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EX-21 - EXHIBIT 21 - IASIS Healthcare LLCc09301exv21.htm
EX-4.8 - EXHIBIT 4.8 - IASIS Healthcare LLCc09301exv4w8.htm
EX-31.1 - EXHIBIT 31.1 - IASIS Healthcare LLCc09301exv31w1.htm
EX-10.19 - EXHIBIT 10.19 - IASIS Healthcare LLCc09301exv10w19.htm
EX-10.50 - EXHIBIT 10.50 - IASIS Healthcare LLCc09301exv10w50.htm
EX-10.20 - EXHIBIT 10.20 - IASIS Healthcare LLCc09301exv10w20.htm
EX-10.49 - EXHIBIT 10.49 - IASIS Healthcare LLCc09301exv10w49.htm
EX-10.21 - EXHIBIT 10.21 - IASIS Healthcare LLCc09301exv10w21.htm
EX-31.2 - EXHIBIT 31.2 - IASIS Healthcare LLCc09301exv31w2.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 2010
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     .
Commission File Number: 333-117362
IASIS HEALTHCARE LLC
(Exact name of registrant as specified in its charter)
     
DELAWARE   20-1150104
(State or other jurisdiction   (I.R.S. Employer
of incorporation or organization)   Identification No.)
     
DOVER CENTRE    
117 SEABOARD LANE, BUILDING E    
FRANKLIN, TENNESSEE   37067
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code: (615) 844-2747
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES o NO þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. YES þ NO o
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. YES þ NO o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES o NO o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large Accelerated filer o
  Accelerated filer o   Non-accelerated filer þ   Smaller reporting company o
    (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES o NO þ
As of December 21, 2010, 100% of the registrant’s common interests outstanding (all of which are privately owned and are not traded on any public market) were owned by IASIS Healthcare Corporation, its sole member.
 
 

 

 


 

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 Exhibit 4.8
 Exhibit 10.19
 Exhibit 10.20
 Exhibit 10.21
 Exhibit 10.49
 Exhibit 10.50
 Exhibit 21
 Exhibit 31.1
 Exhibit 31.2

 

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IASIS HEALTHCARE LLC
PART I
Item 1. Business.
Company Overview
We are a leading owner and operator of medium-sized acute care hospitals in high-growth urban and suburban markets. We operate our hospitals with a strong community focus by offering and developing healthcare services targeted to the needs of the markets we serve, promoting strong relationships with physicians and working with local managed care plans. As of September 30, 2010, we owned or leased 15 acute care hospital facilities and one behavioral health hospital facility with a total of 3,185 licensed beds. We operate in the following regions:
    Salt Lake City, Utah;
    Phoenix, Arizona;
    Tampa-St. Petersburg, Florida;
    three cities in Texas, including San Antonio;
    Las Vegas, Nevada; and
    West Monroe, Louisiana;
Effective October 1, 2010, through a cash-for-stock acquisition of Brim Holdings, Inc. (“Brim”), we added two acute care hospital facilities with 385 licensed beds to our business: one, a 370 bed acute care hospital facility in Texarkana, Texas, and the other a 15 bed critical access acute care hospital facility in Woodland Park, Colorado.
Our general, acute care hospital facilities offer a variety of medical and surgical services commonly available in hospitals, including emergency services, general surgery, internal medicine, cardiology, obstetrics, orthopedics, psychiatry and physical rehabilitation. In addition, our facilities provide outpatient and ancillary services including outpatient surgery, physical therapy, radiation therapy, diagnostic imaging and respiratory therapy.
We also own and operate Health Choice Arizona, Inc. (“Health Choice” or the “Plan”), a Medicaid and Medicare managed health plan in Phoenix that served over 198,000 members as of September 30, 2010.
For the year ended September 30, 2010, we generated net revenue of $2.5 billion, of which 68.6% was derived from our acute care segment.
Our principal executive offices are located at Dover Centre, 117 Seaboard Lane, Building E, Franklin, Tennessee 37067 and our telephone number at that address is (615) 844-2747. Our Internet website address is www.iasishealthcare.com. Information contained on our website is not part of this annual report on Form 10-K.
In this report, unless we indicate otherwise or the context requires, “we,” “us,” “our” or “our company” refers to IASIS Healthcare LLC (“IASIS”) and its consolidated subsidiaries. Our parent company, IASIS Healthcare Corporation (“IAS”), is our sole member.

 

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Industry Overview
Growth of Healthcare Spending
According to the Centers for Medicare & Medicaid Services (“CMS”), U.S. healthcare expenditures were $2.3 trillion in 2008. CMS projects that total U.S. healthcare expenditures are expected to grow by 4.2% in 2011 and by an average of 6.3% annually from 2009 to 2019. As a result of this growth, total U.S. healthcare expenditures are estimated to be $4.6 trillion, or 19.6% of the total U.S. gross domestic product by 2019. The hospital services sector represents the single largest category of healthcare spending at $718.4 billion, or 30% of total healthcare spending in 2008. CMS expects continued increases in hospital services based on the aging of the U.S. population, advances in medical procedures, expansion of health coverage, increasing consumer demand for expanded medical services and increased prevalence of chronic conditions such as diabetes, heart disease and obesity. As a result, CMS projects the hospital services category to grow at an annual rate of at least 6.0% through 2018, and to continue as the largest category of healthcare spending.
According to the U.S Census Bureau, the U.S. population includes 40.2 million Americans aged 65 or older, which represents 13.0% of the total population. By the year 2030, the number of Americans aged 65 or older is expected to increase to 71.5 million, or 19.7% of the total population. Additionally, as a result of the increasing life expectancy of Americans, the number of people aged 85 years and older is also expected to increase by 57% by the year 2030.
Changes in the Delivery of Healthcare Services
We believe the U.S. healthcare system and the demand for healthcare services are evolving in ways that favor large-scale, comprehensive and integrated service networks. Specifically, we believe there are a number of initiatives that will continue to gain importance in the foreseeable future, including: introduction of value-based payment methodologies tied to performance, quality and coordination of care, implementation of integrated electronic health records (“EHR”) and information, and an increasing ability for patients and consumers to make choices about all aspects of healthcare. Due in large part to our investment in information technology and physician alignment strategies, we believe our company is well positioned to respond to these emerging trends and has the resources, expertise and flexibility necessary to adapt in a timely manner to the changing healthcare regulatory and reimbursement environment.
The Impact of Health Reform
The recently enacted Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, the “Health Reform Law”), will change how healthcare services are covered, delivered, and reimbursed through expanded coverage of previously uninsured individuals and reduced government healthcare spending. In addition, as enacted, the new law reforms certain aspects of health insurance, expands existing efforts to tie Medicare and Medicaid payments to performance and quality, places restrictions on physician owned hospitals, and contains provisions intended to strengthen fraud and abuse enforcement. Because of the many variables involved, including the law’s complexity, lack of implementing regulations or interpretive guidance, gradual and potentially delayed implementation, pending court challenges and possible amendment, the impact of the Health Reform Law, including how individuals and businesses will respond to the choices afforded them under the new law, is not yet fully known.
Business Strategy
Our objective is to provide high-quality, cost-effective healthcare services to the communities we serve, while enhancing long-term growth and profitably that allows for the creation of value and opportunities for reinvestment. In order to achieve these objectives, we are focusing on the following elements, which we consider to be the key components of our business strategy:
Focus on Operational Excellence. We believe that a continuous focus on operational excellence sets the standard for managing all aspects of our business, including growth, quality and operating results. Our management team, which has extensive multi-facility operating experience, continually emphasizes the importance of operational excellence. We believe that in order to successfully achieve operational excellence we must focus on the following:
    growing our presence in our existing markets;
    providing high-quality services to the communities we serve;
    achieving operational efficiencies and effective cost management in all aspects of patient care delivery;

 

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    improving all aspects of the revenue cycle, including our processes for patient registration, such as patient qualification for financial assistance and point-of-service collections, billing, collections, and managed care contract compliance; and
    effectively deploying capital resources in a disciplined manner, including initiatives related to business development, growth, quality of care, information technology and plant maintenance.
Provide High-Quality Services. The keys to providing high-quality services, which include patient safety, patient satisfaction and clinical quality, are at the center of success for our facilities. We strive each day to provide high-quality services at all of our facilities, as we believe the achievement of high-quality care results in the long-term growth of revenue and profitability. Our strategy for focusing on improving quality of care includes enhancing the patient care experience by:
    attracting and retaining high-quality healthcare professionals;
    monitoring and tracking clinical performance and patient safety for numerous purposes, including the establishment of best practices;
    utilizing our advanced clinical information system, which provides more timely key clinical care data, to enable our hospitals to enhance patient safety, reduce medical errors through bar coding, increase staff time available for direct patient care and continue to achieve high quality patient care outcomes;
    utilizing our hospital medical management quality program to drive improvements in core management and allocation of resources, as well as quality and safety of care; and
    dedicating well-trained corporate and hospital resources to the improvement of patient care.
Recruit and Employ Physicians to Meet Community Needs in Our Markets. We believe that a critical element to providing high quality healthcare to the communities we serve is a comprehensive physician alignment strategy, which includes the continued investment in the employment, recruitment and retention of high-quality healthcare professionals. We believe the objective of attracting and retaining quality physicians is best accomplished by:
    expanding the reach of our outpatient and other specialty services;
    equipping our hospitals with technologically advanced equipment;
    enhancing physician convenience and access, including the development of medical office space on or near our hospital campuses;
    enabling physicians to remotely access clinical data through our advanced information systems, facilitating more convenient and timely patient care; and
    sponsoring training programs to educate physicians on advanced medical procedures.
Pursue a Comprehensive Development Strategy. We will continue to assess opportunities to expand our regional and national presence. We believe the many factors currently affecting the healthcare industry will result in increased consolidation and business development opportunities across the industry, which we intend to actively pursue. We believe the successful pursuit of a comprehensive development strategy, including both the expansion of our national presence through the acquisition of hospitals in existing and new markets and a continued focus to capitalize on the opportunities in the communities we serve, will result in overall growth of our revenue and profitability. We believe that our existing markets will continue to benefit from strategic investments that expand the scope and reach of services provided through a variety of healthcare delivery access points. Our disciplined approach to enhancing our competitive position within our existing markets includes the development and expansion of profitable product lines, and the acquisition of new hospitals and other healthcare service providers, including outpatient and ancillary service centers.

 

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Focus on Managed Care Relationships. We are focused on maintaining market-based relationships, as we believe that the broad geographic coverage of our hospitals in certain of the regions in which we operate, the expansion of our physician networks and our commitment to providing high-quality services increases our attractiveness to managed care plans in those areas. We believe these factors provide a platform that allows for negotiating reasonable terms with managed care plans, entering into contracts with additional managed care plans and aligning reimbursement with acuity of services.
Implement Operational Initiatives in Response to Healthcare Reform. In March 2010, President Obama signed the Health Reform Law into law. We believe that our consistent focus on quality and patient satisfaction programs, coupled with the significant investments we have made in information systems, positions us to respond promptly and effectively to the changes resulting from the Health Reform Law, as well as any additional reform initiatives at both the federal and state levels.
Although we expect our business strategy to increase our patient volumes and reimbursement and allow us to control costs, certain risk factors could offset those increases to our net revenue and profitability. Please see Item 1A., “Risk Factors” beginning on page 34 for a discussion of risk factors affecting our business.

 

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Our Markets
The following includes a discussion of the acute care operations in each of our markets as of September 30, 2010.
Salt Lake City, Utah
We operate four acute care hospital facilities with a total of 705 licensed beds in the Salt Lake City area, which has consistently been a very competitive environment. We believe that our hospitals in this market benefit from attractive strategic locations, participate in a more favorable reimbursement environment and possess significant opportunity to capture additional market share. For the year ended September 30, 2010, we generated 26.8% of our total acute care revenue in this market.
Our strategy to capitalize on these elements focuses on providing high-quality patient care, a disciplined deployment of capital and the expansion of our footprint by developing a more extensive network of services, including outpatient services and the implementation of a comprehensive physician employment strategy. In response to this strategy, we have completed various capital projects at our facilities in this market over the past five years, including patient tower expansion projects at Jordan Valley Medical Center and Davis Hospital and Medical Center, as well as emergency room and intensive care unit expansions at Salt Lake Regional Medical Center. These projects have provided increased bed capacity, as well as additional capacity for women’s and neonatal services, inpatient and outpatient surgery, including cardiac catheterization services, intensive care, emergency rooms, pediatric services, inpatient psychiatric and various diagnostic services, along with upgraded imaging technology.

 

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Phoenix, Arizona
We operate three acute care hospital facilities and one behavioral health hospital facility with a total of 621 licensed beds in the Phoenix area, which has historically experienced high population growth. We have made strategic investments in this market, which have focused on capturing market share through expansion of various service lines, as well as capacity. For the year ended September 30, 2010, exclusive of Health Choice, we generated 20.8% of our total acute care revenue in this market.
Since its opening in July 2007, Mountain Vista Medical Center (“Mountain Vista”) has already become a state-of-the-art market leader. With the expanded capacity provided by Mountain Vista, as well as our continued focus on profitable product lines in our other facilities, such as outpatient imaging, psychiatric and orthopedic services, we believe we can continue to achieve growth in this market.
We have also implemented a physician employment strategy in our Arizona market. Our strategy focuses on enhancing our physician specialty and emergency room coverage and is allowing our hospitals to more effectively meet the needs of the communities we serve.
Texas
As of September 30, 2010, we operated three acute care hospital facilities with a total of 773 licensed beds in San Antonio, Odessa, and Port Arthur, Texas. We believe our facilities in Texas benefit from the lack of a single dominant competitor in their service areas. For the year ended September 30, 2010, we generated 26.8% of our total acute care revenue in this market.
On October 1, 2010, through the acquisition of Brim, we acquired Wadley Regional Medical Center (“Wadley”), a 370 licensed bed acute care hospital facility located in Texarkana, Texas, that serves a surrounding population of approximately 275,000, with one primary competitor. Additionally, Wadley benefits from existing market share opportunities and a strategic partnership with physician investors. Wadley’s services include a full range of medical and surgical specialties such as internal medicine, family practice, cardiology, cardiovascular surgery, urology, neurology, pulmonology, orthopedics, gastroenterology, radiology and women’s services. The facility is fully equipped with a 24-bed trauma-ready emergency department, eight general operating rooms, two open-heart operating rooms, two cardiac catheterization labs, a gastro-intestinal lab and a 23-bed outpatient surgery pavilion.

 

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Our strategic focus in our Texas market is centered on providing high-quality patient care, developing a more extensive network of primary care physicians, including expansion of our physician employment strategy, extending the reach of our outpatient business, including both surgical and imaging services, and continuing to expand profitable product lines within our higher acuity service lines, including neurosurgery, cardiology and cardio-thoracic services, neonatology and other surgical services. In recent years, we have completed various growth capital projects in our Texas market that we believe provide the basis for future success in this market.
Tampa-St. Petersburg, Florida
We operate three acute care hospital facilities with a total of 688 licensed beds in the Tampa-St. Petersburg area. As a result of a large Medicare population, high managed care penetration and state restrictions regarding the expansion of operations, the operating environment in Florida can be more challenging than other markets in which we operate. Certain material capital projects, including the addition of new beds or services, require regulatory approval under Florida’s certificate of need program, which restricts our ability to expand operations in this market. Despite these limitations, we believe we can maintain our competitive position in the Tampa-St. Petersburg market through maintaining and improving quality of services and continuing our focus on profitable product lines, such as orthopedic, psychiatric, bariatric, outpatient imaging and non-invasive radiosurgery services. For the year ended September 30, 2010, we generated 12.1% of our total acute care revenue in this market.
West Monroe, Louisiana
We operate Glenwood Regional Medical Center (“Glenwood”) with a total of 223 licensed beds, in West Monroe, Louisiana, which we believe benefits from a strong market position, opportunities for strategic growth of profitable product lines and a lower than average rate of self-pay utilization. For the year ended September 30, 2010, we generated 7.6% of our total acute care revenue in this market.
Our strategic focus for growth in the market is exemplified in our capital spending during the first four years of our ownership, which has included renovations, expansion and other various capital projects at Glenwood, with an emphasis on expanding the hospital’s cardiovascular program, expanding and renovating operating rooms, and purchasing new diagnostic imaging, automated laboratory systems and other equipment. In addition to our capital projects, as part of our effort to more effectively serve the community in which Glenwood operates, we have improved the facility’s hospitalist program, expanded emergency room coverage and re-opened the inpatient psychiatric program.
Glenwood also owns a majority ownership interest in Ouachita Community Hospital (“Ouachita”), a ten-bed surgical hospital located in West Monroe, Louisiana. We believe this strategic acquisition has provided additional surgical capacity and allowed us to expand our market presence.
In connection with these strategic initiatives and capital investments, we believe our focus on providing high-quality patient care, and our efforts to expand the reach of our physician network in this market, will result in capturing additional market share.

 

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Our Properties
As of October 1, 2010, which includes the acquisition of Brim, we operate 17 acute care hospital facilities and one behavioral health hospital facility. We own 15 and lease three of our hospital facilities. Eight of our acute care hospitals have third-party investors. The following table contains information concerning our hospitals.
             
        Licensed  
Hospitals   City   Beds  
Utah
           
Davis Hospital & Medical Center (1)
  Layton     225  
Jordan Valley Medical Center (2)
  West Jordan     183  
Pioneer Valley Hospital (3)
  West Valley City     139  
Salt Lake Regional Medical Center (4)
  Salt Lake City     158  
Arizona
           
Mountain Vista Medical Center (5)
  Mesa     178  
St. Luke’s Medical Center (6)
  Phoenix     232  
St. Luke’s Behavioral Health Hospital
  Phoenix     124  
Tempe St. Luke’s Hospital (7)
  Tempe     87  
Texas
           
Odessa Regional Medical Center (8)
  Odessa     222  
Southwest General Hospital (9)
  San Antonio     327  
The Medical Center of Southeast Texas (10)
  Port Arthur     224  
Wadley Regional Medical Center (11)
  Texarkana     370  
Florida
           
Memorial Hospital of Tampa
  Tampa     180  
Palms of Pasadena Hospital
  St. Petersburg     307  
Town & Country Hospital
  Tampa     201  
Louisiana
           
Glenwood Regional Medical Center (12)
  West Monroe     223  
Colorado
           
Pikes Peak Regional Hospital (13)
  Woodland Park     15  
Nevada
           
North Vista Hospital
  Las Vegas     175  
 
         
Total
        3,570  
 
         
 
     
(1)   Owned by a limited partnership in which we own a 96.2% interest.
 
(2)   On July 1, 2007, Jordan Valley Medical Center acquired Pioneer Valley Hospital, a wholly-owned subsidiary of IASIS. The combined entity is owned by a limited partnership in which we own a 95.6% interest.
     
(3)   A separate campus of Jordan Valley Medical Center, which is leased under an agreement that expires on January 31, 2019. We have options to extend the term of the lease through January 31, 2039.
 
(4)   Owned by a limited partnership in which we own a 98.1% interest.
 
(5)   Owned by a limited partnership in which we own a 90.8% interest.
 
(6)   On September 28, 2007, St. Luke’s Medical Center acquired Tempe St. Luke’s Hospital, a wholly-owned subsidiary of IASIS.
 
(7)   A separate campus of St. Luke’s Medical Center.
 
(8)   Owned by a limited partnership in which we own an 88.4% interest.
 
(9)   Owned by a limited partnership in which we own a 93.9% interest.
 
(10)   Owned by a limited partnership in which we own an 88.0% interest.
 
(11)   Wadley is leased under an agreement that contains unlimited successive renewal options, at our discretion. The operations are owned by a limited liability company in which we own a 72.7% interest.
 
(12)   Includes Ouachita, a surgical hospital with 10 licensed beds.
 
(13)   Pikes Peak Regional Hospital is leased under an agreement that expires on September 11, 2017, and is subject to three five year renewal periods at our option.
We also operate and lease medical office buildings in conjunction with our hospitals. These office buildings are occupied primarily by physicians who practice at our hospitals.

