,400 at June 30, 2008 primarily due to a new contract with Arizona Health Care Cost Containment System (“AHCCCS”) that went into effect on October 1, 2008, as discussed below. Premium revenues from these three plans increased $227.8 million or 50.6% during the year ended June 30, 2009 compared to the prior year period.

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        In May 2008, PHP was awarded a new contract with AHCCCS effective for the three-year period beginning October 1, 2008 and ending September 30, 2011. AHCCCS has the option to renew the new contract, in whole or in part, for two additional one-year periods commencing on October 1, 2011 and on October 1, 2012. The new contract covers the three counties covered under the previous contract (Gila, Maricopa and Pinal) plus an additional six Arizona counties: Apache, Coconino, Mohave, Navajo, Pima and Yavapai. We experienced a significant increase in PHP membership and premium revenues during our second, third and fourth quarters of our fiscal year ended June 30, 2009 as a result of this new contract. The new contract utilizes a national episodic/diagnostic risk adjustment factor for non-reconciled enrollee risk groups, the calculation of which AHCCCS expects to finalize by September 30, 2009 and then apply retroactively to October 1, 2008, that was not part of PHP’s previous AHCCCS contract. Our financial statements include an estimated reserve for the impact of this risk adjustment factor, and we will adjust the reserve as necessary once the calculation is finalized by AHCCCS. Given the State of Arizona’s recent budget crisis and continued concerns about economic indicators during its 2010 fiscal year, AHCCCS could cut reimbursement rates, reduce enrollment, defer capitation payments, reduce or limit covered services or take other steps to reduce program expenditures including cancelling PHP’s contract.  Any of these actions could materially adversely impact our future results of operations, financial position or cash flows.

Critical Accounting Policies

        Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing these financial statements, we make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses included in the financial statements. Management bases its estimates on historical experience and other available information, the results of which form the basis of the estimates and assumptions. We consider the following accounting policies to be critical because they involve highly subjective and complex assumptions and assessments, are subject to a great degree of fluctuation period over period and are the most critical to our operating performance.

       Revenues and Revenue Deductions

        We recognize patient service revenues during the period the healthcare services are provided based upon estimated amounts due from payers. We record contractual adjustments to our gross charges to reflect expected reimbursement negotiated with or prescribed by third party payers. We estimate contractual adjustments and allowances based upon payment terms set forth in managed care health plan contracts and by federal and state regulations. For the majority of our patient service revenues, we apply contractual adjustments to patient accounts at the time of billing using specific payer contract terms entered into the accounts receivable systems, but in some cases we record an estimated allowance until payment is received. If our estimated contractual adjustments as a percentage of gross revenues were 1% higher for all insured accounts, our net revenues would have been reduced by approximately $79.0 million for the year ended June 30, 2009. We derive most of our patient service revenues from healthcare services provided to patients with Medicare (including managed Medicare plans) or managed care insurance coverage.

        Services provided to Medicare patients are generally reimbursed at prospectively determined rates per diagnosis (“PPS”), while services provided to managed care patients are generally reimbursed based upon predetermined rates per diagnosis, per diem rates or discounted fee-for-service rates. Medicaid reimbursements vary by state. Other than Medicare, no individual payer represents more than 10% of our patient service revenues.

        Medicare regulations and many of our managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in our healthcare facilities. To obtain reimbursement for certain services under the Medicare program, we must submit annual cost reports and record estimates of amounts owed to or receivable from Medicare. These cost reports include complex calculations and estimates related to indirect medical education, disproportionate share payments, reimbursable Medicare bad debts and other items that are often subject to interpretation that could result in payments that differ from recorded estimates. We estimate amounts owed to or receivable from the Medicare program using the best information available and our interpretation of the applicable Medicare regulations. We include differences between original estimates and subsequent revisions to those estimates (including final cost report settlements) in our consolidated statements of operations in the period in which the revisions are made. Net adjustments for final third party settlements increased patient service revenues and income from continuing operations before income taxes by $6.3

62


million, $7.9 million and $8.0 million during the years ended June 30, 2007, 2008 and 2009, respectively. Additionally, updated regulations and contract negotiations with payers occur frequently, which necessitates continual review of revenue estimation processes by management. Management believes that future adjustments to its current third party settlement estimates will not materially impact our results of operations, cash flows or financial position.

        Effective for service dates on or after April 1, 2009, as a result of a state mandate, we implemented a new uninsured discount policy for those patients receiving services in our Illinois hospitals who had no insurance coverage and who did not otherwise qualify for charity care under our guidelines. Under this policy, we apply an uninsured discount (calculated as a standard percentage of gross charges) at the time of patient billing and include this discount as a reduction to patient service revenues. These discounts were approximately $11.7 million for the year ended June 30, 2009. We implemented this policy for most of our remaining facilities effective July 1, 2009 and expect to implement it at all of our facilities by the end of our fiscal year 2010.

        We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We deduct charity care accounts from revenues when we determine that the account meets our charity care guidelines. We also provide discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines. During the past three fiscal years, a significant percentage of our charity care deductions represented services provided to undocumented aliens under the Section 1011 border funding reimbursement program. Border funding qualification has ended in Texas, and we expect that qualification will end sometime during our fiscal 2010 in Arizona and Illinois when funds appropriated to those states have been exhausted.

        The following table provides a breakdown of our charity care deductions during the years ending June 30, 2007, 2008 and 2009, respectively (in millions).

 

 

 

 

Year ended June 30,


 

2007

 

 

2008

 

 

2009

 

 




Total charity care deductions

 

$

           86.1

 

$

           86.1

 

$

           91.8

Border funding charity deductions, net of payments received

$

19.4

$

29.6

$

34.9

Payments received for border funding accounts

$

2.0

$

3.8

$

4.6

        We record revenues related to the Illinois PTA program, as previously described, when the receipt of payment from the state entity is assured. For the Texas UPL program, as previously described, we recognize revenues that offset the expenses associated with the provision of charity care when the services are provided. We recognize federal match revenues under the Texas UPL program when payments are assured.

        We earned premium revenues of $401.4 million, $450.2 million and $678.0 million during the years ended June 30, 2007, 2008 and 2009, respectively, from our health plans. Our health plans, PHP, AAHP and MHP, have agreements with AHCCCS, CMS and various health maintenance organizations (“HMOs”), respectively, to contract to provide medical services to subscribing participants. Under these agreements, our health plans receive monthly payments based on the number of HMO participants in MHP or the number and coverage type of enrollees in PHP and AAHP. Our health plans recognize the payments as revenues in the month in which members are entitled to healthcare services with the exception of AAHP Medicare Part D reinsurance premiums and low income subsidy cost sharing premiums that are recorded as a liability to fund future healthcare costs or else repaid to CMS.

       Allowance for Doubtful Accounts and Provision for Doubtful Accounts

        Our ability to collect the self-pay portions of our receivables is critical to our operating performance and cash flows. Our allowance for doubtful accounts was approximately 28.1% and 30.6% of accounts receivable, net of contractual discounts, as of June 30, 2008 and 2009, respectively. The primary collection risk relates to uninsured

63


patient accounts and patient accounts for which primary insurance has paid but patient deductibles or co-insurance portions remain outstanding.

        We estimate our allowance for doubtful accounts using a standard policy that reserves all accounts aged greater than 365 days subsequent to discharge date plus percentages of uninsured accounts and self-pay after primary accounts less than 365 days old. We test our allowance for doubtful accounts policy quarterly using a hindsight calculation that utilizes write-off data for all payer classes duringthe previous twelve-month period to estimate the allowance for doubtful accounts at a point in time. We also supplement our analysis by comparing cash collections to net patient revenues and monitoring self-pay utilization. We adjust the standard percentages in our allowance for doubtful accounts reserve policy as necessary given changes in trends from these analyses. We most recently adjusted this reserve policy when we implemented our uninsured discount policy in Illinois. If our uninsured accounts receivable as of June 30, 2009 were 1% higher, our provision for doubtful accounts would have increased by $1.0 million. Significant changes in payer mix, business office operations, general economic conditions and healthcare coverage provided by federal or state governments or private insurers may have a significant impact on our estimates and significantly affect our liquidity, results of operations and cash flows.

