0001498068-18-000103.txt : 20181109 0001498068-18-000103.hdr.sgml : 20181109 20181109163440 ACCESSION NUMBER: 0001498068-18-000103 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 75 CONFORMED PERIOD OF REPORT: 20180930 FILED AS OF DATE: 20181109 DATE AS OF CHANGE: 20181109 FILER: COMPANY DATA: COMPANY CONFORMED NAME: American Renal Associates Holdings, Inc. CENTRAL INDEX KEY: 0001498068 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-MISC HEALTH & ALLIED SERVICES, NEC [8090] IRS NUMBER: 272170749 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-37751 FILM NUMBER: 181173562 BUSINESS ADDRESS: STREET 1: AMERICAN RENAL HOLDINGS, INC. STREET 2: 500 CUMMINGS CENTER, SUITE 6550 CITY: BEVERLY STATE: MA ZIP: 01915 BUSINESS PHONE: 978-922-3080 MAIL ADDRESS: STREET 1: AMERICAN RENAL HOLDINGS, INC. STREET 2: 500 CUMMINGS CENTER, SUITE 6550 CITY: BEVERLY STATE: MA ZIP: 01915 FORMER COMPANY: FORMER CONFORMED NAME: C.P. Atlas Holdings, Inc. DATE OF NAME CHANGE: 20100802 10-Q 1 ara-9302018x10q.htm 10-Q Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
or
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 001-37751
 
ara20160930x10q001a05.jpg
American Renal Associates Holdings, Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
27-2170749
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification Number)
 
 
500 Cummings Center
Beverly, Massachusetts
01915
(Address of principal executive offices)
(Zip code)
 
(978) 922-3080
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes ☒ No ☐ 
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of 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 such files).  Yes ☒ No ☐
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
 
 
Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

As of November 8, 2018 there were 32,517,065 shares of the registrant’s common stock outstanding.



INDEX
 
 
 
PAGE
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


    

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This Quarterly Report on Form 10-Q (“Form 10-Q”) contains certain “forward-looking statements” and information relating to us that are based on the beliefs of our management as well as assumptions made by, and information currently available to, us. Forward-looking statements include, but are not limited to, those statements that are based upon management’s current plans and expectations as opposed to historical and current facts and are often identified in this report by use of words including but not limited to “estimates,” “expects,” “contemplates,” “anticipates,” “projects,” “plans,” “intends,” “believes,” “forecasts,” “may,” “should” and variations of such words or similar expressions. These statements are based upon estimates and assumptions made by our 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. These and other important factors, including those discussed in “Part I. Item 1A. Risk Factors” in the Company’s Form 10-K for the year ended December 31, 2017, and in “Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-Q, as such risk factors may be updated from time to time in our periodic filings with the Securities and Exchange Commission, may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. Some of the factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements include, among others, the following:

continuing decline in the number of patients with commercial insurance, including as a result of changes to the healthcare exchanges or changes in regulations or enforcement of regulations regarding the healthcare exchanges and challenges from commercial payors or any regulatory or other changes leading to changes in the ability of patients with commercial insurance coverage to receive charitable premium support;

decline in commercial payor reimbursement rates;

the ultimate resolution of the Centers for Medicare and Medicaid Services (“CMS”) Interim Final Rule published December 14, 2016 related to dialysis facilities Conditions for Coverage (CMS 3337-IFC), including an issuance of a different but related Final Rule;

reduction of government-based payor reimbursement rates or insufficient rate increases or adjustments that do not cover all of our operating costs;

our ability to successfully develop de novo clinics, acquire existing clinics and attract new physician partners;

our ability to compete effectively in the dialysis services industry;

the performance of our joint venture subsidiaries and their ability to make distributions to us;

changes to the Medicare end-stage renal disease (“ESRD”) program that could affect reimbursement rates and evaluation criteria, as well as changes in Medicaid or other non-Medicare government programs or payment rates, including the ESRD prospective payment rate system final rule for 2019 issued November 1, 2018;

federal or state healthcare laws that could adversely affect us;

our ability to comply with all of the complex federal, state and local government regulations that apply to our business, including those in connection with federal and state anti-kickback laws and state laws prohibiting the corporate practice of medicine or fee-splitting;

heightened federal and state investigations and enforcement efforts;

the impact of the now-settled litigation by affiliates of UnitedHealth Group, Inc. and the resolution thereof, including entry into a national network agreement with United;

the impact of the ongoing Department of Justice inquiry;

changes in the availability and cost of erythropoietin-stimulating agents and other pharmaceuticals used in our business;


1

    

changes in the reimbursement rates of the calcimimetics pharmaceutical class under the Medicare Transitional Drug Add-on Payment Adjustment;

development of new technologies that could decrease the need for dialysis services or decrease our in-center patient population;

our ability to timely and accurately bill for our services and meet payor billing requirements;

claims and losses relating to malpractice, professional liability and other matters; the sufficiency of our insurance coverage for those claims and rising insurances costs; and any negative publicity or reputational damage arising from such matters;

loss of any members of our senior management;

damage to our reputation or our brand and our ability to maintain brand recognition;

our ability to maintain relationships with our medical directors and renew our medical director agreements;

shortages of qualified skilled clinical personnel, or higher than normal turnover rates;

competition and consolidation in the dialysis services industry;

deteriorations in economic conditions, particularly in states where we operate a large number of clinics, or disruptions in the financial markets;

the participation of our physician partners in material strategic and operating decisions and our ability to favorably resolve any disputes;

our ability to honor obligations under the joint venture operating agreements with our physician partners were they to exercise certain put rights and other rights;

unauthorized disclosure of personally identifiable, protected health or other sensitive or confidential information;

our ability to meet our obligations and comply with restrictions under our substantial level of indebtedness; and

the ability of our principal stockholder, whose interests may conflict with yours, to strongly influence or effectively control our corporate decisions.
 
You should evaluate all forward-looking statements made in this Form 10-Q in the context of these risks and uncertainties.
We caution you that the risks, uncertainties and other factors referenced above, many of which are beyond our control, may not contain all of the risks, uncertainties and other factors that are important to you. In addition, we cannot assure you that we will realize the results, benefits or developments that we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our business in the way expected. All forward-looking statements in this Form 10-Q apply only as of the date made and are expressly qualified in their entirety by the cautionary statements included in this Form 10-Q. We undertake no obligation to publicly update or revise any forward-looking statements to reflect subsequent events or circumstances.

All subsequent written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by these cautionary statements.

2


PART I.
FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except for share data)
 
September 30, 2018
 
December 31, 2017
 
(Unaudited)
 
 
Assets
 
 
 
Cash
$
61,872

 
$
71,521

Accounts receivable, less allowance for doubtful accounts of $426 and $6,757, respectively
90,596

 
79,662

Inventories
6,382

 
4,665

Prepaid expenses and other current assets
20,608

 
24,998

Income tax receivable
5,306

 
6,745

Total current assets
184,764

 
187,591

Property and equipment, net of accumulated depreciation of $191,979 and $167,390, respectively
168,346

 
168,537

Intangible assets, net of accumulated amortization of $24,022 and $23,419, respectively
24,811

 
25,368

Other long-term assets
18,198

 
9,285

Goodwill
570,944

 
573,427

Total assets
$
967,063

 
$
964,208

 
 
 
 
Liabilities and Equity
 
 
 
Accounts payable
$
54,023

 
$
33,421

Accrued compensation and benefits
34,658

 
28,985

Accrued expenses and other current liabilities
43,153

 
49,963

Current portion of long-term debt
47,206

 
44,534

Total current liabilities
179,040

 
156,903

Long-term debt, less current portion
506,750

 
515,554

Income tax receivable agreement payable
9,476

 
7,500

Other long-term liabilities
24,378

 
14,880

Deferred tax liabilities
4,843

 
8,991

Total liabilities
724,487

 
703,828

Commitments and contingencies (Note 14 and Note 15)

 

Noncontrolling interests subject to put provisions
150,152

 
139,895

Equity:
 
 
 
Preferred stock, $0.01 par value; 1,000,000 shares authorized; none issued

 

Common stock, $0.01 par value; 300,000,000 shares authorized; 32,514,777 and 32,034,439 issued and outstanding at September 30, 2018 and December 31, 2017, respectively
195

 
193

Additional paid-in capital
65,965

 
67,853

Receivable from noncontrolling interests
(1,340
)
 
(358
)
Accumulated deficit
(140,003
)
 
(123,789
)
Accumulated other comprehensive income (loss), net of tax
1,654

 
(677
)
Total American Renal Associates Holdings, Inc. deficit
(73,529
)
 
(56,778
)
Noncontrolling interests not subject to put provisions
165,953

 
177,263

Total equity
92,424

 
120,485

Total liabilities and equity
$
967,063

 
$
964,208

See accompanying notes to consolidated financial statements.

3



AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES  
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(dollars in thousands, except for share data)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Patient service operating revenues
$
211,019

 
$
187,711

 
$
622,869

 
$
550,728

Operating expenses:
 
 
 
 
 
 
 
Patient care costs
145,300

 
119,599

 
419,593

 
357,959

General and administrative
24,619

 
22,292

 
76,382

 
79,917

Transaction-related costs (Note 1)

 

 
856

 
717

Depreciation and amortization
10,023

 
9,438

 
29,460

 
27,894

Certain legal matters (Note 15)
1,028

 
3,481

 
37,677

 
11,714

Total operating expenses
180,970

 
154,810

 
563,968

 
478,201

Operating income
30,049

 
32,901

 
58,901

 
72,527

Interest expense, net
(8,241
)
 
(7,255
)
 
(23,829
)
 
(22,052
)
Loss on early extinguishment of debt

 

 

 
(526
)
Income tax receivable agreement (expense) income
(3,480
)
 
3,585

 
(2,765
)
 
5,461

Income before income taxes
18,328

 
29,231

 
32,307

 
55,410

Income tax (benefit) expense
34

 
2,559

 
(1,977
)
 
(555
)
Net income
18,294

 
26,672

 
34,284

 
55,965

Less: Net income attributable to noncontrolling interests
(15,804
)
 
(18,689
)
 
(50,712
)
 
(51,339
)
Net income (loss) attributable to American Renal Associates Holdings, Inc.
2,490

 
7,983

 
(16,428
)
 
4,626

Less: Change in the difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests
(481
)
 
5

 
(783
)
 
(13,605
)
Net income (loss) attributable to common shareholders
$
2,009

 
$
7,988

 
$
(17,211
)
 
$
(8,979
)
 
 
 
 
 
 
 
 
Earnings (loss) per share (Note 12):
 
 
 
 
 
 
 
Basic
$
0.06

 
$
0.26

 
$
(0.54
)
 
$
(0.29
)
Diluted
$
0.06

 
$
0.24

 
$
(0.54
)
 
$
(0.29
)
Weighted-average number of common shares outstanding
 
 
 
 
 
 
 
Basic
32,005,544

 
31,095,418

 
31,912,934

 
30,997,218

Diluted
34,578,592

 
33,833,822

 
31,912,934

 
30,997,218

 
See accompanying notes to consolidated financial statements.

4


AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
(dollars in thousands)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
18,294

 
$
26,672

 
$
34,284

 
$
55,965

Unrealized gain (loss) on derivative agreements, net of tax
427

 
(27
)
 
2,545

 
(1,347
)
Total comprehensive income
18,721

 
26,645

 
36,829

 
54,618

Less: Comprehensive income attributable to noncontrolling interests
(15,804
)
 
(18,689
)
 
(50,712
)
 
(51,339
)
Total comprehensive income (loss) attributable to American Renal Associates Holdings, Inc.
$
2,917

 
$
7,956

 
$
(13,883
)
 
$
3,279

 
See accompanying notes to consolidated financial statements.