 

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Hospital Operations
At each hospital we operate, we have implemented policies and procedures to improve the hospital’s operating and financial performance. A hospital’s local management team is generally comprised of a chief executive officer, chief financial officer and chief nursing officer. Local management teams, in consultation with our corporate staff, develop annual operating plans setting forth quality and patient satisfaction goals, revenue growth and operating profit strategies. These strategies can include the expansion of services offered by the hospital, market development to improve community access to care, the recruitment and employment of physicians in each community, plans to enhance quality of care and improvements in operating efficiencies to reduce costs. We believe that the competence, skills and experience of the management team at each hospital is critical to the hospital’s success because of its role in executing the hospital’s operating plan. Our performance-based compensation program for each local management team is based upon the achievement of qualitative and quantitative goals set forth in the annual operating plan. Our hospital management teams are advised by boards of trustees that include members of hospital medical staffs, as well as community leaders. Each board of trustees establishes policies concerning medical, professional and ethical practices, monitors such practices and is responsible for ensuring that these practices conform to established standards.
Factors that affect demand for our services include:
    local economic conditions;
    the geographic location of our hospital facilities and their convenience for patients and physicians;
    our participation in managed care programs;
    utilization management practices of managed care plans;
    consolidation of managed care payors;
    strategic investment and improvements in healthcare access points;
    capital investment at our facilities;
    the quality of our medical staff;
    competition from other healthcare providers;
    the size of and growth in local population; and
    improved treatment protocols as a result of advances in medical technology and pharmacology.
We believe that the ability of our hospitals to meet the healthcare needs of their communities is determined by the:
    level of physician support;
    availability of nurses and other healthcare professionals;
    quality, skills and compassion of our employees;
    breadth of our services;
    physical capacity and level of technological advancement at our facilities; and
    emphasis on quality of care.
We continually evaluate our services with the intention of improving quality of care, expanding our profitable lines of business and improving our business mix. We use our advanced information systems to perform detailed clinical process reviews, product line margin analyses and monitor the profitability of the services provided at our facilities. We employ these analyses to capitalize on price and volume trends through the expansion and improvement of certain services. We use our information systems to monitor patient care and other quality of care assessment activities on a continuing basis.
Competition
Our facilities and related businesses operate in competitive environments. A number of factors affect our competitive position, including:
    the local economies in which we operate;
    decline in tourism in our service areas;
    our managed care contracting relationships;
    the number, availability, quality and specialties of physicians, nurses and other healthcare professionals;
    the scope, breadth and quality of services;
    the reputation of our facilities and physicians;
    growth in hospital capacity and healthcare access points in the markets we serve;
    the physical condition of our facilities and medical equipment;
    the location of our facilities and availability of physician office space;
    certificate of need restrictions, where applicable;
    the availability of parking or proximity to public transportation;
    accumulation, access and interpretation of publicly reported quality indicators;
    growth in outpatient service providers;
    charges for services; and
    the geographic coverage of our hospitals in the regions in which we operate.
We currently face competition from established, not-for-profit healthcare companies, investor-owned hospital companies, large tertiary care centers, specialty hospitals and outpatient service providers, such as surgery centers and imaging centers. In addition, some of our hospitals operate in regions with vertically integrated healthcare providers that include both payors and healthcare providers, which could affect our ability to obtain managed care contracts. We continue to encounter increased competition from specialty hospitals, outpatient service providers, not-for-profit healthcare companies and companies, like ours, that consolidate hospitals and healthcare companies in specific geographic markets. Continued consolidation in the healthcare industry will be a leading contributing factor to increased competition in markets in which we already have a presence and in markets we may enter in the future.
Another factor in the competitive position of a hospital is the ability of its management to obtain contracts with purchasers of group healthcare services. The importance of obtaining managed care contracts continues as private and government payors and others turn to managed care organizations to help control rising healthcare costs. Most of our markets have experienced significant managed care penetration, along with consolidation of major managed care plans. The revenue and operating results of our hospitals are significantly affected by our hospitals’ ability to negotiate reasonable contracts with managed care plans. Health maintenance organizations and preferred provider organizations use managed care contracts to encourage patients to use certain hospitals in exchange for discounts from the hospitals’ established charges. Traditional health insurers also contain costs through similar contracts with hospitals.
An additional competitive factor is whether a hospital is part of a local hospital network, as well as the scope and quality of services offered by the network compared to competing networks. A hospital that is part of a network offering a broad range of services in a wide geographic area is more likely to obtain more favorable managed care contracts. On an ongoing basis, we evaluate changing circumstances in each geographic area in which we operate. We may position ourselves to compete in these managed care markets by forming our own, or joining with others to form, local hospital networks.
As we continue to focus on our physician employment strategy, we face significant competition for skilled physicians in certain of our markets, as more providers are adopting a physician staffing model approach, coupled with a general shortage of physicians across most specialties, especially primary care. This increased competition has resulted in efforts by managed care organizations to align with certain provider networks in the markets in which we operate. While we anticipate that our physician employment strategy will help us compete more effectively in our markets, we are unable to provide any assurance regarding the success of our strategy.
Health Choice
Health Choice is a prepaid Medicaid and Medicare managed health plan in the Phoenix, Arizona area. Premium revenue is generated through capitated contracts whereby the Plan provides healthcare services in exchange for fixed periodic payments from the Arizona Health Care Cost Containment System (“AHCCCS”) and CMS. Most premium revenue at Health Choice is derived through its contract with AHCCCS to provide specified health services to qualified Medicaid enrollees through contracted providers. AHCCCS is the state agency that administers Arizona’s Medicaid program. The contract requires Health Choice to arrange for healthcare services for enrolled Medicaid patients in exchange for fixed monthly premiums, based upon negotiated per capita member rates, and supplemental payments from AHCCCS. Capitation payments received by Health Choice are recognized as revenue in the month that members are entitled to healthcare services.
In connection with our contract effective October 1, 2008, AHCCCS implemented a risk-based or severity-adjusted payment methodology for all health plans. Capitation rates for each health plan and geographic service area are adjusted annually based on the severity of treatment episodes experienced by each plan’s membership compared to the average over a specified 12 month period. Adjustments are calculated using diagnosis codes and procedural information from medical and pharmacy claims data, in addition to member demographic information. Capitation rates are risk adjusted prospectively before the start of each contract year, and are not adjusted retroactively.
The Plan receives reinsurance and other supplemental payments from AHCCCS for healthcare costs that exceed stated amounts at a rate ranging from 75% to 100% of qualified healthcare costs in excess of stated levels of up to $35,000 per claim, depending on the eligibility classification of the member. Qualified costs must be incurred during the contract year and are the lesser of the amount paid by the Plan or the AHCCCS fee schedule. Reinsurance recoveries are recognized under the contract with AHCCCS when healthcare costs exceed stated amounts as provided under the contract, including estimates of such costs at the end of each accounting period.
Health Choice’s current contract with AHCCCS, which was effective October 1, 2008, provides for a three-year term, with AHCCCS having the option to renew for two additional one-year periods. The contract, which continued our state-wide presence, covers Medicaid members in the following Arizona counties: Apache, Coconino, Maricopa, Mohave, Navajo, Pima, Yuma, La Paz and Santa Cruz.

 

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Health Choice also contracts with CMS to provide coverage as a Medicare Advantage Prescription Drug (“MAPD”) Special Needs Plan (“SNP”). This contract allows Health Choice to offer Medicare and Part D drug benefit coverage to new and existing dual-eligible members (i.e. those that are eligible for Medicare and Medicaid). The contract with CMS includes successive one-year renewal options at the discretion of CMS. CMS has notified Health Choice that it is exercising its option to extend the contract through December 31, 2011. Under current law, CMS’ authority to designate SNPs has been extended through December 31, 2013. Additionally, SNPs are required to meet additional CMS requirements, including requirements relating to model of care, cost-sharing, disclosure of information, and reporting of quality measures.
Health Choice is subject to state and federal laws and regulations, and CMS and AHCCCS have the right to audit Health Choice to determine the plan’s compliance with such standards. Health Choice is required to file periodic reports with CMS and AHCCCS and to meet certain financial viability standards. Health Choice also must provide its enrollees with certain mandated benefits and must meet certain quality assurance and improvement requirements. Health Choice must also comply with the electronic transactions regulations and privacy and security standards of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”).
The federal anti-kickback statute has been interpreted to prohibit the payment, solicitation, offering or receipt of any form of remuneration in return for the referral of federal healthcare program patients or any item or service that is reimbursed, in whole or in part, by any federal healthcare program. Similar anti-kickback statutes have been adopted in Arizona, which apply regardless of the source of reimbursement. The U.S. Department of Health and Human Services (the “Department”) has adopted safe harbor regulations specifying the following relationships and activities that are deemed not to violate the federal anti-kickback statute that specifically relate to managed care:
    waivers by health maintenance organizations of Medicare and Medicaid beneficiaries’ obligation to pay cost-sharing amounts or to provide other incentives in order to attract Medicare and Medicaid enrollees;
    certain discounts offered to prepaid health plans by contracting providers;
    certain price reductions offered to eligible managed care organizations; and
    certain price reductions offered by contractors with substantial financial risk to managed care organizations.
We believe that the incentives offered by Health Choice to its Medicaid and Medicare enrollees and the discounts it receives from contracting healthcare providers satisfy the requirements of the safe harbor regulations. However, failure to satisfy each criterion of the applicable safe harbor does not mean that the arrangement constitutes a violation of the law; rather the safe harbor regulations provide that the arrangement must be analyzed on the basis of its specific facts and circumstances. We believe that Health Choice’s arrangements comply in all material respects with the federal anti-kickback statute and similar Arizona statutes.
Sources of Acute Care Revenue
Acute care revenue is comprised of net patient revenue and other revenue. A large percentage of our hospitals’ net patient revenue consists of fixed payment, discounted sources, including Medicare, Medicaid and managed care organizations. Reimbursement for Medicare and Medicaid services are often fixed regardless of the cost incurred or the level of services provided. Similarly, various managed care companies with which we contract reimburse providers on a fixed payment basis regardless of the costs incurred or the level of services provided. Net patient revenue is reported net of discounts and contractual adjustments. Contractual adjustments principally result from differences between the hospitals’ established charges and payment rates under Medicare, Medicaid and various managed care plans. Additionally, discounts and contractual adjustments result from our uninsured discount and charity care programs. Other revenue includes medical office building rental income and other miscellaneous revenue.
We receive payment for patient services primarily from:
    the federal government, primarily under the Medicare program;

 

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    state Medicaid programs, including managed Medicaid plans;
    managed care payors, including health maintenance organizations, preferred provider organizations and managed Medicare plans; and
    individual patients and private insurers.
The following table presents the approximate percentages of our hospitals’ net patient revenue from these sources:
                         
    Year Ended September 30,  
Payor Source   2010     2009     2008  
Medicare
    23.4 %     22.7 %     23.4 %
Managed Medicare
    8.5       8.0       7.7  
Medicaid
    6.6       6.5       5.4  
Managed Medicaid
    9.1       8.7       8.4  
Managed care
    40.2       43.0       46.0  
Self-pay
    12.2       11.1       9.1  
 
                 
Total(1)
    100.0 %     100.0 %     100.0 %
 
                 
 
     
(1)   For the years ended September 30, 2010, 2009 and 2008, net patient revenue comprised 68.6%, 70.4% and 73.8%, respectively, of our consolidated net revenue.
Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with Lou Gehrig’s Disease and end-stage renal disease. All of our hospitals are certified as providers of Medicare services. Under the Medicare program, acute care hospitals receive reimbursement under a prospective payment system for inpatient and outpatient hospital services. Currently, certain types of facilities are exempt or partially exempt from the prospective payment system methodology, including children’s hospitals, cancer hospitals and critical access hospitals. Hospitals and units exempt from the prospective payment system are reimbursed on a reasonable cost-based system, subject to cost limits.
Our hospitals offer discounts from established charges to managed care plans if they are large group purchasers of healthcare services. Additionally, we offer discounts to all uninsured patients receiving healthcare services who do not qualify for assistance under state Medicaid, other federal or state assistance plans or charity care. These discount programs generally limit our ability to increase net patient revenue in response to increasing costs. Patients generally are not responsible for any difference between established hospital charges and amounts reimbursed for such services under Medicare, Medicaid, health maintenance organizations, preferred provider organizations or private insurance plans. Patients generally are responsible for services not covered by these plans, along with exclusions, deductibles or co-insurance features of their coverage. Collecting amounts due from patients is more difficult than collecting from governmental programs, managed care plans or private insurers. Increases in the population of uninsured individuals, changes in the states’ indigent and Medicaid eligibility requirements, continued efforts by employers to pass more out-of-pocket healthcare costs to employees in the form of increased co-payments and deductibles, and the effects of the recent economic downturn have resulted in increased levels of uncompensated care.
Medicare
Inpatient Acute Care
Under the inpatient prospective payment system, a hospital receives a fixed payment based on the patient’s assigned Medicare severity diagnosis-related group (“MS-DRG”). In federal fiscal year 2009, CMS completed a two-year transition to full implementation of MS-DRGs to replace the previously used Medicare diagnosis related groups in an effort to better recognize severity of illness in Medicare payment rates. The MS-DRG system classifies categories of illnesses according to the estimated intensity of hospital resources necessary to furnish care for each principal diagnosis. The MS-DRG rates for acute care hospitals are based upon a statistically normal distribution of severity. The MS-DRG payments do not consider a specific hospital’s actual costs but are adjusted for geographic area wage differentials. Inpatient capital costs for acute care hospitals are reimbursed on a prospective system based on diagnosis related group weights multiplied by geographically adjusted federal weights. When treatments for patients fall well outside the normal distribution, providers may receive additional payments known as outlier payments. For federal fiscal year 2011, CMS has established an outlier threshold of $23,075.

 

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The MS-DRG rates are adjusted each federal fiscal year and have been affected by federal legislation. The index used to adjust the MS-DRG rates, known as the “market basket index,” gives consideration to the inflation experienced by hospitals and entities outside of the healthcare industry in purchasing goods and services. In past years, the percentage increases to the MS-DRG rates have been lower than the percentage increases in the costs of goods and services purchased by hospitals. For federal fiscal year 2010, CMS updated the MS-DRG rates by the full market basket of 2.1%. However, the Health Reform Law reduced the market basket by 0.25% for discharges occurring on or after April 1, 2010. The Health Reform Law also requires an additional 0.25% reduction to the market basket for federal fiscal year 2011. For federal fiscal year 2011, CMS issued a final rule updating the MS-DRG rates by a market basket of 2.35%, representing the full market basket of 2.6% reduced by 0.25% as required by the Health Reform Law. The Health Reform Law provides for additional reductions to the inpatient prospective payment system market basket update, as well as other payment adjustments, in future years as discussed below in the section entitled “Government Regulation and Other Factors—Healthcare Reform.”
In federal fiscal years 2008 and 2009, CMS reduced payments to hospitals through a documentation and coding adjustment intended to account for coding and classification changes under the new MS-DRG system that were unrelated to changes in patient case mix. In addition, Congress gave CMS the ability to determine retrospectively whether the documentation and coding adjustment levels for federal fiscal years 2008 and 2009 were adequate to account for changes in payments not related to changes in patient case mix. CMS did not impose an adjustment for federal fiscal year 2010, but announced its intent to impose reductions to payments in federal fiscal years 2011 and 2012 because of what CMS has determined to be an inadequate adjustment in federal fiscal year 2008. For federal fiscal year 2011, CMS issued a final rule implementing a documentation and coding adjustment of negative 2.9%. When combined with the market basket increase of 2.35% for federal fiscal year 2011, this documentation and coding adjustment will result in a net decrease of 0.55% to MS-DRG rates for federal fiscal year 2011. CMS noted that this documentation and coding reduction is only half of the full recoupment of 5.8% needed to offset its estimations of excess payments in 2008 and 2009 and that CMS intends to implement the remaining negative 2.9% in federal fiscal year 2012. In addition, CMS acknowledges that a prospective 3.9% reduction in rates is required to offset changes in documentation and coding as a result of the MS-DRG system. CMS has decided not to implement this prospective reduction in federal fiscal year 2011, but has stated that it will be required in the future.
Quality of care provided is becoming an increasingly important factor in Medicare reimbursement. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Medicare Modernization Act”) provides for diagnosis related group rate increases at the full market basket if the facility submits data for certain patient care indicators to the Secretary of the Department. Initially, CMS required the reporting of ten quality measures. As required by the Deficit Reduction Act of 2005 (“DEFRA”), CMS has expanded, through a series of rulemakings, the number of patient care indicators that hospitals must report. Currently, CMS requires hospitals to report 46 quality measures in order to qualify for the full market basket update to the inpatient prospective payment system in fiscal year 2011. For federal fiscal year 2011, CMS will require hospitals to report 55 quality measures to receive the full market basket update in federal fiscal year 2012. Those hospitals not submitting the required data will receive an increase in payment equal to the market basket minus two percentage points. We currently have the ability to monitor our compliance with the quality indicators and intend to submit the quality data required to receive the full market basket pricing update when appropriate.
For discharges occurring on or after October 1, 2008, Medicare no longer pays hospitals additional amounts for the treatment of certain preventable adverse events, also known as hospital-acquired conditions (“HACs”), unless the condition was present at admission. Currently, there are ten categories of conditions on the list of HACs. DEFRA provides that CMS may revise the list of conditions from time to time. On January 15, 2009, CMS announced three National Coverage Determinations (“NCDs”) that prohibit Medicare reimbursement for erroneous surgical procedures performed on an inpatient or outpatient basis. These three erroneous surgical procedures are in addition to the HACs designated by regulation. The Health Reform Law contains additional measures to further tie Medicare payments to performance and quality as discussed below in the section entitled “Government Regulation and Other Factors—Healthcare Reform.”
Outpatient
CMS reimburses hospital outpatient services and certain Medicare Part B services furnished to hospital inpatients who have no Part A coverage on a prospective payment system basis. CMS uses fee schedules to pay for physical, occupational and speech therapies, durable medical equipment, clinical diagnostic laboratory services and nonimplantable orthotics and prosthetics.

 

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All services paid under the prospective payment system for hospital outpatient services are classified into groups called ambulatory payment classifications or “APCs.” Services in each APC are similar clinically and in terms of the resources they require. A payment rate is established for each APC. CMS increased the conversion factor by approximately 2.1% for calendar year 2010. However, the Health Reform Law reduced the market basket by 0.25% in 2010 and provides for an additional 0.25% reduction in 2011. For calendar year 2011, CMS has issued a final rule updating the market basket by 2.35%, representing the full market basket of 2.6% reduced by 0.25% as required by the Health Reform Law. The Health Reform Law provides for additional reductions to the outpatient prospective payment system market basket update, as well as other payment adjustments, in future years as discussed below in the section entitled “Government Regulation and Other Factors—Healthcare Reform.”
Hospitals must submit quality data regarding eleven measures relating to outpatient care in order to receive the full market basket increase under the outpatient prospective payment system in calendar year 2010 and calendar year 2011. CMS has issued a final rule that requires hospitals to report 15 total measures in 2011 to receive the full market basket increase for payment in calendar year 2012. Hospitals that fail to submit such data will receive the market basket update minus two percentage points for the outpatient prospective payment system.
Rehabilitation
Inpatient rehabilitation hospitals and designated units are reimbursed under a prospective payment system. Under this prospective payment system, patients are classified into case mix groups based upon impairment, age, co-morbidities and functional capability. Inpatient rehabilitation facilities are paid a predetermined amount per discharge that reflects the patient’s case mix group and is adjusted for area wage levels, low-income patients, rural areas and high-cost outliers. For fiscal year 2010, CMS issued a final rule setting the market basket increase factor at 2.5%. However, the Health Reform Law provides for annual decreases to the market basket, including a 0.25% reduction for discharges occurring on or after April 1, 2010 and an additional 0.25% reduction in 2011. For federal fiscal year 2011, CMS has issued a notice updating the market basket by 2.25%, representing the full market basket of 2.5% reduced by 0.25% as required by the Health Reform Law. The Health Reform Law provides for additional reductions to the inpatient rehabilitation facility prospective payment system market basket update, as well as other payment adjustments, in future years as discussed below in the section entitled “Government Regulation and Other Factors—Healthcare Reform.”
In 2004, CMS issued a final rule modifying the criteria for classification as an inpatient rehabilitation facility as a result of data indicating that most facilities do not meet the existing criteria. Under the previous requirements, in order for a facility to be considered an inpatient rehabilitation facility, at least 75% of the facility’s inpatient population during the most recent 12-month cost reporting period must have required intensive rehabilitation services for one or more of ten specified conditions. A subsequent rule expanded the list of specified conditions to 13, and subsequent legislation and regulations temporarily reduced the percentage of the patient population who must have one of the specified conditions. For cost reporting periods beginning on or after July 1, 2007, CMS required 65% of the patient population to have one of the specified conditions. Currently, the percentage is set by statute at 60% of the patient population. Effective January 1, 2010, inpatient rehabilitation facilities must meet additional coverage criteria, including patient selection and care requirements relating to pre-admission screenings, post-admission evaluations, ongoing coordination of care and involvement of rehabilitation physicians. As of September 30, 2010, we operated nine inpatient rehabilitation units within our hospitals.
Psychiatric
Inpatient psychiatric facilities are paid based on a prospective payment system. Under this prospective payment system, inpatient psychiatric facilities receive a federal per diem base rate that is based on the sum of the average routine operating, ancillary and capital costs for each patient day of psychiatric care in an inpatient psychiatric facility, adjusted for budget neutrality. This federal per diem base rate is further adjusted to reflect certain patient and facility characteristics, including patient age, certain diagnostic related groups, facility wage index adjustment, and facility rural location. The payment rates are adjusted annually on a July 1 update cycle. Inpatient psychiatric facilities receive additional outlier payments for cases in which estimated costs for the case exceed an adjusted threshold amount plus the total adjusted payment amount for the stay. CMS updated payments for rate year 2010 by 2.1%. However, the Health Reform Law provides for annual decreases to the market basket, including a 0.25% reduction for discharges occurring on or after April 1, 2010 and an additional 0.25% reduction in 2011. For rate year 2011, CMS has issued a notice updating the market basket by 2.15%, representing the full market basket of 2.4% reduced by 0.25% as required by the Health Reform Law. The Health Reform Law provides for additional reductions to the inpatient psychiatric facility prospective payment system market basket update, as well as other payment adjustments, in future years as discussed below in the section entitled “Government Regulation and Other Factors—Healthcare Reform.” As of September 30, 2010, we operated one behavioral health hospital facility and six specially designated psychiatric units that are subject to these rules.