        Prior to the implementation of our new uninsured discount policy, we classified accounts pending Medicaid approval as Medicaid accounts in our accounts receivable aging report and recorded a contractual allowance for these accounts equal to the average Medicaid reimbursement rate for that specific state until qualification was confirmed at which time the account was netted in the aging. In the event an account did not successfully qualify for Medicaid coverage and did not meet our charity guidelines, the previously recorded Medicaid contractual adjustment remained a revenue deduction (similar to a self-pay discount), and the remaining net account balance was reclassified to uninsured status and subjected to our allowance for doubtful accounts policy. If accounts did not qualify for Medicaid coverage but did qualify as charity care, the contractual adjustments were reversed and the gross account balances was recorded as charity deductions.

        Upon the implementation of our new uninsured discount policy, all uninsured accounts (including those pending Medicaid qualification) that do not qualify for charity care receive the standard uninsured discount. The balance of these accounts are subject to our allowance for doubtful accounts policy. For those accounts that subsequently qualify for Medicaid coverage, the uninsured discount is reversed and the account is reclassified to Medicaid accounts receivable with the appropriate contractual discount applied. Thus, the contractual allowance for Medicaid pending accounts is no longer necessary for those accounts subject to the uninsured discount policy. The following table provides the value of accounts pending Medicaid qualification, the balance successfully qualified for Medicaid coverage, the balance not qualified and transferred to uninsured status, the balance not qualified and transferred to charity and the percentage successfully qualified for Medicaid coverage during the respective fiscal years (dollars in millions).

 

 

 

 

 

Fiscal Year June 30, 2008

      

 

Fiscal Year June 30, 2009

 

 

 

 

 


 

 


 

 

 

 

 

Accounts prior

   

 

Accounts subject

   

 

 

 

 

Accounts prior

   

 

Accounts subject

   

 

 

to uninsured

to uninsured

to uninsured

to uninsured

discount policy

 

 

discount policy

 

 

Total

discount policy

 

 

discount policy

 

 

Total



Medicaid pending accounts receivable balance

$

12.5

 

$

   

$

12.5

 

$

12.5

 

$

3.3

 

$

15.8

Medicaid pending accounts successfully qualified

$

22.5

$

$

22.5

$

23.5

$

$

23.5

Medicaid pending accounts not qualified (uninsured)

$

25.1

$

$

25.1

$

29.4

$

0.2

$

29.6

Medicaid pending accounts not qualified (charity)

$

7.2

$

$

7.2

$

8.0

$

$

8.0

Medicaid pending qualification success percentage

41%

39%

        Because we require patient verification of coverage at the time of admission, reclassifications of Medicare or managed care accounts to self-pay, other than patient coinsurance or deductible amounts, occur infrequently and are not material to our financial statements.  Additionally, the impact of these classification changes is further limited by our ability to identify any necessary classification changes prior to patient discharge or soon thereafter.  Due to information system limitations, we are unable to quantify patient deductible and co-insurance receivables that are included in the primary payer classification in the accounts receivable aging report at any given point in time. When classification changes occur, the account balance remains aged from the patient discharge date.

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       Insurance Reserves

        As of June 30, 2008, we maintained a self-insured medical plan for a limited number of our employees. Claims were accrued under the self-insured plan as the incidents that gave rise to them occurred. Unpaid claims accruals were based on the estimated ultimate cost of settlement, including claim settlement expenses, in accordance with an average lag time and historical experience. Effective July 1, 2008, we began covering all of our employees under a self-insured medical plan, which subjected us to significantly higher risks and reserve levels.

        Due to the nature of our operating environment, we are subject to professional and general liability and workers compensation claims and related lawsuits in the ordinary course of business.  For professional and general liability claims incurred from June 1, 2002 to May 31, 2006, our wholly owned captive subsidiary insured our professional and general liability risks at a $10.0 million retention level. For professional and general liability claims incurred subsequent to May 31, 2006 through June 30, 2009, we self-insured the first $9.0 million per claim, and the captive subsidiary insured the next $1.0 million per claim. We maintain excess coverage from independent third party insurers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate.

        We insure our excess professional and general liability coverage under a retrospectively rated policy, and premiums under this policy are recorded at the minimum premium amount unless our claims experience leads us to believe that a higher premium applies. We self-insure our workers compensation claims up to $1.0 million per claim and purchase excess insurance coverage for claims exceeding $1.0 million.

        The following tables summarize our employee health, professional and general liability and workers compensation reserve balances (including the current portions of such reserves) as of June 30, 2008 and 2009 and claims loss and claims payment information during the years ended June 30, 2007, 2008 and 2009.

 

Employee
Health

               

Professional and
General Liability

               

Workers
Compensation

 

 

 


 

 


 

 


 

(in millions)

Reserve balance:

     June 30, 2006

$

1.6 

$

58.8 

$

15.3 

     June 30, 2007

$

1.2 

$

64.6 

$

18.5 

     June 30, 2008

$

1.5 

               

            $

74.3 

               

         $

18.8 

     June 30, 2009

$

13.4 

 

$

92.9 

 

$

18.2 

 

 

 

 

 

 

 

 

 

 

Current year provision for claims losses:

     Fiscal year 2007

$

6.8 

$

24.7 

$

9.4 

     Fiscal year 2008

$

7.3 

$

22.4 

$

7.6 

     Fiscal year 2009

$

93.2 

 

$

22.2 

$

7.8 

 

 

 

 

 

 

 

 

 

 

Adjustments to prior year claims losses:

     Fiscal year 2007

$

– 

$

(4.5)

$

     Fiscal year 2008

$

– 

$

(0.6)

$

(2.3)

     Fiscal year 2009

$

(0.6)

$

13.4 

$

(3.8)

 

 

 

 

 

 

 

 

 

 

Claims paid related to current year:

 

     Fiscal year 2007

$

6.0 

$

0.2 

 

$

1.3 

     Fiscal year 2008

$

5.8 

$

0.1 

 

$

1.0 

     Fiscal year 2009

$

79.8 

$

0.3 

 

$

1.6 

 

 

 

 

 

 

 

 

 

 

Claims paid related to prior years:

     Fiscal year 2007

$

1.2 

$

14.2 

$

4.9 

     Fiscal year 2008

$

1.2 

$

12.0 

$

4.0 

     Fiscal year 2009

$

0.9 

$

16.7 

$

3.0 

        In developing our estimates of our reserves for employee health, professional and general liability and workers compensation claims, we utilize actuarial and certain case-specific information. Each reserve is comprised of

65


estimated indemnity and expense payments related to:  1) reported events (“case reserves”) and 2) incurred but not reported (“IBNR”) events as of the end of the period. Management uses information from its human resource and risk managers and its best judgment to estimate case reserves. Actuarial IBNR estimates are dependent on multiple variables including our risk exposures, our self-insurance limits, geographic locations in which we operate, the severity of our historical losses compared to industry averages and the reporting pattern of our historical losses compared to industry averages, among others. Most of these variables require judgment, and changes in these variables could result in significant period over period fluctuations in our estimates. We discount our workers compensation reserve using actuarial estimates of projected cash payments in future periods (approximately 5.0% for each of the past three fiscal years). We do not discount our professional and general liability reserve. We adjust these reserves from time to time as we receive updated information.

        In April 2009, a jury awarded damages to the plaintiff in a professional liability case against one of our hospitals in the amount of approximately $14.9 million, which exceeded our captive subsidiary’s $10.0 million self insured limit. Based upon this verdict, we increased our professional and general liability reserve by the excess of the verdict amount over our previously established case reserve estimate and recorded a receivable from our captive subsidiary’s third party excess carrier for that portion exceeding $10.0 million. We then reduced this receivable by the additional premium due to the excess carrier under our retrospectively rated insurance policy for that particular policy year. These developments resulted in an increase to insurance expense of approximately $11.9 million during the year ended June 30, 2009. We appealed this verdict since most of the verdict represented non-economic damages like pain and suffering, but we can not predict whether or not the verdict will be reduced at this time.

        Our best estimate of professional and general liability and workers compensation IBNR utilizes statistical confidence levels that are below 75%. Using a higher statistical confidence level, while not permitted under United States generally accepted accounting principles, would increase the estimated reserve. The following table illustrates the sensitivity of the reserve estimates at 75% and 90% confidence levels.