5


AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES  
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
(Unaudited)
(dollars in thousands, except share data)
 
 
 
 
Total American Renal Associates Holdings, Inc. Equity (Deficit)
 
 
 
Noncontrolling
Interests
subject to put provisions
 
Common Stock
 
Additional
Paid-in
Capital
 
Receivable
from
Noncontrolling
Interest
Holders
 
Retained Earnings (Deficit)
 
Accumulated
Other
Comprehensive Income (loss)
 
 
 
Noncontrolling
Interests not
subject to put provisions
 
 
Shares
 
Par Value
 
 
 
 
 
Total
 
Balance at December 31, 2017
$
139,895

 
32,034,439

 
$
193

 
$
67,853

 
$
(358
)
 
$
(123,789
)
 
$
(677
)
 
$
(56,778
)
 
$
177,263

Net income (loss)
14,164

 

 

 

 

 
(16,428
)
 

 
(16,428
)
 
36,548

Reclassification of stranded tax effects related to the Tax Cuts and Jobs Act of 2017

 

 

 

 

 
214

 
(214
)
 

 

Stock-based compensation

 

 

 
4,174

 

 

 

 
4,174

 

Exercise of stock options

 
212,383

 
2

 
1,155

 

 

 

 
1,157

 

Issuance of restricted stock awards

 
357,275

 

 

 

 

 

 

 

Forfeiture of restricted stock awards

 
(70,382
)
 

 

 

 

 

 

 

Vested restricted stock awards withheld on net share settlement

 
(18,938
)
 

 
(421
)
 

 

 

 
(421
)
 

Cash dividend equivalents accrued on share-based payments, net

 

 

 
494

 

 

 

 
494

 

Distributions to noncontrolling interests
(16,511
)
 

 

 

 

 

 

 

 
(38,620
)
Contributions from noncontrolling interests
1,383

 

 

 

 
(982
)
 

 

 
(982
)
 
3,244

Purchases of noncontrolling interests
(1,062
)
 

 

 
(6,081
)
 

 

 

 
(6,081
)
 
(1,586
)
Sales of noncontrolling interests
166

 

 

 
(51
)
 

 

 

 
(51
)
 
63

Reclassification/other adjustments
10,405

 

 

 
554

 

 

 

 
554

 
(10,959
)
Change in fair value of derivative agreements, net of tax

 

 

 

 

 

 
2,545

 
2,545

 

Change in fair value of noncontrolling interests
1,712

 

 

 
(1,712
)
 

 

 

 
(1,712
)
 

Balance at September 30, 2018
$
150,152

 
32,514,777

 
$
195

 
$
65,965

 
$
(1,340
)
 
$
(140,003
)
 
$
1,654

 
$
(73,529
)
 
$
165,953

 
See accompanying notes to consolidated financial statements.


6

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 (dollars in thousands) 


 
Nine Months Ended September 30,
Operating activities
2018
 
2017
Net income
$
34,284

 
$
55,965

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Depreciation and amortization
29,460

 
27,894

Amortization of discounts, fees and deferred financing costs
1,384

 
1,534

Loss on extinguishment of debt

 
526

Stock-based compensation
4,174

 
14,762

Premium paid for interest rate cap agreements

 
(1,186
)
Deferred taxes
(5,014
)
 
730

Income tax receivable agreement expense (income)
2,765

 
(5,461
)
Non-cash charge related to derivative agreements
18

 
173

Non-cash rent charges
400

 
588

Loss (gain) on disposal of assets
342

 
(377
)
Change in operating assets and liabilities, net of acquisitions:
 
 
 
Accounts receivable
(10,934
)
 
(107
)
Inventories
(1,717
)
 
4

Prepaid expenses and other current assets
6,809

 
(1,425
)
Other assets
(7,291
)
 
(558
)
Accounts payable
20,602

 
2,736

Accrued compensation and benefits
5,673

 
2,664

Accrued expenses and other liabilities
2,916

 
(1,090
)
Cash provided by operating activities
83,871

 
97,372

Investing activities
 

 
 
Purchases of property, equipment and intangible assets
(29,074
)
 
(24,780
)
Proceeds from asset sales
2,502

 
1,075

Cash used in investing activities
(26,572
)
 
(23,705
)
Financing activities
 

 
 
Net proceeds from issuance of long-term debt

 
267,564

Cash paid for financing costs

 
(3,914
)
Proceeds from term loans, net of deferred financing costs
52,576

 
34,742

Payments on long-term debt
(59,903
)
 
(312,800
)
Dividends and dividend equivalents paid
(320
)
 
(8,715
)
Proceeds from exercise of stock options
1,157

 
683

Vested restricted stock awards withheld on net share settlement
(421
)
 

Distributions to noncontrolling interests
(55,131
)
 
(60,509
)
Contributions from noncontrolling interests
3,645

 
3,847

Purchases of noncontrolling interests
(8,729
)
 
(27,854
)
Proceeds from sales of additional noncontrolling interests
178

 
66

Cash used in financing activities
(66,948
)
 
(106,890
)
 
 
 
 
Decrease in cash and restricted cash
(9,649
)
 
(33,223
)
Cash and restricted cash at beginning of period
71,621

 
100,916

Cash and restricted cash at end of period
$
61,972

 
$
67,693

 
 
 
 
Supplemental Disclosure of Cash Flow Information
 

 
 
Cash paid for income taxes
$
2,152

 
$
1,571

Cash paid for interest
22,221

 
20,111

 
 
 
 
Supplemental Disclosure of Non-Cash Financing Activities
 

 
 
Accrued purchases of noncontrolling interests

 
3,696

Liability for accrued dividend equivalent payments, net
494

 
2,711

See accompanying notes to consolidated financial statements.

7


AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(dollars in thousands, except per share amounts)
1. BASIS OF PRESENTATION AND ORGANIZATION
 
Business
 
American Renal Associates Holdings, Inc. (“the Company”) owns 100% of the membership units of its subsidiary American Renal Holdings Intermediate Company, LLC, which itself has no assets other than 100% of the shares of capital stock of American Renal Holdings Inc. All of the Company's operating activities are conducted through American Renal Holdings Inc. and its operating subsidiaries (“ARH”).
 
The Company is a national provider of kidney dialysis services for patients suffering from chronic kidney failure, also known as end stage renal disease (“ESRD”). As of September 30, 2018, the Company owned and operated 235 dialysis clinics treating 16,092 patients in 26 states and the District of Columbia. The Company’s operating model is based on shared ownership of its facilities with physicians, known as nephrologists, who specialize in treating kidney-related diseases in the local market served by the clinic. Each clinic is maintained as a separate joint venture (“JV”) in which the Company has a controlling interest and its local nephrologist partners have noncontrolling interests.
 
Basis of Presentation and Consolidation
 
The accompanying unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“U.S.”) for complete financial statements. The Company's consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and variable interest entities that operate its clinics (“joint ventures”). All significant intercompany balances and transactions of the Company's wholly owned subsidiaries and joint ventures, including management fees from subsidiaries, are eliminated in consolidation. Refer to Note 7 - Variable Interest Entities.
 
In the opinion of management, the Company has prepared the accompanying unaudited consolidated financial statements on the same basis as its audited consolidated financial statements, and these financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented. These unaudited consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company's Form 10-K for the year ended December 31, 2017. Prior year balances and amounts have been reclassified to conform to the current year presentation. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year.
 
Segment Information
 
Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker as of September 30, 2018, or decision-making group, in making decisions how to allocate resources and assess performance. The Company views its operations and manages its business as one reportable business segment, the ownership and operation of dialysis clinics, all of which are located in the United States.

2018 Secondary Offering

The Company recognized $856 of transaction-related costs in the nine months ended September 30, 2018, reflecting expenses incurred for the registration statement and the secondary offering that was withdrawn in March 2018. These costs include legal, accounting, valuation and other professional or consulting fees.

Recent Accounting Pronouncements
 
In August 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This amendment modifies the disclosure requirements for assets and liabilities measured at fair value.    The requirements to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the

8

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


policy for timing of transfers between levels and the valuation processes for Level 3 fair value measurements have all been removed. However, the changes in unrealized gains and losses included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period must be disclosed along with the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements (or other quantitative information if it is more reasonable). This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. The Company is currently assessing the impact the adoption of ASU 2018-13 will have on the consolidated financial statements.

In February 2018, the FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This amendment provides for the reclassification of the effect of remeasuring deferred tax balances related to items within accumulated other comprehensive income (“AOCI”) to retained earnings resulting from the Tax Cuts and Jobs Act of 2017. For public business entities, the ASU is effective for fiscal years beginning after December 15, 2018, and interim periods within those years, with early adoption permitted. Adoption of this ASU is to be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the tax laws or rates were recognized. The Company elected to early adopt ASU 2018-02 during the first quarter of 2018, and elected to reclassify the income tax effects from the Tax Cuts and Jobs Act of 2017 from AOCI to retained earnings. The reclassification decreased AOCI and increased retained earnings by $214.

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which amends and simplifies existing guidance in order to allow companies to more accurately present the economic effects of risk management activities in the financial statements. For public business entities, the ASU is effective for fiscal years beginning after December 15, 2018, and interim periods therein; however, early adoption by all entities is permitted. The Company does not believe this ASU will have a material impact on its financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) - Leases: Amendments to the FASB Accounting Standards Codification. The amendments are expected to increase transparency and comparability by recognizing lease assets and liabilities of lessees on the balance sheet and disclosing key information about leasing arrangements in the financial statements. Since February 2016, the FASB has issued additional updates to serve as targeted improvements to the original standard update. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted for all organizations.

The Company will adopt ASU 2016-02 effective January 1, 2019. The Company has engaged a professional services firm and has implemented lease accounting systems to assist in the implementation of ASU 2016-02. The Company expects the standard will add approximately $125,000 in right of use assets and lease liabilities to our consolidated balance sheet principally for certain leases currently accounted for as operating leases. The ultimate impact on the Company will depend on the contract portfolio and interest rates at the effective date. The Company does not expect any impact on the current debt covenants, as described in Note 9 - Debt. The guidance should be applied under a modified retrospective transition approach, with an option to apply the guidance either at the beginning of the earliest comparative period presented, or to apply the new guidance at the adoption date. The Company expects to apply the modified retrospective method at the beginning of the period of adoption after review of the analysis is performed.
 
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”), which requires companies to recognize revenue when a customer obtains control rather than when companies have transferred substantially all risks and rewards of a good or service. Since May 2014, the FASB has issued additional updates to serve as clarification to the original standard update. The standard also requires entities to enhance disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.
 
The Company adopted ASU 2014-09 on January 1, 2018, using the modified retrospective transition method. As a practical expedient, the Company adopted using the portfolio approach, applying the ASU to a portfolio of contracts with similar characteristics. The Company reasonably expects that the effects on the financial statements of applying this guidance to the portfolio of contracts would not differ materially from applying this guidance to the individual contracts within the portfolio. Additionally, the Company elected the practical expedient that allows the recognition of revenue with each dialysis treatment, as that is when the Company has the right to invoice. The Company also adopted the practical expedient to only assess the recognition of revenue for open contracts during the transition period and there was no adjustment to the opening balance of retained earnings at January 1, 2018. The comparative information has not been restated and continues to be reported under the accounting standards in effect for that period.

9

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


The adoption of ASU 2014-09 did not have a material impact to the timing of revenue recognition; however, a majority of the provision for uncollectible accounts is now recognized as a direct reduction to revenues, instead of separately as a deduction to arrive at net revenue. The Company no longer separately presents a provision for uncollectible accounts on the consolidated statements of operations as it is included in Patient care costs after the adoption of the new accounting standard.
As a result of the Company’s election to apply ASU 2014-09 only to contracts not substantially completed as of January 1, 2018, the Company continues to maintain an allowance for doubtful accounts related to performance obligations satisfied prior to the adoption of the accounting standards. Changes to this allowance for doubtful accounts, other than write-offs of uncollectible accounts, are recorded through the provision for uncollectible accounts in accordance with prior accounting standards. The Company's provision for uncollectible accounts was $1,786 and $5,003 for the three and nine months ended September 30, 2017.

See Note 2 - Revenue for additional discussion of the Company's revenue recognition accounting policies and expanded disclosures required by the new standard.
2. REVENUE

The major component of the Company's revenues, which is included in patient service operating revenues, is derived from dialysis treatments and related services. Sources of revenues are principally from government-based programs, including Medicare, Medicaid and state workers' compensation programs, commercial insurance payors and other sources such as the U.S. Department of Veterans Affairs (the “VA”), hospitals as well as patient pay. Patient service operating revenue is reported at the amount that reflects the consideration to which the Company expects to be entitled in exchange for providing dialysis treatments and related services. These amounts are due from third-party payors, including government-based programs and commercial insurance payors, patients and others and may include variable consideration for discounts, price concessions and retroactive revenue adjustments due to new information obtained, such as actual payment receipt, as well as settlement of audits, reviews and investigations. Third-party payors, patients and other payors are generally billed at least monthly, typically in the month the dialysis treatment is performed, and payment is due upon receipt. Revenue is recognized as performance obligations are satisfied.
A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is defined as the unit of account under ASC 606. The Company has determined that one performance obligation exists, the dialysis treatment, which is satisfied over time as a dialysis treatment is provided. While the Company provides patients with other related services, they are considered a bundle of interrelated services with dialysis treatment as the primary service. Revenue is measured using the output method, which is based upon the delivery of a dialysis treatment to the patient. The Company believes that this method provides a faithful depiction of the satisfaction of the performance obligation. All performance obligations are satisfied at the end of each reporting period.
A usual and customary fee schedule is maintained for dialysis treatment and other related services; however, the transaction price is typically at a discount to the fee schedule. The transaction prices for Medicare and Medicaid programs are based on predetermined net realizable rates per treatment that are established by statutes or regulation. The transaction prices for contracted payors are based on contracted rates. For other payors, the Company determines the transaction price based on usual and customary rates for services provided, reduced by contractual adjustments provided to third-party payors, discounts provided to uninsured patients in accordance with the Company’s policy, and/or implicit price concessions. The Company determines its estimates of contractual allowances and discounts based on contractual agreements, regulatory compliance, and historical collection experience. The Company determines its estimate of implicit price concessions based on its historical collection experience with each payor. Amounts billed that have not yet been collected and that meet the conditions for unconditional right to payment are presented as patient receivables.
Contractual adjustments result from differences between the rates charged for services performed and expected reimbursements from third-party payors and are largely comprised of balances relating to services billed to non-contracted providers. Contractual adjustments and discounts with third-party payors are considered variable consideration and are included in the determination of the estimated transaction price for providing patient care. In assessing the probability of these claim payments, the Company reviews previous payment history and records a reserve that results in an estimate of expected revenue such that it is probable that a significant revenue reversal will not occur in future periods, at the payor level. This constraint on variable consideration is based on the probability of a reversal of an amount that is significant relative to the cumulative revenue recognized for the contract.