 

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Physician Services Reimbursement
Physician services are reimbursed under the physician fee schedule (“PFS”) system, under which CMS has assigned a national relative value unit (“RVU”) to most medical procedures and services that reflects the various resources required by a physician to provide the services relative to all other services. Each RVU is calculated based on a combination of work required in terms of time and intensity of effort for the service, practice expense (overhead) attributable to the service and malpractice insurance expense attributable to the service. These three elements are each modified by a geographic adjustment factor to account for local practice costs then aggregated. The aggregated amount is multiplied by a conversion factor that accounts for inflation and targeted growth in Medicare expenditures (as calculated by the sustainable growth rate (“SGR”)) to arrive at the payment amount for each service. While RVUs for various services may change in a given year, any alterations are required by statute to be virtually budget neutral, such that total payments made under the PFS may not differ by more than $20 million from what payments would have been if adjustments were not made.
The PFS rates are adjusted each year, and reductions in both current and future payments are anticipated. The SGR formula, mandated by statute, is intended to control growth in aggregate Medicare expenditures for physicians’ services. For calendar year 2011, CMS has issued a final rule applying the SGR in a manner that would result in an aggregate reduction of 24.9% to all physician payments under the PFS. Since 2003, Congress has passed multiple legislative acts delaying application of the SGR to the PFS, including postponing the cut from December 1, 2010 until January 1, 2012, but we cannot predict whether Congress will intervene to prevent this reduction to payments in the future.
Ambulatory Surgery Centers
CMS reimburses ambulatory surgical centers (“ASC”) using a predetermined fee schedule. Reimbursements for ASC overhead costs are limited to no more than the overhead costs paid to hospital outpatient departments under the Medicare hospital outpatient prospective payment system. Effective January 1, 2008, CMS issued final regulations that change payment for procedures performed in an ASC. Under this rule, ASC payment groups increased from nine clinically disparate payment groups to over 200 APCs used under the outpatient prospective payment system for these surgical services. In addition, CMS significantly expanded the types of procedures that may be performed in ASCs. More Medicare procedures that are now performed in hospitals, such as ours, may be moved to ASCs, potentially reducing surgical volume in our hospitals.
Recovery Audit Contractors
The Medicare Modernization Act established the Recovery Audit Contractor (“RAC”) three-year demonstration program. Under this program, CMS contracted with third-parties to conduct post-payment reviews on a contingency fee basis to detect and correct improper payments in the Medicare program. The Tax Relief and Health Care Act of 2006 made the RAC program permanent and mandated its nationwide expansion by 2010. CMS has awarded contracts to four RACs that have implemented the permanent RAC program on a nationwide basis.
Managed Medicare
Managed Medicare plans represent arrangements where CMS contracts with private companies to provide members with Medicare Part A, Part B and Part D benefits. Managed Medicare plans can be structured as health maintenance organizations, preferred provider organizations, or private fee-for-service plans. The Medicare program allows beneficiaries to choose enrollment in certain managed Medicare plans. Legislative changes in 2003 increased reimbursement to managed Medicare plans and limited, to some extent, the financial risk to the companies offering the plans. Following these changes, the number of beneficiaries choosing to receive their Medicare benefits through such plans has increased. However, the Health Reform Law provides for reductions to managed Medicare plan payments beginning in 2010 that will result in managed Medicare per capita premium payments becoming equal, on average, to traditional Medicare payments. The Health Reform Law also expands the RAC program to include managed Medicare by December 31, 2010.

 

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Medicaid
Medicaid programs are jointly funded by federal and state governments and are administered by states under an approved plan that provides hospital and other healthcare benefits to qualifying individuals who are unable to afford care. All of our hospitals are certified as providers of Medicaid services. State Medicaid programs may use a prospective payment system, cost-based payment system or other payment methodology for hospital services. However, Medicaid reimbursement is often less than a hospital’s cost of services. In addition, effective July 1, 2011, the Health Reform Law will prohibit the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat certain HACs.
The federal government and many states from time to time consider altering the level of Medicaid funding or expanding Medicaid benefits in a manner that could adversely affect future levels of Medicaid reimbursement received by our hospitals. DEFRA, signed into law on February 8, 2006, included Medicaid cuts of approximately $4.8 billion over five years. CMS has published a number of proposed and final regulations that, if implemented, would result in significant additional reductions in Medicaid funding. These regulations have been subject to Congressional moratoria, rescinded, invalidated by court order or otherwise delayed. However, CMS could pursue implementation of these regulations or other regulatory measures that would further reduce Medicaid funding in the future.
Additionally, the states in which we operate have experienced budget constraints as a result of increased costs and lower than expected tax collections. Many state have experienced or projected shortfalls in their budgets, and economic conditions may increase these budget pressures. Health and human services programs, including Medicaid and similar programs, represent a significant portion of state budgets. The states in which we operate have responded to these budget concerns by decreasing funding for healthcare programs or making structural changes that have resulted or may result in a reduction to Medicaid hospital revenues. Additional Medicaid spending cuts or other program changes may be implemented in the future in the states in which we operate. However, effective March 23, 2010, the Health Reform Law generally requires states at least to maintain Medicaid eligibility standards established prior to the enactment of the law until January 1, 2014 for adults and until October 1, 2019 for children. The Health Reform Law also requires states to significantly expand their Medicaid program coverage by 2014.
The American Recovery and Reinvestment Act of 2009 (“ARRA”), allocated approximately $87.0 billion to temporarily increase the share of program costs paid by the federal government to fund each state’s Medicaid program. Although initially scheduled to expire at the end of 2010, Congress has allocated additional funds to extend this increased federal funding to states through June 2011. These funds provide a benefit to state Medicaid programs by helping to avoid more extensive program and reimbursement cuts, but this increased federal funding is not permanent, and state legislatures are anticipating that the expiration of the increased federal funding could result in significant reductions to states’ Medicaid programs.
Through DEFRA, Congress has expanded the federal government’s involvement in fighting fraud, waste and abuse in the Medicaid program by creating the Medicaid Integrity Program. Among other things, this legislation requires CMS to employ private contractors, referred to as Medicaid Integrity Contractors (“MICs”), to perform reviews and post-payment audits of Medicaid claims and identify overpayments. MICs are assigned to five geographic jurisdictions and have commenced audits of Medicaid providers in several states in each jurisdiction. The Health Reform Law increases federal funding for the MIC program for federal fiscal year 2011 and later years. In addition to MICs, several other contractors and state Medicaid agencies have increased their review activities. The Health Reform Law also expands the RAC program’s scope to include Medicaid claims by requiring all states to establish programs to contract with RACs by December 31, 2010.
Private Supplemental Medicaid Reimbursement Programs
Certain of our acute care hospitals receive supplemental Medicaid reimbursement, including reimbursement from programs for participating private hospitals that enter into indigent care affiliation agreements with public hospitals or county governments in the state of Texas. Under the CMS approved programs, affiliated hospitals, including our Texas hospitals, have expanded the community healthcare safety net by providing indigent healthcare services. Participation in indigent care affiliation agreements by our Texas hospitals has resulted in an increase in acute care revenue by virtue of the hospitals’ entitlement to supplemental Medicaid inpatient reimbursement. It is unclear whether our revenues from these programs will be adversely affected as the provisions of the Health Reform Law are implemented.

 

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Managed Medicaid
Managed Medicaid programs represent arrangements in which states contract with one or more entities for patient enrollment, care management and claims adjudication. The states usually do not give up program responsibilities for financing, eligibility criteria and core benefit plan design. We generally contract directly with one of the designated entities, usually a managed care organization. The provisions of these programs are state-specific.
As state governments seek to control the cost of their Medicaid programs, enrollment in managed Medicaid plans, including states in which we operate, has increased in recent years. For example, Florida legislation has established a goal of statewide implementation of Medicaid managed care programs by 2011. Legislative efforts to meet this goal failed in the 2010 legislative session but are anticipated to be pursued again in the 2011 legislative session. Furthermore, Florida could lose $300.0 million of federal funding for hospital charity care if this goal is not met. Louisiana has requested a section 1115 Medicaid waiver from the federal government that, if approved, would result in an expansion of Medicaid managed care plans. The Texas legislature and the Texas Health and Human Services Commission have recommended expanding Medicaid managed care enrollment for certain Medicaid beneficiaries. However, fiscal budgetary issues resulting from general economic conditions in the states in which we operate may require reductions in premium payments to these plans.
Disproportionate Share Hospital Payments
In addition to making payments for services provided directly to beneficiaries, Medicare makes additional payments to hospitals that treat a disproportionately large number of low-income patients (Medicaid and Medicare patients eligible to receive Supplemental Security Income). Disproportionate share hospital (“DSH”) payments are determined annually based on certain statistical information required by the Department and are calculated as a percentage addition to MS-DRG payments. The primary method used by a hospital to qualify for Medicare DSH payments is a complex statutory formula that results in a DSH percentage that is applied to payments on MS-DRGs.
Hospitals that provide care to a disproportionately high number of low-income patients may also receive Medicaid DSH payments. The federal government distributes federal Medicaid DSH funds to each state based on a statutory formula. The states then distribute the DSH funding among qualifying hospitals. States have broad discretion to define which hospitals qualify for Medicaid DSH payments and the amount of such payments.
Annual Cost Reports
All hospitals participating in the Medicare and Medicaid programs, whether paid on a reasonable cost basis or under a prospective payment system, are required to meet specific financial reporting requirements. Federal regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients. These annual cost reports are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. The audit process may take several years to reach the final determination of allowable amounts under the programs. Providers also have the right of appeal, and it is common to contest issues raised in audits of prior years’ reports.
Cost reports filed by our facilities generally remain open for three years after the notice of program reimbursement date. If any of our facilities are found to have been in violation of federal or state laws relating to preparing and filing of Medicare or Medicaid cost reports, whether prior to or after our ownership of these facilities, we and our facilities could be subject to substantial monetary fines, civil and criminal penalties and exclusion from participation in the Medicare and Medicaid programs. If an allegation is lodged against one of our facilities for a violation occurring during the time period before we owned the facility, we may have indemnification rights against the former owner of the facility for any damages we may incur based on negotiated indemnification and hold harmless provisions in the transaction documents. However, we offer no assurances that any such matter would be covered by indemnification, or if covered, that such indemnification would be adequate to cover any potential losses, fines and penalties. Additionally, we offer no assurances that the former owner would have the financial ability to satisfy indemnification claims.

 

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Managed Care
Managed care payors, including health maintenance organizations and preferred provider organizations, are organizations that provide insurance coverage and a network of healthcare providers to members for a fixed monthly premium. To control costs, these organizations typically contract with hospitals and other providers for discounted prices, review medical services to ensure that no unnecessary services are provided, and market providers within their networks to patients. A significant percentage of our overall payor mix is commercial managed care. We generally receive lower payments from commercial managed care payors than from traditional commercial/indemnity insurers for similar services.
Commercial Insurance
Our hospitals provide services to a decreasing number of individuals covered by traditional private healthcare insurance. Private insurance carriers make direct payments to hospitals or, in some cases, reimburse their policy holders, based upon negotiated discounts from the particular hospital’s established charges and the particular coverage provided in the insurance policy.
Commercial insurers are continuing efforts to limit the payments for hospital services by adopting discounted payment mechanisms, including prospective payment or diagnosis related group-based payment systems, for more inpatient and outpatient services. In addition, commercial insurers increasingly are implementing quality requirements and refusing to pay for serious adverse events, similar to Medicare. To the extent that these efforts are successful, hospitals may receive reduced levels of reimbursement.
Charity Care
In the ordinary course of business, we provide care without charge to patients who are financially unable to pay for the healthcare services they receive. Because we do not pursue collection of amounts determined to qualify as charity care, they are not reported in net revenue. We currently record revenue deductions for patient accounts that meet our guidelines for charity care. We provide charity care to patients with income levels below 200% of the federal poverty level (“FPL”). Additionally, at all of our hospitals, a sliding scale of reduced rates is offered to all uninsured patients, who are not covered through federal, state or private insurance, with incomes between 200% and 400% of the FPL.
Government Regulation and Other Factors
A framework of extremely complex federal and state laws, rules and regulations governs the healthcare industry and, for many provisions, there is little history of regulatory or judicial interpretation upon which to rely.
Healthcare Reform
The Health Reform Law, as enacted, will change how healthcare services are covered, delivered and reimbursed through expanded coverage of uninsured individuals, reduced growth in Medicare program spending, reductions in Medicare and Medicaid DSH payments, and the establishment of programs where reimbursement is tied to quality and integration. In addition, the new law reforms certain aspects of health insurance, expands existing efforts to tie Medicare and Medicaid payments to performance and quality and contains provisions intended to strengthen fraud and abuse enforcement. Although some federal district courts have upheld the constitutionality of the Health Reform Law, on December 13, 2010, a Virginia federal district court held the requirement that individuals maintain health insurance or pay a penalty to be unconstitutional, while leaving the remainder of the Health Reform Law intact. These lawsuits are subject to appeal.
Expanded Coverage
Based on estimates of the Congressional Budget Office (“CBO”) and CMS, by 2019, the Health Reform Law, as enacted, will expand coverage to 32 to 34 million additional individuals (resulting in coverage of an estimated 94% of the legal U.S. population). This increased coverage will occur through a combination of public program expansion and private sector health insurance and other reforms.

 

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Medicaid Expansion. The primary public program coverage expansion will occur through changes in Medicaid, and to a lesser extent, expansion of the Children’s Health Insurance Program (“CHIP”). The most significant changes will expand the categories of individuals eligible for Medicaid coverage and permit individuals with relatively higher incomes to qualify. The federal government reimburses the majority of a state’s Medicaid expenses, and it conditions its payment on the state meeting certain requirements. The federal government currently requires that states provide coverage for only limited categories of low-income adults under 65 years old (e.g., women who are pregnant, and the blind or disabled). In addition, the income level required for individuals and families to qualify for Medicaid varies widely from state to state.
The Health Reform Law materially changes the requirements for Medicaid eligibility. Commencing January 1, 2014, all state Medicaid programs are required to provide, and the federal government will subsidize, Medicaid coverage to virtually all adults under 65 years old with incomes at or under 133% of the FPL. This expansion will create a minimum Medicaid eligibility threshold that is uniform across states. Further, the Health Reform Law also requires states to apply a “5% income disregard” to the Medicaid eligibility standard, so that Medicaid eligibility will effectively be extended to those with incomes up to 138% of the FPL. These new eligibility requirements will expand Medicaid and CHIP coverage by an estimated 16 to 18 million people nationwide. A disproportionately large percentage of the new Medicaid coverage is likely to be in states that currently have relatively low income eligibility requirements.
As Medicaid is a joint federal and state program, the federal government provides states with “matching funds” in a defined percentage, known as the federal medical assistance percentage (“FMAP”). Beginning in 2014, states will receive an enhanced FMAP for the individuals enrolled in Medicaid pursuant to the Health Reform Law. The FMAP percentage is as follows: 100% for calendar years 2014 through 2016; 95% for 2017; 94% in 2018; 93% in 2019; and 90% in 2020 and thereafter.
The Health Reform Law also provides that the federal government will subsidize states that create non-Medicaid plans for residents whose incomes are greater than 133% of the FPL but do not exceed 200% of the FPL. Approved state plans will be eligible to receive federal funding. The amount of that funding per individual will be equal to 95% of subsidies that would have been provided for that individual had he or she enrolled in a health plan offered through one of the Exchanges, as discussed below.
Historically, states often have attempted to reduce Medicaid spending by limiting benefits and tightening Medicaid eligibility requirements. Effective March 23, 2010, the Health Reform Law requires states to at least maintain Medicaid eligibility standards established prior to the enactment of the law for adults until January 1, 2014 and for children until October 1, 2019. States with budget deficits may, however, seek exemptions from this requirement, but only to address eligibility standards that apply to adults making more than 133% of the FPL.
Private Sector Expansion. The expansion of health coverage through the private sector as a result of the Health Reform Law, as enacted, will occur through new requirements on health insurers, employers and individuals. Commencing January 1, 2014, health insurance companies will be prohibited from imposing annual coverage limits, dropping coverage, excluding persons based upon pre-existing conditions or denying coverage for any individual who is willing to pay the premiums for such coverage. Effective January 1, 2011, each health plan must keep its annual non-medical costs lower than 15% of premium revenue for the group market and lower than 20% in the small group and individual markets or rebate its enrollees the amount spent in excess of the percentage. In addition, effective September 23, 2010, health insurers are not permitted to deny coverage to children based upon a pre-existing condition and must allow dependent care coverage for children up to 26 years old.
Larger employers will be subject to new requirements and incentives to provide health insurance benefits to their full-time employees. Effective January 1, 2014, employers with 50 or more employees that do not offer health insurance will be held subject to a penalty if an employee obtains coverage through an Exchange, if the coverage is subsidized by the government. The employer penalties will range from $2,000 to $3,000 per employee, subject to certain thresholds and conditions.

 

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As enacted, the Health Reform Law uses various means to induce individuals who do not have health insurance to obtain coverage. By January 1, 2014, individuals will be required to maintain health insurance for a minimum defined set of benefits or pay a tax penalty. The penalty in most cases is $95 in 2014, $325 in 2015, $695 in 2016, and indexed to a cost of living adjustment in subsequent years. The Internal Revenue Service (“IRS”), in consultation with the Department, is responsible for enforcing the tax penalty, although the Health Reform Law limits the availability of certain IRS enforcement mechanisms. In addition, for individuals and families below 400% of the FPL, the cost of obtaining health insurance will be subsidized by the federal government. Those with lower incomes will be eligible to receive greater subsidies. It is anticipated that those at the lowest income levels will have the majority of their premiums subsidized by the federal government, in some cases in excess of 95% of the premium amount.
To facilitate the purchase of health insurance by individuals and small employers, each state must establish an Exchange by January 1, 2014. Based on CBO and CMS estimates, between 29 and 31 million individuals will obtain their health insurance coverage through an Exchange by 2019. Of that amount, an estimated 16 million will be individuals who were previously uninsured, and 13 to 15 million will be individuals who switched from their prior insurance coverage to a plan obtained through the Exchange. The Health Reform Law requires that the Exchanges be designed to make the process of evaluating, comparing and acquiring coverage simple for consumers. For example, each state’s Exchange must maintain an internet website through which consumers may access health plan ratings that are assigned by the state based on quality and price, view governmental health program eligibility requirements and calculate the actual cost of health coverage. Health insurers participating in the Exchange must offer a set of minimum benefits to be defined by the Department and may offer more benefits. Health insurers must offer at least two, and up to five, levels of plans that vary by the percentage of medical expenses that must be paid by the enrollee. These levels are referred to as platinum, gold, silver, bronze and catastrophic plans, with gold and silver being the two mandatory levels of plans. Each level of plan must require the enrollee to share the following percentages of medical expenses up to the deductible/co-payment limit: platinum, 10%; gold, 20%; silver, 30%; bronze, 40%; and catastrophic, 100%. Health insurers may establish varying deductible/co-payment levels, up to the statutory maximum (estimated to be between $6,000 and $7,000 for an individual). The health insurers must cover 100% of the amount of medical expenses in excess of the deductible/co-payment limit. For example, an individual making 100% to 200% of the FPL will have co-payments and deductibles reduced to about one-third of the amount payable by those with the same plan with incomes at or above 400% of the FPL.
Public Program Spending
The Health Reform Law provides for Medicare, Medicaid and other federal healthcare program spending reductions between 2010 and 2019. The CBO estimates that these will include $156 billion in Medicare fee-for-service market basket and productivity reimbursement reductions for all providers, the majority of which will come from hospitals; CMS sets this estimate at $233 billion. The CBO estimates also include an additional $36 billion in reductions of Medicare and Medicaid DSH funding ($22 billion for Medicare and $14 billion for Medicaid). CMS estimates include an additional $64 billion in reductions of Medicare and Medicaid DSH funding, with $50 billion of the reductions coming from Medicare.
Payments for Hospitals and ASCs
Inpatient Market Basket and Productivity Adjustment. Under the Medicare program, hospitals receive reimbursement under a prospective payment system for general, acute care hospital inpatient services. CMS establishes fixed prospective payment system payment amounts per inpatient discharge based on the patient’s assigned MS-DRG. These MS-DRG rates are updated each federal fiscal year, which begins October 1, using the market basket, which takes into account inflation experienced by hospitals and other entities outside the healthcare industry in purchasing goods and services.
The Health Reform Law provides for three types of annual reductions in the market basket. The first is a general reduction of a specified percentage each federal fiscal year starting in 2010 and extending through 2019. These reductions are as follows: federal fiscal year 2010, 0.25% for discharges occurring on or after April 1, 2010; 2011, 0.25%; 2012, 0.1%; 2013, 0.1%; 2014, 0.3%; 2015, 0.2%; 2016, 0.2%; 2017, 0.75%; 2018, 0.75%; and 2019, 0.75%.