 

 

Professional and
General Liability

               

Workers
Compensation

 

 


 


 

 

(in millions)

June 30, 2008 reserve:

 

 

 

 

 

 

     As reported

$

74.3

 

$

18.8

     With 75% Confidence Level

$

85.7

 

$

21.5

     With 90% Confidence Level

 

$

97.2

 

$

23.8

 

 

 

 

 

 

 

June 30, 2009 reserve:

 

 

 

 

 

 

     As reported

$

92.9

 

$

18.2

     With 75% Confidence Level

$

104.9

 

$

21.2

     With 90% Confidence Level

$

116.9

 

$

23.8

        Our best estimate of employee health claims IBNR relies primarily upon payment lag data. If our estimate of the number of unpaid days of employee health claims expense changed by 5 days, our employee health IBNR estimate would change by approximately $1.3 million.

       Health Plan Claims Reserves

        During the years ended June 30, 2007, 2008 and 2009, medical claims expense was $297.0 million, $328.2 million and $525.6 million, respectively, primarily representing medical claims of PHP. Vanguard estimates PHP’s reserve for medical claims using historical claims experience (including cost per member and payment lag time) and other actuarial data including number of enrollees and certain enrollee demographic information. The following table provides the health plan reserve balances as of June 30, 2008 and 2009 and health plan claims and payment information during the years ended June 30, 2007, 2008 and 2009, respectively (in millions).

66



 

Year ended June 30,

 


 

 

2007

 

 

2008

 

 

2009

 

 


 

 


 

 


Health plan reserves, beginning of year

$

46.6

$

61.4

$

51.1 

Current year provision for health plan claims

293.9

329.7

525.5 

Current year adjustments to prior year health plan claims

3.1

(1.5

)

0.1 

Program settlement, capitation and other activity

(9.7

)

(24.2

)

19.3 

Claims paid related to current year

(231.2

)

(268.4

)

(424.6)

Claims paid related to prior years

(41.3

)

(45.9

)

(53.8)




Health plan reserves, end of year

$

61.4

$

51.1

$

117.6




        The increases in reserves, claims losses and claims payments from 2008 to 2009 were primarily due to the significant increase in enrollees during the current year period as a result of the new AHCCCS contract that went into effect on October 1, 2008. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from its estimates given changes in the healthcare cost structure or adverse experience. During the years ended June 30, 2007, 2008 and 2009, approximately $34.2 million, $31.2 million and $34.0 million, respectively, of accrued and paid claims for services provided to our health plan enrollees by our hospitals and our other healthcare facilities were eliminated in consolidation. Our operating results and cash flows could be materially affected by increased or decreased utilization of our healthcare facilities by enrollees in our health plans.

        Income Taxes

        We believe that our income tax provisions are accurate and supportable, but certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. To reflect the possibility that all of our tax positions may not be sustained, we maintain tax reserves that are subject to adjustment as updated information becomes available or as circumstances change. We record the impact of tax reserve changes to our income tax provision in the period in which the additional information, including the progress of tax audits, is obtained.

        We assess the realization of our deferred tax assets to determine whether an income tax valuation allowance is required. Based on all available evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, we determine whether it is more likely than not that all or a portion of the deferred tax assets will be realized. The factors used in this determination include the following:

                •  Cumulative losses in recent years
                •  Income/losses expected in future years
                •  Unsettled circumstances that, if favorably resolved, would adversely affect future operations
                •  Availability, or lack thereof, of taxable income in prior carryback periods that would limit realization of
                   tax benefits
                •  Carryforward period associated with the deferred tax assets and liabilities
                •  Prudent and feasible tax planning strategies

        In addition, financial forecasts used in determining the need for or amount of federal and state valuation allowances are subject to changes in underlying assumptions and fluctuations in market conditions that could significantly alter our recoverability analysis and thus have a material adverse effect on our consolidated financial condition, results of operations or cash flows. Effective July 1, 2007, we adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109 (“FIN 48”). The following table provides the detail comprising our FIN 48 net liability from the date of adoption through June 30, 2009 (in millions).

67


Reclassification from  income taxes payable

$

           0.3

 

Increase to non-current deferred tax assets

 

2.7

 

Cumulative impact of change recorded to retained earnings

 

(2.6

)

 

 


 

     Opening balance at July 1, 2007

$

0.4

 

Additions for tax provisions of prior years

 

0.2

 

 

 


 

     Balance at June 30, 2008

$

0.6

 

Additions for tax positions of prior years

 

2.9

 

Reductions for tax positions of prior years

 

(0.3

)

 

 


 

     Balance at June 30, 2009

$

3.2

 

 

 


 

        The provisions of FIN 48 allow for the classification election of interest on an underpayment of income taxes, when the tax law requires interest to be paid, and penalties, when a tax position does not meet the minimum statutory threshold to avoid payment of penalties, in income taxes, interest expense or another appropriate expense classification based on the accounting policy election of the entity. We elected to continue our historical practice of classifying interest and penalties as a component of income tax expense. All $3.2 million of the unrecognized tax benefits, if recognized, would impact the effective tax rate.

        Long-Lived Assets and Goodwill

        Long-lived assets, including property, plant and equipment and amortizable intangible assets, comprise a significant portion of our total assets. We evaluate the carrying value of long-lived assets when impairment indicators are present or when circumstances indicate that impairment may exist under the provisions of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. When management believes impairment indicators may exist, projections of the undiscounted future cash flows associated with the use of and eventual disposition of long-lived assets held for use are prepared. If the projections indicate that the carrying values of the long-lived assets are not recoverable, we reduce the carrying values to fair value. In May 2009, we recorded a $6.2 million ($3.8 million net of taxes) impairment charge to write-down the value of a building that we currently lease to other healthcare service providers to fair value. For long-lived assets held for sale, we compare the carrying values to an estimate of fair value less selling costs to determine potential impairment. We test for impairment of long-lived assets at the lowest level for which cash flows are measurable. These impairment tests are heavily influenced by assumptions and estimates that are subject to change as additional information becomes available. Given the relatively few number of hospitals we own and the significant amounts of long-lived assets attributable to those hospitals, an impairment of the long-lived assets for even a single hospital could materially adversely impact our operating results or financial position.

        Goodwill also represents a significant portion of our total assets. We review goodwill for impairment annually during our fourth fiscal quarter or more frequently if certain impairment indicators arise under the provisions of SFAS 142, Goodwill and Other Intangible Assets. We review goodwill at the reporting level unit, which is one level below an operating segment. We review the carrying value of the net assets of each reporting unit  to the net present value of estimated discounted future cash flows of the reporting unit. If the carrying value exceeds the net present value of estimated discounted future cash flows, an impairment indicator exists and an estimate of the impairment loss is calculated. The fair value calculation includes multiple assumptions and estimates, including the projected cash flows and discount rates applied. Changes in these assumptions and estimates could result in goodwill impairment that could materially adversely impact our financial position or results of operations. In December 2006, we recorded a goodwill impairment charge in the amount of $123.8 million ($110.5 million, net of tax benefit) related to our Chicago hospitals.

        We completed our annual goodwill impairment test during the fourth quarter of fiscal 2009 noting no impairment. However, we will continue to closely monitor the operations of our Chicago hospitals reporting unit, which has goodwill of approximately $43.0 million, due to the sensitivity of the projected operating results of this reporting unit to the goodwill impairment analysis. If projected future cash flows become less favorable than those

68


projected by management, an additional impairment charge relating to our Chicago hospitals may become necessary that could have a material adverse impact on our financial position and results of operations.

Selected Operating Statistics

        The following table sets forth certain operating statistics for the periods indicated below.