10

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


Patient service operating revenues may be subject to adjustment of the estimated transaction price as a result of (i) new information obtained, such as actual payment receipt, (ii) examinations of the Company, or Medicare or Medicaid Managed Care programs that the Company serves, by government agencies or contractors, for which the resolution of any matters raised may take extended periods of time to finalize; (iii) differing interpretations of government regulations by different fiscal intermediaries or regulatory authorities; (iv) differing opinions regarding a patient’s medical diagnosis or the medical necessity of service provided; (v) retroactive applications or interpretations of governmental requirements; and (vi) claims for refunds from private payors, including as the result of government actions.
Settlements with third-party payors for retroactive adjustments due to audits, reviews or investigations are considered variable consideration and are included in the determination of the estimated transaction price for providing dialysis treatments and related services. These settlements are estimated based on the terms of the payment agreement with the payor, correspondence from the payor and the Company’s historical settlement activity, including an assessment to ensure that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the retroactive adjustment is subsequently resolved. Estimated settlements are adjusted in future periods as adjustments become known (i.e., new information becomes available), or as years are settled or are no longer subject to such audits, reviews, and investigations.
Adjustments arising from a change in the transaction price in instances where the performance obligation was satisfied in a previous period were immaterial for the three and nine months ended September 30, 2018. These changes in transaction price are mostly attributable to an adjustment for balances with non-contracted payors. The Company obtained new information, such as actual cash receipt, and adjusted the estimated transaction price at the patient level.
Amounts pending approval from third-party payors associated with Medicare bad debt claims as of September 30, 2018 and December 31, 2017, other than standard monthly billing, consisted of approximately $12,148 and $10,744, respectively. As of September 30, 2018, $5,380 is classified as Prepaid and other current assets and $6,768 is classified as Other long-term assets. As of December 31, 2017, the entire balance is classified as Prepaid and other current assets.
The composition of patient care service revenue by source is as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Source of Revenues:
2018
 
2017
 
2018
 
2017
Medicare and Medicare Advantage
65
%
 
59
%
 
64
%
 
59
%
Commercial and other (1)
30
%
 
36
%
 
32
%
 
37
%
Medicaid and Managed Medicaid
4
%
 
4
%
 
4
%
 
4
%
Other (2)
1
%
 
1
%
 
%
 
%
 
100
%
 
100
%
 
100
%
 
100
%
_____________________
(1)
Principally commercial insurance companies and also includes the VA, which we refer to collectively as “Commercial and other.”

(2)
Other sources of revenues include hospitals and patient pay. “Patient pay” revenues consist of payments received directly from patients who are either uninsured or self-pay a portion of the bill.












11


3. CASH

The following table provides a reconciliation of cash and restricted cash reported within the balance sheet that sum to the total of the same such amounts shown in the statement of cash flows.
 
September 30, 2018
 
Cash
$
61,872

 
Restricted cash included in other long-term assets
100

 
Total cash and restricted cash shown in the statement of cash flows
$
61,972

 

Restricted cash included in other long-term assets on the balance sheet represent those amounts required to be set aside by contractual agreement with a financial institution.

4. GOODWILL

Changes in goodwill were as follows:

Balance at December 31, 2017
$
573,427

Acquisitions

Divestitures
(2,483
)
Balance at September 30, 2018
$
570,944


5. FAIR VALUE MEASUREMENTS
 
The Company’s interest rate swap and interest rate cap agreements, Income Tax Receivable Agreement and noncontrolling interests subject to put provisions are accounted for at fair value on a recurring basis and are classified and disclosed in one of the following three categories:
 
Level 1:  Financial instruments with unadjusted, quoted prices listed on active market exchanges.
 
Level 2:  Financial instruments determined using prices for recently traded financial instruments with similar underlying terms, as well as directly or indirectly observable inputs, such as interest rates and yield curves that are observable at commonly quoted intervals.
 
Level 3:  Financial instruments not actively traded on a market exchange. This category includes situations where there is little, if any, market activity for the financial instrument. The prices are determined using significant unobservable inputs or valuation techniques.
 
The asset or liability fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. There were no changes in the methodologies used at September 30, 2018.

Noncontrolling interests subject to put provisions—See Note 8 - Noncontrolling Interests Subject to Put Provisions for a discussion of the Company’s methodology for estimating fair value of noncontrolling interest subject to put provisions.
 
Derivative agreements—See Note 9 - Debt for a discussion of the Company’s methodology for estimating fair value of interest rate swap and interest rate cap agreements.
 
Income Tax Receivable Agreement—The fair value of the Company's Income Tax Receivable Agreement, entered into on April 26, 2016 in connection with the Company's initial public offering (“TRA”), relies upon both Level 2 data and Level 3 data. The liability is remeasured at fair value each reporting period with the change in fair value recognized as Income tax receivable agreement income or expense in the Company’s Consolidated Statements of Operations. The fair value is calculated using a Monte Carlo simulation-based approach that relies on significant assumptions about the Company's stock price, stock volatility and risk-free rate as well as the timing and amounts of options exercised. Changes in assumptions based on future events, including the price of the Company's common stock, will impact the fair value for the TRA. See Note 13 - Related Party Transactions for further discussion of the TRA.
 

12

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


Transfers among levels are calculated on values as of the transfer date. There were no transfers between Levels 1, 2 and 3 during the nine months ended September 30, 2018 and the year ended December 31, 2017.
 
 
September 30, 2018
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
Interest rate derivative agreements (included in Prepaid expenses and other current assets)
$
1,027

 
$

 
$
1,027

 
$

Interest rate derivative agreements (included in Other long-term assets)
2,066

 

 
2,066

 

Total Assets
$
3,093

 
$

 
$
3,093

 
$

Liabilities
 
 
 
 
 

 
 

Tax Receivable Agreement Liability (included in Income tax receivable agreement payable)
$
9,500

 
$

 
$

 
$
9,500

Temporary Equity
 
 
 
 
 

 
 

Noncontrolling interests subject to put provisions
$
150,152

 
$

 
$

 
$
150,152

 
 
December 31, 2017
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
Interest rate derivative agreements (included in Prepaid expenses and other current assets)
$
46

 
$

 
$
46

 
$

Interest rate derivative agreements (included in Other long-term assets)
255

 

 
255

 

Total Assets
$
301

 
$

 
$
301

 
$

Liabilities
 
 
 
 
 
 
 

Tax Receivable Agreement Liability (included in Income tax receivable agreement payable)
$
7,500

 
$

 
$

 
$
7,500

Interest rate swap agreement (included in Accrued expenses and other current liabilities)
403

 

 
403

 

Interest rate swap agreement (included in Other long-term liabilities)
198

 

 
198

 

Total Liabilities
$
8,101

 
$

 
$
601

 
$
7,500

Temporary Equity
 
 
 
 
 
 
 

Noncontrolling interests subject to put provisions
$
139,895

 
$

 
$

 
$
139,895

 
The following table provides the fair value rollforward for the nine months ended September 30, 2018 for the TRA liability, which is classified as a Level 3 financial instrument. 

Balance at December 31, 2017
$
7,500

Options exercised and dividend equivalent payment vesting
(765
)
Total realized/unrealized losses:
 
Included in earnings and reported as Income tax receivable agreement expense
2,765

Balance at September 30, 2018
$
9,500




13

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


The carrying amounts reported in the accompanying consolidated balance sheets for cash, accounts receivable, accounts payable and accrued liabilities approximate fair value because of their short-term nature. The fair value of the Company’s debt is estimated using Level 2 inputs based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. The Company estimates the fair value of the first lien term loans to be $431,241 as of September 30, 2018, compared to a carrying value of $434,500. As of December 31, 2017, the Company estimates the fair value of the first lien term loans to be $436,158 compared to the carrying value of $437,800.

6. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
 
Accrued compensation and benefits consist of the following: 
 
September 30, 2018
 
December 31, 2017
Accrued compensation
$
21,027

 
$
17,987

Accrued vacation pay
13,631

 
10,998

 
$
34,658

 
$
28,985


Accrued expenses and other current liabilities consist of the following: 
 
September 30, 2018
 
December 31, 2017
Payor refunds and retractions
$
24,968

 
$
28,935

Other
10,544

 
21,028

Accrued settlement
7,641

 

 
$
43,153

 
$
49,963

 
7. VARIABLE INTEREST ENTITIES
 
The Company relies on the operating activities of certain entities for which it does not have the majority voting interest, but over which it has indirect influence and of which it is considered the primary beneficiary. These entities are subject to the consolidation guidance applicable to variable interest entities (“VIEs”).
 
Under U.S. generally accepted accounting principles, VIEs typically include entities for which (i) the entity’s equity is not sufficient to finance its activities without additional subordinated financial support; (ii) the equity holders as a group lack the power to direct the activities that most significantly influence the entity’s economic performance, the obligation to absorb the entity’s expected losses, or the right to receive the entity’s expected returns; or (iii) the voting rights of some investors are not proportional to their obligations to absorb the entity’s losses.
 
The Company has determined that substantially all of the entities it is associated with that qualify as VIEs must be included in its consolidated financial statements. For its joint ventures, the Company has determined that contractual rights granted to it provide the Company with the ability to direct the most significant activities of these entities, including development, administrative and management services. In some cases, the contractual agreements include financial terms that may result in the Company absorbing more than an insignificant amount of the entities' expected losses. Therefore, the Company has determined that it is the primary beneficiary of these entities. Accordingly, the financial results of these joint ventures are fully consolidated into the Company’s operating results. The equity interests of the outside investors in the equity and results of operations of these consolidated entities are accounted for and presented as noncontrolling interests.


14

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


The analysis upon which these consolidation determinations rest is complex, involves uncertainties, and requires significant judgment on various matters, some of which could be subject to different interpretations. As of September 30, 2018, these consolidated financial statements include total assets of VIEs of $17,314 and total liabilities of VIEs of $9,240.
 
Term Loan Holdings
 
The Company has determined that it is not the primary beneficiary under VIE accounting guidance for Term Loan Holdings LLC (“Term Loan Holdings”). Based on its involvement with Term Loan Holdings, the Company does not have the power to direct the activities which most significantly impact Term Loan Holding’s economic performance, and therefore this entity is not included in the Company's consolidated financial statements. The Company’s financial responsibility to repay the loans under its guarantee of a proportionate share of each clinic’s borrowing was not a factor in the Company’s assessment of the power criterion. The maximum exposure to loss with respect to Term Loan Holdings is limited to the proportion of the assigned clinic loans which the Company guarantees. See Note 13 - Related Party Transactions.

8. NONCONTROLLING INTERESTS SUBJECT TO PUT PROVISIONS
 
The Company has potential obligations to purchase a portion or all of the noncontrolling interests held by third parties in certain of its consolidated subsidiaries. These obligations are in the form of put provisions and are exercisable at the third-party owners’ discretion within specified periods as outlined in each specific put provision. Additionally, the Company has certain put agreements which are exercisable upon the occurrence of specific events, including the sale of all or substantially all of the Company's assets, closure of the clinic, change of control, departure of key executives, third-party members’ death, disability, bankruptcy, retirement, or if third-party members are dissolved and other events, which could accelerate vesting of the put. The Company has evaluated the applicable terms and determined that the put provisions are not mandatorily redeemable. Some of these puts accelerated as a result of the Company’s IPO, of which some were exercised during the nine months ended September 30, 2018. If the remaining unexercised put provisions are exercised, the Company would be required to purchase all or a portion of the third-party owners’ noncontrolling interests at the estimated fair value as defined within the put provisions. The majority of the put provisions are reported at the greater of the carrying value or estimated fair value for accounting purposes, while some put provisions are stated at the contractual estimated fair value or redemption value, as outlined in each specific put provision. The put options of such noncontrolling interest holders were determined based on inputs that were not readily available in public markets or able to be derived from information available in publicly quoted markets.