 

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The second type of reduction to the market basket is a “productivity adjustment” that will be implemented by the Department beginning in federal fiscal year 2012. The amount of that reduction will be the projected nationwide productivity gains over the preceding 10 years. To determine the projection, the Department will use the Bureau of Labor Statistics (“BLS”) 10-year moving average of changes in specified economy-wide productivity (the BLS data is typically a few years old). The Health Reform Law does not contain guidelines for the Department to use in projecting the productivity figure. Based upon the latest available data, federal fiscal year 2012 market basket reductions resulting from this productivity adjustment are likely to range from 1% to 1.4%. CMS estimates that the combined market basket and productivity adjustments will reduce Medicare payments under the inpatient prospective payment system by $112.6 billion from 2010 to 2019.
The third type of reduction is in connection with the value-based purchasing program discussed in more detail below. Beginning in federal fiscal year 2013, CMS will reduce the inpatient prospective payment system payment amount for all discharges by the following: 1% for 2013; 1.25% for 2014; 1.5% for 2015; 1.75% for 2016; and 2% for 2017 and subsequent years. For each federal fiscal year, the total amount collected from these reductions will be pooled and used to fund payments to hospitals that satisfy certain quality metrics. While some or all of these reductions may be recovered if a hospital satisfies these quality metrics, the recovery amounts may be delayed.
If the aggregate of the three market basket reductions described above is more than the annual market basket adjustments made to account for inflation, there will be a reduction in the MS-DRG rates paid to hospitals. For example, if market basket increases to account for inflation would result in a 2% market basket update and the aggregate Health Reform Law market basket adjustments would result in a 3% reduction, then the rates paid to a hospital for inpatient services would be 1% less than rates paid for the same services in the prior year.
Quality-Based Payment Adjustments and Reductions for Inpatient Services. The Health Reform Law establishes or expands three provisions to promote value-based purchasing and to link payments to quality and efficiency. First, in federal fiscal year 2013, the Department is directed to implement a value-based purchasing program for inpatient hospital services. This program will reward hospitals that meet certain quality performance standards established by the Department. The Health Reform Law provides the Department considerable discretion over the value-based purchasing program. For example, the Department will have the authority to determine the quality performance measures, the standards hospitals must achieve in order to meet the quality performance measures, and the methodology for calculating payments to hospitals that meet the required quality threshold. The Department will also determine how much money each hospital will receive from the pool of dollars created by the reductions related to the value-based purchasing program as described above. Because the Health Reform Law provides that the pool will be fully distributed, hospitals that meet or exceed the quality performance standards set by the Department will receive greater reimbursement under the value-based purchasing program than they would have otherwise. On the other hand, hospitals that do not achieve the necessary quality performance will receive reduced Medicare inpatient hospital payments.
Second, beginning in federal fiscal year 2013, inpatient payments will be reduced if a hospital experiences “excessive readmissions” within a 30-day period of discharge for heart attack, heart failure, pneumonia or other conditions designated by the Department. Hospitals with what the Department defines as “excessive readmissions” for these conditions will receive reduced payments for all inpatient discharges, not just discharges relating to the conditions subject to the excessive readmission standard. Each hospital’s performance will be publicly reported by the Department. The Department has the discretion to determine what “excessive readmissions” means, the amount of the payment reduction and other terms and conditions of this program.
Third, reimbursement will be reduced based on a facility’s HAC rates. A HAC is a condition that is acquired by a patient while admitted as an inpatient in a hospital, such as a surgical site infection. Beginning in federal fiscal year 2015, hospitals that rank in the highest 25% nationally of HACs for all hospitals in the previous year will receive a 1% reduction in their total Medicare payments. In addition, effective July 1, 2011, the Health Reform Law prohibits the use of federal funds under the Medicaid program to reimburse providers for medical services provided to treat HACs.
Outpatient Market Basket and Productivity Adjustment. Hospital outpatient services paid under the prospective payment system are classified into APCs. The APC payment rates are updated each calendar year based on the market basket. The first two market basket changes outlined above — the general reduction and the productivity adjustment — apply to outpatient services as well as inpatient services, although these are applied on a calendar year basis. The percentage changes specified in the Health Reform Law summarized above as the general reduction for inpatients — e.g., 0.2% in 2015 — are the same for outpatients. CMS estimates that the combined market basket and productivity adjustments will reduce Medicare payments under the outpatient prospective payment system by $26.3 billion from 2010 to 2019.
Inpatient Rehabilitation Hospitals and Units. The first two market basket changes outlined above for inpatient services—the general reduction and the productivity adjustment—also apply to inpatient rehabilitation services. The percentage changes specified in the Health Reform Law summarized above as the general reduction for inpatients—e.g., 0.2% in 2015—are the same for rehabilitation inpatients. CMS estimates that the combined market basket and productivity adjustments will reduce Medicare payments under the inpatient rehabilitation facilities prospective payment system by $5.7 billion from 2010 to 2019. Further, beginning in federal fiscal year 2014, inpatient rehabilitation facilities will be required to report quality measures to the Department or will receive a two percentage point reduction to the market basket update.
Inpatient Psychiatric Facilities. The first two market basket changes outlined above for inpatient services—the general reduction and the productivity adjustment—also apply to inpatient psychiatric services. The percentage changes specified in the Health Reform Law summarized above as the general reduction for inpatients—e.g., 0.2% in 2015—are the same for psychiatric inpatients, although these are applied on a rate year basis. CMS estimates that the combined market basket and productivity adjustments will reduce Medicare payments under the inpatient psychiatric facilities prospective payment system by $4.3 billion from 2010 to 2019.

 

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Medicare and Medicaid Disproportionate Share Hospital Payments. The Medicare DSH program provides for additional payments to hospitals that treat a disproportionate share of low-income patients. Under the Health Reform Law, beginning in federal fiscal year 2014, Medicare DSH payments will be reduced to 25% of the amount they otherwise would have been absent the new law. The remaining 75% of the amount that would otherwise be paid under Medicare DSH will be effectively pooled, and this pool will be reduced further each year by a formula that reflects reductions in the national level of uninsured who are under 65 years of age. In other words, the greater the level of coverage for the uninsured nationally, the more the Medicare DSH payment pool will be reduced. Each hospital will then be paid, out of the reduced DSH payment pool, an amount allocated based upon its level of uncompensated care.
It is difficult to predict the full impact of the Medicare DSH reductions. The CBO estimates that the Health Reform Law will result in $22 billion in reductions to Medicare DSH payments between 2010 and 2019, but CMS estimates reimbursement reductions totaling $50 billion during that same time period. The Health Reform Law does not mandate what data source the Department must use to determine the reduction, if any, in the uninsured population nationally. In addition, the Health Reform Law does not contain a definition of “uncompensated care.” As a result, it is unclear how a hospital’s share of the Medicare DSH payment pool will be calculated. CMS could use the definition of “uncompensated care” used in connection with hospital cost reports.
However, in July 2009, CMS proposed material revisions to the definition of “uncompensated care” used for cost report purposes. Those revisions would exclude certain significant costs that had historically been covered, such as unreimbursed costs of Medicaid services. CMS has not issued a final rule, and the Health Reform Law does not require the Department to use this definition, even if finalized, for DSH purposes. How CMS ultimately defines “uncompensated care” for purposes of these DSH funding provisions could have a material effect on a hospital’s Medicare DSH reimbursements.
In addition to Medicare DSH funding, hospitals that provide care to a disproportionately high number of low-income patients may receive Medicaid DSH payments. The federal government distributes federal Medicaid DSH funds to each state based on a statutory formula. The states then distribute the DSH funding among qualifying hospitals. Although federal Medicaid law defines some level of hospitals that must receive Medicaid DSH funding, states have broad discretion to define additional hospitals that also may qualify for Medicaid DSH payments and the amount of such payments. The Health Reform Law will reduce funding for the Medicaid DSH hospital program in federal fiscal years 2014 through 2020 by the following amounts: 2014, $500 million; 2015, $600 million; 2016, $600 million; 2017, $1.8 billion; 2018, $5 billion; 2019, $5.6 billion; and 2020, $4 billion. How such cuts are allocated among the states, and how the states allocate these cuts among providers, have yet to be determined.
Accountable Care Organizations. The Health Reform Law requires the Department to establish a Medicare Shared Savings Program that promotes accountability and coordination of care through the creation of Accountable Care Organizations (“ACOs”). Beginning no later than January 1, 2012, the program will allow providers (including hospitals), physicians and other designated professionals and suppliers to form ACOs and voluntarily work together to invest in infrastructure and redesign delivery processes to achieve high quality and efficient delivery of services. The program is intended to produce savings as a result of improved quality and operational efficiency. ACOs that achieve quality performance standards established by the Department will be eligible to share in a portion of the amounts saved by the Medicare program. The Department has significant discretion to determine key elements of the program, including what steps providers must take to be considered an ACO, how to decide if Medicare program savings have occurred and what portion of such savings will be paid to ACOs. In addition, the Department will determine to what degree hospitals, physicians and other eligible participants will be able to form and operate an ACO without violating certain existing laws, including the federal Civil Monetary Penalty Law, the anti-kickback statute and the Stark Law. However, the Health Reform Law does not authorize the Department to waive other laws that may impact the ability of hospitals and other eligible participants to participate in ACOs, such as antitrust laws.

 

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Bundled Payment Pilot Programs. The Health Reform Law requires the Department to establish a five-year, voluntary national bundled payment pilot program for Medicare services beginning no later than January 1, 2013. Under the program, providers would agree to receive one payment for services provided to Medicare patients for certain medical conditions or episodes of care. The Department will have the discretion to determine how the program will function. For example, the Department will determine what medical conditions will be included in the program and the amount of the payment for each condition. In addition, the Health Reform Law provides for a five-year bundled payment pilot program for Medicaid services to begin January 1, 2012. The Department will select up to eight states to participate based on the potential to lower costs under the Medicaid program while improving care. State programs may target particular categories of beneficiaries, selected diagnoses or geographic regions of the state. The selected state programs will provide one payment for both hospital and physician services provided to Medicaid patients for certain episodes of inpatient care. For both pilot programs, the Department will determine the relationship between the programs and restrictions in certain existing laws, including the federal Civil Monetary Penalty Law, the anti-kickback statute, the Stark Law and the HIPAA privacy, security and transaction standard requirements. However, the Health Reform Law does not authorize the Department to waive other laws that may impact the ability of hospitals and other eligible participants to participate in the pilot programs, such as antitrust laws.
Ambulatory Surgery Centers. The Health Reform Law reduces reimbursement for ASCs through a productivity adjustment to the market basket similar to the productivity adjustment for inpatient and outpatient hospital services, beginning in federal fiscal year 2011.
Medicare Managed Care (Medicare Advantage or “MA”). Under the MA program, the federal government contracts with private health plans to provide inpatient and outpatient benefits to beneficiaries who enroll in such plans. Nationally, approximately 24% of Medicare beneficiaries have elected to enroll in MA plans. Effective in 2014, the Health Reform Law requires MA plans to keep annual administrative costs lower than 15% of annual premium revenue. The Health Reform Law reduces, over a three year period, premium payments to the MA Plans such that CMS’ managed care per capita premium payments are, on average, equal to traditional Medicare. As a result of these changes, the CBO and CMS, respectively, estimate that payments to MA plans will be reduced by $138 to $145 billion between 2010 and 2019. These reductions to MA plan premium payments may cause some plans to raise premiums or limit benefits, which in turn might cause some Medicare beneficiaries to terminate their MA coverage and enroll in traditional Medicare.
Physician-owned Hospitals. The Health Reform Law prohibits newly created physician-owned hospitals from billing for Medicare patients referred by their physician owners. As a result, the new law effectively prevents the formation of physician-owned hospitals after December 31, 2010. While the new law grandfathers existing physician-owned hospitals, including our facilities that have physician ownership, it does not allow these hospitals to increase the percentage of physician ownership and significantly restricts their ability to expand services.
Program Integrity and Fraud and Abuse
The Health Reform Law makes several significant changes to healthcare fraud and abuse laws, provides additional enforcement tools to the government, increases cooperation between agencies by establishing mechanisms for the sharing of information and enhances criminal and administrative penalties for non-compliance. For example, the Health Reform Law: (1) provides $350 million in increased federal funding over the next 10 years to fight healthcare fraud, waste and abuse; (2) expands the scope of the RAC program to include MA plans and Medicaid; (3) authorizes the Department, in consultation with the Office of Inspector General (“OIG”), to suspend Medicare and Medicaid payments to a provider of services or a supplier “pending an investigation of a credible allegation of fraud;” (4) provides Medicare contractors with additional flexibility to conduct random prepayment reviews; and (5) tightens up the requirements for returning overpayments made by governmental health programs and expands the federal False Claims Act liability to include failure to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later.
Impact of Health Reform Law on Our Company
The expansion of health insurance coverage under the Health Reform Law may result in a material increase in the number of patients using our facilities who have either private or public program coverage. In addition, a disproportionately large percentage of the new Medicaid coverage is likely to be in states that currently have relatively low income eligibility requirements. Further, the Health Reform Law provides for a value-based purchasing program, the establishment of ACOs and bundled payment pilot programs, which will create possible sources of additional revenue.

 

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However, it is difficult to predict the potential amount of additional revenue resulting from these elements of the Health Reform Law, because of uncertainty surrounding a number of material factors, including the following:
    how many previously uninsured individuals will obtain coverage as a result of the Health Reform Law (while the CBO estimates 32 million, CMS estimates almost 34 million; both agencies made a number of assumptions to derive that figure, including how many individuals will ignore substantial subsidies and decide to pay the penalty rather than obtain health insurance and what percentage of people in the future will meet the new Medicaid income eligibility requirements);
 
    what percentage of the newly insured patients will be covered under the Medicaid program and what percentage will be covered by private health insurers;
 
    the extent to which states will enroll new Medicaid participants in managed care programs;
 
    the pace at which insurance coverage expands, including the pace of different types of coverage expansion;
 
    the change, if any, in the volume of inpatient and outpatient hospital services that are sought by and provided to previously uninsured individuals;
 
    the rate paid to hospitals by private payors for newly covered individuals, including those covered through the newly created Exchanges and those who might be covered under the Medicaid program under contracts with the state;
 
    the rate paid by state governments under the Medicaid program for newly covered individuals;
 
    how the value-based purchasing and other quality programs will be implemented;
 
    the percentage of individuals in the Exchanges who select the high deductible plans, since health insurers offering those kinds of products have traditionally sought to pay lower rates to hospitals;
 
    the extent to which the net effect of the Health Reform Law, including the prohibition on excluding individuals based on pre-existing conditions, the requirement to keep medical costs lower than a specified percentage of premium revenue, other health insurance reforms and the annual fee applied to all health insurers, will put pressure on the profitability of health insurers, which in turn might cause them to seek to reduce payments to hospitals with respect to both newly insured individuals and their existing business; and
 
    the possibility that implementation of provisions expanding health insurance coverage will be delayed or even blocked due to court challenges or revised or eliminated as a result of court challenges and efforts to repeal or amend the new law.

 

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On the other hand, the Health Reform Law provides for significant reductions in the growth of Medicare spending, reductions in Medicare and Medicaid DSH payments and the establishment of programs where reimbursement is tied to quality and integration. Reductions in Medicare and Medicaid spending may significantly impact our business and could offset any positive effects of the Health Reform Law. It is difficult to predict the amount of potential revenue reductions resulting from reduced Medicare and Medicaid spending because of uncertainty regarding a number of material factors, including the following:
    the amount of overall revenues we will generate from Medicare and Medicaid business when the reductions are implemented;
 
    whether reductions required by the Health Reform Law will be changed by statute prior to becoming effective;
 
    the size of the Health Reform Law’s annual productivity adjustment to the market basket beginning in 2012 payment years;
 
    the amount of the Medicare DSH reductions that will be made, commencing in federal fiscal year 2014;
 
    the allocation to our hospitals of the Medicaid DSH reductions, commencing in federal fiscal year 2014;
 
    what the losses in revenues will be, if any, from the Health Reform Law’s quality initiatives;
 
    how successful ACOs will be at coordinating care and reducing costs;
 
    the scope and nature of potential changes to Medicare reimbursement methods, such as an emphasis on bundling payments or coordination of care programs;
 
    whether our revenues from private supplemental Medicaid reimbursement programs will be adversely affected, because there may be fewer indigent, non-Medicaid patients for whom we provide services pursuant to these programs; and
 
    reductions to Medicare payments CMS may impose for “excessive readmissions.
Because of the many variables involved, we are unable to predict the net effect of the expected increases in insured individuals using our facilities, the reductions in Medicare spending, including Medicare and Medicaid DSH funding, and numerous other provisions in the Health Reform Law that may affect our business. Further, it is unclear how federal lawsuits challenging the constitutionality of the Health Reform Law will be resolved or what the impact will be of any resulting changes to the law. For example, should the requirement that individuals maintain health insurance ultimately be deemed unconstitutional but the prohibition on health insurers excluding coverage due to pre-existing conditions be maintained, significant disruption to the health insurance industry could result, which could impact our revenues and operations.
Licensure, Certification and Accreditation
Healthcare facility construction and operation is subject to federal, state and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, rate-setting and compliance with building codes and environmental protection laws. Our facilities also are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation. We believe that all of our operating healthcare facilities are properly licensed under appropriate state healthcare laws, but we cannot assure you that government agencies or other entities enforcing licensure requirements would find our facilities in compliance with such requirements.
All of our operating hospitals are certified under the Medicare program and are accredited by either The Joint Commission or Det Norske Veritas (“DNV”), the effect of which is to permit the facilities to participate in the Medicare and Medicaid programs. If any facility loses its accreditation by either The Joint Commission or DNV, as applicable, the facility would be subject to state surveys, potentially be subject to increased scrutiny by CMS and likely lose payment from non-government payors. We intend to conduct our operations in compliance with current applicable federal, state, local and independent review body regulations and standards, but we cannot assure you that government agencies or other entities enforcing such requirements would find our facilities in compliance with such requirements. Licensure, certification, or accreditation requirements also may require notification or approval in the event of certain transfers or changes in ownership or organization. Requirements for licensure, certification and accreditation are subject to change and, in order to remain qualified, we may need to make changes in our facilities, equipment, personnel and services.

 

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Utilization Review
Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of diagnosis related group classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.
Federal and State Fraud and Abuse Provisions
Participation in any federal healthcare program, like Medicare, is regulated heavily by statute and regulation. If a hospital provider fails to substantially comply with the numerous conditions of participation in the Medicare or Medicaid program or performs specific prohibited acts, the hospital’s participation in the Medicare and Medicaid programs may be terminated or civil or criminal penalties may be imposed upon it under provisions of the Social Security Act and other statutes.
Among these statutes is a section of the Social Security Act known as the federal anti-kickback statute. This law prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent of generating referrals or orders for services or items covered by a federal healthcare program. Courts have interpreted this law broadly and held that there is a violation of the anti-kickback statute if just one purpose of the remuneration is to generate referrals, even if there are other lawful purposes. The Health Reform Law further provides that knowledge of the law or intent to violate the law is not required to establish a violation of the anti-kickback statute.
The OIG has published final safe harbor regulations that outline categories of activities that are deemed protected from prosecution under the anti-kickback statute. Currently there are safe harbors for various activities, including the following: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, ambulatory surgery centers, and referral agreements for specialty services.
The fact that conduct or a business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the anti-kickback statute. The conduct or business arrangement, however, does risk increased scrutiny by government enforcement authorities. We may be less willing than some of our competitors to take actions or enter into business arrangements that do not clearly satisfy the safe harbors. As a result, this unwillingness may put us at a competitive disadvantage.
The OIG, among other regulatory agencies, is responsible for identifying and eliminating fraud, abuse and waste. The OIG carries out this mission through a nationwide program of audits, investigations and inspections. In order to provide guidance to healthcare providers, the OIG has from time to time issued “fraud alerts” that, although they do not have the force of law, identify features of a transaction that may indicate that the transaction could violate the anti-kickback statute or other federal healthcare laws. The OIG has identified several incentive arrangements as potential violations, including:
    payment of any incentive by the hospital when a physician refers a patient to the hospital;
    use of free or significantly discounted office space or equipment for physicians in facilities usually located close to the hospital;
    provision of free or significantly discounted billing, nursing, or other staff services;

 

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    free training for a physician’s office staff, including management and laboratory techniques;
    guarantees that provide that, if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder;
    low-interest or interest-free loans, or loans that may be forgiven if a physician refers patients to the hospital;
    payment of the costs of a physician’s travel and expenses for conferences or a physician’s continuing education courses;
    coverage on the hospital’s group health insurance plans at an inappropriately low cost to the physician;
    rental of space in physician offices, at other than fair market value terms, by persons or entities to which physicians refer;
    payment for services that require few, if any, substantive duties by the physician, or payment for services in excess of the fair market value of the services rendered; or
    “gainsharing,” the practice of giving physicians a share of any reduction in a hospital’s costs for patient care attributable in part to the physician’s efforts.
In addition to issuing fraud alerts, the OIG from time to time issues compliance program guidance for certain types of healthcare providers. In January 2005, the OIG issued supplemental compliance program guidance for hospitals. In the supplemental compliance guidance, the OIG identifies areas of potential risk of liability under federal fraud and abuse statutes and regulations. These areas of risk include compensation arrangements with physicians, recruitment arrangements with physicians and joint venture relationships with physicians. The OIG recommends structuring arrangements to fit squarely within a safe harbor.
We have a variety of financial relationships with physicians who refer patients to our hospitals. As of October 1, 2010, physicians own interests in eight of our full service acute care hospitals. We also have other joint venture relationships with physicians and contracts with physicians providing for a variety of financial arrangements, including employment contracts, leases and professional service agreements. We provide financial incentives to recruit physicians to relocate to communities served by our hospitals, including minimum cash collections guarantees and forgiveness of repayment obligations. Although we have established policies and procedures to ensure that our arrangements with physicians comply with current law and available interpretations, we cannot assure you that regulatory authorities that enforce these laws will not determine that some of these arrangements violate the anti-kickback statute or other applicable laws. Violation of the anti-kickback statute is a felony, and such a determination could subject us to liabilities under the Social Security Act, including criminal penalties of imprisonment or fines, civil penalties up to $50,000, damages up to three times the total amount of the improper payment to the referral source and exclusion from participation in Medicare, Medicaid or other federal healthcare programs, any of which could have a material adverse effect on our business, financial condition or results of operations.
The Social Security Act also imposes criminal and civil penalties for submitting false claims to Medicare and Medicaid. False claims include, but are not limited to, billing for services not rendered, misrepresenting actual services rendered in order to obtain higher reimbursement and cost report fraud. Like the anti-kickback statute, these provisions are very broad. Further, the Social Security Act contains civil penalties for conduct including improper coding and billing for unnecessary goods and services. Pursuant to the Health Reform Law, civil penalties may be imposed for the failure to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later. To avoid liability, providers must, among other things, carefully and accurately code claims for reimbursement, as well as accurately prepare cost reports.

