Radnet, Inc. quarterly report, Q3 FY2013

Business Context and Reporting Period

RadNet, Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2013. It operated 251 diagnostic imaging centers, directly or through joint ventures, across seven states. The filing compares results with the corresponding 2012 periods; dollar amounts below are in millions unless noted.

Financial Performance and Liquidity

Metric	Q3 2013	Q3 2012	Nine months 2013	Nine months 2012
Total net revenue	$175.2	$160.5	$524.6	$487.8
Operating income	$8.6	$13.8	$29.9	$38.6
Net income (loss) attributable to RadNet common stockholders	$(0.5)	$5.1	$0.9	$7.9
Basic EPS	$(0.01)	$0.13	$0.02	$0.21
Adjusted EBITDA (non-GAAP)	$25.4	$28.6	$81.0	$89.1

• Revenue increased 9.2% in Q3 and 7.5% year to date. Net service fee revenue was $158.3 million and $475.6 million, respectively; capitation revenue was $16.8 million and $49.0 million.
• Management reported operating margins of 4.7% versus 8.3% in Q3 and 5.5% versus 7.6% for the nine-month periods. Cost of operations rose to 83.3% of revenue in Q3 from 79.8%; the filing does not present a separate gross margin.
• Interest expense was $11.1 million in Q3 and $34.5 million year to date, down from $13.9 million and $40.9 million. The company attributed the declines mainly to the end of interest-rate swaps and lower revolver balances.
• Operating cash flow was $42.5 million, down from $55.6 million. Investing cash outflow was $40.6 million, including $39.9 million of property and equipment purchases. Financing cash outflow was $1.9 million. Cash decreased $0.1 million to $0.3 million.
• At September 30, working capital was $46.8 million; accounts receivable were $134.3 million. Total stockholders’ equity was $0.4 million, compared with a $6.7 million deficit at year-end 2012.
• Debt disclosures included $200.0 million principal of 10.375% senior notes due 2018, $386.3 million principal of senior secured term loans, and $3.4 million drawn on a revolving facility. The filing reports $198.3 million of notes and $375.3 million of term loans net of unamortized discounts. Debt facilities are secured and subject to financial covenants; the company reported compliance at quarter-end.

Material Changes Versus Prior Period

• Despite higher reported revenue, comparable-center service fee revenue fell 5.9% in Q3 and 6.8% year to date, which management attributed to lower procedure volumes and reduced collection rates. The reported revenue growth reflected, in part, acquired centers.
• Imaging procedures increased to 3.39 million for the first nine months from 3.13 million, while same-center service revenue declined. Capitation revenue rose 15.0% in Q3 and 12.6% year to date, partly from new contracts.
• Operating expenses grew faster than revenue, compressing operating income and adjusted EBITDA. Management cited acquired operations, higher insurance and outside professional-service costs; vendor rebates reduced medical-supply expenses.
• In April 2013, the company amended and repriced its term loan, borrowing an additional $40.0 million and reducing the loan’s interest-rate spreads. It estimated approximately $19.9 million of interest savings over the comparable financing period on the prior principal balance.
• Acquisitions included Manhattan Diagnostic Radiology and other imaging-center interests; the company also acquired a 40% interest in an oncology joint venture. It sold a New Jersey imaging center for $3.9 million, recording a $2.1 million gain, and sold a 10% interest in a Maryland imaging-center entity for approximately $2.6 million.

Outlook, Risks, Contingencies, and Unusual Items

• Management said operating cash flow, available cash, and borrowing availability were expected to meet short- and long-term liquidity needs. It cautioned that economic, business, and other factors could affect liquidity and that replacement financing, if needed, might not be available on acceptable terms. No quantified earnings or revenue guidance is provided.
• The company identified reimbursement changes as a significant risk. CMS had proposed separate CT and MRI cost centers for 2014 hospital outpatient payment calculations, which RadNet said could adversely affect Medicare reimbursement; a final rule had not yet been published. Medicare physician-fee-rate changes also remained subject to legislative action.
• The company restated its December 31, 2012 balance sheet after discovering an error in historical tax accounting for interest-rate-swap mark-to-market adjustments. Deferred tax assets had been overstated by approximately $4.3 million and an unrecognized tax-benefit liability understated by approximately $0.4 million; the restatement increased accumulated deficit by approximately $4.7 million.
• RadNet disclosed a material weakness in income-tax controls and concluded disclosure controls were ineffective as of September 30, 2013. Management planned additional review and controls over uncertain tax positions, targeting remediation by December 31, 2013, but said remediation was not assured until controls had operated effectively for a sufficient period.
• Other period-specific items included the $2.1 million imaging-center sale gain and, in the prior-year comparisons, a $2.8 million gain on deconsolidation of a joint venture and approximately $3.9 million of other income, primarily from interest-rate-swap fair-value adjustments. A November 1, 2013 acquisition of an Encino center for $1.3 million was reported as a subsequent event.
• The company reported ordinary-course litigation that it did not believe would materially affect results. It also noted that consolidated physician-practice variable-interest entities may require RadNet to cover operating expenses exceeding their revenues.

Important Facts for Investors to Verify

1. Whether same-center procedure volumes and collection rates stabilize, and whether reported growth is sustainable apart from acquisitions and capitation contracts.
2. Accounts-receivable aging, bad-debt trends, and the conversion of reported earnings into operating cash flow.
3. Debt service capacity, borrowing availability, covenant headroom, variable-rate exposure, and refinancing needs ahead of debt maturities.
4. Progress in remediating the tax-control material weakness, and whether the restatement has implications for other reporting periods or tax balances.
5. The final CMS reimbursement rules for CT and MRI and any subsequent Medicare or commercial-payer rate changes.
6. The effects of acquisitions, divestitures, and physician-related VIE arrangements on comparable results, cash needs, and potential financial support obligations.