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USMD > SEC Filings for USMD > Form 10-K on 1-Apr-2013All Recent SEC Filings

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Form 10-K for USMD HOLDINGS, INC.


1-Apr-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") pertains to USMD Holdings, Inc. and its consolidated subsidiaries. The MD&A is intended to provide the reader of our financial statements with a narrative from the perspective of our management on Holdings' financial condition, results of operations, cash flows, liquidity and certain other factors that may affect our future results. The MD&A should be read in conjunction with the accompanying consolidated financial statements and related notes included in this Annual Report on Form 10-K.

Executive Overview

On August 31, 2012, Holdings and the other parties consummated the Contribution. For accounting purposes, the Contribution qualifies as a business combination and was accounted for as a reverse acquisition by USMD into Holdings, previously a business combination related shell company. Under reverse acquisition accounting, the financial statements are issued in the name of Holdings, but represent a continuation of USMD's financial statements, with an adjustment to retroactively restate USMD's legal capital to reflect the legal capital of Holdings.

We intend to build a regional, then national physician-led integrated health system and face many challenges in executing our business strategy. Our efforts to grow involve increasing our primary care and specialist physician count; this may occur through hiring or the acquisition of physician or other healthcare practices that share our vision of patient-first care. In addition, we intend to grow our ancillary services commensurate with the growth in our physician services. We may also explore or enter into other business lines or affiliations that meet our strategic objectives. Efforts to increase physician counts and the introduction of new business lines or affiliations would likely have a near-term negative effect on margins as we develop our physician-led integrated health system. In addition, it is likely that additional financing will be required to execute our strategy. We face challenges in integrating the recent and any future acquisitions into the Holdings' patient centric model, which continues to evolve, and is expected to offer numerous opportunities for improving healthcare delivery and growing our business.

At December 31, 2012, USMD Physician Services operated out of 62 clinics and other healthcare facilities and employed 89 primary care and pediatric physicians and 112 physician specialists. In the four months ending December 31, 2012 - the period following the close of the Contribution - we had the following:

                        Patient encounters(i)      271,320
                        New patients(ii)            13,668
                        RVU's(iii)                 474,095
                        Lab tests(iv)              295,173
                        Imaging procedures(iv)      17,286

For the years ended December 31, 2012 and 2011, we had the following:

                                                          2012         2011
        Cancer Treatment Center fractions treated(iv)     60,707       66,191
        Lithotripsy cases(iv)                              9,348        9,175


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(i) A patient encounter is registered when a patient sees their physician.

(ii) New patients are registered for patients not previously seen by a service provider within the Holdings system.

(iii) Relative value units are equivalent to physician work RVU's as defined by the Medicare Physician Fee Schedule. RVUs reflect the relative level of time, skill, training and intensity required of a physician to provide a given service. We use RVU's as measures of physician performance and utilization and RVU's are also a component of physician compensation.

(iv) Lab tests, imaging procedures, cancer treatment center fractions and lithotripsy cases are all production metrics based on Current Procedural Terminology codes.

We use various evidence-based quality metrics such as specific cancer screenings to measure how well our physicians manage their populations of patients. Since the Contribution, the percentage of physicians meeting their monthly quality targets has ranged from 82% to 100%. We believe our quality criteria have enabled us to reduce the total medical cost of care of our managed patients, including reductions in emergency room visits and hospital readmissions. We use these and other metrics to measure the performance of our business.

Industry Trends

Healthcare Reform

In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the "Healthcare Reform Law") was enacted. The Healthcare Reform Law is intended to expand health insurance coverage to uninsured individuals and reform the healthcare delivery system with the objectives of improving quality and lowering the overall cost of providing healthcare. Many provisions within the Healthcare Reform Law could impact us in the future, resulting in potential variances in third-party reimbursement rates, payer mix and patient encounter volumes. Although certain provisions of the Healthcare Reform Law are currently in effect, the most impactful provisions will be implemented in future years and the details of those provisions will be shaped significantly by future interpretations of the provisions and execution of those interpretations. We cannot predict with any assurance the ultimate effect of the Healthcare Reform Law and related regulations and interpretive legislation on our business. We believe that we are well positioned to respond effectively to the opportunities and challenges presented by this important legislation as a result of our physician-led, high quality, patient centered care model.