 

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Some of these provisions, including the federal Civil Monetary Penalty Law, require a lower burden of proof than other fraud and abuse laws, including the federal anti-kickback statute. Civil monetary penalties that may be imposed under the federal Civil Monetary Penalty Law range from $10,000 to $50,000 per act, and in some cases may result in penalties of up to three times the remuneration offered, paid, solicited or received. In addition, a violator may be subject to exclusion from federal and state healthcare programs. Federal and state governments increasingly use the federal Civil Monetary Penalty Law, especially where they believe they cannot meet the higher burden of proof requirements under the federal anti-kickback statute.
HIPAA broadened the scope of the fraud and abuse laws by adding several criminal provisions for healthcare fraud offenses that apply to all health benefit programs. This act also created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. In addition, federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers and managing employees associated with business entities that have committed healthcare fraud. Additionally, this act establishes a violation for the payment of inducements to Medicare or Medicaid beneficiaries in order to influence those beneficiaries to order or receive services from a particular provider or practitioner.
The Social Security Act also includes a provision commonly known as the “Stark Law.” This law prohibits physicians from referring Medicare and Medicaid patients to entities with which they or any of their immediate family members have a financial relationship for the provision of certain designated health services that are reimbursable by Medicare or Medicaid, including inpatient and outpatient hospital services. The law also prohibits the entity from billing the Medicare program for any items or services that stem from a prohibited referral. Sanctions for violating the Stark Law include civil monetary penalties up to $15,000 per item or service improperly billed and exclusion from the federal healthcare programs. There are a number of exceptions to the self-referral prohibition, including an exception for a physician’s ownership interest in an entire hospital, although the Health Reform Law significantly restricts this exception. There are also exceptions for many of the customary financial arrangements between physicians and providers, including employment contracts, leases, professional services agreements, non-cash gifts having a value less than $355 (effective for calendar year 2010) and recruitment agreements. Unlike safe harbors under the anti-kickback statute, with which compliance is voluntary, an arrangement must comply with every requirement of the appropriate Stark Law exception or the arrangement is in violation of the Stark Law. Further, intent does not have to be proven to establish a violation of the Stark Law.
Through a series of rulemakings, CMS has issued final regulations implementing the Stark Law. Additional changes to these regulations, which became effective October 1, 2009, further restrict the types of arrangements that hospitals and physicians may enter, including restrictions on certain leases, percentage compensation arrangements, and agreements under which a hospital purchases services under arrangements. While these regulations help clarify the requirements of the exceptions to the Stark Law, it is unclear how the government will interpret many of these exceptions for enforcement purposes. CMS has indicated that it is considering additional changes to the Stark Law regulations. We cannot assure you that the arrangements entered into by us and our hospitals will be found to be in compliance with the Stark Law, as it ultimately may be implemented or interpreted.
Historically the Stark Law has contained an exception, commonly referred to as the whole hospital exception, allowing physicians to own an interest in an entire hospital, as opposed to an interest in a hospital department. However, the Health Reform Law significantly narrows the Stark Law’s whole hospital exception. Specifically, the whole hospital exception will be available only to hospitals that have physician ownership in place as of March 23, 2010 and a Medicare provider agreement effective as of December 31, 2010. Thus, the Health Reform Law effectively prevents the formation of new physician-owned hospitals. On November 2, 2010, CMS issued a final rule implementing certain provisions of the amended whole hospital exception. While the amended whole hospital exception grandfathers certain existing physician-owned hospitals, including ours, it generally prohibits a grandfathered hospital from increasing its aggregate percentage of physician ownership beyond the aggregate level that was in place as of March 23, 2010. Further, subject to limited exceptions, a grandfathered physician-owned hospital may not increase its aggregate number of operating rooms, procedure rooms, and beds for which it is licensed beyond the number as of March 23, 2010.

 

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The whole hospital exception, as amended, also contains additional disclosure requirements. For example, a grandfathered physician-owned hospital is required to submit an annual report to the Department listing each investor in the hospital, including all physician owners. In addition, grandfathered physician-owned hospitals must have procedures in place that require each referring physician owner to disclose to patients, with enough notice for the patient to make a meaningful decision regarding receipt of care, the physician’s ownership interest and, if applicable, any ownership interest held by the treating physician. A grandfathered physician-owned hospital also must disclose on its web site and in any public advertising the fact that it has physician ownership. The Health Reform Law requires grandfathered physician-owned hospitals to comply with these new requirements by September 23, 2011 and requires the Department to audit hospitals’ compliance beginning no later than May 1, 2012.
In addition to the restrictions and disclosure requirements applicable to physician-owned hospitals set forth in the Health Reform Law, CMS regulations require physician-owned hospitals and their physician owners to disclose certain ownership information to patients. Physician-owned hospitals that receive referrals from physician owners must disclose in writing to patients that such hospitals are owned by physicians and that patients may receive a list of the hospitals’ physician investors upon request. Additionally, a physician-owned hospital must require all physician owners who are members of the hospital’s medical staff to agree, as a condition of continued medical staff membership or admitting privileges, to disclose in writing to all patients whom they refer to the hospital their (or an immediate family member’s) ownership interest in the hospital. A hospital is considered to be physician-owned if any physician, or an immediate family member of a physician, holds debt, stock or other types of investment in the hospital or in any owner of the hospital, excluding physician ownership through publicly traded securities that meet certain conditions. If a hospital fails to comply with these regulations, the hospital could lose its Medicare provider agreement and be unable to participate in Medicare.
Sanctions for violating the Stark Law include denial of payment, civil monetary penalties of up to $15,000 per claim submitted and exclusion from the federal healthcare programs. The statute also provides for a penalty of up to $100,000 for a scheme intended to circumvent the Stark Law prohibitions.
Evolving interpretations of current, or the adoption of new, federal or state laws or regulations could affect many of the arrangements entered into by each of our hospitals. In addition, law enforcement authorities, including the OIG, the courts and Congress are increasing scrutiny of arrangements between healthcare providers and potential referral sources to ensure that the arrangements are not designed as a mechanism to improperly pay for patient referrals and or other business. Investigators also have demonstrated a willingness to look behind the formalities of a business transaction to determine the underlying purpose of payments between healthcare providers and potential referral sources.
Many of the states in which we operate also have adopted laws that prohibit payments to physicians in exchange for referrals similar to the federal anti-kickback statute or that otherwise prohibit fraud and abuse activities. Many states also have passed self-referral legislation similar to the Stark Law, prohibiting the referral of patients to entities with which the physician has a financial relationship. Often these state laws are broad in scope and may apply regardless of the source of payment for care. These statutes typically provide criminal and civil penalties, as well as loss of licensure. Little precedent exists for the interpretation or enforcement of these state laws.
Our operations could be adversely affected by the failure of our arrangements to comply with the anti-kickback statute, the Stark Law, billing laws and regulations, current state laws or other legislation or regulations in these areas adopted in the future. We are unable to predict whether other legislation or regulations at the federal or state level in any of these areas will be adopted, what form such legislation or regulations may take or how they may affect our operations. We are continuing to enter into new financial arrangements with physicians and other providers in a manner structured to comply in all material respects with these laws. We cannot assure you, however, that governmental officials responsible for enforcing these laws or whistleblowers will not assert that we are in violation of them or that such statutes or regulations ultimately will be interpreted by the courts in a manner consistent with our interpretation.
The Federal False Claims Act and Similar State Laws
Another trend affecting the healthcare industry today is the increased use of the federal False Claims Act (“FCA”) and, in particular, actions being brought by individuals on the government’s behalf under the FCA’s “qui tam” or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. If the government intervenes in the action and prevails, the party filing the initial complaint may share in any settlement or judgment. If the government does not intervene in the action, the whistleblower plaintiff may pursue the action independently and may receive a larger share of any settlement or judgment. When a private party brings a qui tam action under the FCA, the defendant generally will not be made aware of the lawsuit until the government commences its own investigation or makes a determination whether it will intervene. Further, every entity that receives at least $5.0 million annually in Medicaid payments must have written policies for all employees, contractors or agents, providing detailed information about false claims, false statements and whistleblower protections under certain federal laws, including the FCA, and similar state laws.

 

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When a defendant is determined by a court of law to be liable under the FCA, the defendant must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 to $11,000 for each separate false claim. Settlements entered into prior to litigation usually involve a less severe calculation of damages. There are many potential bases for liability under the FCA. Liability often arises when an entity knowingly submits a false claim for reimbursement to the federal government. The FCA broadly defines the term “knowingly”. Although simple negligence will not give rise to liability under the FCA, submitting a claim with reckless disregard to its truth or falsity can constitute “knowingly” submitting a false claim and result in liability. In some cases, whistleblowers, the federal government and courts have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law, have thereby submitted false claims under the FCA. The Health Reform Law clarifies this issue with respect to the anti-kickback statute by providing that submission of a claim for an item or service generated in violation of the anti-kickback statute constitutes a false or fraudulent claim under the FCA. The Fraud Enforcement and Recovery Act of 2009 expanded the scope of the FCA by, among other things, creating liability for knowingly and improperly avoiding repayment of an overpayment received from the government and broadening protections for whistleblowers. Under the Health Reform Law, the FCA is implicated by the knowing failure to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later. Further, the FCA will cover payments involving federal funds in connection with the new health insurance exchanges to be created pursuant to the Health Reform Law.
A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. DEFRA creates an incentive for states to enact false claims laws that are comparable to the FCA. From time to time, companies in the healthcare industry, including ours, may be subject to actions under the FCA or similar state laws.
Corporate Practice of Medicine/Fee Splitting
Certain of the states in which we operate have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians or laws that prohibit certain direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements that may violate these restrictions. These statutes vary from state to state, are often vague and seldom have been interpreted by the courts or regulatory agencies. Although we exercise care to structure our arrangements with healthcare providers to comply with relevant state laws, we cannot assure you that governmental officials responsible for enforcing these laws will not assert that we, or transactions in which we are involved, are in violation of such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretations.
HIPAA Administrative Simplification and Privacy and Security Requirements
HIPAA requires the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce in the healthcare industry. The Department has established electronic data transmission standards that all healthcare providers must use when submitting or receiving certain healthcare transactions electronically. In addition, HIPAA requires that each provider use a National Provider Identifier. In January 2009, CMS published a final rule making changes to the formats used for certain electronic transactions and requiring the use of updated standard code sets for certain diagnoses and procedures known as ICD-10 code sets. Although use of the ICD-10 code sets is not mandatory until October 1, 2013, we will be modifying our payment systems and processes to prepare for their implementation. Use of the ICD-10 code sets will require significant changes; however, we believe that the cost of compliance with these regulations has not had and is not expected to have a material adverse effect on our business, financial position or results of operations. The Health Reform law requires the Department to adopt standards for additional electronic transactions and to establish operating rules to promote uniformity in the implementation of each standardized electronic transaction.

 

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As required by HIPAA, the Department has issued privacy and security regulations that extensively regulate the use and disclosure of individually identifiable health-related information and require healthcare providers to implement administrative, physical and technical practices to protect the security of individually identifiable health information that is electronically maintained or transmitted. ARRA broadens the scope of the HIPAA privacy and security regulations. In addition, ARRA extends the application of certain provisions of the security and privacy regulations to business associates (entities that handle identifiable health-related information on behalf of covered entities) and subjects business associates to civil and criminal penalties for violation of the regulations. On July 14, 2010, the Department issued a proposed rule that would implement these ARRA provisions. If finalized, these changes would likely require amendments to existing agreements with business associates and would subject business associates and their subcontractors to direct liability under the HIPAA privacy and security regulations. We have developed and utilize a HIPAA compliance plan as part of our effort to comply with HIPAA privacy and security requirements. The privacy regulations and security regulations have and will continue to impose significant costs on our facilities in order to comply with these standards.
As required by ARRA, the Department published an interim final rule on August 24, 2009, that requires covered entities to report breaches of unsecured protected health information to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by the covered entity or its agents. Notification must also be made to the Department and, in certain situations involving large breaches, to the media. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.
Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties, and ARRA has strengthened the enforcement provisions of HIPAA, which may result in increased enforcement activity. Under ARRA, the Department is required to conduct periodic compliance audits of covered entities and their business associates. ARRA broadens the applicability of the criminal penalty provisions to employees of covered entities and requires the Department to impose penalties for violations resulting from willful neglect. ARRA significantly increases the amount of the civil penalties, with penalties of up to $50,000 per violation for a maximum civil penalty of $1,500,000 in a calendar year for violations of the same requirement. Further, ARRA authorizes state attorneys general to bring civil actions seeking either injunction or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents. Our facilities also are subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary and could impose additional penalties.
There are numerous other laws and legislative and regulatory initiatives at the federal and state levels addressing privacy and security concerns. For example, in October 2007, the Federal Trade Commission issued a final rule requiring financial institutions and creditors, which arguably included hospitals and other healthcare providers, to implement written identity theft prevention programs to detect, prevent, and mitigate identity theft in connection with certain accounts. The enforcement date for this rule has been postponed until December 31, 2010. In addition, Congress recently has passed legislation that would restrict the definition of a “creditor” and may exempt many hospitals from complying with the rule.
The Emergency Medical Treatment and Active Labor Act
The Federal Emergency Medical Treatment and Active Labor Act (“EMTALA”) was adopted by Congress in response to reports of a widespread hospital emergency room practice of “patient dumping.” At the time of the enactment, patient dumping was considered to have occurred when a hospital capable of providing the needed care sent a patient to another facility or simply turned the patient away based on such patient’s inability to pay for his or her care. The law imposes requirements upon physicians, hospitals and other facilities that provide emergency medical services. Such requirements pertain to what care must be provided to anyone who comes to such facilities seeking care before they may be transferred to another facility or otherwise denied care. The government broadly interprets the law to cover situations in which patients do not actually present to a hospital’s emergency department, but

 

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present to a hospital-based clinic that treats emergency medical conditions on an urgent basis or are transported in a hospital-owned ambulance, subject to certain exceptions. At least one court has interpreted the law also to apply to a hospital that has been notified of a patient’s pending arrival in a non-hospital owned ambulance. Sanctions for violations of this statute include termination of a hospital’s Medicare provider agreement, exclusion of a physician from participation in Medicare and Medicaid programs and civil money penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law, and a medical facility that suffers a financial loss as a direct result of another participating hospital’s violation of the law, to sue the offending hospital for damages and equitable relief. We can give no assurance that governmental officials responsible for enforcing the law, individuals or other medical facilities will not assert from time to time that our facilities are in violation of this statute.
Conversion Legislation
Many states have enacted or are considering enacting laws affecting the conversion or sale of not-for-profit hospitals. These laws generally include provisions relating to attorney general approval, advance notification and community involvement. In addition, attorneys general in states without specific conversion legislation may exercise authority over these transactions based upon existing law. In many states, there has been an increased interest in the oversight of not-for-profit conversions. The adoption of conversion legislation and the increased review of not-for-profit hospital conversions may increase the cost and difficulty or prevent the completion of transactions with or acquisitions of not-for-profit organizations in various states.
Healthcare Industry Investigations
Significant media and public attention has focused in recent years on the hospital industry. Recently, increased attention has been paid by government investigators as well as private parties pursuing civil lawsuits to the amounts charged by hospitals to uninsured and indigent patients and the related collection practices of hospitals. Other current areas of interest include hospitals with high Medicare outlier payments and recruitment arrangements with physicians. Further, there are numerous ongoing federal and state investigations regarding multiple issues that have targeted hospital companies as well as their executives and managers. We have substantial Medicare, Medicaid and other governmental billings, which could result in heightened scrutiny of our operations. We continue to monitor these and all other aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices are consistent with both legal principles and current industry standards. However, because the law in this area is complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations that are inconsistent with industry practices, including ours. In public statements surrounding current investigations, governmental authorities have taken positions on a number of issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some instances, government investigations that have in the past been conducted under the civil provisions of federal law may now be conducted as criminal investigations. Additionally, the federal government has indicated that it plans to expand its use of civil monetary penalties and Medicare program exclusions to focus on those in the healthcare industry who accept kickbacks or present false claims, in addition to the federal government’s continuing efforts to focus on the companies that offer or pay kickbacks. Failure to comply with applicable laws and regulations could subject us to significant regulatory action, including fines, penalties and exclusion from the Medicare and Medicaid programs.
Many current healthcare investigations are national initiatives in which federal agencies target an entire segment of the healthcare industry. One example is the federal government’s initiative regarding hospital providers’ improper requests for separate payments for services rendered to a patient on an outpatient basis within three days prior to the patient’s admission to the hospital, where reimbursement for such services is included as part of the reimbursement for services furnished during an inpatient stay. In particular, the government has targeted all hospital providers to ensure conformity with this reimbursement rule. Further, the federal government continues to investigate Medicare overpayments to prospective payment hospitals that incorrectly report transfers of patients to other prospective payment system hospitals as discharges. We are aware that prior to our acquisition of them, several of our hospitals were contacted in relation to certain government investigations that were targeted at an entire segment of the healthcare industry. Although we take the position that, under the terms of the acquisition agreements, the prior owners of these hospitals retained any liability resulting from these government investigations, we cannot assure you that the prior owners’ resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, will not have a material adverse effect on our operations.

 

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The Health Reform Law allocates $350.0 million of additional federal funding over the next 10 years to fight healthcare fraud, waste and abuse, including $95.0 million for federal fiscal year 2011, $55.0 million for federal fiscal year 2012 and additional increased funding through 2016. In addition, government agencies and their agents, including Medicare Administrative Contractors, may conduct audits of our healthcare operations. Private payors may conduct similar audits, and we also perform internal audits and monitoring.
Certificates of Need
In some states, the construction of new facilities, acquisition of existing facilities or addition of new beds or services may be subject to review by state regulatory agencies under a certificate of need program. Florida and Nevada are the only states in which we currently operate that require approval of acute care hospitals under a certificate of need program. These laws generally require appropriate state agency determination of public need and approval prior to the addition of beds or services or other capital expenditures. Failure to obtain necessary state approval can result in the inability to expand facilities, add services and complete an acquisition or change ownership. Further, violation may result in the imposition of civil sanctions or the revocation of a facility’s license.
Environmental Matters
We are subject to various federal, state and local environmental laws and regulations, including those relating to the protection of human health and the environment. The principal environmental requirements applicable to our operations relate to:
    the proper handling and disposal of medical waste, hazardous waste and low-level radioactive medical waste;
    the proper use, storage and handling of mercury and other hazardous materials;
    underground and above-ground storage tanks;
    management of hydraulic fluid or oil associated with elevators, chiller units or other equipment;
    management of asbestos-containing materials or lead-based paint present or likely to be present at some locations; and
    air emission permits and standards for boilers or other equipment.
We do not expect our obligations under these or other applicable environmental laws and requirements to have a material effect on us. In the course of our operations, we may also identify other circumstances at our facilities, such as water intrusion or the presence of mold or fungus, which warrant action, and we can and do incur additional costs to address those circumstances. Under various environmental laws, we may also be required to clean up or contribute to the cost of cleaning up substances that have been released to the environment either at properties owned or operated by us or our predecessors or at properties to which substances from our operations were sent for off-site treatment or disposal. These remediation obligations may be imposed without regard to fault, and liability for environmental remediation can be substantial. While we cannot predict whether or to what extent we might be held responsible for such cleanup costs in the future, at present we have not identified any significant cleanup costs or liabilities that are expected to have a material effect on us.
Professional and General Liability Insurance
As is typical in the healthcare industry, we are subject to claims and legal actions by patients in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts that we believe to be sufficient for our operations, including our employed physicians, although some claims may exceed the scope of the coverage in effect. We also maintain umbrella coverage. Losses up to our self-insured retentions and any losses incurred in excess of amounts maintained under such insurance will be funded from working capital.