As such, the Company categorized the put options of the noncontrolling interest holders as Level 3. The fair value of noncontrolling interests subject to puts is arrived at based on the respective merits of the Income, Market and Asset Based Approaches. The primary inputs associated with these valuation methods are Clinic forecasts, Weighted Average Cost of Capital (15.00% - 20.50%) and EBITDA multiples. The estimated fair values of the noncontrolling interests subject to put provisions can also fluctuate, and the implicit multiple of earnings at which these noncontrolling interest obligations may ultimately be settled could vary significantly from our current estimates depending upon market conditions including potential purchasers’ access to the credit and capital markets, which can impact the level of competition for dialysis and non-dialysis related businesses, the economic performance of these businesses and the restricted marketability of the third-party owners’ noncontrolling interests.

The Company's computation of the difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests as of September 30, 2018 and December 31, 2017 is set forth below:

 
September 30, 2018
 
December 31, 2017
Redemption value
$
11,149

 
$
12,211

Estimated fair value for accounting purposes
4,930

 
6,550

Difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests
$
6,219

 
$
5,661






15

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


In addition, the tables below set forth a reconciliation of noncontrolling interest subject to put provisions.

September 30, 2018
 
December 31, 2017
Noncontrolling interest subject to put provisions - estimated fair value
$
143,933

 
$
134,234

Difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests
6,219

 
5,661

Noncontrolling interests subject to put provisions - maximum redemption value
$
150,152

 
$
139,895


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Change in estimated fair value for accounting purposes
$
4,447

 
$
2,260

 
$
929

 
$
(5,915
)
Change in the difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests
481

 
(5
)
 
783

 
13,605

Total change in fair value of noncontrolling interests subject to put provisions - maximum redemption
$
4,928

 
$
2,255

 
$
1,712

 
$
7,690


9. DEBT
 
Long-term debt consists of the following:
 
September 30, 2018
    
December 31, 2017
2017 Credit Agreement
$
434,500

 
$
437,800

Term Loans (1)
119,984

 
125,619

Lines of Credit
5,765

 
3,600

Other
2,182

 
2,601

 
562,431

 
569,620

Less: discounts and fees, net of accumulated amortization
(8,475
)
 
(9,532
)
Less: current maturities
(47,206
)
 
(44,534
)
 
$
506,750

 
$
515,554

_____________________________
(1)    Includes assigned clinic loans
 
Scheduled maturities of long-term debt as of September 30, 2018 are as follows:  
2018 (remainder)
$
11,804

2019
42,759

2020
33,599

2021
25,854

2022
20,161

Thereafter
428,254

 
$
562,431


16

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


 
During the nine months ended September 30, 2018, the Company made mandatory principal payments of $3,300 under the 2017 Credit Agreement (as defined below).
 
As of September 30, 2018, there were $3,500 of borrowings outstanding under the 2017 Revolving Credit Facility as provided for under our 2017 Credit Agreement (as defined below).

2017 Credit Agreement and Repayment of First Lien Credit Agreement

On June 22, 2017, ARH entered into a new credit agreement (the “2017 Credit Agreement) to refinance the credit facilities under ARH's prior existing First Lien Credit Agreement. The 2017 Credit Agreement provides ARH with (a) a $100,000 senior secured revolving credit facility (the “2017 Revolving Credit Facility); (b) a $440,000 senior secured term B loan facility (the “2017 Term B Loan Facility), and (c) an uncommitted incremental accordion facility equal to the sum of the greater of (i) $125,000 and (ii) 100% of Consolidated EBITDA (as defined in the 2017 Credit Agreement) plus an amount such that certain leverage ratios will not be exceeded after giving pro forma effect to the increase. ARH borrowed the full amount of the 2017 Term B Loan Facility and used such borrowings to repay the outstanding balances under the First Lien Credit Agreement and to pay a portion of the transaction costs and expenses. The obligations of ARH under the 2017 Credit Agreement are guaranteed by American Renal Holdings Intermediate Company, LLC and all of its existing and future wholly owned domestic subsidiaries (collectively, the “Guarantors”) and secured by a pledge of all of ARH’s capital stock and substantially all of the assets of ARH and the Guarantors, including their respective interests in their joint ventures.

The 2017 Credit Agreement contains customary events of default, the occurrence of which would permit the lenders to accelerate payment of the full amounts outstanding. Additionally, the 2017 Credit Agreement contains customary representations and warranties, affirmative covenants and negative covenants, including restrictive financial and operating covenants. These include covenants that restrict ARH's and its restricted subsidiaries’ ability to complete acquisitions, pay cash dividends, incur indebtedness, make investments, sell assets and take certain other corporate actions. The 2017 Credit Agreement events of default, representations and warranties, mandatory prepayments and affirmative and negative covenants are substantially the same as those under the prior first lien credit agreement; provided that the 2017 Credit Agreement contains additional exceptions to the negative covenants that increase the amount ARH and its restricted subsidiaries can use to make restricted payments and increases the flexibility for ARH and its restricted subsidiaries to undertake permitted acquisitions. As of September 30, 2018, ARH is in compliance with these covenants.

The Company incurred $9,259 of costs associated with these refinancing activities, of which $717 were charged as transaction costs in 2017, $4,628 represent debt discounts and $3,914 were deferred as financing costs upon the execution of the 2017 Credit Agreement. The write-off of deferred financing fees and discounts in the amount of $526 was charged as early extinguishment of debt in 2017.

2017 Term B Loan Facility    

The term B loans under the 2017 Term B Loan Facility bear interest at a rate equal to, at ARH's option, either (a) an alternate base rate equal to the higher of (1) the prime rate in effect on such day, (2) the federal funds effective rate plus 0.5% or (3) the Eurodollar rate applicable for a one-month interest period plus 1.0%, plus an applicable margin of 2.25%, (collectively, the “ABR Rate”) or (b) LIBOR, adjusted for changes in Eurodollar reserves, plus a margin of 3.25%. As of September 30, 2018, interest payable quarterly was 5.49% per annum. The 2017 Term B Loan Facility matures in June 2024.

The 2017 Credit Agreement includes provisions requiring ARH to offer to prepay term B loans in an amount equal to (i) the net cash proceeds above certain thresholds received from (a) asset sales and (b) casualty events resulting in the receipt of insurance proceeds, subject to customary provisions for the reinvestment of such proceeds, (ii) the net cash proceeds from the incurrence of debt not otherwise permitted under the 2017 Credit Agreement, and (iii) a percentage of consolidated excess cash flow retained in the business from the preceding fiscal year minus voluntary prepayments. There is no prepayment required as of September 30, 2018.
    
ARH is required to make principal payments on the term B loans under the 2017 Term B Loan Facility in equal quarterly installments of $1,100.


17

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


2017 Revolving Credit Facility

The 2017 Revolving Credit Facility of $100,000 is available through its maturity date of June 2022. Any outstanding loans under the 2017 Revolving Credit Facility bear interest at a rate equal to, at ARH’s option, the ABR Rate or LIBOR, adjusted for changes in Eurodollar reserves, plus, in each case, an applicable margin priced off a grid based upon the consolidated total net leverage ratio of ARH and its restricted subsidiaries. The commitment fee applicable to undrawn revolving commitments under the 2017 Revolving Credit Facility is also priced off a grid based upon the consolidated total net leverage ratio of ARH and its restricted subsidiaries, and as of September 30, 2018, the fee was 0.50%. There were $3,500 of borrowings outstanding under the 2017 Revolving Credit Facility as of September 30, 2018 which had an interest rate of 7.00%.

Interest Rate Swap Agreements
 
In March 2017, ARH entered into a forward starting interest rate swap agreement (the “2017 Swap”) with a notional amount of $133,000, as a means of fixing the floating interest rate component on $440,000 of its variable-rate debt under the 2017 Term B Loan Facility, with an effective date of March 31, 2018. The 2017 Swap is designated as a cash flow hedge, with a termination date of March 31, 2021.

As a result of the application of hedge accounting treatment, to the extent the 2017 Swap is effective, the unrealized gains and losses related to the derivative instrument are recorded in accumulated other comprehensive income (loss) and are reclassified into operations in the same period in which the hedged transaction affects earnings, and to the extent the swap is ineffective and produces gains and losses differently from the losses or gains being hedged, the ineffectiveness portion is recognized in earnings, immediately. Hedge effectiveness is tested quarterly. Neither the Company nor ARH uses derivative instruments for trading or speculative purposes.

Interest Rate Cap Agreements

In March 2017, ARH entered into two interest rate cap agreements (the “Caps”) with notional amounts totaling $147,000, as a means of capping the floating interest rate component on $440,000 of its variable-rate debt under the 2017 Term B Loan Facility. The Caps are designated as a cash flow hedge, with a termination date of March 31, 2021. As a result of the application of hedge accounting treatment, to the extent the Caps are effective, the unrealized gains and losses related to the derivative instrument are recorded in accumulated other comprehensive income (loss) and are reclassified into operations in the same period in which the hedged transaction affects earnings and to the extent the Caps are ineffective and produce gains and losses differently from the losses or gains being hedged, the ineffective portion is recognized in earnings immediately. Hedge effectiveness is tested quarterly. Neither the Company nor ARH uses derivative instruments for trading or speculative purposes.
 
As more fully described within Note 5 - Fair Value Measurements, the Company uses a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. The fair value of the derivative instruments are recorded at fair value based upon valuation models utilizing the income approach and commonly accepted valuation techniques that use inputs from closing prices for similar assets and liabilities in active markets as well as other relevant observable market inputs at quoted intervals such as current interest rates, forward yield curves, and implied volatility. The Company does not believe the ultimate amount that could be realized upon settlement would be materially different from the fair values currently reported.

10. INCOME TAXES
 
The income tax expense included in the accompanying consolidated statements of operations principally relates to the Company’s proportionate share of the pre-tax income of its joint venture subsidiaries. The determination of income tax expense for interim reporting purposes is based upon the estimated effective tax rate for the year adjusted for the impact of any discrete items which are accounted for in the period in which they occur.
 
The Company’s effective income tax rate for the three months ended September 30, 2018 and 2017 was 0.2% and 8.8%, respectively, and (6.1)% and (1.0)% for the nine months ended September 30, 2018 and 2017, respectively. These rates differ from the federal statutory rate of 21% and 35%, respectively, principally due to the portion of pre-tax income that is allocable to noncontrolling interests from the Company's joint venture subsidiaries, which are pass-through entities for income tax purposes, the valuation allowance, as well as the change in fair value of the TRA liability, which is not deductible for income tax purposes, and also other non-deductible expenses.


18


The Company has established a valuation allowance for certain deferred tax assets with respect to which the Company believes future taxable income levels would not be sufficient to realize the tax benefits.  

On December 22, 2017, the United States enacted tax reform legislation commonly known as the Tax Cuts and Jobs Act (the “2017 Tax Act”), resulting in significant modifications to existing law, which includes a reduction in the federal corporate tax rate from 35% to 21%. On December 22, 2017, Staff Accounting Bulletin No. 118 was issued by the SEC, which provides for a measurement period of one year from the enactment date to finalize the accounting for effects of the 2017 Tax Act. At September 30, 2018, the Company has not completed its accounting for all of the tax effects of the 2017 Tax Act; however, the Company has made a reasonable estimate of the effects. For the nine months ended September 30, 2018 there were no adjustments to the provisional amount initially recorded at December 31, 2017. The Company will continue to make and refine its calculations as additional analysis is completed and as the Company gains a more thorough understanding of the tax law. These changes could be material to income tax expense.

11. STOCK-BASED COMPENSATION
 
For the three and nine months ended September 30, 2018 and 2017, stock-based compensation expense was reflected in the accompanying consolidated statements of operations as follows: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Patient care costs
$
308

 
$
127

 
$
750

 
$
2,620

General and administrative
939

 
904

 
3,424

 
12,142

Total stock-based compensation before tax
$
1,247

 
$
1,031

 
$
4,174

 
$
14,762

Income tax benefit
(324
)
 
(412
)
 
(1,085
)
 
(5,905
)
 
As of September 30, 2018, the Company had 5,110,636 options outstanding.
 
2016 Omnibus Plan
 
On April 7, 2016, the Company approved the 2016 Omnibus Incentive Plan (the “2016 Plan”). The 2016 Plan authorized the Company to issue options and other awards to directors, officers, employees, consultants and advisors to purchase up to a total of 4,000,000 shares of common stock. As of September 30, 2018, options to purchase an aggregate of 2,121,933 shares of common stock were available for future grants under the 2016 Plan. 
 