Growing premium on high performance, patient centered care networks

The U.S. healthcare system continues to evolve in a manner that places an increasing emphasis on high performance, patient centered care supported by robust information technology and effective care coordination. There are a number of initiatives that we expect to continue to gain importance, including introduction of value based payment methodologies tied to performance, quality and coordination of care, implementation of integrated electronic health records and information and an increasing ability for patients and consumers to make choices about all aspects of healthcare. We believe our focus on developing a clinically integrated, comprehensive healthcare delivery network, our commitment to patient centered care and our experienced management team position us well to respond to these emerging trends and to manage the changing healthcare regulatory and reimbursement environment.

Electronic Health Records

The American Recovery and Reinvestment Act of 2009 provides for incentive payments under the Medicare and Medicaid programs for certain hospitals and physicians that demonstrate meaningful use of certified electronic health record ("EHR") technology. Physicians and other professionals may be eligible for either Medicare or Medicaid incentive payments, but not both. We anticipate that nearly all of our physicians will participate in the meaningful use program in 2013. We have incurred and will continue to incur both capital expenditures and operating expenses in order to implement EHR technology and meet the meaningful use requirements; the timing of recognition of EHR incentive income does not correlate with those expenditures and expenses. We believe that the operational benefits of EHR technology, including anticipated improved clinical outcomes and increased operational and administrative efficiencies, will contribute to our long-term ability to grow our business and meet targeted quality objectives.

Economic Uncertainties

The United States continues to be affected by economic uncertainty resulting in unfavorable economic conditions. As a result, the number of unemployed, underemployed and uninsured workers remains significant and exposed to fluctuation. A shift in payer mix to a higher percentage of self-pay and/or government-sponsored programs could have an unfavorable impact on our net operating revenue and net income.

Industry Consolidation

The accelerated pace of business consolidation in the hospital industry also represents a challenge because these mergers are essentially creating monopolies in many urban and rural areas. These large systems can employ a significant percentage of the available pool of physicians making it very difficult for physicians that are not employed by the hospital to access services available in their hospitals. We believe Holdings' plan to significantly grow our physician base with both primary care and specialty physicians will provide a significant enough lever to offset any threats that may be directed our way.

Results of Operations

Year ended December 31, 2012 Compared to Year Ended December 31, 2011

As a result of the August 31, 2012 Contribution, which was accounted for as a reverse acquisition by USMD into Holdings, previously a business combination related shell company, results of operations and cash flows have limited comparability to prior periods. Our results of operations and cash flows for the year ended December 31, 2012 include eight months of results of operations and cash flows of pre-Contribution USMD and four months of results of operations and cash flows of post-Contribution Holdings. Our results of operations and cash flows for the year ended December 31, 2011 include the historical results and cash flows of USMD for that period.


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The following table summarizes our results of operations for the periods indicated and is used in the discussions that follow (in thousands):

                                                     Years Ended December 31,                      Annual Variance
                                                 2012                        2011                   2012 vs. 2011
                                         Amount         Ratio        Amount         Ratio        Amount        Ratio
Revenues:
Net patient service revenue             $  60,076         56.8 %    $     -            0.0 %    $ 60,076           n/a
Management services revenue                23,400         22.1 %       23,211         47.5 %         189           0.8 %
Lithotripsy revenue                        22,226         21.0 %       21,975         45.0 %         251           1.1 %
Other operating revenue                       -            0.0 %        3,690          7.5 %      (3,690 )      -100.0 %

Net operating revenue                     105,702        100.0 %       48,876        100.0 %      56,826         116.3 %

Operating expenses:
Salaries, wages and employee benefits      62,694         59.3 %       20,208         41.3 %      42,486         210.2 %
Medical supplies and services expense       7,060          6.7 %          376          0.8 %       6,684        1777.7 %
Rent expense                                5,086          4.8 %          485          1.0 %       4,601         948.7 %
Provision for doubtful accounts               107          0.1 %           35          0.1 %          72         205.7 %
Other operating expenses                   15,711         14.9 %        8,061         16.5 %       7,650          94.9 %
Electronic Health Record incentive
income                                       (474 )       -0.4 %          -            0.0 %        (474 )         n/a
Depreciation and amortization               3,302          3.1 %          916          1.9 %       2,386         260.5 %