 

 

Year Ended June 30,

 

 

 


 

 

 

 

2007

 

 

2008

 

 

 

2009

 

 

 

 


 

 


 

 

 


 

Number of hospitals at end of period

 

 

15

 

 

15

 

 

 

15

 

Number of licensed beds at end of period

 

 

4,143

 

 

4,181

 

 

 

4,135

 

Discharges (a)

 

 

166,873

 

 

169,668

 

 

 

167,880

 

Adjusted discharges - hospitals (b)

 

 

264,698

 

 

270,076

 

 

 

274,767

 

Adjusted discharges (c)

278,820

284,680

289,997

Net revenue per adjusted discharge-hospitals (d)

$

7,766

$

8,110

$

8,623

Net revenue per adjusted discharge (e)

$

7,690

$

8,059

$

8,517

Patient days (f)

721,832

734,838

709,952

Average length of stay (days) (g)

 

 

4.3

 

 

4.3

 

 

 

4.2

 

Inpatient surgeries (h)

37,227

37,538

37,970

Outpatient surgeries (i)

76,606

73,339

76,378

Emergency room visits (j)

572,946

588,246

605,729

Occupancy rate (k)

 

 

48.2

%

 

48.0

%

 

 

47.0

%

Member lives (l)

145,600

149,600

218,700

Health plan claims expense percentage (m)

74.0

%

72.9

%

77.5

%


____________________

(a)

 

Discharges represent the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatient volumes.

 

 

 

(b)

 

Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined hospital inpatient and hospital outpatient volumes. Adjusted discharges-hospitals is computed by multiplying discharges by the sum of gross hospital inpatient revenues and gross hospital outpatient revenues and then dividing the result by gross hospital inpatient revenues.

 

 

 

(c)

Adjusted discharges is used by management and certain investors as a general measure of consolidated inpatient and outpatient volumes. Adjusted discharges is computed by multiplying discharges by the sum of gross inpatient revenues and gross outpatient revenues and then dividing the result by gross inpatient revenues.

(d)

Net revenue per adjusted discharge-hospitals is calculated by dividing net hospital patient revenues by adjusted discharge-hospitals and measures the average net payment expected to be received for a patient’s stay in the hospital.

 

 

 

(e)

Net revenue per adjusted discharge is calculated by dividing net patient revenues by adjusted discharges and measures the average net payment expected to be received for an episode of service provided to a patient.

(f)

Patient days represent the number of days (calculated as overnight stays) our beds were occupied by patients during the periods.

 

 

(g)

Average length of stay represents the average number of days an admitted patient stays in our hospitals.

 

 

(h)

 

Inpatient surgeries represent the number of surgeries performed in our hospitals where overnight stays are necessary.

 

 

 

(i)

Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stay not necessary).

 

 

 

(j)

Emergency room visits represent the number of patient visits to a hospital emergency room where treatment is received, regardless of whether an overnight stay is subsequently required.

 

 

 

(k)

Occupancy rate represents the percentage of hospital licensed beds occupied by patients. Occupancy rate provides a measure of the utilization of inpatient beds.

 

 

(l)

Member lives represent the total number of enrollees in PHP, AAHP and MHP as of the end of the respective period.

 

 

(m)

Health plan claims expense percentage is calculated by dividing health plan claims expense by premium revenues.

69



Results of Operations

        The following tables present a summary of our operating results for the respective periods shown.

 

 

 

Year Ended June 30,

 

 

 

 


 

 

 

 

2007

 

 

2008

 

 

 

2009

 

 

 

 


 

 


 

 

 


 

 

Amount

%

Amount

%

Amount

%

 

 

 


 

 


 

 

 


 

 


 

 

 


 

 


 

 

 

 

(Dollars in millions)

 

 

 

 

 

 

Patient service revenues

 

$

2,179.3

 

 

84.4

%

 

$

2,340.5

 

 

83.9

%

 

$

2,521.7

 

 

78.8

%

Premium revenues

 

 

401.4

15.6

450.2

16.1

678.0

21.2

 

 

 


 

 


 

 

 


 

 


 

 

 


 

 


 

Total revenues

2,580.7

100.0

2,790.7

100.0

3,199.7

100.0

Salaries and benefits (includes stock compensation
   of $1.2, $2.5 and $4.4 respectively)

1,067.9

41.4

1,152.7

41.3

1,240.1

38.7

Health plan claims expense

297.0

11.5

328.2

11.8

525.6

16.4

Supplies

421.8

16.4

434.5

15.5

456.3

14.3

Provision for doubtful accounts

175.2

6.8

205.6

7.4

210.8

6.6

Other operating expenses

375.0

14.5

405.8

14.5

468.9

14.6

Depreciation and amortization

118.6

4.6

131.0

4.7

130.6

4.1

Interest, net

123.8

4.8

122.1

4.4

111.6

3.5

Impairment loss

123.8

4.8

0.0

6.2

0.2

Other expenses

2.8

0.1

9.5

0.3

5.9

0.2

 







Income (loss) from continuing operations

   before income taxes

(125.2

)

(4.9

)

1.3

0.1

43.7

1.4

Income tax expense (benefit)

(11.6

)

(0.5

)

1.7

0.1

16.0

0.5

 







Income (loss) from continuing operations

(113.6

)

(4.4

)

(0.4

)

0.0

27.7

0.9

Income (loss) from discontinued operations,

   net of taxes

(19.1

)

(0.7

)

(0.3

)

0.0

0.9

0.0







Net income (loss)

$

(132.7

)

(5.1

)%

$

(0.7

)

0.0

%

$

28.6

0.9

%

 

 

 







Year Ended June 30, 2009 Compared to the Year Ended June 30, 2008

        Revenues.  Patient service revenues increased 7.7% year over year primarily as a result of a 5.7% increase in patient revenues per adjusted discharge and a 1.9% increase in adjusted discharges. Total outpatient volumes increased year over year, including a 3.0% and 4.1% increase in emergency room visits and outpatient surgeries, respectively. Our volumes by payer remained relatively consistent during both years. However, our combined Medicaid and managed Medicaid net revenues as a percentage of total net revenues increased to 16.7% during the current year compared to 15.1% during the prior year, primarily as a result of the increase in Texas UPL and Illinois PTA revenues previously discussed. The acuity level of our patients also increased year over year. However, during the current year, we continued to generate most of our admissions from emergency room visits and experienced lower elective admissions. Patients often elect to defer elective procedures when general economic conditions are weak. We also face continued intense competition from other hospitals to recruit and retain the best physicians to practice in our facilities. Further improvement in our operating results will depend on our ability to increase elective inpatient and outpatient business to maintain a favorable payer mix. We believe our quality initiatives will be the catalyst for long-term revenue growth, especially given the forecasted population growth for most of the markets in which we operate. However, environmental factors outside our control, including patient demand, potential healthcare reform, deterioration of general economic conditions, payer pressures and increased competition could limit our future revenue growth.

        Premium revenues increased $227.8 million or 50.6% during the current year as a result of higher enrollment at PHP compared to the prior year. PHP’s new contract with AHCCCS began on October 1, 2008, and average enrollment increased from 101,435 during the prior year to 150,468 during the current year. PHP was awarded six new counties under the new contract in addition to the three counties served under the prior AHCCCS contract.

70


        We continue to implement our quality of care initiatives and streamline our processes from admission to discharge to provide our patients effective healthcare solutions in an efficient manner. Part of this process includes identifying the optimal service line mix that both meets the needs of our patients and improves our operating results. The success of these objectives depends on our ability to engage our nursing workforce, recruit and retain physicians who share our commitment to quality, strengthen the primary care infrastructure for our hospitals and complete capital improvements projects including advanced clinical systems in a timely manner.

        Costs and Expenses.  Total costs and expenses from continuing operations, exclusive of income taxes, were $3,156.0 million or 98.6% of total revenues during the current year, compared to 99.9% during the prior year. Salaries and benefits, supplies, health plan claims and provision for doubtful accounts represent the most significant of our normal costs and expenses and those typically subject to the greatest level of fluctuation period over period.

               •

  

Salaries and benefits.  Salaries and benefits as a percentage of total revenues decreased to 38.7% during the current year from 41.3% during the prior year. This ratio was positively impacted by the significant increase in premium revenues, which utilize a much lower rate of salaries and benefits than acute care services, during the current year compared to the prior year and by the increase in Texas UPL and Illinois PTA revenues during the current year compared to the prior year. Salaries and benefits as a percentage of acute care segment revenues were 47.2% during the current year compared to 47.8% during the prior year, which improvement was primarily attributable to the Texas UPL and Illinois PTA revenues growth during the current year.