The assumptions used for options granted to acquire common stock during 2018 and the fair value at the date of grant under the 2016 Plan are noted in the following table:
 
Nine Months Ended September 30, 2018
Expected volatility
30-35%
Weighted average expected term in years
6.00
Weighted average risk-free interest rate
2.74-2.92%
Expected annual dividend yield
—%
Weighted average grant-date fair value
$7.00
    

19

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


Information concerning options activity under the 2016 Plan for options to acquire common stock is summarized as follows:
 
Nine Months Ended September 30, 2018
 
Number
of Options
 
Weighted-Average
Exercise Price
Outstanding, beginning of period
5,280,261

 
$
11.79

Granted (1)
233,389

 
19.28

Exercised
(212,383
)
 
5.44

Forfeited
(190,631
)
 
18.97

Outstanding, end of period
5,110,636

 
$
12.12

Options vested and expected to vest, end of period
5,110,636

 
$
12.12

Options exercisable, end of period
3,265,998

 
$
8.01

____________________________
(1)    Subject to vesting terms of three years. 

Restricted Stock Awards

Employees and directors are eligible to receive grants of restricted stock, which entitle the holder to shares of common stock as the awards vest. The Company determines stock-based compensation expense using the fair value method. The fair value of restricted stock is equal to the closing sale price of the Company’s common stock on the date of grant.

In March 2018, the Company granted approximately 95,000 performance-based restricted stock awards to certain executives, with a weighted average grant date fair value per share of $22.33. These awards will vest at the end of the three-year service period and the quantity of awards that vest is dependent upon the Company's achievement of defined performance metrics. The Company has determined that the majority of the performance conditions for these awards are probable of achievement as of September 30, 2018.

As of September 30, 2018, a total of 438,647 shares of restricted stock were unvested and outstanding, which results in unamortized stock-based compensation of $5,636 to be recognized as stock-based compensation expense over the remaining weighted average vesting period of 1.58 years.

A summary of restricted stock award activity is as follows: 
 
Nine Months Ended September 30, 2018
 
Number Outstanding
 
Weighted-Average Grant Date Fair Value per Award
Unvested at December 31, 2017
252,307

 
$
16.70

Granted (1)
357,275

 
$
22.20

Vested
(100,553
)
 
$
16.91

Forfeited
(70,382
)
 
$
19.48

Unvested at September 30, 2018
438,647

 
$
20.69

(1) Weighted average vesting of 3.5 years.


20

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


Special Dividends and Stock Option Modification

On April 26, 2016, the Company declared and paid a cash dividend to its pre-IPO stockholders equal to $1.30 per share, or $28,886 in the aggregate. In connection with the dividend, all employees with outstanding options had their option exercise price reduced and in some cases were awarded a future dividend equivalent payment, which were paid on vested options and become due upon vesting for unvested options. This resulted in a modification. Additionally, in connection with the cash dividend, as of September 30, 2018, the Company has made payments equal to $1.30 per share, or $5,329 in the aggregate, to option holders, and, in the case of some performance and market options, a future payment will be due upon vesting totaling $1,397.
    
In connection with these dividends, equitable adjustments are required by the terms of some of the Company's equity incentive plans and, for other plans, were modified at the discretion of our board of directors. The Company also elected to modify the vesting conditions of certain market and performance-based stock options. These modifications are treated as an option modification and the Company accounted for the option modification under ASC Topic 718, Compensation – Stock Compensation. As a result of these modifications made to its outstanding market and performance-based stock options at the time of the IPO, the amount of the unrecognized non-cash compensation costs increased by approximately $38,877. These compensation costs, after giving effect to the modifications, were recognized over a period of approximately 12 months from the time of the IPO. As a result, the Company recognized $9,104 in incremental compensation expense during the nine months ended September 30, 2017.

12. EARNINGS (LOSS) PER SHARE
 
Basic loss per share is computed by dividing net loss attributable to American Renal Associates Holdings, Inc., net of the change in the difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interest put provisions, by the weighted-average number of common shares outstanding during the applicable period, less unvested restricted stock. Diluted loss per share is computed using the weighted-average number of common shares outstanding during the applicable period, plus the dilutive effect of outstanding options, using the treasury stock method and the average market price of the Company’s common stock during the applicable period. Certain shares related to some of the Company’s outstanding stock options were excluded from the computation of diluted earnings per share because they were anti-dilutive in the periods presented but could be dilutive in the future.
 

21

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
Basic
 

 
 

 
 
 
 
 
Net income (loss) attributable to American Renal Associates Holdings, Inc.
$
2,490

 
$
7,983

 
$
(16,428
)
 
$
4,626

 
Change in the difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests
(481
)
 
5

 
(783
)
 
(13,605
)
 
Net income (loss) attributable to common shareholders for basic earnings per share calculation
$
2,009

 
$
7,988

 
$
(17,211
)
 
$
(8,979
)
 
Weighted-average common shares outstanding used to calculate basic net loss per share
32,005,544

 
31,095,418

 
31,912,934

 
30,997,218

 
Income (loss) per share, basic
$
0.06

 
$
0.26

 
$
(0.54
)
 
$
(0.29
)
 
Diluted
 

 
 

 
 
 
 
 
Net income (loss) attributable to American Renal Associates Holdings, Inc.
$
2,490

 
$
7,983

 
$
(16,428
)
 
$
4,626

 
Change in the difference between the redemption value and estimated fair value for accounting purposes of the related noncontrolling interests
(481
)
 
5

 
(783
)
 
(13,605
)
 
Net income (loss) attributable to common shareholders for diluted earnings per share calculation
$
2,009

 
$
7,988

 
$
(17,211
)
 
$
(8,979
)
 
Weighted-average common shares outstanding, basic
32,005,544

 
31,095,418

 
31,912,934

 
30,997,218

 
Weighted-average effect of dilutive securities:
 

 
 

 
 
 
 
 
Effect of assumed exercise of stock options
2,129,736

 
2,536,750

 

 

 
Effect of unvested restricted stock
443,312

 
201,654

 

 

 
Weighted-average common shares outstanding used to calculate diluted net loss per share
34,578,592

 
33,833,822

 
31,912,934

 
30,997,218

 
Income (loss) per share, diluted
$
0.06

 
$
0.24

 
$
(0.54
)
 
$
(0.29
)
 
Outstanding options and restricted stock excluded as impact would be anti-dilutive
1,234,245

 
1,357,957

 
2,736,134

 
1,988,257

 

13. RELATED PARTY TRANSACTIONS
 
Term Loan Holdings
 
The Company partly finances the de novo clinic development costs of some of its joint venture subsidiaries by providing intercompany term loans and revolving loans through its wholly owned operating subsidiary American Renal Associates LLC (“ARA OpCo”). On April 26, 2016, the Company transferred substantially all of the then existing intercompany term loans (“assigned clinic loans”) provided to its joint venture subsidiaries by ARA OpCo to a newly formed entity, Term Loan Holdings, which ownership interest was distributed to our pre-IPO stockholders pro rata in accordance with their ownership in the Company. As a result of the distribution of membership interests in Term Loan Holdings, the balance of such assigned clinic loans is reflected on the Company's consolidated balance sheet.    
    
An entity affiliated with Centerbridge Capital Partners, L.P. (together with its affiliates, “Centerbridge”), which does not hold any economic interest in Term Loan Holdings, is the manager of Term Loan Holdings, and affiliates of Centerbridge and certain of the Company's current and former directors and executive officers own economic interests in Term Loan Holdings. As of September 30, 2018, such assigned clinic loans aggregated $6,377, had maturities ranging from November 2018 to July 2020, with a weighted average maturity of approximately 1.1 years (November 2019), and interest rates ranging from 4.25% to 8.08%, with a weighted average interest rate of 5.11%. Fixed principal and interest payments with respect to such assigned clinic loans are payable monthly. The Company will continue to administer and manage the assigned clinic loans

22

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


as servicer pursuant to the terms of a loan servicing agreement as entered into between the Company and Term Loan Holdings. The Company is paid a quarterly fee for its services based on its reasonable costs and expenses, plus a specified percentage of such costs and expenses, which may be adjusted annually based on negotiations between the Company and Term Loan Holdings. The quarterly fee charged for the nine months ended September 30, 2018 is immaterial. Each assigned clinic loan is guaranteed by the Company and the applicable joint venture partner or partners in proportion to their respective ownership interests in the applicable joint venture with maturities consistent with the aggregate assigned clinic loans. The maximum potential liability for future payments under the assigned clinic loans, not including interest, is $6,377, of which the Company guaranteed $3,523 as of September 30, 2018. These guarantees would become payable if the joint venture fails to meet its obligations under the applicable assigned clinic loan.
 
Income Tax Receivable Agreement
 
On April 26, 2016, the Company entered into the TRA for the benefit of its pre-IPO stockholders, including Centerbridge and certain of the Company's executive officers. The TRA provides for the payment by the Company to its pre-IPO stockholders on a pro rata basis of 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes as a result of any deductions (including net operating losses resulting from such deductions) attributable to the exercise of (or any payment, including any dividend equivalent right or payment, in respect of ) any compensatory stock option issued by the Company that is outstanding (whether vested or unvested) as of April 20, 2016, which is the record date set by the board of directors of the Company for this distribution. The Company recorded an estimated liability of $23,400 based on the fair value of the TRA as of April 20, 2016. As of September 30, 2018, the Company’s total liability under the TRA was estimated to be $10,390, of which $914 is included as a component of accrued expenses and other current liabilities on the consolidated balance sheet. For the nine months ended September 30, 2018, the Company paid $6,376.
 
Due from Related Party

The Company entered into a sublease agreement with a clinic group, who are also noncontrolling interest shareholders, to provide for various facility buildouts. The total amount of initial financing was $2,168. As of September 30, 2018, the loans had an interest rate of 6% with maturities ranging from March 2026 through September 2032. Fixed principal and interest payments with respect to such loans are payable monthly. As of September 30, 2018, the remaining balance to be paid to the Company was $1,998.

Software Services

Kinetic Decision Solutions LLC (“Kinetic”), a company from which the Company licenses software relating to electronic medical record solutions, is owned 51% by an executive officer of the Company, and 2.5% by his spouse. The executive is also Co-Founder, Chief Executive Officer and Managing Partner of Kinetic. Under the terms of this arrangement, the Company paid to Kinetic $237 and $259 during the nine months ended September 30, 2018 and 2017, respectively. The amounts paid during the three months ended September 30, 2018 and 2017, respectively, were not material.

Financing Transactions with Executive Officer

An executive officer and his spouse, through a trust in which the executive officer's spouse is trustee and beneficiary, are partners in certain of the Company's clinic joint ventures. The clinics in which the executive officer and/or his spousal trust have an ownership interest all receive intercompany revolving loans made through the Company, and have a portion of their financing in the form of term loans held by Term Loan Holdings. As of September 30, 2018, the aggregate principal amount outstanding of the intercompany revolving loans and assigned clinic loans made to the Company's joint ventures in which the executive officer and/or his spousal trust have an ownership interest was approximately $4,579. As of September 30, 2018, such loans had maturities ranging from February 2019 to August 2024, with a weighted average maturity of approximately 2.26 years (October 2020), and interest rates ranging from 3.31% to 6.30%, with a weighted average interest rate of 4.54%. Fixed principal and interest payments with respect to such loans are payable monthly. Each loan is secured by the assets of the applicable joint venture clinic and is, and will continue to be, guaranteed by the Company and the executive officer and/or his spousal trust in proportion to each party’s ownership interests in the applicable joint venture. Based on their proportionate ownership interest in such joint ventures, the executive officer and/or his spousal trust guaranteed approximately $755 of such outstanding loans as of September 30, 2018.

14. COMMITMENTS AND CONTINGENCIES
 
Income Tax Receivable Agreement
 
As described in Note 13 - Related Party Transactions, the Company is a party to the TRA under which it is contractually committed to pay its pre-IPO stockholders on a pro rata basis 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax that it actually realizes (or are deemed to realize in the case of an early termination payment by the Company, or a change of control, as discussed below) as a result of any option deductions (as defined in the TRA). The actual amount and timing of any payments under the TRA will vary depending upon a number of factors, including the amount and timing of taxable income we generate in the future, changes in the income tax rate, whether and when any relevant stock options, as defined in the TRA, are exercised and the value of our common stock at the time of such exercise.
    
Litigation
 
The Company and its subsidiaries are defendants in various legal actions in the normal course of business. In the opinion of the Company’s management, based in part on the advice of outside counsel, the resolution of these matters will not have a material effect on the Company’s financial position, results of operations or cash flows. See Note 15 - Certain Legal Matters.