                                           93,486         88.4 %       30,081         61.5 %      63,405         210.8 %

Income from operations                     12,216         11.6 %       18,795         38.5 %      (6,579 )       -35.0 %
Other income (expense), net                 3,024          2.9 %          111          0.2 %       2,913        2624.3 %

Income before provision for income
taxes                                      15,240         14.4 %       18,906         38.7 %      (3,666 )       -19.4 %
Provision for income taxes                  1,487          1.4 %        2,952          6.0 %      (1,465 )       -49.6 %

Net income                                 13,753         13.0 %       15,954         32.6 %      (2,201 )       -13.8 %
Less: net income attributable to
noncontrolling interests                  (11,653 )      -11.0 %      (13,296 )      -27.2 %       1,643         -12.4 %

Net income attributable to USMD
Holdings, Inc.                          $   2,100          2.0 %    $   2,658          5.4 %    $   (558 )       -21.0 %

Revenues

Net operating revenue increased 116.3% to $105.7 million for the year ended December 31, 2012 as compared to the year ended 2011, due primarily to increases in net patient service revenue related to businesses acquired in the Contribution, offset by a $3.7 million decline in other operating revenue.

Management services revenue includes revenue earned through the provision of management and staffing services to Holdings' managed entities and increased 0.8% to $23.4 million for the year ended December 31, 2012 from $23.2 million in 2011. Hospital management services revenue increased $0.8 million as a result of inflation adjustments to the reimbursable management costs and improvements in adjusted net operating revenue at USMD Arlington and USMD Fort Worth. In addition, lithotripsy management services revenue decreased $0.1 million. Cancer treatment center management services revenue decreased $0.9 million in 2012 as compared to 2011 due to the termination of a management contract in September 2011. The remaining $0.4 million increase is related to the businesses acquired in the Contribution.

Lithotripsy revenue consists of revenue of the consolidated lithotripsy entities, which increased 1.1% to $22.2 million for the year ended December 31, 2012 from $22.0 million in 2011. This increase in revenue coincides with the lithotripsy entity case count increase of 1.9% in 2012 as compared to 2011.

Other operating revenue for the year ended December 31, 2011 includes a $3.7 million gain on early termination of our management contract by a managed cancer treatment center.

Operating Expenses

Salaries, wages and employee benefits increased 210.2% to $62.7 million for the year ended December 31, 2012 from $20.2 million in 2011 due primarily to a $41.7 million increase related to businesses acquired in the Contribution. The remaining $0.8 million increase is due to a $0.5 million increase related to the expansion of accounting and finance, legal and other corporate overhead departments and a $0.3 million increase in contract labor related to the hospital management services entities. The salaries, wages and employee benefits of the acquired businesses used to generate net patient service revenue have a higher relative cost than our historical salaries, wages and employee benefits. This higher cost of revenue accounted for the majority of the increase in salaries, wages and employee benefits as a percentage of net operating revenue to 59.3% in 2012 from 41.3% in 2011.

Medical supplies and services expense increased due to the nature of businesses acquired in the Contribution. The businesses provide health care services to patients in physician clinics and other health care facilities and utilize significant medical supplies and services in the provision of those services.

Rent expense increased related to businesses acquired in the Contribution. The acquired businesses provide their primary healthcare services in rented facilities.


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Other operating expenses consist primarily of professional fees, purchased services, repairs & maintenance, travel expense and other expense. Other operating expenses increased 94.9% to $15.7 million for the year ended December 31, 2012 from $8.1 million in 2011. The net increase is primarily due to an $8.0 million increase related to businesses acquired in the Contribution, a $0.2 million increase in other expenses and a $0.2 million increase in repairs & maintenance expenses offset by a $0.8 million decrease in professional fees related to the filing of the Registration Statement on Form S-4 in 2011 and a $0.1 million decrease in purchased services.

The physicians of USMD Physician Services generate Electronic Health Record incentive income, which we began recording after the Contribution.