 

 

 

 

 

These ratios were adversely impacted during the current year by our investments in physician services and quality initiatives. We continue to employ more physicians to support the communities our hospitals serve and have added significant corporate resources during the past year to manage and oversee the physician growth. Implementation of our quality initiatives have also resulted in additional labor costs associated with training staff to utilize new clinical quality systems and additional hospital and corporate resources to monitor and manage quality indicators. As of June 30, 2009, we had approximately 19,200 full-time and part-time employees compared to 18,500 as of June 30, 2008. Our contract labor expense as a percentage of patient service revenues decreased to 2.6% for the current year compared to 3.5% for the prior year. We have been successful in our nurse recruiting and retention initiatives during the current year, much of which we attribute to our commitment to delivering quality patient care. While the national nursing shortage has abated to some degree during the current year as a result of weakened economic conditions, shortages in certain pockets of the communities we serve still exist. We expect that our nurse leadership program will help mitigate this risk.

 

 

 

               •

 

Supplies.  Supplies as a percentage of total revenues decreased to 14.3% during the current year  compared to 15.5% during the prior year. Supplies as a percentage of patient service revenues decreased to 18.1% during the current year quarter compared to 18.6% during the prior year. The increase in Texas UPL and Illinois PTA revenues during the current year quarter accounted for approximately half of this improvement. Although the acuity of our services provided increased during the current year compared to the prior year, we were successful in limiting the ratio of supplies to patient service revenues by further implementing certain supply chain initiatives such as increased use of our group purchasing contract and pharmacy formulary management. Because our growth strategies include expansion of higher acuity services and due to inflationary pressures on medical supplies and pharmaceuticals, our ability to reduce this ratio in future periods may be limited.

 

 

 

               •

 

Health plan claims.  Health plan claims expense as a percentage of premium revenues increased to 77.5% during the current year compared to 72.9% during the prior year. The new PHP contract resulted in a significant change in the mix of our AHCCCS enrollees with a significant increase in enrollees in geographic areas not previously served by PHP. As a result of the bid process for these new areas, the rates paid to providers in those six new counties and capitated payment rates received from AHCCCS for those counties were not necessarily the same as those applicable to the three counties previously served by PHP. Also, the additional PHP revenues diluted the impact of the third party administrator revenues at MHP that have no corresponding medical claims expense. We could experience changes in this ratio during upcoming quarters as we receive more PHP historical claims payment information, especially for the new counties where service began on October 1, 2008. During fiscal 2009, we accrued

71


 

 

for the estimated amount payable to AHCCCS for the risk adjustment factor payment methodology that will be retroactively applied to October 1, 2008, which also caused the health plan claims expense as a percentage of premium revenues to increase during the current year.

 

 

 

 

 

Health plan claims expense represents the amounts paid by the health plans for healthcare services provided to their members, including an estimate of incurred but not yet reported claims that is determined based upon lag data and other actuarial assumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $34.0 million, or 6.1% of gross health plan claims expense, were eliminated in consolidation during the current year.

 

 

 

               •

 

Provision for doubtful accounts.  The provision for doubtful accounts as a percentage of patient service revenues decreased to 8.4% during the current year from 8.8% during the prior year. On a combined basis, the provision for doubtful accounts, uninsured discounts and charity care deductions as a percentage of patient service revenues was 12.0% for both the current year and prior year periods. During the current year, our self-pay revenues as a percentage of net patient revenues decreased to 8.2% compared to 8.6% during the prior year. We have also experienced improved upfront cash collections and success in qualifying patients for coverage under Medicaid or similar programs. We utilized hindsight testing analysis, cash collections data and other metrics to conclude that our policies adequately provided for uncompensated care during the year ended June 30, 2009. Our combined allowances for doubtful accounts, uninsured discounts and charity care as of June 30, 2009 represented 96.5% of total self-pay accounts receivable compared to 96.3% as of June 30, 2008. We expect our bad debts ratios to remain sensitive to environmental factors including deteriorating economic conditions that could result in a greater number of uninsured patients and increased difficulty for patients to pay their co-payment and deductible balances.

        Other operating expenses. Other operating expenses include, among others, purchased services, insurance, non-income taxes, rents and leases, repairs and maintenance and utilities. Other operating expenses as a percentage of total revenues increased to 14.6% during the current year compared to 14.5% during the prior year. Other operating expenses as a percentage of patient service revenues increased to 18.6% during the current year compared to 17.3% during the prior year. In April 2009, a jury awarded damages to the plaintiff in a professional liability case against one of our hospitals in the amount of approximately $14.9 million, which exceeded our captive insurance subsidiary’s $10.0 million self-insured limit. Based upon this verdict, we recognized additional insurance expense of $11.9 million during the current year representing the amount necessary to reach our captive’s self-insured limit plus additional premiums due to the third party excess coverage carrier under our retrospectively rated insurance policy with that carrier. Also, non-income taxes increased by $23.9 million during the current year primarily as a result of $13.4 million of Illinois PTA program cash receipts that were subsequently paid to the state in the form of a provider tax and higher premiums taxes related to the significant enrollment growth at PHP.

        Other. Depreciation and amortization was flat year over year.  Net interest decreased by $10.5 million during the current year primarily due to lower interest rates on the variable portion of our term debt. We incurred an impairment loss of $6.2 million ($3.8 million, net of taxes) during the current year resulting from the write-down of a non-hospital building to fair value.

        Income taxes.  Our effective tax rate was approximately 36.6% during the current year. Income taxes during the prior year were not significant.

        Net income.  Net income increased by $29.3 million during the current year compared to the prior year primarily due to improved operating results both from our acute care services and health plan segments.

Year Ended June 30, 2008 Compared to the Year Ended June 30, 2007

        Revenues.  Patient service revenues increased 7.4% year over year primarily as a result of a 4.8% increase in patient revenues per adjusted discharge and a 2.1% increase in adjusted discharges. Total outpatient volumes increased year over year, including a 2.7% increase in emergency room visits, although outpatient surgeries decreased year over year. We experienced positive year over year payer mix shifts highlighted by an increase in combined Medicare and managed Medicare volumes compared to a decrease in combined Medicaid and managed

72


Medicaid volumes. The acuity level of our patients also increased year over year. However, we continued to generate most of our inpatient stays from emergency room visits and struggled to improve our elective admissions.

        Premium revenues increased 12.2% during fiscal 2008 primarily as a result of a 5.7% in year over year annual membership at PHP and a capitation rate increase that went into effect for PHP as of October 1, 2007. PHP’s membership increased as a result of a greater number of AHCCCS-eligible residents as a result of weakened general economic conditions and a greater allocation of the AHCCCS enrollees to PHP.

        Costs and Expenses.  Total costs and expenses, exclusive of income taxes and discontinued operations, were $2,789.4 million or 99.9% of total revenues during fiscal 2008 compared to 104.9% during fiscal 2007. Fiscal 2007 costs and expenses were negatively impacted by the $123.8 million impairment loss related to our Chicago hospitals. Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent our most significant individual costs and expenses or those subject to the greatest level of fluctuation period over period.

               •

  

Salaries and benefits.  Salaries and benefits as a percentage of total revenues were relatively flat period over period. Excluding the growth in our health plan operations, salaries and benefits would have increased to 42.0% during fiscal 2008 compared to the 41.4% during the prior year. The national nursing shortage, which was particularly prevalent in Phoenix, hindered our ability to fully manage salaries and benefits costs. Even with the nursing shortage in Phoenix, we made progress in stabilizing our nurse workforce in Phoenix to reduce contract labor utilization. We incurred a significant increase in period over period salaries and benefits costs in our Massachusetts hospitals primarily resulting from requirements set forth in our collective bargaining agreement ratified with the nurses union at St. Vincent Hospital.

 

 

 

               •

 

Supplies. Supplies as a percentage of total revenues decreased from 16.3% during fiscal 2007 to 15.5% during fiscal 2008. Supplies as a percentage of patient service revenues decreased to 18.6% during fiscal 2008 compared to 19.4% during fiscal 2007. Fiscal 2008 was the first full year that certain of our supply chain corporate initiatives were fully implemented. These initiatives included formulary refinements, standardization of commodities and supplies reprocessing and improved compliance with our group purchasing contract. Effective May 2008, we renewed our group purchasing contract with HealthTrust Purchasing Group for an additional five years.

