Surgery Partners, Inc. — Q3 2017 Form 10-Q
Reporting period: Quarter ended September 30, 2017. Surgery Partners operates ambulatory surgery centers, surgical hospitals, physician practices and ancillary services. At September 30, it operated in 32 states with 124 surgical facilities (104 ASCs and 20 hospitals) and 60 physician practices.
Comparability note: Bain’s change of control on August 31 led the company to apply pushdown accounting. The filing labels periods before and after that date “Predecessor” and “Successor”; their accounting bases differ. The combined quarterly and nine-month comparisons below are the company’s MD&A presentation and should be interpreted with that limitation.
Financial results and liquidity
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Revenue | $306.3 million | $282.7 million | $880.9 million | $839.4 million |
| Operating income (loss) | $(1.6) million | $42.8 million | $77.9 million | $128.1 million |
| Net income | $1.7 million | $14.3 million | $27.8 million | $47.0 million |
| Net loss attributable to Surgery Partners | $(13.6) million | $(2.3) million | $(20.8) million | $(7.4) million |
| Adjusted EBITDA | $23.2 million | $44.7 million | $100.4 million | $129.2 million |
- Reported revenue grew 8.4% in Q3 and 4.9% for the nine months, primarily reflecting the August 31 acquisition of NSH, which added 22 facilities. Excluding the company’s estimated hurricane impact and receivables reserve adjustment, normalized revenue was $329.9 million for Q3 and $904.4 million for nine months—growth of 16.7% and 7.7%, respectively.
- Reported operating margin was (0.5)% in Q3 and 8.8% for nine months, versus 15.2% and 15.3%. Cost of revenues rose to 80.5% of revenue in Q3 and 76.6% for nine months, from 71.2% and 72.3%. Management cited higher-acuity case mix, unfavorable payor mix and higher supply costs. Adjusted EBITDA also fell; normalized Adjusted EBITDA was $43.1 million for Q3 and $120.3 million for nine months.
- Operating cash flow was $66.5 million for nine months, versus $92.9 million a year earlier. Investing cash outflow was $747.6 million, including the NSH acquisition; financing cash outflow was $811.1 million. Cash ended the period at $199.7 million.
- At September 30, cash was $199.7 million, working capital was $298.6 million, and total debt was $2.19 billion, including $48.5 million of current maturities. The $75 million revolving facility had $71.9 million available, including $3.1 million of letters of credit. Management said cash flow, cash on hand and revolver availability should meet short- and longer-term liquidity needs.
- Variable-rate debt was approximately $1.30 billion; a 100-basis-point LIBOR increase was estimated to raise quarterly interest expense by approximately $3.2 million. The company reported compliance with credit-agreement covenants.
Material changes and unusual items
- NSH acquisition and control change: The company acquired NSH on August 31 for approximately $711.7 million net of cash acquired. Bain became controlling stockholder, with approximately 65.7% of voting power. Bain also invested $310 million in Series A preferred stock.
- Preferred stock: Series A carries a 10% dividend that compounds quarterly and is convertible into common stock at $19 per share, subject to terms. Its reported redemption value was $326.9 million at September 30.
- Revenue and operating impacts: Hurricanes Harvey and Irma caused temporary facility closures and an estimated loss of about 2,828 cases. Management estimated a $7–$9 million reduction in second-half 2017 revenue, with most impact in Q3. A $15.6 million non-recurring receivables reserve adjustment, mainly involving older balances and select payors in ancillary services, also reduced revenue.
- Financing and transaction costs: Refinancing the former credit facilities generated an $18.2 million loss. Q3 also included $5.3 million of merger and integration costs. The company recorded a $16.4 million gain related to amendment and assignments of its tax receivable agreement (TRA).
- TRA obligations: The amended TRA uses a fixed payment schedule. The company estimated total payments of approximately $120.5 million, assuming a 38% effective tax rate, and made upfront payments of about $9.9 million to acquire certain executives’ and employees’ future TRA interests.
Outlook, risks and controls
- Management expected residual hurricane effects in Q4 2017. No broader earnings or revenue guidance is provided in the filing.
- The company expects an effective tax rate of 41%–42% as a percentage of income after non-controlling interests, while noting interim-period variability.
- On October 23, 2017, the company received a federal civil investigative demand under the False Claims Act seeking information dating to 2010 about medical necessity of certain drug tests performed by company physicians and submitted to company-owned laboratories. The company said it would cooperate. Management said it knew of no other proceeding expected to have a material adverse effect.
- Disclosure controls were not effective because of a material weakness involving documentation of controls over revenue, accounts receivable and related allowances. Management was implementing remediation but could not assure when the weakness would be fully addressed.
- Key business risks include government and commercial reimbursement changes, physician relationships, acquisition integration, healthcare fraud-and-abuse and billing regulation, medical malpractice, and limitations on using tax net operating losses following ownership changes. The filing notes that approximately $449.7 million of NOL carryforwards became subject to Section 382 limits after the Bain transaction.
Important facts for investors to verify
- How much of reported growth and the NSH contribution translates into sustainable same-facility revenue and cash generation, given the pushdown accounting break and Q3 normalization adjustments.
- Whether the receivables reserve adequately reflects collection risk, and whether the material weakness in revenue and receivables controls is remediated.
- The operating and financial effects of the federal drug-testing investigation, including any potential exposure or required changes.
- Debt-service capacity under the new capital structure, sensitivity to interest rates, and the terms and compounding economics of the Series A preferred stock and TRA.
- Whether hurricane-related revenue effects and higher-acuity/payor-mix pressures persist beyond the periods described.