Depreciation and amortization expense increased $2.4 million to $3.3 million for the year ended December 31, 2012 from $0.9 million in 2011. The increase is due primarily to increases in depreciation and amortization of $1.7 million and $0.6 million, respectively, related to property and equipment and intangible assets acquired and recorded at fair value in the Contribution.

Other Income (Expense), net

Other income (expense), net increased $2.9 million to $3.0 million for the year ended December 31, 2012 from $0.1 million in 2011 due primarily to a $2.1 million increase in equity in income of nonconsolidated affiliates. Increased ownership interest in USMD Arlington and USMD Fort Worth, as a result of the Contribution, accounted for $1.7 million of the increase and the remaining $0.4 million increase in equity in income of nonconsolidated affiliates is a result of increased profitability at USMD Arlington and USMD Fort Worth. Impairment charges related to investments in nonconsolidated affiliates decreased $0.8 million for the year ended December 31, 2012 from $0.8 million in 2011. Other income increased $0.2 million due to a $0.1 million gain on asset disposal and a $0.1 million partial recovery of an investment. Interest expense increased $0.2 million as a result of the net increase in borrowings related to the Contribution.

Provision for Income Taxes

The income tax provision decreased $1.5 million to $1.5 million for the year ended December 31, 2012, from $3.0 million for the same period in 2011. Holdings' effective tax rates were 9.7% and 15.5% for the years ended December 31, 2012 and 2011, respectively. The decrease in the effective rate is primarily due to the decline of net income attributable to noncontrolling interests for the year ended December 31, 2012 compared to 2011 and prior year adjustments to the tax basis of certain investments during the year ended December 31, 2011.

Net Income Attributable to Noncontrolling Interests

Noncontrolling interests eliminate the income or loss attributable to non-Holdings ownership interests in our consolidated entities. Net income attributable to noncontrolling interests decreased $1.6 million to $11.7 million for the year ended December 31, 2012 from $13.3 million in 2011. Of this decrease, $0.9 million is related to a decline in net income of the consolidated lithotripsy entities and $0.7 million is due to Holdings' increased ownership interest in three of the consolidated lithotripsy entities as a result of the Contribution.

Liquidity and Capital Resources

We primarily rely on cash flows from operations to fund our operating activity cash requirements. At December 31, 2012, we had unrestricted available cash of $4.9 million, which is net of $2.0 million of consolidated lithotripsy entity cash that is unavailable for wholly owned cash flow operating activities. Additionally, on February 28, 2013, we renewed our revolving credit facility for one year from the renewal date. The revolving credit facility is available for working capital needs.

Cash flows associated with the Contribution have resulted in a significant drain on our cash balance. Under the new credit agreement entered into contemporaneously with the Contribution, we are required to maintain a $5.0 million restricted cash balance. In addition, we began making principal payments under the new credit facility in December 2012. Current liabilities acquired in the Contribution have become due and payable faster than we have been able to monetize the current assets acquired. In addition, we have incurred increased cash outflows associated with integration and strategic planning and execution efforts, and had a net cash outflow of $0.5 million associated with dissolution of a deferred compensation plan of an acquired business. For the same reasons, subsequent to December 31, 2012, we have continued to experience a cash drain; at February 28, 2013, our unrestricted available cash balance was $3.0 million, net of consolidated lithotripsy entity cash. This is a minimum level of cash we believe is practical to manage operations effectively. As cash flow activity normalizes, we expect that our cash flows from operations will increase in the second half of 2013; however, as we continue to incur integration and infrastructure improvement costs, we may be required to borrow under the revolving credit facility ($10.0 million available to borrow at February 28, 2013). At this time we do not anticipate drawing on the revolving credit facility, but a decline in projected collections may also necessitate accessing those funds. Although the business combination of three management platforms and existing infrastructures and two physician practices creates an opportunity for cost synergies, we don't expect to benefit from significant cost synergies until 2014.

Our near term business plan contemplates expansion in the North Texas service area by developing or acquiring complementary physician group practices and building or acquiring ancillary healthcare service providers. We also plan to expand our count of primary care physicians and specialists in our areas of focus and areas that expand our integrated health system offerings. Execution of these activities and of our broader strategic plan will likely require additional capital, which we may seek through public or private financings or through other arrangements. In such an event, adequate funds may not be available when needed or may be available only on terms which could have a negative impact on our business and results of operations. In addition, if we raise additional funds by issuing equity or convertible securities, dilution to then existing stockholders may result.