 

 

 

               •

 

Health plan claims expense.  Health plan claims expense as a percentage of premium revenues decreased from 74.0% during fiscal 2007 to 72.9% during fiscal 2008. Capitation revenues for our health plans increased at a greater rate year over year than did the utilization of medical services by our health plans’ enrollees. Health plan claims expense represents the amounts paid by health plans for healthcare services provided to their members, including an estimate of incurred but not reported claims that is determined based upon lag data and other actuarial assumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $31.2 million, or 8.7% of gross health plan claims expense, were eliminated in consolidation during fiscal 2008 compared to $34.2 million or 10.3% of gross health plan claims expense during fiscal 2007.

 

 

 

               •

 

Provision for doubtful accounts.  During fiscal 2008, the provision for doubtful accounts as a percentage of patient service revenues increased to 8.8% from 8.0% during fiscal 2007. During fiscal 2008, our self-pay discharges as a percentage of total discharges decreased to 3.5% from 3.7% during fiscal 2007. However, price increases at our hospitals and increased levels of patient co-insurance and deductibles under managed care plans increased our exposure to uncollectible revenues. The previously discussed change in our allowance for doubtful accounts policy during fiscal 2008 resulted in a higher provision for doubtful accounts as a percentage of patient service revenues during fiscal 2008 compared to fiscal 2007. Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy of deducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines. On a combined basis, the provision for doubtful accounts and charity care deductions as a percentage of patient service revenues increased to 12.5% during fiscal 2008 compared to 12.0% during fiscal 2007.

73


        Other operating expenses. Other operating expenses include, among others, purchased services, insurance, non-income taxes, rents and leases, repairs and maintenance and utilities.  Other operating expenses as a percentage of total revenues were flat year over year. We incurred higher physician recruiting costs, higher repairs and maintenance costs related to the implementation of our clinical information systems in our hospitals and higher utilities costs during 2008 compared to 2007.

        Other. Depreciation and amortization as a percentage of total revenues increased to 4.7% during fiscal 2008 compared to 4.6% during fiscal 2007 as a result of our capital improvement and expansion initiatives.  Portions of our clinical quality systems were placed into service during fiscal 2008, and fiscal 2008 was the first full year in which all of our previous significant expansion projects in Phoenix and San Antonio had been fully in service. The decrease in net interest as a percentage of total revenues to 4.4% during fiscal 2008 compared to 4.8% during fiscal 2007 resulted primarily from the increase in total revenues during fiscal 2008 compared to fiscal 2007 without additional debt borrowings.

        Income taxes.  Income taxes were not significant during fiscal 2008. The effective tax rate for fiscal 2007 was 9.3% due to the majority of the impairment loss being nondeductible for tax purposes.

        Discontinued operations. Our loss from discontinued operations was not significant during the fiscal year ended June 30, 2008 due to the winding down of operations at PMH compared to fiscal 2007 when PMH operated as an acute care hospital for the majority of the fiscal year.

        Net loss. The $132.0 million year over year decrease in net loss resulted primarily from the improved operating results during fiscal 2008 and the after tax impact of the impairment loss recorded during fiscal 2007.

Liquidity and Capital Resources

        Operating Activities

        At June 30, 2009, we had working capital of $251.6 million, including cash and cash equivalents of $308.2 million.  Working capital at June 30, 2008 was $217.8 million. Cash provided by operating activities increased $135.1 million during the year ended June 30, 2009 compared to the prior year.  The increase in operating cash flows was primarily due to improved net cash collections of accounts receivable, the impact of the significant enrollee growth at PHP on capitation payments received from AHCCCS and the timing of claims payments made for new members, the timing of claims payments related to the expansion of our self-insured employee medical plan, the increase in net payments received under the Bexar County, Texas UPL program and the Illinois PTA program and improved operating results during the year ended June 30, 2009 compared to the prior year. Net accounts receivable days decreased by approximately 6 days to 45 days at June 30, 2009 compared to 51 days at June 30, 2008.

        Investing Activities

        Cash used in investing activities decreased from $143.8 million during the prior year to $133.6 million during the current year, primarily as a result of net $26.3 million purchases of auction rate securities during the prior year that we continued to hold during the current year. Capital expenditures increased $10.5 million during the current year compared to the prior year.

        We anticipate spending a total of $180.0 million to $200.0 million in capital expenditures during fiscal 2010 This estimated range includes $71.0 million of replacement, regulatory or maintenance capital and $129.0 million of combined information technology upgrades and other discretionary initiatives. We could choose to defer or cancel most of the information technology and discretionary capital projects included in our fiscal year 2010 capital expenditures estimate should we need to conserve cash, avoid debt covenant violations or for other reasons. Any decision to defer or cancel such capital projects, while providing some short-term benefits, could have negative long-term implications to our operating results and cash flows.

        We expect to fund our fiscal 2010 capital expenditures with cash on hand and cash flows from operations. We also have $218.8 million available under our revolving credit facility as of June 30, 2009. We believe our current

74


capital expenditure program is sufficient to service, expand and improve our existing facilities to meet our quality objectives and growth strategies.

        Financing Activities

        Cash flows used in financing activities were flat year over year. As of June 30, 2009, we had outstanding $1,551.6 million in aggregate indebtedness. Our liquidity requirements are significant, primarily due to debt service requirements. The 9.0% Notes require semi-annual interest payments until their maturity in September 2014. The indenture related to the 9.0% Notes contains a customary restricted payments covenant that restricts certain of our cash payments, including repurchase or redemption prior to maturity of the 11.25% Notes. This covenant restriction does not apply to cash interest payments for the 11.25% Notes. However, at June 30, 2009, we would be able to expend up to approximately $143.0 million free of any such restrictions pursuant to the general restricted payment basket provisions set forth in this covenant. Through October 1, 2009, our interest expense on the 11.25% Notes consists solely of non-cash accretions of principal. Commencing April 1, 2010 through the maturity of the 11.25% Notes in September 2015, we will make semi-annual cash interest payments under the 11.25% Notes.

        Our $766.4 million outstanding term loan borrowings bear interest at a rate equal to, at our option, a base rate plus 1.25% per annum or LIBOR plus 2.25% per annum and mature in September 2011. However, $450.0 million of our term loan borrowings are subject to a fixed interest rate under the terms of an interest rate swap agreement effective June 30, 2008 that expires March 31, 2010. We make quarterly principal payments on our outstanding term loan borrowings equal to one-fourth of one percent. Borrowings under our $250.0 million revolving credit facility, which matures in September 2010, would currently bear interest at a rate equal to, at our option, a base rate plus 1.0% per annum or LIBOR plus 2.0% per annum. These rates are subject to increase by up to 0.50% per annum should our leverage ratio exceed certain designated levels. We are required to pay a commitment fee to the lenders under the revolving credit facility in respect of the unutilized commitments thereunder at a rate equal to 0.50% per annum.  We also pay customary letter of credit fees.

        Debt Covenants

        Our term loan facility and revolving credit facility contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability, and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, repay other indebtedness (including the 9.0% Notes and 11.25% Notes), pay dividends and distributions or repurchase our capital stock, create liens on assets, make investments, loans or advances, make certain acquisitions, engage in mergers or consolidations, enter into sale and leaseback transactions, engage in certain transactions with affiliates, amend certain material agreements governing our indebtedness, including the 9.0% Notes and 11.25% Notes, change the business conducted by our subsidiaries and enter into certain hedging agreements. In addition, the senior credit facilities require us to maintain the following financial covenants: a maximum total leverage ratio, a maximum senior leverage ratio, a minimum interest coverage ratio and a maximum capital expenditures limitation. As of June 30, 2009, our capital expenditures, as defined in the senior secured credit agreement, were below the maximum covenant amount, and we were in compliance with the other debt covenant ratios as defined in our senior secured credit agreement, as follows.

 

 

Debt Covenant Ratio

           

Actual Ratio

 

 



Interest coverage ratio requirement

 

2.00x

 

3.56x

Total leverage ratio limit

 

4.50x

 

3.35x

Senior leverage ratio limit

 

3.50x

 

1.45x

        While we are currently in compliance with all of our debt covenants, factors outside our control may make it more difficult for us to remain in compliance during future periods. These factors include a prolonged economic recession, a higher number of uninsured or underinsured patients and decreased governmental or managed care payer reimbursement, among others, any or all of which could negatively impact our results of operations and cash flows and cause us to violate one or more of these covenants. Violation of one or more of the covenants under our senior secured credit agreement could result in an immediate call of the outstanding principal amount of our term loans or the necessity of lender waivers with more onerous terms including adverse pricing or repayment provisions or more restrictive covenants.