Regulatory
 
The healthcare industry is subject to numerous laws and regulations of federal, state, and local governments. Government activity has increased with respect to investigations and allegations concerning possible violations by healthcare providers of fraud and abuse statutes and regulations, which could result in the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations are subject to government review and interpretations, as well as regulatory actions unknown or unasserted at this time.


23

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


15. CERTAIN LEGAL MATTERS

United Litigation

As previously disclosed, the wholly owned operating subsidiary of ARA, American Renal Associates LLC (“ARA OpCo”), and its subsidiary, American Renal Management LLC (“ARM”), were defendants in lawsuits filed by affiliates of UnitedHealth Group Incorporated (“United”) in the United States District Court for the Southern District of Florida (Case Number 9:16-cv-81180-KAM) and the United States District Court for the District of Massachusetts (Case Number 1:18-cv-10622-ADB).

On May 30, 2018, the Company and United engaged in a mediation, following which the parties continued to negotiate the terms of a potential settlement. On July 2, 2018, ARA OpCo and ARM executed a binding Settlement Term Sheet with the plaintiffs with respect to a settlement to resolve all ongoing litigation between the Company and United, and on August 1, 2018, the parties entered into a final settlement agreement (the “Settlement Agreement”) on substantially the same terms as provided in the Settlement Term Sheet. The Settlement Agreement includes a release of all claims arising from or related to the above-referenced litigations that were asserted or that could have been asserted against the Company or against the nephrologists or other healthcare providers who have entered into joint venture arrangements or medical directorships with the Company (the “Joint Venture Providers”) and the joint venture entities without any admission of liability or wrongdoing. Pursuant to the Settlement Agreement, the Company will make total settlement payments of $32,000, inclusive of administrative fees and fees for plaintiffs’ counsel, in five installments, with an initial present value of $29,614, which is included in Certain legal matters in the Statement of Operations during the nine months ended September 30, 2018, and a remaining present value of $19,614. As of September 30, 2018, $7,641 is classified as Accrued expenses and other current liabilities and $11,973 is classified in Other long-term liabilities. The Company paid the first installment in the amount of $10,000 on August 1, 2018, and expects to pay $8,000 on August 1, 2019, $7,000 on August 1, 2020, $3,500 on August 1, 2021 and $3,500 on August 1, 2022. The Company also agreed to share certain information with United and to follow certain procedures with respect to patients covered by United. Subject to the mutual releases provided in the Settlement Agreement, United also agreed to renew, reinstate, and/or not to terminate the network agreements for any Joint Venture Providers whose network agreements United terminated or chose not to renew from August 1, 2017 through the date of the Settlement Agreement. The Settlement Agreement includes customary terms and conditions. In connection with the Settlement Agreement, the Company also entered into a three-year national network agreement with United on August 1, 2018 that provides for specified reimbursement rates for patients covered by Medicare Advantage, Medicaid HMO and commercial insurance products over the term of the agreement.
Certain Other Legal Matters
On June 15, 2018, the United States District Court for the Southern District of New York approved the Stipulation of Settlement, entered into between the Company and Lead Plaintiff on January 30, 2018 in the matter captioned Esposito, et al. v. American Renal Associates Holdings, Inc., et al., Case No. 16-cv-11797 (ADB). The Stipulation of Settlement provides for a total settlement payment of $4,000, inclusive of administrative fees and fees for the lead plaintiff’s counsel. Substantially all of the settlement was funded by insurance proceeds. The settlement releases all claims asserted against the Company and the other named defendants in the action without any liability or wrongdoing attributed to them.

In addition, on May 31, 2018, the United States District Court for the District of Massachusetts approved the settlement agreement, entered into between the Company and Steven Bushansky on March 29, 2018 in the matter captioned Stephen Bushansky, Derivatively on Behalf of American Renal Associates Holdings, Inc. v. Joseph A. Carlucci, et. al., Case No. 17-cv-12091 (ADB). The settlement agreement provides for, among other things, a settlement payment of $350, inclusive of attorney’s fees, and certain corporate governance changes. The payment was made by the Company’s insurer. The settlement resolves the claims asserted against all defendants in the action without any liability or wrongdoing attributed to them.


24

AMERICAN RENAL ASSOCIATES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(Unaudited)
(dollars in thousands, except per share amounts)


On January 3, 2017, the Company received a subpoena from the United States Attorney’s Office, District of Massachusetts, requesting information relating to the Company’s payments and other interactions with the AKF and any efforts to educate patients qualified or enrolled in Medicare or Medicaid about enrollment in ACA-compliant individual marketplace plans, among other related matters under applicable healthcare laws for the period from January 1, 2013 through the present. As it has done with the other regulators who have expressed interest in such matters, the Company has cooperated fully with the government and will continue to do so. In the event that the United States Attorney’s Office, District of Massachusetts, were to find violations of any federal criminal or civil laws, our business, financial condition and results of operations could be materially adversely affected.

In October 2018, the Staff of the Securities and Exchange Commission requested that the Company voluntarily provide documents and information relating to certain revenue recognition, collections and related matters. The Company intends to fully cooperate with this inquiry.

Other
From time to time, we are subject to various legal actions and proceedings involving claims incidental to the conduct of our business, including contractual disputes and professional and general liability claims, as well as audits and investigations by various government entities, in the ordinary course of business. Based on information currently available, established reserves, available insurance coverage and other resources, we do not believe that the outcomes of any such pending actions, proceedings or investigations are likely to be, individually or in the aggregate, material to our business, financial condition, results of operations or cash flows. However, legal actions and proceedings are subject to inherent uncertainties, and it is possible that the ultimate resolution of such matters, if unfavorable, may be materially adverse to our business, financial condition, results of operations or cash flows.

Although we are not currently subject to any regulatory proceedings, there is no assurance that formal regulatory investigations or proceedings will not be commenced by any U.S. federal or state healthcare or other regulatory agencies. In addition, we may in the future be subject to additional inquiries, litigation or other proceedings or actions, regulatory or otherwise, arising in relation to the matters described above and related litigation and investigative matters. An unfavorable outcome of any such litigation or regulatory proceeding or action could have a material adverse effect on our business, financial condition and results of operations.

We also record in Certain legal matters legal fees and other expenses relating to matters outside the ordinary course of our business.
16. CHANGES IN OWNERSHIP INTEREST IN CONSOLIDATED SUBSIDIARIES

The effects of changes in the Company's ownership interest on the Company's equity are as follows:

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
2017
 
2018
 
2017
Net income (loss) attributable to American Renal Holdings Associates, Inc.
$
2,490

$
7,983

 
$
(16,428
)
 
$
4,626

(Decrease) increase in paid-in capital for the sales of noncontrolling interest
(80
)
34

 
(51
)
 
34

Decrease in paid-in capital for the purchase of noncontrolling interest and adjustments to ownership interest
(128
)

 
(6,081
)
 
(5,980
)
Net transfers to/from noncontrolling interests
$
(208
)
$
34

 
$
(6,132
)
 
$
(5,946
)
Net income (loss) attributable to American Renal Holdings Associates, Inc., net of transfers to/from noncontrolling interests
$
2,282

$
8,017

 
$
(22,560
)
 
$
(1,320
)

25


 
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 
 
This discussion contains management’s discussion and analysis of our financial condition and results of operations for the period covered by this Form 10-Q and should be read in conjunction with the unaudited consolidated financial statements and notes thereto included elsewhere in this Form 10-Q and the audited consolidated financial statements and the notes thereto included in the Company’s Form 10-K for the fiscal year ended December 31, 2017.
 
The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs and involve numerous risks and uncertainties. Actual results may differ materially from those contained in any forward-looking statement, due to a number of factors, including those discussed in the section of this Form 10-Q entitled “Special Note Regarding Forward-Looking Statements” and the section entitled “Risk Factors” in this Form 10-Q and in the Form 10-K. You should read these sections carefully.
 
Unless otherwise indicated or the context otherwise requires, references in this Form 10-Q to “we,” “our,” “us” and the “Company” and similar terms refer to American Renal Associates Holdings, Inc. and its consolidated entities taken together as a whole, except where these terms refer to providers of dialysis services, in which case they refer to our dialysis clinic joint ventures, in which we have a controlling interest and our physician partners have the noncontrolling interest, or to the dialysis facilities owned by such joint venture companies, as applicable. References to “ARA” refer to American Renal Associates Holdings, Inc. and not any of its consolidated entities. References to “ARH” refer to American Renal Holdings Inc., an indirect wholly owned subsidiary of ARA. 

Executive Overview
 
We are the largest dialysis services provider in the United States focused exclusively on joint venture partnerships with physicians. We provide high-quality patient care and clinical outcomes through physicians, known as nephrologists, who specialize in treating patients suffering from end stage renal disease (“ESRD”). Our core values create a culture of clinical autonomy and operational accountability for our physician partners and staff members. We believe our joint venture model has helped us become one of the fastest-growing national dialysis services platforms in terms of the growth rate of our non-acquired treatments since 2013.
 
We derive our patient service operating revenues from providing outpatient and inpatient dialysis treatments. The sources of these patient service operating revenues are principally government-based programs, including Medicare and Medicaid plans, as well as commercial insurance plans. Substantially all of our payors (both government-based and commercial) have moved toward a bundled payment system of reimbursement, with a single lump-sum per treatment covering not only the dialysis treatment itself but also the ancillary items and services provided to a patient during the treatment, such as laboratory services and pharmaceuticals.
 
We operate our clinics principally through our joint venture (“JV”) model, in which we share the ownership and operational responsibility of our dialysis clinics with our nephrologist partners and other joint venture partners, while the providers of the majority of dialysis services in the United States operate through a combination of wholly owned subsidiaries and joint ventures. Substantially all of our clinics are maintained as separate joint ventures in which generally we have the controlling interest and our nephrologist partners and other joint venture partners have a noncontrolling interest. We believe that our exclusive focus on a JV model makes us well-positioned to increase our market share by attracting nephrologists who are not only interested in our service platform but also want greater clinical autonomy and a potential return on capital investment associated with ownership of a noncontrolling interest in a dialysis clinic. We believe our JV model best aligns our interests with those of our nephrologist partners and their patients. By owning a portion of the clinics where their patients are treated, our nephrologist partners have a vested stake in the quality, reputation and performance of the clinics. We believe that this enhances patient and staff satisfaction and retention, clinical outcomes, patient growth, and operational and financial performance.


26


Key Factors Affecting Our Results of Operations
 
Clinic Growth and Start-Up Clinic Costs
 
Our results of operations are dependent on increases in the number of, and growth at, our de novo clinics and acquired clinics, as well as growth at our existing clinics. We have experienced significant growth since opening our first clinic in December 2000. As of September 30, 2018, we had developed 184 de novo clinics and 51 acquired clinics. The following table shows the number of de novo and acquired clinics over the periods indicated: 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
De novo clinics (1)
2

 
1

 
8

 
6

Acquired clinics (2)

 

 

 

Sold or merged clinics (3)

 
(1
)
 
(1
)
 
(3
)
Total net new clinics
2

 

 
7

 
3

_____________________________
(1)
Clinics formed by us which began to operate and dialyze patients in the applicable period.
(2)
Clinics acquired by us in the applicable period.
(3)
Clinics sold or merged by us in the applicable period.

De novo clinics. We have primarily grown through de novo clinic development. A typical de novo facility requires approximately $1.7 to $2.1 million of capital for equipment purchases, leasehold improvements and initial working capital. A portion of the total capital required to develop a de novo clinic may be equity capital funded by us and our nephrologist partners in proportion to our respective ownership interests. The balance of such development cost may be funded through third-party debt financing or through intercompany loans provided by one of our wholly owned subsidiaries to the joint venture entity that, in each case, we and our nephrologist partners generally guarantee on a basis proportionate to our respective ownership interests. For the three months ended September 30, 2018 and September 30, 2017, our development capital expenditures were $6.6 million and $9.2 million, respectively, representing 3.1% and 4.9% of our patient service operating revenues, respectively.
 
Our results of operations have been and will continue to be materially affected by the timing and number of openings, the timing of certifications of de novo clinic openings and the amount of de novo clinic opening costs incurred. In particular, our patient care costs on an absolute basis and as a percentage of our patient service operating revenues may fluctuate from quarter to quarter due to the timing and number of de novo clinic openings, which affect our operating income in a given quarter. Our patient care costs reflect pre-opening expenses, which primarily consist of staff expenses, including the costs of hiring and training new staff, as well as rent and utilities. In addition, a de novo clinic builds its patient volumes over time and, as a result, generally has lower revenue than our existing clinics. Newly established de novo clinics, although contributing to increased revenues, have adversely affected our results of operations in the short term due to a smaller patient base to absorb operating expenses. We consider a de novo clinic to be a “start-up clinic” until the first month it generates positive clinic-level EBITDA. We typically achieve positive clinic-level monthly EBITDA within, on average, six months after the first treatment at a clinic. However, approximately 27% of our de novo clinics have exceeded six months from first treatment to positive clinic-level monthly EBITDA, with these clinics averaging approximately 12 months to positive clinic-level monthly EBITDA. Clinic-level EBITDA differs from our consolidated EBITDA in that management fees, consisting of a percentage of the clinic’s net revenues paid to ARA for management services, are eliminated in consolidation but are reflected on a clinic-level basis.