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The following table summarizes our cash flows for the periods indicated and is used in the discussions that follow (in thousands):

                                                                                        Annual
                                                   Years Ended December 31,            Variance
                                                     2012              2011          2012 vs. 2011
Cash flows from operating activities:
Net income                                       $     13,753        $  15,954      $        (2,201 )
Net income to net cash reconciliation
adjustments                                             4,143            1,476                2,667
Change in operating assets and liabilities            (11,904 )            679              (12,583 )

Net cash provided by operating activities               5,992           18,109              (12,117 )

Cash flows from investing activities:
Cash acquired in business combination                   6,967              -                  6,967
Capital expenditures                                   (1,311 )           (395 )               (916 )
Investments in nonconsolidated affiliates                 (77 )           (340 )                263
Proceeds from surrender of life insurance
policies                                                3,184              -                  3,184
Proceeds from sale of property and equipment              106               86                   20
Increase in cash due to consolidation of
investee                                                   50              -                     50

Net cash provided by (used in) investing
activities                                              8,919             (649 )              9,568

Cash flows from financing activities:
Proceeds from long-term debt                           21,124              -                 21,124
Principal payments on long-term debt and
capital lease obligations                             (23,926 )           (921 )            (23,005 )
Restricted cash                                        (5,000 )            -                 (5,000 )
Issuance of USMD common stock                             980              -                    980
Distributions to noncontrolling interests, net
of contributions                                      (12,033 )        (13,194 )              1,161

Net cash used in financing activities                 (18,855 )        (14,115 )             (4,740 )

Net increase (decrease) in cash and cash
equivalents                                            (3,944 )          3,345               (7,289 )
Cash and cash equivalents at beginning of year         10,822            7,477                3,345

Cash and cash equivalents at end of year         $      6,878        $  10,822      $        (3,944 )

Operating Activities

Net cash provided by operating activities was $6.0 million and $18.1 million for the years ended December 31, 2012 and 2011 respectively. For the years ended December 31, 2012 and 2011 we had net income after net cash reconciliation adjustments of $17.9 million and $17.4 million respectively. Changes in operating assets and liabilities, excluding the impact of the Contribution, negatively impacted operating cash flows by $11.9 million for the year ended December 31, 2012 and positively impacted operating cash flows by $0.7 million for the year ended 2011.

At December 31, 2012, we were in the process of obtaining the necessary approvals of Medicaid provider numbers for our physician clinics, which we acquired on August 31, 2012. While the necessary approvals are pending, we are unable to bill for the Medicaid services that we provided at those facilities, which caused our accounts receivable to grow, resulting in a use of cash of $1.1 million. In addition, at December 31, 2012, we recognized $0.5 million of EHR incentive income, resulting in an additional $0.5 million increase in accounts receivable and use of cash in 2012.

After the Contribution, we began to pay at the end of the preceding month rather than the 1st of the rent month certain property and facility rent of the businesses acquired in the Contribution. This change in the timing of payments resulted in a use of cash of $0.5 million in 2012 due to changes in prepaid expenses and other current assets.

In 2012, changes in current liabilities used $9.2 million of cash. As a result of the Contribution, a deferred compensation plan previously maintained by one of the acquired businesses required dissolution. In September 2012, we paid $3.7 million to the participants of the plan to satisfy all liabilities of that plan prior to dissolution; participant liabilities were recorded in accrued payroll. Subsequent to the Contribution, we paid down significant current liabilities of the acquired companies in order to conform the age of those liabilities to a Holdings target range.

Investing Activities

Net cash provided by investing activities of $8.9 million in 2012 was primarily attributable to $7.0 million of cash acquired in the Contribution. Shortly after the Contribution, we surrendered life insurance policies to the issuer for their cash surrender value of $3.2 million; the proceeds were used to satisfy the liabilities of the deferred compensation income plan. Cash paid for capital expenditures of $1.3 million was primarily for lithotripsy services equipment.

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