75


        Credit Ratings

        The table below summarizes our credit ratings as of the date of this filing.

 

 

Standard & Poor’s

           

Moody’s

 

 



Corporate credit rating

 

B

 

B2

9% Senior Subordinated Notes

 

CCC+

 

Caal

11¼% Senior Discount Notes

 

CCC+

 

Caal

Senior credit facilities

B+

Ba3

        Our credit ratings are subject to periodic reviews by the ratings agencies. If our results of operations deteriorate either as a result of the current economic recession or other factors, any or all of our corporate ratings may be downgraded. A credit rating downgrade could further impede our ability to refinance all or a portion of our outstanding debt.

        Capital Resources

        We expect that cash on hand, cash generated from our operations and cash expected to be available to us under our revolving credit facility will be sufficient to meet our working capital needs, debt service requirements and planned capital expenditure programs during the next twelve months and into the foreseeable future prior to the maturity dates of our outstanding debt. However, we cannot assure you that our operations will generate sufficient cash or that future borrowings under our senior credit facilities will be available to enable us to meet these requirements, especially given the current diminished credit availability and general economic weakness.

        Our $250.0 million revolving credit facility expires in September 2010, and we are not certain if we will be able to replace the revolving credit facility with favorable terms at such time given the current instability in the capital and credit markets and with the current uncertainty of when normal credit market liquidity conditions will return. Additionally, our financial position and cash flows could be materially adversely impacted should we be unable to access the current amounts available under our revolving credit facility due to default by one or more of the lenders. Our $766.4 million term debt under our term loan facility matures in September 2011. Our ability to refinance or obtain funds to repay this term debt could also be compromised if the current capital and credit markets do not improve.

        We had $308.2 million of cash and cash equivalents as of June 30, 2009. We rely on available cash, cash flows generated by operations and available borrowing capacity under our revolving credit facility to fund our operations and capital expenditures. We invest our cash in accounts in high-quality financial institutions. We continually explore various options to increase the return on our invested cash while preserving our principal cash balances. However, the significant majority of our cash and cash equivalents are not federally-insured and could be at risk in the event of a collapse of those financial institutions.

        At June 30, 2009, we held $21.6 million in total available for sale investments in auction rate securities (“ARS”) backed by student loans, which are included in long-term investments in auction rate securities on our consolidated balance sheet due to inactivity in the primary ARS market during the past year. The par value of the ARS was $26.3 million as of June 30, 2009.

        We also intend to continue to pursue acquisitions or partnering arrangements, either in existing markets or new markets, which fit our growth strategies. To finance such transactions, we might draw upon cash on hand, amounts available under our revolving credit facility or seek additional funding sources. We continually assess our capital needs and may seek additional financing, including debt or equity, as considered necessary to fund potential acquisitions, fund capital projects or for other corporate purposes. However, we may be unable to raise additional equity proceeds from Blackstone or other investors should we need to obtain cash for any of these purposes. Our future operating performance, ability to service our debt and ability to draw upon other sources of capital will be subject to future economic conditions and other business factors, many of which are beyond our control.

76


Obligations and Commitments

        The following table reflects a summary of obligations and commitments outstanding with payment dates as of June 30, 2009.

 

 

Payments due by period

 

 

 

 


Within
1 year

During
Years 2-3

During
Years 4-5

After
5 years

Total


Contractual Cash Obligations::

(In  millions)

Long-term debt (1)

 

$

99.8

 

 

$

935.0

 

 

$

152.1

 

 

$

853.3

 

$

 

2,040.2

 

Operating leases (2)

 

 

30.4

 

 

 

48.1

 

32.2

 

 

 

42.3

 

 

 

153.0

 

Purchase obligations (2)

 

 

17.4

 

 

 

 

 

 

 

 

 

 

17.4

 

Health plan claims payable (3)

117.6

117.6

Estimated self-insurance liabilities (4)      

 

 

47.8

 

 

 

39.0

 

22.9

 

 

 

14.8

 

 

 

124.5

 

 

 

 


 

 

 


 

 

 


 



    Subtotal

 

$

313.0

 

 

$

1,022.1

 

$

207.2

 

 

$

910.4

 

 

$

2,452.7

 

 

 

 


 

 

 


 


 

 

 


 

 

 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


Within
1 year

During
Years 2-3

During
Years 4-5

After
5 years

Total


Other Commitments:

(In  millions)

Construction and capital improvements (5)         

 

$

31.8

 

 

$

1.3

 

 

$

 

 

$

 

$

 

33.1

Guarantees of surety bonds (6)

40.0

40.0

Letters of credit (7)

31.2

31.2

Physician commitments (8)

4.4

4.4

FIN 48 net liability (9)

3.2

3.2






    Subtotal

$

79.4

$

32.5

$

$

$

111.9






    Total obligations and commitments

$

392.4

$

1,054.6

$

207.2

$

910.4

$

2,564.6







____________________

(1)

 

Includes both principal and interest portions of outstanding debt. The interest portion of our debt assumes an approximate 5.0% rate over the remaining term of the debt.

 

 

 

(2)

These obligations are not reflected in our consolidated balance sheets.

 

 

 

(3)

 

Represents estimated payments to be made in future periods for healthcare costs incurred by enrollees in PHP, AAHP and MHP and is separately stated on our consolidated balance sheets.

 

 

 

(4)

 

Includes the current and long-term portions of our professional and general liability, workers’ compensation and employee health reserves.

 

 

 

(5)

 

Represents our estimate of amounts we are committed to fund in future periods through executed agreements to complete projects included as construction in progress on our consolidated balance sheets.

 

 

 

(6)

 

Represents performance bonds we have purchased related to health claims liabilities of PHP.

 

 

 

(7)

 

Amounts relate primarily to instances in which we have letters of credit outstanding with the third party administrator of our self-insured workers’ compensation program.

 

 

 

(8)

 

Includes physician guarantee liabilities recognized in our consolidated balance sheets under the provisions of FSP 45-3, Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners, and liabilities for other fixed expenses under physician relocation agreements not yet paid.

 

 

 

(9)

 

Represents expected future tax liabilities determined under the provisions of FIN 48.

77


Guarantees and Off Balance Sheet Arrangements

        We are currently a party to a certain rent shortfall agreement with a certain unconsolidated entity. We also enter into physician income guarantees and service agreement guarantees and other guarantee arrangements, including parent-subsidiary guarantees, in the ordinary course of business. We have not engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to materially affect liquidity.

Effects of Inflation and Changing Prices

        Various federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices. Revenues for acute hospital services rendered to Medicare patients are established under the federal government’s prospective payment system. We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of changes in payer mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. In addition, as a result of increasing regulatory and competitive pressures, our ability to maintain operating margins through price increases to non-Medicare patients is limited.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

        We are subject to market risk from exposure to changes in interest rates based on our financing, investing, and cash management activities. As of June 30, 2009, we had in place $1,016.4 million of senior credit facilities bearing interest at variable rates at specified margins above either the agent bank’s alternate base rate or its LIBOR rate. The senior credit facilities consist of $766.4 million in term loans maturing in September 2011 and a $250.0 million revolving credit facility maturing in September 2010 (of which $31.2 million of capacity was utilized by outstanding letters of credit as of June 30, 2009). Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates would not be material to our results of operations or cash flows. The variable interest rate risk is partially mitigated by the interest rate swap that became effective on June 30, 2008, as discussed below. As of June 30, 2009, the estimated fair values of our term debt, our 9.0% senior subordinated notes and our 11.25% senior discount notes were approximately $735.7 million, $547.7 million and $209.3 million, respectively.

        Our $250.0 million revolving credit facility bears interest at the alternate base rate plus a margin ranging from 1.00%-1.50% per annum or the LIBOR rate plus a margin ranging from 2.00%-2.50% per annum, in each case dependent upon our leverage ratio. Our revolving credit facility matures in September 2010. Our $766.4 million in outstanding term loans bear interest at the alternate base rate plus a margin of 1.25% per annum or the LIBOR rate plus a margin of 2.25% per annum and mature in September 2011.  The interest rate related to the unhedged term loans was approximately 2.6% as of June 30, 2009.