    

27


Start-up clinic losses affect the comparability of our results from period to period and may disproportionately impact our operating margins in any given quarter, including quarters during which we have a significant number of clinics qualifying as start-up clinics. The following table sets forth the number of de novo clinics opened during the periods indicated.
 
 
Three Months Ended 
 
 
 
March 31,
 
June 30,
 
September 30,
 
December 31,
 
Total
2018
1

 
5

 
2

 

 
8

2017
3

 
2

 
1

 
9

 
15

2016
2

 
6

 
5

 
7

 
20

2015
1

 
5

 
6

 
4

 
16

2014
2

 
4

 
3

 
6

 
15

    
Existing clinics. Depending on demand and capacity utilization, we may have space within our existing clinics to accommodate a greater number of dialysis stations or operate additional shifts in order to increase patient volume without compromising our quality standards. Such expansions leverage the fixed cost infrastructure of our existing clinics. From January 1, 2013 to September 30, 2018, we added 169 dialysis stations to our existing clinics, representing the equivalent of nearly ten de novo clinics.
 
Acquired clinics. We have also grown through acquisitions of existing clinics, and our results of operations have been and will continue to be affected by the timing and number of our acquisitions. Our acquisition strategy is primarily driven by the quality of the nephrologist in the market. We opportunistically pursue select acquisitions in situations where we believe the clinic offers us an attractive opportunity to enter a new market or expand within an existing market. Acquiring an existing dialysis clinic requires a greater initial investment, but an acquired clinic contributes positively to our results of operations sooner than a de novo clinic. Acquisition integration costs are typically minimal compared with start-up costs in connection with opening de novo clinics.
 
Our clinic growth drives our treatment growth. The following table summarizes the sources of our treatment growth for the periods indicated:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Source of Treatment Growth:
2018
 
2017
 
2018
 
2017
Non-acquired treatment growth(1)
3.9
%
 
6.8
%
 
4.2
%
 
8.6
%
Acquired treatment growth(2)
1.1
%
 
%
 
1.1
%
 
%
Total treatment growth
5.0
%
 
6.8
%
 
5.3
%
 
8.6
%
_____________________________
(1)
Represents net growth in treatments attributable to clinics operating at the end of the period that were also open at the end of the prior period and de novo clinics opened since the end of the prior period.
(2)
Represents net growth in treatments attributable to clinics acquired since the end of the prior period.

Sources of Revenues by Payor
 
Our patient service operating revenues are principally driven by our mix of commercial and government payor patients and commercial and government payment rates. We are generally paid more for services provided to patients covered by commercial healthcare plans than we are for patients covered by Medicare or Medicaid. ESRD patients covered by employer group health plans generally transition to Medicare coverage after a maximum of 33 months. Medicare payment rates are determined under the Medicare ESRD prospective payment rate system (“PPS”), a bundled payment system, which sets a base rate on an annual basis that is subject to adjustments to arrive at the actual payment rate for individual clinics. During the years ended December 31, 2017, 2016 and 2015, the Medicare ESRD PPS payment rates for our clinics were approximately $248, $247 and $247, respectively, per treatment. The ESRD PPS final rule for 2018, released on October 27, 2017, increased the base rate from $231.55 to $232.37. The Centers for Medicare and Medicaid Services (“CMS”) issues annual updates to the ESRD PPS, which may impact the base rate as well as the various adjusters. The ESRD PPS final rule for 2019 was released on November 1, 2018 by CMS (the “2019 Final Rule”). The 2019 Final Rule includes a base rate of $235.27, representing a $2.90 increase from the 2018 base rate of $232.37. CMS has estimated that the 2019 Final Rule will result in an overall increase of payments to ESRD facilities of 1.6%.

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Medicare payment rates are generally insufficient to cover our total operating expenses allocable to providing dialysis treatments for Medicare patients. As a result, our ability to generate operating income is substantially dependent on revenues derived from commercial payors, which typically pay us either negotiated payment rates or at a discount to our usual and customary fee schedule. Many commercial insurance programs have been moving towards a bundled payment system, which may not reimburse us for all of our operating costs, such as the cost of erythropoietin-stimulating agents (“ESAs”) and other pharmaceuticals.
 
The following table summarizes our patient service operating revenues by source for the periods indicated. 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Source of Revenues:
2018
 
2017
 
2018
 
2017
Medicare and Medicare Advantage
65
%
 
59
%
 
64
%
 
59
%
Commercial and other (1)
30
%
 
36
%
 
32
%
 
37
%
Medicaid and Managed Medicaid
4
%
 
4
%
 
4
%
 
4
%
Other (2)
1
%
 
1
%
 
%
 
%
 
100
%
 
100
%
 
100
%
 
100
%
_____________________________
(1)
Principally commercial insurance companies and also includes the U.S. Department of Veterans Affairs (the “VA”), which we refer to collectively as “Commercial and other.”

(2)
Other sources of revenues include hospitals and patient pay. “Patient pay revenues consist of payments received directly from patients who are either uninsured or self-pay a portion of the bill.
 
The percentage of treatments by payor source does not necessarily correlate with our results of operations or margins in any given period because of a number of other factors, including the effect of the difference in rates per treatment associated with each commercial payor. For the three years and one year ended December 31, 2017, commercial payors and others, including the VA, accounted for an average of approximately 14.8% and 13.0%, respectively, of the treatments we performed. The change in the mix of patients and treatments between the three-year average and the year ended December 31, 2017 was largely driven by enrollment in Affordable Care Act (“ACA”)-compliant plans (“ACA plans”), both on-exchange and off-exchange. For the year ended December 31, 2017, we derived approximately 2% of patient service operating revenues from ACA plans, both on-exchange and off-exchange, and these ACA plans were the source of reimbursement for approximately 1% of the treatments performed. During the year ended December 31, 2017, we experienced an adverse change in the commercial treatment mix as compared to the year ended December 31, 2016, due primarily to a decline in ACA plans, as discussed below. In addition, for the year ended December 31, 2017, the percentage of treatments accounted for by commercial payors and others, including the VA, but not including ACA plans, was 11.8%. For the year ended December 31, 2017, the percentage of treatments accounted for by commercial payors and others, including the VA, but not including ACA plans, was approximately 1% below the percentage for the year ended December 31, 2016, and we expect it to remain lower.
 
Effective in November 2016, for patients enrolled in minimum essential Medicaid coverage, we suspended assistance in the application process for charitable premium support from the American Kidney Fund ("AKF"), which caused an adverse change in the mix of patients and treatments in 2017. This change has not affected our provision of such assistance in the application process to other patients. Prior to the 2017 ACA open enrollment period, approximately 2% of our total patients chose to enhance their pre-existing minimum essential Medicaid coverage by electing to enroll in an ACA plan. Before we suspended assistance in the application process for charitable premium support from the AKF, this percentage had been growing. Virtually all of these low-income patients have relied on charitable premium assistance because they were ineligible for federal premium tax credits. Due to the suspension of assistance in the application process for charitable premium support from the AKF, virtually all of our patients with ACA primary insurance coverage and secondary minimum essential Medicaid coverage reverted back to Medicaid-only coverage during 2017.
 
In addition, prior to the 2017 ACA open enrollment period, approximately 2% of our total patients were enrolled in an ACA plan and not enrolled in the Medicaid program. Approximately 85% of these patients relied on charitable premium assistance. These patients chose ACA plans for a variety of reasons, including ineligibility for government programs, the shift of coverage options from the individual and/or small group markets to ACA exchanges, lack of requisite work credits to be eligible for Medicare coverage, the opportunity to consolidate family coverage under one insurance plan and the lack of Medicare supplemental insurance policy coverage due to certain state insurance department restrictions, among other reasons. These patients enrolled in ACA plans and not enrolled in the Medicaid program have experienced insurance coverage

29


disruptions due to payors disallowing charitable premium assistance, the lack of availability of viable ACA insurance products in some markets, and a more uncertain regulatory environment. The average revenue per treatment for ACA plans is below that of our overall average commercial revenue per treatment but above our Medicare rate. 
In 2016, following an internal review, in addition to the suspension described above, the Company adopted policies and procedures to ensure that its patient insurance education program meets robust certification standards to provide broad-based information to patients about their insurance options, so that the patients are in the best possible position to choose coverage based on their own best interests. Under this program, the Company informs patients, when appropriate, about insurance plans available under the ACA and other individual marketplace plans as alternatives or supplements to coverage under Medicare or Medicaid. The Company will continue to advise its patients about the potential availability of assistance with the payment of premiums from the AKF under the AKF Health Insurance Premium Program (“HIPP”), subject to the suspension described above, and compliance with the AKF’s policies and procedures and approved regulatory guidance from CMS.
In addition, there have been other significant developments in the market that may affect our business, including the withdrawal of some insurers from offering ACA and individual marketplace plans in certain states, increases in premiums for ACA plans, and continuing efforts on the part of insurers to reduce the amount paid to dialysis providers per treatment. Further, there could be additional changes in our business in the future resulting from potential regulatory actions and other third-party practices following the 2016 CMS request for information seeking public comment on concerns relating to steering of patients eligible for Medicare and Medicaid into ACA plans, and the recent changes to the AKF HIPP program announced by the AKF, including the expansion of funding for patients under age 65 who must pay higher premiums for Medicare supplemental insurance. 
The suspension has adversely impacted, and any CMS action relating to establishing policies to restrict or limit charitable assistance for ACA plans or other individual marketplace plans could adversely impact, the number of patients covered by ACA plans and other individual marketplace plans, the Company’s average reimbursement rate and its results of operations and cash flows, which impact has been and may continue to be material. Further, the other changes to the Company’s patient insurance education program, whether or not the suspension continues or CMS restricts charitable premium assistance, together with the other developments in the market, including the impact of such changes on enrollment in ACA plans and other individual marketplace plans, other insurance coverage, and/or potential regulatory changes in the future, have adversely impacted and are expected to continue to adversely impact the number of the Company’s patients covered by insurance, as well as the Company’s average reimbursement rate in the future.
During 2017, the Company received letters from certain insurance companies indicating that they will not insure patients who receive premium payment assistance from third-party charitable organizations. In addition to charitable premium support for patients enrolled in ACA plans, the AKF provides charitable premium support to patients with other insurance coverage, including Medicare supplemental insurance and commercial insurance. If patients are unable to obtain or to continue to receive AKF charitable premium support due to insurance company challenges to covering patients receiving charitable premium support, legislative changes, rules or interpretations issued by the U.S. Department of Health and Human Services limiting such support or other reasons, the financial impact on our Company could be substantially greater than the estimated annual financial impact described above relating to patients previously enrolled in ACA plans and, accordingly, could materially and adversely affect our results of operations. [See “Part I. Item 1A. Risk Factors—Risks Related to Our Business—If the number of patients with commercial insurance declines, our operating results and cash flows would be adversely affected” and “—Increased scrutiny in our industry and potential regulatory changes could adversely affect our operating results and financial condition” in our Form 10-K for the year ended December 31, 2017.]
We believe that the operating environment will continue to be challenging due to the uncertainty around the ACA and the ability of our patients overall to access charitable premium assistance from non-profit organizations such as the AKF. We also believe that pressure on commercial mix and commercial rates due to more restrictive health plan benefit design will continue to create additional challenges. In addition, actions by the current Administration and Congress have caused the future state of the exchanges and other ACA reforms to be less certain. We are unable to predict the full effect of the foregoing factors on our business, results of operations and cash flows. See also “Part I. Item 1A. Risk Factors—Risks Related to Our Business—If the rates paid by commercial payors decline, our operating results and cash flow would be adversely affected” in our Form 10-K for the year ended December 31, 2017.
Clinical Staff, Pharmaceutical and Medical Supply Costs
 
Because our ability to influence the pricing of our services is limited, our profitability depends not only on our ability to grow but also on our ability to manage patient care costs, including clinical staff, pharmaceutical and medical supply costs.