 

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For fiscal 2011, our self-insured retention for professional and general liability coverage remains unchanged at $5.0 million per claim, with an excess aggregate limit of $55.0 million, and maximum coverage under our insurance policies of $75.0 million. Our self-insurance reserves for estimated claims incurred but not yet reported is based upon estimates determined by third-party actuaries. Funding for the self-insured retention of such claims is derived from operating cash flows. We cannot assure you that this insurance will continue to be available at reasonable prices that will allow us to maintain adequate levels of coverage. We also cannot assure you that our cash flow will be adequate to provide for professional and general liability claims in the future.
Our Information Systems
We use a common information systems platform across all of our hospitals. We use McKesson’s clinical, patient accounting, laboratory, radiology and decision support software and Lawson’s financial application and enterprise resource planning software. We use other vendors for specialized information systems needs for our decision support, emergency and radiology departments.
Our information systems are essential to the following areas of our business operations, among others:
    patient accounting, including billing and collection of net revenue;
    financial, accounting, reporting and payroll;
    coding and compliance;
    laboratory, radiology and pharmacy systems;
    materials and asset management;
    negotiating, pricing and administering our managed care contracts; and
    monitoring of quality of care and collecting data on quality measures necessary for full Medicare payment updates.
Utilizing a common information systems platform across all our hospitals allows us to:
    enhance patient safety, automate medication administration and increase staff time available for direct patient care;
    optimize staffing levels according to patient volumes, acuity and seasonal needs at each facility;
    perform product line analyses;
    continue to meet or exceed quality of care indicators on a current basis;
    effectively monitor registration, billing, collections, managed care contract compliance and all other aspects of our revenue cycle;
    control supply costs by complying with our group purchasing organization contract; and
    effectively monitor financial results.
The cost of maintaining our information systems has increased significantly in recent years. Information systems maintenance expense increased $1.0 million to $9.0 million for the fiscal year ended September 30, 2010, as compared to the prior year. We expect the trend of increased maintenance costs in this area to continue in the future.

 

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ARRA included approximately $26.0 billion in funding for various healthcare information technology (“IT”) initiatives, including incentives for hospitals and physicians to implement EHR - compatible systems. Implementation of these IT initiatives has been divided into three stages, with stage 1 requiring satisfaction in the 2012 year. Stage 1 requires providers and physicians to meet “meaningful use” standards which include electronically capturing health information in structured format, tracking key clinical conditions for coordination of care purposes, implementing clinical decision support tools to facilitate disease and medication management, using EHRs to engage patients and families, and reporting clinical quality measures and public health information. We have currently spent a total of $16.6 million towards meeting the meaningful use standards. Though additional investments in hardware and software will be required, we believe our historical capital investments in advanced clinicals and other information systems, as well as quality of care programs, provides a solid platform to build upon for timely compliance with the healthcare IT requirements of ARRA.
Employees and Medical Staff
As of September 30, 2010, we had 12,041 employees, including 3,431 part-time employees. We consider our employee relations to be good. We recruit and retain nurses and medical support personnel by creating a desirable, professional work environment, providing competitive wages, benefits and long-term incentives, and providing career development and other training programs. In order to supplement our current employee base, we have expanded our relationship with local colleges and universities, including our sponsorship of nursing scholarship programs, in our markets.
Our hospitals are staffed by licensed physicians who have been admitted to the medical staff of our individual hospitals. Any licensed physician may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by each hospital’s medical staff and the appropriate governing board of the hospital in accordance with established credentialing criteria. In an effort to meet community needs in certain markets in which we operate, we have implemented a strategy of employing physicians, with an emphasis on those practicing within certain specialties. While we believe this strategy is consistent with industry trends, we cannot be assured of the long-term success of such a strategy, which includes related integration of physician practice management.
Compliance Program
Our compliance program is designed to ensure that we maintain high standards of conduct in the operation of our business and implement policies and procedures so that employees act in compliance with all applicable laws, regulations and company policies. The organizational structure of our compliance program includes a compliance committee of our board of directors, a corporate management compliance committee and local management compliance committees at each of our hospitals. These committees have the oversight responsibility for the effective development and implementation of our program. Our Vice President of Ethics and Business Practices, who reports directly to our Chief Executive Officer and to the compliance committee of our board of directors, serves as Chief Compliance Officer and is charged with direct responsibility for the development and implementation of our compliance program. Other features of our compliance program include the designation of a Regional Compliance Officer for each of our hospitals, periodic ethics and compliance training and effectiveness reviews, the development and implementation of policies and procedures, including a mechanism for employees to report, without fear of retaliation, any suspected legal or ethical violations.
Item 1A. Risk Factors.
Risks Related to Our Business
If We Are Unable To Retain And Negotiate Reasonable Contracts With Managed Care Plans, Our Net Revenue May Be Reduced.
Our ability to obtain reasonable contracts with health maintenance organizations, preferred provider organizations and other managed care plans significantly affects the revenue and operating results of our hospitals. Revenue derived from health maintenance organizations, preferred provider organizations and other managed care plans accounted for 40.2%, 43.0% and 46.0% of our hospitals’ net patient revenue for the years ended September 30, 2010, 2009 and 2008, respectively. Our hospitals have over 300 managed care contracts with no one commercial payor representing more than 10.0% of our net patient revenue. In most cases, we negotiate our managed care contracts annually as they come up for renewal at various times during the year. Further, many of these contracts are terminable by either party on relatively short notice. Our future success will depend, in part, on our ability to retain and renew our

 

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managed care contracts and enter into new managed care contracts on terms favorable to us. Other healthcare providers, including some with integrated health systems, provider networks, greater geographic coverage or a wider range of services, may impact our ability to enter into managed care contracts or negotiate increases in our reimbursement and other favorable terms and conditions. For example, some of our competitors may negotiate exclusivity provisions with managed care plans or otherwise restrict the ability of managed care companies to contract with us. In one region in which we operate, the largest healthcare provider organization controls one of the largest payor organizations and operates it primarily as a closed network. The patients enrolled in this integrated health system are largely unavailable to us. In addition, consolidation among managed care companies may reduce our ability to negotiate favorable contracts with such payors. It is not clear what impact, if any, the increased obligations on managed care and other payors imposed by the Health Reform Law will have on our ability to negotiate reimbursement increases. If we are unable to retain and negotiate favorable contracts with managed care plans or experience reductions in payment increases or amounts received from nongovernmental payors, our revenues may be reduced.
We Are Unable to Predict The Impact Of The Health Reform Law, Which Represents Significant Change To The Healthcare Industry.
The Health Reform Law represents significant change across the healthcare industry. As enacted, the Health Reform Law will decrease the number of uninsured individuals by expanding coverage to additional individuals through a combination of public program expansion and private sector health insurance reforms. The Health Reform Law expands eligibility under existing Medicaid programs and subsidizes states that create non-Medicaid plans for certain residents that do not qualify for Medicaid. Further, the Health Reform Law requires states to establish health insurance exchanges to facilitate the purchase of health insurance by individuals and small businesses. It also imposes financial penalties on individuals who fail to carry insurance coverage and certain employers that do not provide health insurance coverage. However, a federal district court recently ruled that the requirement for individuals to carry health insurance is unconstitutional. This ruling is subject to appeal. The Health Reform Law also establishes a number of health insurance market reforms, including a ban on lifetime limits and pre-existing condition exclusions, new benefit mandates, and increased dependent coverage. Although the expansion of health insurance coverage should increase revenues from providing care to certain previously uninsured individuals, many of these provisions of the Health Reform Law will not become effective until 2014 or later.
The Health Reform Law could adversely affect our business and results of operations due to provisions of the Health Reform Law that are intended to reduce Medicare and Medicaid healthcare costs. Among other things, the Health Reform Law will reduce market basket updates, reduce Medicare and Medicaid DSH funding, and expand efforts to tie payments to quality and integration. Any decrease in payment rates or an increase in rates that is below our increase in costs may adversely affect our results of operations. The Health Reform Law also provides additional resources to combat fraud, waste, and abuse, including expansion of the RAC program, which may result in increased costs for us to appeal or refund any alleged overpayments.
The Health Reform Law contains additional provisions intended to promote value-based purchasing. Effective July 1, 2011, the Health Reform Law will prohibit the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat any HACs. Further, effective in federal fiscal year 2013, hospitals with excessive readmissions for conditions designated by the Department will receive reduced payments for all inpatient discharges, not just discharges relating to the conditions subject to the excessive readmission standard. Beginning in federal fiscal year 2015, hospitals that fall into the highest 25% of national risk-adjusted HAC rates for all hospitals in the previous year will receive a 1% reduction in their total Medicare payments. The Health Reform Law also requires the Department to implement a value-based purchasing system for hospitals that will provide incentive payments to hospitals that meet or exceed certain quality performance standards and that will be funded through decreases in the inpatient prospective payment system market basket updates to all hospitals beginning in federal fiscal year 2013.
As enacted, the Health Reform Law will change how healthcare services are covered, delivered, and reimbursed. Because of the many variables involved, we are unable to predict the net effect on our operations of the expected increases in insured individuals using our facilities, the reductions in government healthcare spending, and numerous other provisions in the Health Reform Law that may affect us. Furthermore, we are unable to predict how providers, payors, and other market participants will respond to the various reform provisions, many of which will not be implemented for several years. There may be legislative efforts to delay implementation of, repeal or amend the Health Reform Law. In addition, implementation of these provisions could be delayed or even blocked due to court challenges. It is unclear how federal lawsuits challenging the constitutionality of the Health Reform Law will be resolved or what the impact will be of any resulting changes to the law. For example, should the requirement that individuals maintain health insurance ultimately be deemed unconstitutional but the prohibition on health insurers excluding coverage due to pre-existing conditions be maintained, significant disruption to the health insurance industry could result, which could impact our revenues and operations.

 

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Changes In Governmental Healthcare Programs May Reduce Our Revenues.
Governmental healthcare programs, principally Medicare and Medicaid, including managed Medicare and managed Medicaid, accounted for 47.6%, 45.9% and 44.9% of our hospitals’ net patient revenue for the years ended September 30, 2010, 2009 and 2008, respectively. However, in recent years legislative and regulatory changes have limited, and in some cases reduced, the levels of payments that our hospitals receive for various services under the Medicare, Medicaid and other federal healthcare programs. For example, CMS has completed its transition to the MS-DRG system, which represents a refinement to the pre-existing diagnosis-related group system. Future changes to the MS-DRG system could impact the margins we receive for certain services. Further, the Health Reform Law provides for material reductions in the growth of Medicare program spending, including reductions in Medicare market basket updates and Medicare DSH funding. Medicare payments in federal fiscal year 2011 for inpatient hospital services are expected to be slightly lower than payments for the same services in federal fiscal year 2010 because of reductions resulting from the Health Reform Law and the MS-DRG implementation.
In some cases, commercial third-party payors and other payors, such as some state Medicaid programs, rely on all or portions of the Medicare MS-DRG system to determine payment rates, and therefore, adjustments that negatively impact Medicare payments may also negatively impact payments from Medicaid programs or commercial third-party payors and other payors.
In addition, from time to time, state legislatures consider measures to reform healthcare programs and coverage within their respective states. Because of economic conditions and other factors, a number of states are experiencing budget problems and have adopted or are considering legislation designed to reduce their Medicaid expenditures, including enrolling Medicaid recipients in managed care programs and imposing additional taxes on hospitals to help finance or expand states’ Medicaid systems. The states in which we operate have decreased funding for healthcare programs or made other structural changes resulting in a reduction in Medicaid hospital rates in recent years. Additional Medicaid spending cuts may be implemented in the future in the states in which we operate, including reductions in supplemental Medicaid reimbursement programs. Our Texas hospitals participate in private supplemental Medicaid reimbursement programs that are structured to expand the community safety net by providing indigent healthcare services and result in additional revenues for participating hospitals. We cannot predict whether the Texas private supplemental Medicaid reimbursement programs will continue or guarantee that revenues recognized from the programs will not decrease. The Health Reform Law provides for significant expansion of the Medicaid program, but these changes are not required until 2014.
We believe that hospital operating margins across the country, including ours, have been and may continue to be under pressure because of limited pricing flexibility and growth in operating expenses in excess of the increase in payments under the Medicare and other governmental programs. Current or future healthcare reform efforts, additional changes in laws or regulations regarding government health programs, or other changes in the administration of government health programs could have a material, adverse effect on our financial position and results of operations.
Our Hospitals Face Competition For Patients From Other Hospitals And Healthcare Providers That Could Impact Patient Volume.
In general, the hospital industry is highly competitive. Our hospitals face competition for patients from other hospitals in our markets, large vertically integrated providers, large tertiary care centers and outpatient service providers that provide similar services to those provided by our hospitals. All of our facilities are located in geographic areas in which at least one other hospital provides services comparable to those offered by our hospitals. Some of the hospitals that compete with ours are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. In addition, the number of freestanding specialty hospitals, outpatient surgery centers and outpatient diagnostic centers has increased significantly in the areas in which we operate. Some of our competitors also have greater geographic coverage, offer a wider range of services or invest more capital or other resources than we do. If our competitors are able to achieve greater geographic coverage, improve access and convenience to physicians and patients, recruit physicians to provide competing services at their facilities, expand or improve their services or obtain more favorable managed care contracts, we may experience a decline in patient volume.

 

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CMS publicizes performance data relating to quality measures that hospitals submit in connection with their Medicare reimbursement. Further, the Health Reform Law requires all hospitals annually to establish, update and make public a list of their standard charges for items and services. If any of our hospitals should achieve poor results (or results that are lower than our competitors) on these quality criteria, or if our standard charges are higher than those published by our competitors, our patient volumes could decline. In the future, other trends toward clinical transparency and value-based purchasing of healthcare services may have an adverse impact on our competitive position and patient volume.
If We Continue To Experience A Shift in Payor Mix From Commercial And Managed Care Payors To Medicaid and Managed Medicaid, Our Revenue and Results Of Operations Could Be Adversely Affected.
We have experienced a shift in our patient volumes and revenue from commercial and managed care payors to Medicaid and managed Medicaid. This has resulted in margin pressures from expending the same amount of resources for patient care, but for less reimbursement. This shift is reflective of continued high unemployment and the resulting increases in states’ Medicaid rolls. The decline in managed care volume and revenue is not only indicative of the depressed labor market, but also utilization behavior of the insured population resulting from higher deductible and co-insurance plans from employers which, in turn, has resulted in delays or deferral of elective and non-emergent procedures. Given the high rate of unemployment and its impact on the economy, particularly in the markets we serve, we expect the increase in our Medicaid and managed Medicaid payor mixes to continue until the U.S. economy experiences an economic recovery that includes job growth and declining unemployment.
If We Experience Further Growth In Volume And Revenue Related To Uncompensated Care, Our Financial Condition Or Results Of Operations Could Be Adversely Affected.
Like others in the hospital industry, we have experienced increased levels of uncompensated care, including charity care and our provision for bad debts. Our provision for bad debts and charity care as a percentage of acute care revenue has increased in recent years due to a growth in self-pay volume and revenue resulting in large part from an increase in the number of uninsured patients, along with an increase in the amount of co-payments and deductibles passed on by employers to employees. In addition, as a result of the recent economic downturn and high levels of unemployment, we believe that our hospitals may continue to experience growth in bad debts and charity care. While the Health Reform Law seeks to decrease over time the number of uninsured individuals through expanding Medicaid and incentivizing employers to offer, and requiring individuals to carry, health insurance or be subject to penalties, these provisions, as enacted, generally will not become effective until January 1, 2014. It is difficult to predict the full impact of the Health Reform Law due to the law’s complexity, lack of implementing regulations or interpretive guidance, gradual and potentially delayed implementation, pending court challenges and possible amendment, as well as our inability to foresee how individuals and businesses will respond to the choices afforded them under the law. We may continue to provide charity care to those who choose not to comply with the insurance requirements and undocumented aliens who are not permitted to enroll in a health insurance exchange or government healthcare programs. Further, a federal district court recently ruled that the requirement for individuals to carry health insurance is unconstitutional. The ruling is subject to appeal. Although we continue to seek ways of improving point of service collection efforts and implementing appropriate payment plans with our patients, if we continue to experience further growth in self-pay volume and revenue, our results of operations could be adversely affected. Further, our ability to improve collections from self-pay patients may be limited by regulatory and investigatory initiatives, including private lawsuits directed at hospital charges and collection practices for uninsured and underinsured patients.
If We Are Unable To Attract And Retain Quality Medical Staffs, Our Financial Condition Or Results Of Operations Could Be Adversely Affected.
The success of our hospitals depends on the following factors, among others:
    the number and quality of the physicians on the medical staffs of our hospitals;
    the admitting practices of those physicians; and
    our maintenance of good relations with those physicians.

 

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Our efforts to attract and retain physicians are affected by our managed care contracting relationships, national shortages in some specialties, such as anesthesiology and radiology, the adequacy of our support personnel, the condition of our facilities and medical equipment, the availability of suitable medical office space and federal and state laws and regulations prohibiting financial relationships that may have the effect of inducing patient referrals.
In an effort to meet community needs in certain markets in which we operate, we have implemented a strategy to employ physicians, which has created an expansion of our employed physician base. The execution of a physician employment strategy includes increased salary costs, potential malpractice insurance coverage costs, risks of unsuccessful physician integration and difficulties associated with physician practice management. While we believe this strategy is consistent with industry trends, we cannot be assured of the long-term success of such a strategy.
Our Hospitals Face Competition For Staffing, Which May Increase Our Labor Costs And Reduce Profitability.
We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In the past, the limited supply of nurses and other medical support personnel presented a significant operating issue. In part, due to the current economic downturn, we have seen an improvement in the availability of nursing personnel and other skilled labor. If such a shortage were to occur again, it may require us to enhance wages and benefits to recruit and retain nurses and other medical support personnel and contract with more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. Because a significant percentage of our revenue consists of fixed, prospective payments, our ability to pass along increased labor costs to third-party payors is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs could have a material adverse effect on our financial condition or results of operations.
If We Fail To Continually Enhance Our Hospitals With The Most Recent Technological Advances In Diagnostic And Surgical Equipment, Our Ability To Maintain And Expand Our Markets May Be Adversely Affected.
Technological advances with respect to computed axial tomography (“CT”), magnetic resonance imaging (“MRI”) and positron emission tomography (“PET”) equipment, as well as other equipment used in our facilities, are continually evolving. In an effort to compete with other healthcare providers, we must constantly be evaluating our equipment needs and upgrading equipment as a result of technological improvements. Such equipment costs typically range from $1.0 million to $3.0 million, exclusive of construction or build-out costs. If we fail to remain current with the technological advancements of the medical community, our volumes and revenue may be negatively impacted.
If We Fail To Comply With Extensive Laws And Government Regulations, We Could Suffer Penalties, Be Required To Alter Arrangements With Investors In Our Hospitals Or Be Required To Make Significant Changes To Our Operations.
The healthcare industry, including our company, is required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things:
    billing and coding for services and proper handling of overpayments;
    relationships with physicians and other referral sources;
    adequacy of medical care;
    quality of medical equipment and services;
    qualifications of medical and support personnel;

 

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    confidentiality, maintenance, data breach, identity theft and security issues associated with individually identifiable information and medical records;
    the screening, stabilization and transfer of patients who have emergency medical conditions;
    licensure and certification;
    hospital rate or budget review;
    preparing and filing of cost reports;
    activities regarding competitors;
    operating policies and procedures;
    addition of facilities and services;
    provider-based reimbursement, including complying with requirements allowing multiple locations of a hospital to be billed under the hospital’s Medicare provider number; and
    disclosures to patients, including disclosure of any physician ownership in a hospital.
Because many of these laws and regulations are relatively new, we do not always have the benefit of significant regulatory or judicial interpretation of these laws and regulations. For that reason and because these laws and regulations are so complex, hospital companies face a risk of inadvertent violations. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses.
If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including:
    criminal penalties;
    civil penalties, including the loss of our licenses to operate one or more of our facilities; and
    exclusion of one or more of our facilities from participation in the Medicare, Medicaid and other federal and state healthcare programs.
The Health Reform Law Imposes Significant New Restrictions On Hospitals That Have Physician Owners, Including Our Hospitals That Have Physician Owners.
Some of our hospitals have physician ownership pursuant to an exception to the Stark Law known as the “whole hospital exception.” However, the Health Reform Law significantly narrows the Stark Law’s whole hospital exception to apply only to hospitals that have physician ownership in place as of March 23, 2010 and a Medicare provider agreement effective as of December 31, 2010. On November 2, 2010, CMS issued a final rule implementing certain provisions of the amended whole hospital exception. While the amended whole hospital exception grandfathers certain existing physician-owned hospitals, including ours, it generally prohibits a grandfathered hospital from increasing its percentage of physician ownership beyond the aggregate level that was in place as of March 23, 2010. Further, subject to limited exceptions, a grandfathered physician-owned hospital may not increase its aggregate number of operating rooms, procedure rooms, and beds for which it is licensed beyond the number as of March 23, 2010.