        In April 2008, we entered into an interest rate swap agreement with Bank of America, N.A. (the counterparty) that became effective on June 30, 2008. Under this agreement and through March 31, 2009, we made or received quarterly net interest rate swap payments based upon the difference between the 90-day LIBOR rate and the swap fixed interest rate of 2.785% on a notional $450.0 million of our term debt. We accounted for this swap as a highly effective cash flow hedge with critical terms that substantially match the underlying term debt and measured any ineffectiveness using the hypothetical derivative method. In March 2009, we and the counterparty executed an amended swap agreement with the same terms and provisions as the original agreement except that after March 31, 2009, we will make or receive net interest payments based upon the difference between the 30-day LIBOR rate and the swap fixed interest rate of 2.5775%. As a result of this amended swap agreement, we de-designated our existing cash flow hedge and re-designated the amended swap agreement as a hedge of the remaining interest payments associated with $450.0 million of our outstanding term debt. As the forecasted transactions (i.e. the future interest payments under our outstanding term debt) are still probable of occurring, we did not immediately recognize the accumulated other comprehensive loss balance related to the de-designated swap in earnings. Based on our assessment, we determined this re-designated swap will be highly effective in offsetting the changes in cash flows related to the hedged risk. Upon the execution of the amended swap agreement, we began measuring hedge ineffectiveness by comparing the fair value of the original swap agreement to a new hypothetical derivative using the amended terms to determine if the underlying term debt has been overhedged. We determined that the hedge ineffectiveness was not significant as of June 30, 2009. The fair value of the interest rate swap as of June 30, 2009

78


was a liability for us of approximately $6.9 million ($4.3 million, net of taxes). We use derivatives such as interest rate swaps from time to time to manage our market risk associated with variable rate debt or similar derivatives for fixed rate debt. We do not hold or issue derivative instruments for trading purposes and are not a party to any instruments with leverage features.

        At June 30, 2009, we held $21.6 million in total available for sale investments in auction rate securities (“ARS”) backed by student loans, which are included in long-term investments in auction rate securities on our consolidated balance sheet due to inactivity in the primary ARS market during the past year. The par value of the ARS was $26.3 million as of June 30, 2009. As of June 30, 2008, we had reflected the ARS as current marketable securities. We recorded a $0.6 million realized holding loss on $10.0 million of these marketable securities during the quarter ended September 30, 2008 as a result of a tender offer we received from the issuer of the ARS and accepted. However, the tender offer contained certain conditions that were not met by the December 2008 deadline, and the tender failed. Thus, we reclassified the $9.4 million of marketable securities to investments in auction rate securities, along with the other outstanding ARS, on our condensed consolidated balance sheet as of December 31, 2008. We also recorded temporary impairments totaling $4.1 million ($2.5 million, net of taxes) related to all $26.3 million par value ARS during the year ended June 30, 2009, which are included in accumulated other comprehensive income (loss) on our consolidated balance sheet as of June 30, 2009.

        Our ARS were rated “AAA” by one or more major credit rating agencies at June 30, 2009 based on their most recent ratings update. The ratings take into account insurance policies guaranteeing both the principal and accrued interest of the investments. The U.S. government guarantees approximately 96%-98% of the principal and accrued interest on each investment in student loans under the Federal Family Education Loan Program or similar programs.

        We will continue to monitor market conditions for this type of ARS to ensure that our classification and fair value estimate remain appropriate. Should market conditions in future periods warrant a reclassification or other than temporary impairment of our ARS, we do not believe our financial position, results of operations, cash flows or compliance with debt covenants would be materially impacted. We believe that we currently have adequate working capital to fund operations during the near future based on access to cash and cash equivalents, expected operating cash flows and availability under our revolving credit facility. We do not expect that our holding of the ARS until market conditions improve will significantly adversely impact our operating cash flows.

79



Item 8.    Financial Statements and Supplementary Data.

INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

 

Page

 

 


VANGUARD HEALTH SYSTEMS, INC.

 

Audited Consolidated Financial Statements:

 

  Report of Independent Registered Public Accounting Firm

 

81

  Consolidated Balance Sheets as of June 30, 2008 and 2009

 

82

  Consolidated Statements of Operations for the years ended June 30, 2007, 2008 and 2009

 

83

  Consolidated Statements of Stockholders’ Equity for the years ended June 30, 2007, 2008 and 2009

 

84

  Consolidated Statements of Cash Flows for the years ended June 30, 2007, 2008 and 2009

 

85

  Notes to Consolidated Financial Statements

 

87

80



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors
Vanguard Health Systems, Inc.

                We have audited the accompanying consolidated balance sheets of Vanguard Health Systems, Inc. as of June 30, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended June 30, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

                We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

                In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vanguard Health Systems, Inc. at June 30, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2009, in conformity with U.S. generally accepted accounting principles.

/s/ Ernst & Young LLP

Nashville, Tennessee
September 2, 2009

81



VANGUARD HEALTH SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS

June 30,
2008

 

 

 

June 30,
2009

 

 

 


 

 

ASSETS

 

(In millions except share and
per share amounts)

 

 

Current assets:

 

 

 

 

 

 

 

 

   Cash and cash equivalents

 

$

141.6

 

 

$

308.2

 

   Restricted cash

2.1

1.9

   Marketable securities

26.3

   Accounts receivable, net of allowance for doubtful accounts of
      approximately $117.7 and $121.5 at June 30, 2008 and 2009, respectively

 

 

300.4

 

 

 

275.3

 

   Inventories

 

 

49.2

 

 

 

48.3

 

   Deferred tax assets

24.5

29.6

   Prepaid expenses and other current assets

 

 

55.8

 

 

 

68.4

 

 

 

 


 

 

 


 

        Total current assets

599.9

 

731.7

 

Property, plant and equipment, net of accumulated depreciation

1,174.0

 

1,174.1

 

Goodwill

689.2

 

692.1

 

Intangible assets, net of accumulated amortization

61.4

 

54.6

 

Investments in and advances to affiliates

6.0

5.4

Investments in auction rate securities

21.6

Other assets

51.8

 

51.6

 

 


 


 

        Total assets

$

2,582.3

 

$

2,731.1

 

 


 


 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

Current liabilities:

 

 

   Accounts payable

$

155.1

 

$

127.9

 

   Accrued salaries and benefits

97.4

133.9

   Accrued health plan claims

51.1

 

117.6

 

   Accrued interest

13.2

 

13.2

 

   Other accrued expenses and current liabilities

57.3

 

79.5

 

   Current maturities of long-term debt

8.0

 

8.0

 

 


 


 

        Total current liabilities

382.1

 

480.1

 

Minority interests in equity of consolidated entities

9.1

8.0

Professional and general liability and workers compensation reserves

74.1

76.7

Other liabilities

22.9

 

34.9

 

Long-term debt, less current maturities

1,529.5

 

1,543.6

 

Commitments and contingencies

Stockholders’ equity:

Common Stock; $.01 par value, 1,000,000 shares authorized, 749,550 shares
    issued and outstanding at June 30, 2008 and 2009, respectively

Additional paid-in capital

647.1

651.3

Accumulated other comprehensive income (loss)

2.8

(6.8

)

Retained deficit

(85.3

)

(56.7

)

 



        Total stockholders’ equity

564.6

587.8

 



        Total liabilities and stockholders’ equity

$

2,582.3

$

2,731.1

 



 

See accompanying notes.

82



VANGUARD HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

 

For the Year Ended June 30,

 

 

 

 


 

 

 

 

2007

 

 

 

2008

 

 

 

2009

 

 

 

 


 

 

 


 

 

 


 

 

 

 

(In millions)

 

 

 

 

Patient service revenues

 

$

2,179.3

 

 

$

2,340.5

 

 

$

2,521.7

 

Premium revenues

 

401.4

 

450.2

 

678.0

 

 




   Total revenues

 

 

2,580.7

 

 

 

2,790.7

 

 

 

3,199.7

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

   Salaries and benefits (includes stock compensation
      of $1.2, $2.5 and $4.4, respectively)

 

 

1,067.9

 

 

1,152.7

 

 

1,240.1

   Health plan claims expense

 

297.0

328.2

525.6

   Supplies

 

 

421.8

 

 

434.5

 

 

456.3

   Provision for doubtful accounts

 

175.2

205.6

210.8

   Purchased services

 

 

141.2