UHS

Business Context and Reporting Period

Company: Universal Health Services, Inc. (UHS)
Filing Type: Form 10-Q (Unaudited)
Period Ended: March 31, 2007
Business Overview: UHS owns and operates acute care hospitals, behavioral health centers, surgical hospitals, ambulatory surgery centers, and radiation oncology centers. As of March 31, 2007, the company operated 31 acute care hospitals and 110 behavioral health centers across 32 states, Washington D.C., and Puerto Rico. Four acute care facilities in Louisiana remain closed due to Hurricane Katrina damage.

Key Financial Metrics

Margins: Net income margin was 4.1% in Q1 2007 compared to 4.9% in Q1 2006. Operating expenses as a percentage of revenue decreased slightly to 91.0% from 91.8%.

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 16% ($163 million) year-over-year. This was driven by a $100 million increase in same-facility revenues, $45 million from acquisitions, and $18 million from a new construction management contract.
• Profitability: Net income decreased slightly by $1.6 million (3%) to $49.5 million. Income before taxes remained flat at approximately $81 million. The decline in net income was primarily due to a higher effective state income tax rate (38.6% vs. 37.6%).
• Expense Drivers: Salaries, wages, and benefits increased 15.5% to $511 million. Supplies expense rose 36.4% to $175 million, largely due to bringing pharmacy services in-house (increasing supplies by ~$29 million but reducing other operating expenses by ~$42 million). Provision for doubtful accounts increased 32% to $99 million due to rising uninsured patient volumes.
• Acquisitions: The company spent $73 million to acquire the Texoma Healthcare System (including a 234-bed acute care hospital) and real property assets of a behavioral health facility in Ohio.
• Debt: Total debt increased due to additional borrowings of $85 million under the revolving credit facility to fund capital expenditures and acquisitions. The credit facility was subsequently increased to $800 million in April 2007.

Guidance, Outlook, Risks, and Unusual Items

• Capital Expenditures: Management expects to spend approximately $350 million on capital expenditures for the remainder of 2007, including new hospital construction in Las Vegas, Palmdale, Chicago, and Bradenton.
• Unusual Items:
  • Hurricane Katrina: No hurricane-related insurance recoveries were recorded in Q1 2007, compared to $15.4 million in recoveries in excess of expenses in Q1 2006. Four Louisiana facilities remain closed.
  • Pharmacy Transition: The in-house transition of pharmacy services in July 2006 favorably impacted pre-tax income by approximately $2 million in Q1 2007.
• Risks and Contingencies:
  • Legal Proceedings: The company is under investigation by the OIG and U.S. Attorney's office regarding South Texas Health System affiliates (False Claims Act). A search warrant was executed in February 2007. Financial exposure is currently indeterminable.
  • Litigation: A wage and hour class action lawsuit in California (Lasko-Hoellinger) remains pending; a $10 million provision was recorded in 2006. A separate Department of Labor claim regarding Stonington Behavioral Health resulted in a $1.1 million provision in Q1 2007.
  • Reimbursement: Significant revenue reliance on Medicare (28% of acute care) and Medicaid (5% of acute care). Potential legislative changes or audit adjustments could materially impact future results.
  • Insurance: Commercial property insurance costs have risen, and coverage for catastrophic events (earthquake/flood) is now limited to annual aggregate losses rather than per occurrence.

Investor Verification Checklist

• Legal Exposure: Monitor the status of the OIG investigation and search warrant regarding South Texas Health System affiliates for potential fines or penalties.
• Uninsured Patient Trends: Verify the trajectory of the provision for doubtful accounts and charity care, which increased significantly ($127 million in charity/uninsured discounts in Q1 2007).
• Capital Allocation: Track the $350 million expected capital expenditure program and its impact on cash flow and debt levels.
• Reimbursement Rates: Assess the impact of proposed Medicare Severity DRG (MS-DRG) changes and state Medicaid funding reductions, particularly in Texas.
• Debt Covenants: Confirm continued compliance with debt covenants (minimum net worth, debt-to-capital ratios) as debt levels rise to fund expansion.