 

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The whole hospital exception, as amended, also contains additional disclosure requirements. For example, a grandfathered physician-owned hospital is required to submit an annual report to the Department listing each investor in the hospital, including all physician owners. In addition, grandfathered physician-owned hospitals must have procedures in place that require each referring physician owner to disclose to patients, with enough notice for the patient to make a meaningful decision regarding receipt of care, the physician’s ownership interest and, if applicable, any ownership interest held by the treating physician. A grandfathered physician-owned hospital also must disclose on its web site and in any public advertising the fact that it has physician ownership. The Health Reform Law requires grandfathered physician-owned hospitals to comply with these new requirements by September 23, 2011 and requires the Department to audit hospitals’ compliance beginning no later than May 1, 2012.
In light of the recently enacted restrictions on the whole hospital exception and limited interpretive guidance, it may be difficult for us to determine how the exception will apply to specific situations that may arise with our hospitals. If any of our hospitals fail to comply with the amended whole hospital exception, those hospitals could be found to be in violation of the Stark Law, and we could incur significant financial or other penalties.
Providers In The Healthcare Industry Have Been The Subject Of Federal And State Investigations, And We May Become Subject To Additional Investigations In The Future That Could Result In Significant Liabilities Or Penalties To Us.
Both federal and state government agencies have increased their focus on and coordination of civil and criminal enforcement efforts in the healthcare area. As a result, there are numerous ongoing investigations of hospital companies, as well as their executives and managers. The OIG and the Department of Justice have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Further, under the FCA, private parties have the right to bring “qui tam” whistleblower lawsuits against companies that submit false claims for payments to, or improperly retain overpayments from, the government. Some states have adopted similar state whistleblower and false claims provisions.
Federal and state investigations relate to a wide variety of routine healthcare operations including:
    cost reporting and billing practices;
    financial arrangements with referral sources;
    physician recruitment activities;
    physician joint ventures; and
    hospital charges and collection practices for self-pay patients.
We engage in many of these and other activities which could be the subject of governmental investigations or inquiries from time to time. For example, we have significant Medicare and Medicaid billings, we have numerous financial arrangements with physicians who are referral sources to our hospitals and we have eight hospitals as of October 1, 2010 that have physician investors. In addition, our executives and managers, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, may be included in governmental investigations or named as defendants in private litigation. Any additional investigations of us, our executives or our managers could result in significant liabilities or penalties to us, as well as adverse publicity.
In addition, governmental agencies and their agents, such as the Medicare Administrative Contractors, fiscal intermediaries and carriers, as well as the OIG, CMS and state Medicaid programs, conduct audits of our healthcare operations. Private payors may conduct similar audits, and we also perform internal audits and monitoring. Depending on the nature of the conduct found in such audits and whether the underlying conduct could be considered systemic, the resolution of these audits could have a material, adverse effect on our financial position, results of operations and liquidity.

 

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CMS is in the process of implementing a nationwide RAC program as required by the Tax Relief and Health Care Act of 2006. Under the RAC program, CMS engages private contractors to conduct post-payment reviews to detect and correct improper payments in the Medicare program, and the contractors receive a contingency fee based on the amount of corrected, improper payments. The Health Reform Law expands the RAC program’s scope to include other Medicare programs, including managed Medicare, by December 31, 2010.
In addition, through DEFRA, Congress has expanded the federal government’s involvement in fighting fraud, waste and abuse in the Medicaid program by creating the Medicaid Integrity Program. Under this program, CMS engages private contractors, referred to as MICs, to perform post-payment audits of Medicaid claims and identify overpayments. In addition, the Health Reform Law expands the RAC program’s scope to include Medicaid claims by requiring all states to establish programs to contract with RACs by December 31, 2010. In addition to MICs and RACs, several other contractors and state Medicaid agencies have increased their review activities.
Any such audit or investigation could have a material adverse effect on the results of our operations.
We May Incur Material Fees, Costs And Expenses In Connection With An Appeal Of The Court Order Dismissing With Prejudice the Qui Tam Action And Investigation of IAS.
On March 31, 2008, the United States District Court for the District of Arizona (the “District Court”) dismissed with prejudice the qui tam complaint against IAS, our parent company. The qui tam action sought monetary damages and civil penalties under the FCA and included allegations that certain business practices related to physician relationships and the medical necessity of certain procedures resulted in the submission of claims for reimbursement in violation of the FCA. The case dates back to March 2005 and became the subject of a subpoena by the OIG in September 2005. In August 2007, the case was unsealed and the U.S. Department of Justice declined to intervene. The District Court dismissed the case from the bench at the conclusion of oral arguments on IAS’ motion to dismiss. On April 21, 2008, the District Court issued a written order dismissing the case with prejudice and entering formal judgment for IAS and denying as moot IAS’ motions related to the relator’s misappropriation of information subject to a claim of attorney-client privilege by IAS. Both parties appealed. On August 12, 2010, United States Court of Appeals for the Ninth Circuit reversed the District Court’s dismissal of the qui tam complaint and the District Court’s denial of IAS’ motions concerning relator’s misappropriation of documents and ordered that the qui tam relator be allowed leave to file a Third Amended Complaint and for the District Court to consider IAS’ motions concerning relator’s misappropriation of documents. The District Court ordered the qui tam relator to file his Third Amended Complaint by November 22, 2010, and set a schedule for the filing of motions related to the relator’s misappropriation of documents. On October 20, 2010, the qui tam relator filed a motion to transfer this action to the United States District Court for the Eastern District of Texas. That motion remains pending. On November 22, 2010, the relator filed his Third Amended Complaint. IAS anticipates filing a motion to dismiss the Third Amended Complaint and motions concerning the relator’s misappropriation of documents. If the qui tam action was to be resolved in a manner unfavorable to us, it could have a material adverse effect on our business, financial condition and results of operations, including exclusion from the Medicare and Medicaid programs. In addition, we may incur material fees, costs and expenses in connection with defending the qui tam action.
Compliance With Section 404 Of The Sarbanes-Oxley Act May Negatively Impact Our Results Of Operations And Failure To Comply May Subject The Company To Regulatory Scrutiny And A Loss Of Investors’ Confidence In Our Internal Control Over Financial Reporting.
We are required to perform an annual evaluation of our internal control over financial reporting and file management’s attestation with our annual report to comply with Section 404 of the Sarbanes-Oxley Act of 2002.
Compliance with all requirements and interpretive guidance associated with Section 404 of the Sarbanes-Oxley Act of 2002, and any changes in our internal control over financial reporting in response to our internal evaluations, may be expensive and time-consuming and may negatively impact our results of operations. In addition, we cannot assure you that we will be able to meet the annual required deadlines for compliance with Section 404. Any failure on our part to meet the required compliance deadlines may subject us to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting.

 

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A Failure Of Our Information Systems Would Adversely Affect Our Ability To Properly Manage Our Operations.
We rely on our advanced information systems and our ability to successfully use these systems in our operations. These systems are essential to the following areas of our business operations, among others:
    patient accounting, including billing and collection of net revenue;
    financial, accounting, reporting and payroll;
    coding and compliance;
    laboratory, radiology and pharmacy systems;
    materials and asset management;
    negotiating, pricing and administering managed care contracts; and
    monitoring quality of care and collecting data on quality measures necessary for full Medicare payment updates.
If we are unable to use these systems effectively, we may experience delays in collection of net revenue and may not be able to properly manage our operations or oversee the compliance with laws or regulations.
If We Fail to Effectively and Timely Implement Electronic Health Record Systems, Our Operations Could Be Adversely Affected.
If we fail to effectively and timely implement EHR systems, our operations could be adversely affected. As required by ARRA, the Department is in the process of developing and implementing an incentive payment program for eligible hospitals and healthcare professionals that adopt and meaningfully use certified EHR technology. If our hospitals and employed professionals are unable to meet the requirements for participation in the incentive payment program, we will not be eligible to receive incentive payments that could offset some of the costs of implementing EHR systems. Further, beginning in 2015, eligible hospitals and professionals that fail to demonstrate meaningful use of certified EHR technology will be subject to reduced payments from Medicare. Failure to implement EHR systems effectively and in a timely manner could have a material adverse effect on our financial position and results of operations.
Regional Economic Downturns Or Other Material Changes In The Economic Condition Could Cause Our Overall Business Results To Suffer.
The U.S. economy is experiencing the effects of a severe economic downturn. Depressed consumer spending and high unemployment rates continue to pressure many industries. During economic downturns, governmental entities often experience budgetary constraints as a result of increased costs and lower than expected tax collections. These budgetary constraints have resulted in decreased spending for health and human service programs, including Medicare, Medicaid and similar programs, which represent significant payor sources for our hospitals. Many states, including states in which we operate, have decreased funding for state healthcare programs or made other structural changes resulting in a reduction in Medicaid spending. Additional Medicaid spending cuts may be implemented in the future in the states in which we operate. Other risks we face from general economic weakness include patient decisions to postpone or cancel elective and non-emergent healthcare procedures, increases in the uninsured population and further difficulties in our collection of patient co-payment and deductible receivables.

 

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Of our 15 acute care hospital facilities at September 30, 2010, four are located in Salt Lake City, three are located in Phoenix, three are located in Tampa-St. Petersburg, three are located in the state of Texas, one is located in Las Vegas and one is located in West Monroe, Louisiana. In addition, our health plan, Health Choice, and our behavioral health hospital facility are located in Phoenix. For the year ended September 30, 2010, our net revenue was generated as follows:
         
Health Choice
    31.4 %
Salt Lake City, Utah
    18.4 %
Phoenix, Arizona (excluding Health Choice)
    14.3 %
Three cities in Texas, including San Antonio
    18.4 %
Tampa-St. Petersburg, Florida
    8.3 %
Other
    9.2 %
Any material change in the current demographic, economic, competitive or regulatory conditions in any of these regions could adversely affect our overall business results because of the significance of our operations in each of these regions to our overall operating performance. Moreover, our business is not as diversified as some competing multi-facility healthcare companies and, therefore, is subject to greater market risks.
We May Be Subject To Liabilities Because Of Claims Brought Against Our Facilities.
Plaintiffs frequently bring actions against hospitals and other healthcare providers, alleging malpractice, product liability or other legal theories. Many of these actions involve large claims and significant defense costs. For example, certain other hospital companies have been subject to class-action claims in connection with their billing practices relating to uninsured patients.
We maintain professional malpractice liability insurance and general liability insurance in amounts we believe are sufficient to cover claims arising out of the operations of our facilities. Some of the claims could exceed the scope of the coverage in effect or coverage of particular claims or damages could be denied.
The volatility of professional liability insurance and, in some cases, the lack of availability of such insurance coverage, for physicians with privileges at our hospitals increases our risk of vicarious liability in cases where both our hospital and the uninsured or underinsured physician are named as co-defendants. As a result, we are subject to greater self-insured risk and may be required to fund claims out of our operating cash flow to a greater extent than during 2010. We cannot assure you that we will be able to continue to obtain insurance coverage in the future or that such insurance coverage, if it is available, will be available on acceptable terms.
Our fiscal 2011 self-insured retention for professional and general liability coverage remains unchanged at $5.0 million per claim, with an excess aggregate limit of $55.0 million, and maximum coverage under our insurance policies of $75.0 million.
If Health Choice’s Contract With AHCCCS Was Discontinued, Our Net Revenue And Profitability Would Be Adversely Affected.
Effective October 1, 2008, Health Choice began its current contract with AHCCCS, which provides for a three-year term, with AHCCCS having the option to renew for two additional one-year periods. The contract is terminable without cause on 90 days’ written notice or for cause upon written notice if we fail to comply with any term or condition of the contract or fail to take corrective action as required to comply with the terms of the contract. Additionally, AHCCCS can terminate our contract in the event of the unavailability of state or federal funding. If our contract with AHCCCS is terminated, our financial condition, cash flows and results of operations would be adversely affected.

 

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If We Are Unable To Control Healthcare Costs At Health Choice, Our Profitability May Be Adversely Affected.
Health Choice derives its premium revenue through a contract with AHCCCS, which is the state agency that administers Arizona’s Medicaid program, and a contract with CMS for the MAPD SNP. For the years ended September 30, 2010, 2009 and 2008, we derived 29.4%, 27.8% and 24.2%, respectively, of our consolidated net revenue from our contract with AHCCCS. AHCCCS and CMS set the capitated rates we receive at Health Choice which, in turn, subcontracts with physicians, hospitals and other healthcare providers to provide services to its enrollees. If we fail to effectively manage healthcare costs, these costs may exceed the payments we receive. Historically, our medical claims expense as a percentage of premium revenue has fluctuated. Our medical loss ratio for the years ended September 30, 2010, 2009 and 2008, was 87.2%, 86.1% and 85.2%, respectively. Relatively small changes in these medical loss ratios can create significant changes in the profitability of Health Choice. Many factors can cause actual healthcare costs to exceed the capitated rates set by AHCCCS and CMS, including:
    our ability to contract with cost-effective healthcare providers;
    the increased cost of individual healthcare services;
    the type and number of individual healthcare services delivered; and
    the occurrence of catastrophes, epidemics or other unforeseen occurrences.
Although we have been able to manage medical claims expense through a variety of initiatives, we may not be able to continue to effectively manage medical claims expense in the future. Additionally, any future growth in members increases the risk associated with effectively managing health claims expense. If our medical claims expense increases, our financial condition or results of operations may be adversely affected.
If AHCCCS Significantly Alters The Payment Structure Of Its Contracts Or The Amount Of Premiums Paid To Us, Our Net Revenue And Profitability May Be Adversely Affected.
In response to state budgetary issues in Arizona, AHCCCS has taken steps to control its costs, including cuts in capitation premiums and the implementation of a risk-based or severity-adjusted payment methodology for all health plans. Capitation rates for each health plan and geographic service area are adjusted annually based on the severity of treatment episodes experienced by each plan’s membership compared to the average over a specified 12 month period. Adjustments are calculated using diagnosis codes and procedural information from medical and pharmacy claims data, in addition to member demographic information. Capitation rates are risk adjusted prospectively before the start of each contract year, and are not adjusted retroactively. If AHCCCS continues to reduce capitation premium rates or makes further alterations to the payment structure of its contracts, our results of operations and cash flows may be adversely affected.
Significant Competition From Other Healthcare Companies And State Efforts To Regulate The Sale Of Not-For-Profit Hospitals May Affect Our Ability To Acquire Hospitals.
One element of our business strategy is to expand through selective acquisitions of hospitals in our existing markets and in new growing markets. We compete for acquisitions with other healthcare companies, some of which have greater competitive advantages or financial resources than us. Therefore, we may not be able to acquire hospitals on terms favorable to us or at all. Additionally, many states, including some where we have hospitals and others where we may in the future acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the not-for-profit seller. These review and approval processes can add time to the closing of an acquisition of a not-for-profit hospital and future actions on the state level could seriously delay or even prevent our ability to acquire not-for-profit hospitals in the future.
Difficulties With The Integration Of Acquisitions May Disrupt Our Ongoing Operations.
The process of integrating acquired hospitals may require a disproportionate amount of management’s time and attention, potentially distracting management from its other day-to-day responsibilities. In addition, poor integration of acquired facilities could cause interruptions to our business activities, including those of the acquired facilities. As a result, we may not realize all or any of the anticipated benefits of an acquisition and we may incur significant costs related to the acquisitions or integration of these facilities. In addition, we may acquire hospitals that have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations. Although we seek indemnification from prospective sellers covering these matters, we may nevertheless have material liabilities for past activities of acquired hospitals.

 

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We Are Dependent On Key Personnel And The Loss Of One Or More Of Our Senior Management Team Or Local Management Personnel Could Have A Material Adverse Effect On Our Business.
Our business strongly depends upon the services and management experience of our senior management team. We depend on the ability of our senior management team and key employees to manage growth successfully and on our ability to attract and retain skilled employees. If any of our executive officers resign or otherwise are unable to serve, our management expertise and ability to deliver healthcare services efficiently and to effectively execute our business strategy could be diminished. If we fail to attract and retain managers at our hospitals and related facilities, our operations could be adversely effected. Moreover, we do not maintain key man life insurance policies on any of our officers.
Our Hospitals Are Subject To Potential Responsibilities And Costs Under Environmental Laws That Could Lead To Material Expenditures Or Liability.
We are subject to various federal, state and local environmental laws and regulations, including those relating to the protection of human health and the environment. We could incur substantial costs to maintain compliance with these laws and regulations. We could become the subject of future investigations, which could lead to fines or criminal penalties if we are found to be in violation of these laws and regulations. We also may be subject to requirements related to the remediation of substances that have been released into the environment at properties owned or operated by us or our predecessors or at properties where substances were sent for off-site treatment or disposal. These remediation requirements may be imposed without regard to fault, and liability for environmental remediation can be substantial.
To our knowledge, we have not been and are not currently the subject of any investigations relating to noncompliance with environmental laws and regulations. We maintain insurance coverage for third-party liability related to the storage tanks located at our facilities in the amount $2.0 million per claim and $25.0 million in the aggregate.
If The Fair Value Of Our Reporting Units Declines, A Material Non-Cash Charge To Earnings From Impairment Of Our Goodwill May Result.
At September 30, 2010, we had $718.2 million of goodwill recorded in our consolidated financial statements. We expect to recover the carrying value of this goodwill through our future cash flows.
On an ongoing basis, we evaluate, based on the fair value of our reporting units, whether the carrying value of our goodwill is impaired. If the carrying value of our goodwill is impaired, we may incur a material non-cash charge to earnings.
As a result of our annual impairment test during the year ended September 30, 2009, we recorded a $64.6 million non-cash charge to pre-tax earnings related to the impairment of goodwill in our Florida market. This impairment was due, in part, to limitations on our ability to expand in our Florida market as a result of CON restrictions, as well as with high Medicare utilization and expanded managed care penetration. In addition, we had experienced changes in market conditions and the business mix in our Florida market, which negatively impacted operating results, producing trends that may not be temporary in nature. As a result, we wrote off all goodwill associated with our Florida market.
Risks Related to Our Capital Structure
Servicing Our Indebtedness Requires A Significant Amount of Cash. Our Ability To Generate Sufficient Cash Depends On Numerous Factors Beyond Our Control, And We May Be Unable To Generate Sufficient Cash Flow To Service Our Debt Obligations, Including Making Payments On Our 8 3/4% Notes And Term Loans.
We have outstanding $475.0 million in aggregate principal amount of 8 3/4% senior subordinated notes due 2014, that have been registered under the Securities Act of 1933, as amended, (the “8 3/4% notes”). We have also entered into our senior secured credit facilities, which includes amounts outstanding under our senior secured term loan and our senior secured delayed draw term loan of $423.6 million and $146.7 million, respectively, both maturing on March 15, 2014. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowing will be available to us under our senior secured credit facilities in an amount sufficient to enable us to pay the principal, if any, and interest on our indebtedness, including the 8 3/4% notes and term loans, or to fund our other liquidity needs. Our ability to fund these payments is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We may need to refinance all or a portion of our indebtedness, including the 8 3/4% notes and term loans, on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness, on commercially reasonable terms or at all. In addition, the terms of existing or future debt agreements, including the amended and restated credit agreement governing the senior secured credit facilities and the indenture governing the 8 3/4% notes, may restrict us from affecting any of these alternatives.

 

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The senior secured credit facilities also include a senior secured revolving credit facility of $225.0 million, with a $100.0 million sub-limit for letters of credit that matures on April 27, 2013. Our ability to borrow funds under our revolving credit facility is subject to the financial viability of the participating financial institutions. On February 9, 2010, Barclays Capital assumed a $20.0 million position in our senior secured revolving credit facility, which represents 8.9% of the total capacity. This position was previously held by Lehman Brothers, which we had identified as a defaulting lender. At completion of this assumption, we had access to 100% of our total revolver capacity. If any of our creditors were to suffer financial difficulties, or if the credit markets were to deteriorate as they did towards the end of calendar 2008, our ability to access available funds under our revolving credit facility could be limited.
During the next twelve months, along with interest on our senior secured credit facilities, we are required to repay $5.9 million in principal under our senior secured credit facilities and $41.6 million in interest under the 8 3/4% notes. If we cannot make scheduled payments on our debt, we will be in default and, as a result:
    our debt holders could declare all outstanding principal and interest to be due and payable;
    our secured debt lenders could terminate their commitments and commence foreclosure proceedings against our assets; and
    we could be forced into bankruptcy or liquidation.
Our Substantial Level Of Indebtedness Could Adversely Affect Our Financial Condition And Prevent Us From Fulfilling Our Obligations Under The 8 3/4% Notes And Senior Secured Credit Facilities.
We have a significant amount of indebtedness at September 30, 2010, including $475.0 million of outstanding 8 3/4% notes and $576.6 million of other indebtedness (of which $570.3 million consisted of borrowings under our senior secured credit facilities and $6.3 million consisted of capital lease obligations and other debt). All of our other indebtedness ranks senior to the 8 3/4% notes. In addition, subject to restrictions in the indenture governing the 8 3/4% notes and the amended and restated credit agreement governing the senior secured credit facilities, we may incur additional indebtedness.
Our substantial indebtedness could have important consequences to our financial condition and results of operations, including the following:
    it may be more difficult for us to satisfy our obligations, including debt service requirements under our outstanding debt;
    our ability to obtain additional financing for working capital, acquisitions, capital expenditures, debt service requirements, or other general corporate purposes may be impaired;
    we must use a substantial portion of our cash flow to pay principal and interest on our 8 3/4% notes, senior secured credit facilities, and other indebtedness which will reduce the funds available to us for other purposes;
    we are more vulnerable to economic downturns and adverse industry conditions;
    our ability to capitalize on business opportunities and to react to competitive pressures as compared to our competitors may be compromised due to our high level of indebtedness; and
    our ability to borrow additional funds or to refinance indebtedness may be limited.

