Surgery Partners, Inc. — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017. Surgery Partners operated 103 surgical facilities across 29 states, alongside physician practices and ancillary services. Results are unaudited.
Financial performance and liquidity
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $288.4 million | $289.7 million | $574.5 million | $556.8 million |
| Operating income | $37.7 million | $50.9 million | $79.5 million | $85.2 million |
| Operating margin | 13.1% | 17.6% | 13.8% | 15.3% |
| Consolidated net income | $11.6 million | $22.3 million | $26.0 million | $32.6 million |
| Net income (loss) attributable to Surgery Partners | ($4.5 million) | $2.1 million | ($7.2 million) | ($5.1 million) |
| Adjusted EBITDA | $37.1 million | $46.0 million | $77.2 million | $84.5 million |
Adjusted EBITDA is a non-GAAP measure defined by the company; it excludes specified expenses and gains and should not be viewed as a substitute for GAAP results. Net income attributable to non-controlling interests exceeded consolidated net income in both 2017 periods, resulting in a net loss attributable to the parent.
- Cash flow: Six-month operating cash flow was $56.5 million, versus $74.0 million a year earlier. Investing cash outflow was $29.2 million; financing cash outflow was $39.9 million. Cash declined to $57.0 million from $69.7 million at year-end 2016.
- Liquidity: Working capital was $166.3 million, compared with $175.2 million at December 31, 2016. Revolver availability was $55.9 million, including outstanding letters of credit. Management said operating cash flow, cash on hand and revolver availability were expected to meet short- and longer-term liquidity needs.
- Debt: Total debt was $1.825 billion, including $1.795 billion of long-term debt, up from $1.442 billion in total debt at year-end. The company issued $370 million of 6.75% notes due 2025 on June 30; proceeds remained in escrow pending the NSH merger. It also had $400 million of 8.875% notes due 2021 and $927.3 million outstanding under the first-lien credit agreement. The company reported compliance with debt covenants.
- Interest-rate exposure: Variable-rate debt principal was $943.4 million. The filing estimates a 100-basis-point increase in LIBOR would add approximately $2.4 million to quarterly interest expense.
- Other balance-sheet items: Total assets were $2.671 billion, including $1.569 billion of goodwill. The $370 million financing escrow asset substantially reflects the 2025 notes proceeds.
Changes versus the prior comparable period
- Q2 revenue declined 0.5%; management said the prior-year quarter included $8.8 million from an anesthesia contract no longer in place. Excluding that contract from both periods, management reported revenue growth of 2.7%. For the first half, revenue rose 3.2%; excluding $17.8 million of prior-year anesthesia-contract revenue, management reported growth of 6.6%.
- For the first half, patient service revenue increased 3.8%, while optical and other service revenue declined. Management attributed patient revenue growth primarily to integrating acquisitions completed after June 30, 2016.
- Profitability weakened: Q2 operating margin fell to 13.1% from 17.6%, and first-half adjusted EBITDA declined to $77.2 million from $84.5 million. Management cited an unfavorable payor-mix shift on higher-acuity cases, which increased supply costs while reimbursement rates were lower. Cost of revenue and doubtful-account provisions also increased as a percentage of revenue.
- Same-facility cases grew 0.4% in Q2 and 1.3% in the first half; revenue per case increased 1.5% and 3.7%, respectively, per the filing’s same-facility table.
- Operating cash flow fell year over year; management attributed the decline primarily to $17.8 million of interest payments on the 2021 notes that were not incurred in the prior-year period.
Outlook, transactions, risks and unusual items
- Pending transactions: The company had agreed to acquire NSH for approximately $760 million, issue Bain Capital up to $320 million of 10% convertible preferred stock, and facilitate Bain’s purchase of H.I.G.’s 26.46 million common shares for $19 per share. These transactions had not closed as of the filing. Closing was subject to conditions and regulatory approvals; the filing cited a potential $45.6 million termination fee in specified circumstances. If the merger did not close, the 2025 notes were subject to redemption under their terms.
- Unusual items: Q2 included a $3.8 million gain from settling litigation relating to a 2009 acquisition. Separately, the company settled a Medicaid audit for $1.3 million during the quarter; the audit had asserted approximately $4.7 million in overpayments and penalties. The first half of 2016 included an $8.3 million debt-refinancing loss, which did not recur in 2017.
- Tax and transaction exposure: The existing tax receivable agreement was estimated at approximately $123.4 million; a proposed amendment tied to the transaction could set payments as high as $120.5 million. The proposed H.I.G. share sale could trigger a tax ownership change and limit use of net operating losses.
- Management outlook: No numerical revenue, earnings or EBITDA guidance was provided. Management expected the full-year tax rate to be 41%–43% as a percentage of net income after non-controlling interests, while noting that interim rates can vary. It also continued to focus on same-facility performance, selective acquisitions and new-facility development.
- Key risks: Reimbursement and payor-mix pressure; dependence on physician relationships; high leverage and variable interest rates; regulatory, billing, fraud-and-abuse and reimbursement-audit exposure; integration and financing risks related to the pending NSH deal; and substantial goodwill and tax receivable agreement obligations.
- Controls: Management concluded disclosure controls were not effective because of a material weakness involving documentation of controls over revenue, accounts receivable and related allowances. Remediation was underway but not complete, and the company gave no assurance about when it would be fully effective.
Important facts for investors to verify
- Whether the NSH acquisition and related Bain Capital and H.I.G. transactions closed, and the final financing, preferred-stock and ownership terms.
- Whether the 2025 notes’ escrow was released or the notes were redeemed, and the resulting debt, interest expense and liquidity position.
- Whether same-facility case growth and revenue per case continued, and whether unfavorable payor mix and supply costs continued to pressure margins.
- Whether operating cash flow, receivables collection and doubtful-account provisions improved; the filing reported a $31.5 million allowance for doubtful accounts and 68 days sales outstanding.
- Progress in remediating the material weakness and whether subsequent reporting confirms effective controls over revenue and receivables.
- Final costs, integration results and any regulatory concessions or termination consequences associated with the proposed transactions.