30


The principal drivers of our patient care costs are clinical staff hours per treatment, salary rates and vendor pricing and utilization of pharmaceuticals, including ESAs and medical supplies. The Company has entered into a rebate agreement with Amgen Inc. (“Amgen”) for the ESAs Aranesp and Epogen, which, under certain circumstances, limits the supplier’s ability to increase the net price it charges the Company, and requires certain volume commitments by the Company, for these drugs through December 31, 2018. In September 2017, the Company entered into a purchase agreement with Vifor International AG (“Vifor”) that expires on December 31, 2022, pursuant to which it will provide our clinics with the ESAs Mircera and Retacrit. The use of Mircera and Retacrit by our clinics could potentially reduce our ESA cost per treatment. Increased utilization of ESAs for patients for whom the cost of ESAs is included in a bundled reimbursement rate, including Medicare patients, could increase our operating costs without any increase in revenue. In addition, shortage of supplies could have a negative impact on our revenues, earnings and cash flows. Other cost categories, such as employee benefit costs and insurance costs, can also result in significant cost changes from period to period. Our results of operations are also affected by the start-up clinic costs described above. See also “Part I. Item 1A. Risk Factors—Risks Related to Our Business—Changes in the availability and cost of ESAs and other pharmaceuticals could adversely affect our operating results and financial condition as well as our ability to care for patients” and “—If our suppliers are unable to meet our needs, if there are material price increases or if we are unable to effectively access new technology, our operating results and financial condition could be adversely affected” in our Form 10-K for the year ended December 31, 2017.
 
Seasonality
 
Our treatment volumes are sensitive to seasonal fluctuations due to generally fewer treatment days during the first quarter of the calendar year. Additionally, our patients are generally responsible for a greater percentage of the cost of their treatments during the early months of the year, due to co-insurance, co-payments and deductibles, which may lead to lower total net revenues and lower net revenues per treatment during the early months of the year. Our quarterly operating results may fluctuate significantly in the future depending on these and other factors.

Impact of the IPO and Future Charges
 
The completion of our initial public offering (“IPO”) of common stock in April 2016 has had effects on our results of operations and financial conditions. In connection with the IPO, our results of operations are affected by one-time costs and recurring costs of being a public company, including increases in executive and board compensation (including equity based compensation), increased insurance, accounting, legal and investor relations costs and the costs of compliance with the Sarbanes-Oxley Act of 2002 and other rules and regulations of the SEC and the New York Stock Exchange. In addition, when the available exemptions under the Jumpstart Our Business Startups Act cease to apply, we expect to incur additional expenses and devote increased management effort toward ensuring compliance with the applicable regulatory and corporate governance requirements. In addition, we have incurred and expect to incur additional legal expenses in connection with various legal and regulatory matters and related matters. See “—Operating Expenses—Certain Legal Matters.”
 
As a result of certain modifications made to our outstanding market and performance-based stock options at the time of the IPO, the amount of the unrecognized non-cash compensation costs increased by approximately $38.9 million (the “Modification Expense”). The Modification Expense was recognized over a period of approximately 12 months from the date of the IPO.
 
In addition, in connection with the distribution (the “Term Loan Holdings Distributions”) of membership interests in an entity holding assigned clinic loans (the “Assigned Clinic Loans”), described in “Note 13 - Related Party Transactions” of the notes to the unaudited consolidated financial statements, since the interest on these loans is no longer eliminated in consolidation, we now incur additional interest expense. These Assigned Clinic Loans have maturities ranging from November 2018 to July 2020.
 
On April 26, 2016, we entered into an income tax receivable agreement (the “TRA”) for the benefit of our pre-IPO stockholders, which provides for the payment by us to our pre-IPO stockholders on a pro rata basis of 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax that we actually realize as a result of the option deductions (as defined in the TRA). While the actual amount and timing of any payments under the TRA will vary depending upon a number of factors, including the amount and timing of the taxable income we generate in the future and whether and when any relevant stock options, as defined in the TRA, are exercised and the value of our common stock at such time, we expect that during the term of the TRA the payments that we make will be material. We recorded a liability for the value of the TRA at the time of the IPO. We calculated fair value of the TRA by using a Monte Carlo simulation-based approach that relies on significant assumptions about our stock price, stock volatility and risk-free rate as well as the timing and amounts of options exercised. Changes in assumptions based on future events, including changes in the price of our common stock from our IPO price and changes to the income tax rate, will change the amount of the liability for the TRA, and such changes may be material. Any

31


changes to the TRA liability will be recognized in our statement of operations as Income tax receivable agreement income (expense) in future periods. See “Note 5 - Fair Value Measurements” of the notes to the unaudited consolidated financial statements.

Key Performance Indicators
 
We use a variety of financial and other information to evaluate our financial condition and operating performance. Some of this information is financial information that is prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), while other financial information, such as Adjusted EBITDA and Adjusted EBITDA-NCI, is not prepared in accordance with GAAP. The following table presents certain operating data, which we monitor as key performance indicators, for the periods indicated.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Operating Data and Other Non-GAAP Financial Data:
2018
 
2017
 
2018
 
2017
Number of clinics (as of end of period)
235

 
217

 
235

 
217

Number of de novo clinics opened (during period)
2

 
1

 
8

 
6

Patients (as of end of period)
16,092

 
15,237

 
16,092

 
15,237

Number of treatments
578,982

 
551,258

 
1,710,847

 
1,625,227

Non-acquired treatment growth
3.9
%
 
6.8
%
 
4.2
%
 
8.6
%
Patient service operating revenues per treatment
$
364

 
$
341

 
$
364

 
$
339

Patient care costs per treatment
$
251

 
$
217

 
$
245

 
$
220

Adjusted patient care costs per treatment (1)
$
251

 
$
217

 
$
245

 
$
219

General and administrative expenses per treatment
$
43

 
$
40

 
$
45

 
$
49

Adjusted general and administrative expenses per treatment (2)
$
43

 
$
40

 
$
45

 
$
43

Adjusted EBITDA (including noncontrolling interests) (3)
$
42,435

 
$
46,838

 
$
131,589

 
$
128,306

Adjusted EBITDA-NCI (3)
$
26,631

 
$
28,149

 
$
80,877

 
$
76,967

_____________________________
(1)
Adjusted patient care costs per treatment excludes $2.2 million of Modification Expense during the nine months ended September 30, 2017. Additionally, the nine months ended September 30, 2017 exclude $0.1 million of severance expense and $0.6 million of gains on sale of assets.
(2)
Adjusted general and administrative expenses per treatment excludes $9.5 million of Modification Expense during the nine months ended September 30, 2017. Additionally, the nine months ended September 30, 2017 exclude $0.8 million of severance expense.
(3)
See “Non-GAAP Financial Measures” below.


Number of Clinics
 
We track our number of clinics as an indicator of growth. The number of clinics as of the end of the period includes all opened de novo clinics, acquired clinics and existing clinics. See “—Key Factors Affecting Our Results of Operations—Clinic Growth and Start-Up Clinic Costs” for a discussion of clinic growth and start-up costs as a factor affecting our operating performance.

Patient Volume
 
The number of patients as of the end of the period is an indicator we use to assess our performance. Our patient volumes are correlated with our de novo clinic openings and, to a lesser extent, our marketing efforts and certain external factors, such as the overall economic environment. We believe that patients choose to get their dialysis services at one of our clinics due to their relationship with our physicians, as well as the quality of care, comfort and amenities and convenience of location and clinic hours.

Non-Acquired Treatments
 
We evaluate our operating performance based on the growth in number of non-acquired treatments, or treatments performed at our existing and de novo clinics, including those de novo clinics opened during the applicable period. Accordingly, our non-acquired treatment growth rate is affected by the timing and number of de novo clinic openings. We

32


calculate non-acquired treatment growth by dividing the number of treatments performed during the applicable period by the number of treatments performed during the corresponding prior period, excluding the number of treatments performed at clinics acquired during the applicable period, and expressing the resulting number as a percentage.
 
Per Treatment Metrics
 
We evaluate our patient service operating revenues, patient care costs, and general and administrative expenses on a per treatment basis to assess our operational efficiency. We believe our disciplined revenue cycle management has contributed to the consistency of our historical results.
 
Non-GAAP Financial Measures
 
This Form 10-Q makes reference to certain non-GAAP financial measures. These non-GAAP financial measures are not recognized measures under GAAP and do not have a standardized meaning prescribed by GAAP. When used, these measures are defined in such terms as to allow the reconciliation to the closest GAAP measure. These measures are therefore unlikely to be comparable to similar measures presented by other companies. Rather, these measures are provided as additional information to complement those GAAP measures by providing further understanding of the Company’s results of operations from management’s perspective. Accordingly, they should not be considered in isolation nor as a substitute for analysis of the Company’s financial information reported under GAAP. We use non-GAAP financial measures, such as Adjusted EBITDA and Adjusted EBITDA-NCI, to provide investors with a supplemental measure of our operating performance and thus highlight trends in our core business that may not otherwise be apparent when relying solely on GAAP financial measures.
 
Adjusted EBITDA
 
We use Adjusted EBITDA and Adjusted EBITDA-NCI to track our performance. “Adjusted EBITDA” is defined as net income before income taxes and other non-income based tax, interest expense, net, depreciation and amortization, as adjusted for stock-based compensation and associated payroll taxes, loss on early extinguishment of debt, transaction-related costs, certain legal matters costs, executive and management severance costs, income tax receivable agreement income and expense, and gain on sale of assets. “Adjusted EBITDA-NCI” is defined as Adjusted EBITDA less net income attributable to noncontrolling interests. We believe Adjusted EBITDA and Adjusted EBITDA-NCI provide information useful for evaluating our business and a further understanding of the Company's results of operations from management's perspective. We believe Adjusted EBITDA is helpful in highlighting trends because Adjusted EBITDA excludes the results of actions that are outside the operational control of management, but can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments. We believe Adjusted EBITDA-NCI is helpful in highlighting the amount of Adjusted EBITDA that is available to us after reflecting the interests of our joint venture partners. Adjusted EBITDA and Adjusted EBITDA-NCI are not measures of operating performance computed in accordance with GAAP and should not be considered as a substitute for operating income, net income, cash flows from operations, or other statement of operations or cash flow data prepared in conformity with GAAP, or as measures of profitability or liquidity. In addition, Adjusted EBITDA and Adjusted EBITDA-NCI may not be comparable to similarly titled measures of other companies. Adjusted EBITDA and Adjusted EBITDA-NCI may not be indicative of historical operating results, and we do not mean for these items to be predictive of future results of operations or cash flows. Adjusted EBITDA and Adjusted EBITDA-NCI have limitations as analytical tools, and you should not consider these items in isolation, or as substitutes for an analysis of our results as reported under GAAP. Some of these limitations are that Adjusted EBITDA and Adjusted EBITDA-NCI:

do not include stock-based compensation expense, and beginning with the quarter ended June 30, 2017, do not include associated payroll taxes;
do not include transaction-related costs; 
do not include depreciation and amortization—because construction and operation of our dialysis clinics requires significant capital expenditures, depreciation and amortization are a necessary element of our costs and ability to generate profits;
do not include interest expense—as we have borrowed money for general corporate purposes, interest expense is a necessary element of our costs and ability to generate profits and cash flows; 
do not include income tax receivable agreement income and expense;
do not include loss on early extinguishment of debt;

33


do not include costs related to certain legal matters;
do not include executive and management severance costs;
do not include income tax expense or benefit and other non-income based taxes; and
do not reflect the gain on sale of assets.
 
You should not consider Adjusted EBITDA and Adjusted EBITDA-NCI as alternatives to income from operations or net income, determined in accordance with GAAP, as an indicator of our operating performance, or as alternatives to cash provided by operating activities, determined in accordance with GAAP, as an indicator of cash flows or as a measure of liquidity. This presentation of Adjusted EBITDA and Adjusted EBITDA-NCI may not be directly comparable to similarly titled measures of other companies, since not all companies use identical calculations.

The following table presents Adjusted EBITDA and Adjusted EBITDA-NCI for the periods indicated and the reconciliation from net income to such amounts: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in thousands)
2018
 
2017
 
2018
 
2017
Net income
$
18,294

 
$
26,672

 
$
34,284

 
$
55,965

Add:
 
 
 
 
 
 
 
Interest expense, net
8,241

 
7,255

 
23,829

 
22,052

Income tax (benefit) expense and other non-income based tax
71

 
2,559

 
(1,638
)
 
(555
)
Depreciation and amortization
10,023

 
9,438

 
29,460

 
27,894

Transaction-related costs (a)

 

 
856

 
717

Loss on early extinguishment of debt (b)

 

 

 
526

Income tax receivable agreement expense (income) (c)
3,480

 
(3,585
)
 
2,765

 
(5,461
)
Certain legal matters (d)
1,028

 
3,481

 
37,677

 
11,714

Executive and management severance costs (e)

 

 

 
917

Stock-based compensation and related payroll taxes
1,298

 
1,054

 
4,356

 
15,090