 

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Our senior secured credit facilities are rated by Moody’s and Standard & Poor’s. If these ratings were ever downgraded, our access to and cost of future capital could be adversely affected. In addition, our ability to borrow additional funds may be reduced and the risks related to our substantial indebtedness would intensify.
An Increase In Interest Rates Would Increase The Cost Of Servicing Our Debt And Could Reduce Our Profitability.
Borrowings under our senior secured credit facilities bear interest at variable rates. As of September 30, 2010, we had outstanding variable rate debt of $570.3 million. We have managed our market exposure to changes in interest rates by converting $425.0 million of this variable rate debt to fixed rate debt through the use of interest rate swap agreements, effectively leaving $145.3 million in debt subject to variable rates. As a result, an increase in interest rates, whether because of an increase in market interest rates or an increase in our own cost of borrowing, would increase the cost of servicing our debt and could materially reduce our profitability. For more discussion on the effect of changes in interest rates, see “Item 7A. — Quantitative and Qualitative Disclosures About Market Risk.”
We Are Controlled By Our Principal Equity Sponsors.
We are controlled by our principal equity sponsors who have the ability to control our financial-related policies and decisions. For example, our principal equity sponsors could cause us to enter into transactions that, in their judgment, could enhance their equity investment, even though such transactions might reduce our cash flows or capital reserves. So long as our principal equity sponsors continue to own a significant amount of our equity interests, they will continue to be able to strongly influence and effectively control the decisions related to our company. Additionally, our principal equity sponsors may from time to time acquire and hold interests in businesses that compete directly or indirectly with us and, therefore, have interests that may conflict with the interests of our company.
Item 2. Properties.
Information with respect to our hospitals and other healthcare related properties can be found in Item 1 of this report under the caption, “Business—Our Properties.”
Additionally, our principal executive offices in Franklin, Tennessee are located in approximately 58,000 square feet of office space. Our office space is leased pursuant to two contracts which both expire on December 31, 2010. We have entered into a new contract to lease approximately 42,000 square feet of office space at the same location, effective January 1, 2011, which expires on December 31, 2020. Our principal executive offices, hospitals and other facilities are suitable for their respective uses and generally are adequate for our present needs.

 

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Item 3. Legal Proceedings.
On March 31, 2008, the District Court dismissed with prejudice the qui tam complaint against IAS, our parent company. The qui tam action sought monetary damages and civil penalties under the FCA and included allegations that certain business practices related to physician relationships and the medical necessity of certain procedures resulted in the submission of claims for reimbursement in violation of the FCA. The case dates back to March 2005 and became the subject of a subpoena by the OIG in September 2005. In August 2007, the case was unsealed and the U.S. Department of Justice declined to intervene. The District Court dismissed the case from the bench at the conclusion of oral arguments on IAS’ motion to dismiss. On April 21, 2008, the District Court issued a written order dismissing the case with prejudice and entering formal judgment for IAS and denying as moot IAS’ motions related to the relator’s misappropriation of information subject to a claim of attorney-client privilege by IAS. Both parties appealed. On August 12, 2010, United States Court of Appeals for the Ninth Circuit reversed the District Court’s dismissal of the qui tam complaint and the District Court’s denial of IAS’ motions concerning relator’s misappropriation of documents and ordered that the qui tam relator be allowed leave to file a Third Amended Complaint and for the District Court to consider IAS’ motions concerning relator’s misappropriation of documents. The District Court ordered the qui tam relator to file his Third Amended Complaint by November 22, 2010, and set a schedule for the filing of motions related to the relator’s misappropriation of documents. On October 20, 2010, the qui tam relator filed a motion to transfer this action to the United States District Court for the Eastern District of Texas. That motion remains pending. On November 22, 2010, the relator filed his Third Amended Complaint. IAS anticipates filing a motion to dismiss the Third Amended Complaint and motions concerning the relator’s misappropriation of documents.
Item 4. (Removed and Reserved).

 

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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
There is no established public trading market for our common interests. At September 30, 2010, all of our common interests were owned by IASIS Healthcare Corporation, a Delaware corporation, referred to as IAS.
See Item 12., “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” included elsewhere in this report for information regarding our equity compensation plans.
Item 6. Selected Financial Data.
The following table presents selected historical financial data for the fiscal years ended September 30, 2010, 2009, 2008, 2007 and 2006, and was derived from the audited consolidated financial statements.
Our audited consolidated financial statements referenced above, together with the related report of the independent registered public accounting firm, are included elsewhere in this report. The selected financial information and other data presented below should be read in conjunction with the information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the related notes thereto included elsewhere in this report.
                                         
    Year Ended     Year Ended     Year Ended     Year Ended     Year Ended  
    September 30,     September 30,     September 30,     September 30,     September 30,  
    2010     2009     2008     2007     2006  
Statement of Operations Data (1):
                                       
Net revenue
  $ 2,521,406     $ 2,361,972     $ 2,065,536     $ 1,766,079     $ 1,539,577  
Costs and expenses:
                                       
Salaries and benefits (2)
    686,303       660,921       632,109       533,792       439,349  
Supplies
    266,545       250,573       231,259       194,915       167,616  
Medical claims
    678,651       592,760       452,055       376,505       347,217  
Other operating expenses
    363,916       325,735       283,123       266,263       223,946  
Provision for bad debts
    197,680       192,563       161,936       136,233       134,614  
Rentals and leases
    39,955       39,127       36,633       31,546       30,277  
Interest expense, net
    66,810       67,890       75,665       71,206       67,124  
Depreciation and amortization
    96,106       97,462       96,741       75,388       69,137  
Management fees
    5,000       5,000       5,000       4,746       4,189  
Impairment of goodwill (3)
          64,639                    
Hurricane-related property damage (4)
          938       3,589              
Business interruption insurance recoveries (5)
                      (3,443 )     (8,974 )
Loss on extinguishment of debt (6)
                      6,229        
 
                             
Total costs and expenses
    2,400,966       2,297,608       1,978,110       1,693,380       1,474,495  
 
                             
Earnings from continuing operations before gain (loss) on disposal of assets and income taxes
    120,440       64,364       87,426       72,699       65,082  
 
                                       
Gain (loss) on disposal of assets, net
    108       1,465       (75 )     (1,359 )     913  
 
                                       
Earnings from continuing operations before income taxes
    120,548       65,829       87,351       71,340       65,995  
Income tax expense
    44,715       27,576       35,325       25,909       22,515  
 
                             
 
                                       
Net earnings from continuing operations
    75,833       38,253       52,026       45,431       43,480  
Earnings (loss) from discontinued operations, net of income taxes
    (1,087 )     (176 )     (11,275 )     669       (385 )
 
                             
 
                                       
Net earnings
    74,746       38,077       40,751       46,100       43,095  
Net earnings attributable to non-controlling interests
    (8,279 )     (9,987 )     (4,437 )     (4,496 )     (3,546 )
 
                             
 
                                       
Net earnings attributable to IASIS Healthcare LLC
  $ 66,467     $ 28,090     $ 36,314     $ 41,604     $ 39,549  
 
                             
 
                                       
Balance Sheet Data (at end of period):
                                       
Cash and cash equivalents
  $ 144,511     $ 206,528     $ 80,738     $     $ 95,415  
Total assets
  $ 2,353,194     $ 2,357,204     $ 2,308,147     $ 2,186,422     $ 1,967,835  
Long-term debt and capital lease obligations (including current portion)
  $ 1,051,578     $ 1,059,837     $ 1,114,622     $ 1,031,657     $ 896,945  
Member’s equity
  $ 702,135     $ 750,932     $ 714,507     $ 674,732     $ 639,714  

 

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(1)  
The results of Glenwood and Alliance are included from January 31, 2007 and May 31, 2007, respectively, their dates of acquisition. Excludes Mesa General Hospital and Biltmore Surgery Center, where operations were discontinued effective May 31, 2008 and April 30, 2008, respectively.
 
(2)  
Results for the year ended September 30, 2010, include $2.0 million in stock compensation expense related to the repurchase of certain equity by our parent company.
 
(3)  
Results for the year ended September 30, 2009, include a $64.6 million non-cash charge ($43.2 million after taxes) related to the impairment of goodwill in our Florida market.
 
(4)  
Results for the years ended September 30, 2009 and 2008, include an adverse financial impact totaling $938,000 and $3.6 million, respectively, before income taxes related to property damage sustained at The Medical Center of Southeast Texas, as a result of Hurricane Ike.
 
(5)  
Results for the years ended September 30, 2007 and 2006, include $3.4 million and $9.0 million, respectively, of business interruption insurance recoveries received in connection with the temporary closure and disruption of operations at The Medical Center of Southeast Texas, as a result of Hurricane Rita. Cumulative business interruption insurance recoveries of $12.4 million received through fiscal 2007 includes the impact of related insurance deductibles of $4.6 million.
 
(6)  
Results for the year ended September 30, 2007, include a $6.2 million loss on extinguishment of debt related to the refinancing of our senior secured credit facilities.
Selected Operating Data
The following table sets forth certain unaudited operating data for each of the periods presented.
                         
    Year Ended September 30,  
    2010     2009     2008  
Acute Care (1)
                       
Number of acute care hospital facilities at end of period (2)
    15       15       15  
Licensed beds at end of period
    3,185       3,162       3,027  
Average length of stay (days) (3)
    4.8       4.7       4.7  
Occupancy rates (average beds in service)
    46.6 %     46.5 %     48.9 %
Admissions (4)
    101,798       101,083       101,302  
Adjusted admissions (5)
    170,812       169,721       165,819  
Patient days (6)
    489,274       473,601       471,853  
Adjusted patient days (5)
    790,958       762,234       741,466  
Net patient revenue per adjusted admission
  $ 10,066     $ 9,703     $ 9,101  
Outpatient revenue as a % of gross patient revenue
    39.6 %     39.0 %     36.9 %
 
                       
Health Choice:
                       
Medicaid covered lives
    194,095       187,104       142,193  
Dual-eligible lives (7)
    4,298       3,659       3,300  
Medical loss ratio (8)
    87.2 %     86.1 %     85.2 %
 
     
(1)  
Excludes Mesa General Hospital and Biltmore Surgery Center, where operations were discontinued effective May 31, 2008 and April 30, 2008, respectively.
 
(2)  
Excludes St. Luke’s Behavioral Hospital.
 
(3)  
Represents the average number of days that a patient stayed in our hospitals.
 
(4)  
Represents the total number of patients admitted to our hospitals for stays in excess of 23 hours. Management and investors use this number as a general measure of inpatient volume.
 
(5)  
Adjusted admissions and adjusted patient days are general measures of combined inpatient and outpatient volume. We compute adjusted admissions/patient days by multiplying admissions/patient days by gross patient revenue and then dividing that number by gross inpatient revenue.
 
(6)  
Represents the number of days our beds were occupied by inpatients over the period.
 
(7)  
Represents members eligible for Medicare and Medicaid benefits under Health Choice’s contract with CMS to provide coverage as a MAPD SNP.
 
(8)  
Represents medical claims expense as a percentage of premium revenue, including claims paid to our hospitals.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis of financial condition and results of operations should be read in conjunction with our audited consolidated financial statements, the notes to our audited consolidated financial statements, and the other financial information appearing elsewhere in this report. We intend for this discussion to provide you with information that will assist you in understanding our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes. It includes the following sections:
   
Forward Looking Statements;
 
   
Executive Overview;
 
   
Critical Accounting Policies and Estimates;
 
   
Results of Operations Summary;
 
   
Liquidity and Capital Resources; and
 
   
Recent Accounting Pronouncements.
Data for the fiscal years ended September 30, 2010, 2009 and 2008, has been derived from our audited consolidated financial statements. References herein to “we,” “us,” “our” and “our company” are to IASIS Healthcare LLC and its subsidiaries, unless indicated otherwise.
FORWARD LOOKING STATEMENTS
Some of the statements we make in this annual report on Form 10-K are forward-looking within the meaning of the federal securities laws, which are intended to be covered by the safe harbors created thereby. Those forward-looking statements include all statements that are not historical statements of fact and those regarding our intent, belief or expectations including, but not limited to, the discussions of our operating and growth strategy (including possible acquisitions and dispositions), financing needs, projections of revenue, income or loss, capital expenditures and future operations. Forward-looking statements involve known and unknown risks and uncertainties that may cause actual results in future periods to differ materially from those anticipated in the forward-looking statements.
Those risks and uncertainties include, among others, the risks and uncertainties discussed under Item 1A, “Risk Factors” in this Annual Report on Form 10-K. Although we believe that the assumptions underlying the forward-looking statements contained in this report are reasonable, any of these assumptions could prove to be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included in this report, you should not regard the inclusion of such information as a representation by us or any other person that our objectives and plans will be achieved. We undertake no obligation to publicly release any revisions to any forward-looking statements contained herein to reflect events and circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

 

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EXECUTIVE OVERVIEW
We are a leading owner and operator of medium-sized acute care hospitals in high-growth urban and suburban markets. We operate our hospitals with a strong community focus by offering and developing healthcare services targeted to the needs of the markets we serve, promoting strong relationships with physicians and working with local managed care plans. At September 30, 2010, we owned or leased 15 acute care hospital facilities and one behavioral health hospital facility, with a total of 3,185 licensed beds, located in six regions:
   
Salt Lake City, Utah;
 
   
Phoenix, Arizona;
 
   
Tampa-St. Petersburg, Florida;
 
   
three cities in Texas, including San Antonio;
 
   
Las Vegas, Nevada; and
 
   
West Monroe, Louisiana.
We also own and operate Health Choice, a Medicaid and Medicare managed health plan in Phoenix.
Acquisition
Effective October 1, 2010, we purchased Brim in a cash-for-stock transaction valued at $95.0 million, subject to changes in working capital. The acquisition of Brim included the operations of Wadley Regional Medical Center, a 370 licensed bed acute care hospital facility located in Texarkana, Texas and Pikes Peak Regional Hospital, a 15 licensed bed critical access acute care hospital facility, in Woodland Park, Colorado.
Revenue and Volume Trends
Net revenue is comprised of acute care and premium revenue. Net revenue for the year ended September 30, 2010, increased 6.8% to $2.5 billion, compared to $2.4 billion in the prior year. Acute care revenue contributed $66.9 million to the increase in total net revenue for the year ended September 30, 2010, while premium revenue contributed $92.6 million.
Acute Care Revenue
Our acute care revenue was $1.7 billion for the year ended September 30, 2010, reflecting an increase of 4.0%, compared to the prior year. Admissions and adjusted admissions increased 0.7% and 0.6%, respectively, for the year ended September 30, 2010, compared to the prior year. Our volume growth has been negatively impacted, in part, by an overall decline in obstetric related services, resulting from the impact of the current economic environment, and the closures of our neonatal intensive care unit on October 1, 2009, and our obstetrics service line on January 1, 2010, both at our North Las Vegas hospital. Excluding these service line closures, admissions and adjusted admissions increased 2.0% and 1.8%, respectively, for the year ended September 30, 2010, compared to the prior year. These volume improvements have been driven primarily by growth in general medicine and psychiatric services.
While we have experienced growth in our inpatient service lines, we believe that outpatient volumes continue to be negatively impacted, in part, by the effect of the economic climate in our markets, including the impact of high unemployment and patient decisions to defer or cancel elective procedures, general primary care and other non-emergent healthcare procedures until their conditions become more acute. The deferral of non-emergent procedures has also been facilitated by an increase in the number of high deductible employer sponsored health plans, which ultimately shift more of the medical cost responsibility onto the patient. As a result, these factors have contributed to declines in both emergency room visits and outpatient surgeries.
We believe our volumes and revenue over the long-term will continue to grow as a result of our business strategies, including the strategic deployment of capital, the expansion of our physician base and outpatient service lines and the general aging of the population.

 

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The following table provides the sources of our gross patient revenue by payor:
                         
    Year Ended September 30,  
    2010     2009     2008  
Medicare
    31.0 %     31.1 %     31.9 %
Managed Medicare
    12.3       11.5       10.9  
Medicaid
    8.5       8.4       7.2  
Managed Medicaid
    12.5       11.2       10.6  
Managed care
    30.7       32.8       34.7  
Self-pay
    5.0       5.0       4.7  
 
                 
Total
    100.0 %     100.0 %     100.0 %
 
                 
Consistent with industry trends, we are currently experiencing a shift in our patient volumes and revenue from commercial and managed care payors to Medicaid and managed Medicaid. Given the high rate of unemployment and its impact on the economy, particularly in the markets we serve, we expect the elevated levels in our Medicaid and managed Medicaid payor mixes to continue until the U.S. economy experiences an economic recovery that includes job growth and declining unemployment. Additionally, the decline in outpatient related volumes, the majority of which are typically comprised of commercial and managed care patients, has contributed to the decline in our managed care revenue mix.
Net patient revenue per adjusted admission increased 3.8% for the year ended September 30, 2010, compared to the prior year. Our net patient revenue per adjusted admission has benefitted, in part, from an overall decline in obstetric related services, which was particularly impacted by the service line closures at our North Las Vegas hospital, continued increases in managed care rates, growth in physician practice revenue as we continue to invest in our physician employment strategy and additional supplemental Medicaid reimbursement associated with our Texas market. Revenue recognized under the Texas private supplemental Medicaid reimbursement programs for the year ended September 30, 2010, was $83.1 million, compared to $57.2 million in the prior year. While our net patient revenue per adjusted admission continues to increase, the impact of high unemployment and other industry pressures, including but not limited to the shift in our payor mix from commercial and managed care payors to more Medicaid and managed Medicaid, both of which typically result in lower reimbursement on a per adjusted admission basis, have contributed to moderating rates of pricing growth. Additionally, the impact of state budgetary issues on Medicaid funding, which has resulted in rate freezes and, in some cases, rate cuts to providers, has caused a decline in pricing related to Medicaid and managed Medicaid volumes, which is compounded by the impact of increasing Medicaid utilization. As states continue working through their budgetary issues, any additional cuts to Medicaid funding would negatively impact our future pricing and earnings.
We offer discounts to all uninsured patients receiving healthcare services who do not qualify for assistance under state Medicaid, other federal or state assistance plans, or charity care. We provided uninsured discounts totaling $71.6 million, $69.7 million and $57.9 million for the years ended September 30, 2010, 2009 and 2008, respectively.
Premium Revenue
Premium revenue generated under the AHCCCS and CMS contracts with Health Choice represented 31.4%, 29.6% and 26.2% of our consolidated net revenue for the years ended September 30, 2010, 2009 and 2008, respectively.
As a result of our current contract and increasing enrollment in the state program, which is attributable to a rising indigent population associated with the current economic downturn, Health Choice’s enrollment through its AHCCCS contract at September 30, 2010, exceeded 194,000 members, compared to over 187,000 members in the prior year. While we anticipate our membership may continue to increase in the near term, we cannot guarantee the continued growth of our membership.
The Health Reform Law reduces, over a three year period, premium payments to managed Medicare plans such that CMS’ managed care per capita premium payments are, on average, equal to traditional Medicare. The Health Reform Law implements fee adjustments based on service benchmarks and quality ratings. The CBO estimated that, as a result of these changes, payments to plans will be reduced by $138.0 billion between 2010 and 2019, while CMS estimated the reduction to be $145.0 billion.

 

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Premiums received from AHCCCS and CMS to provide services to our members, which have been declining on a per member per month basis, will be further affected by the significant budgetary concerns that continue to face the state of Arizona. As Arizona continues working to eliminate its budget deficit, its recently enacted budget for fiscal year 2011 includes additional reimbursement cuts, including elimination of Medicaid coverage for some services and a cut of up to 5% for all Medicaid providers beginning in April 2011. In an effort to relieve some of the budget pressures, on May 18, 2010, voters passed a sales tax referendum that would temporarily raise money at the state level to help fund these budgetary shortfalls. The state legislature may have to consider additional cuts to Medicaid funding beyond the initial 5% that is planned for fiscal 2011, as a result of the impact of the Health Reform Law and the uncertainty surrounding the impact of the extension of the FMAP, which was originally implemented in 2009 by ARRA. Depending upon member mix, we generally believe Health Choice could continue to experience a decline in rates received on a per member per month basis, which may negatively impact our premium revenue over the near-term.
Significant Industry Trends
The following paragraphs discuss recent trends that we believe are significant factors in our current and/or future operating results and cash flows. Certain of these trends apply to the entire acute care hospital industry while others may apply to us more specifically. These trends could be short-term in nature or could require long-term attention and resources. While these trends may involve certain factors that are outside of our control, the extent to which these trends affect our hospitals and our ability to manage the impact of these trends play vital roles in our current and future success. In many cases, we are unable to predict what impact, if any, these trends will have on us.
Payor Mix Shift
Like others in the hospital industry, we have experienced a shift in our patient volumes and revenue from commercial and managed care payors to Medicaid and managed Medicaid. This has resulted in margin pressures created from expending the same amount of resources to provide patient care, but for less reimbursement. This shift is reflective of continued high unemployment and the resulting increases in states’ Medicaid rolls. The decline in managed care volume and revenue mix is not only indicative of the depressed labor market, but also utilization behavior of the insured population resulting from higher deductible and co-insurance plans implemented by employers, which, in turn, has resulted in delays or the deferral of elective and non-emergent procedures. Given the high rate of unemployment and its impact on the economy, particularly in the markets we serve, we expect the elevated levels in our Medicaid and managed Medicaid payor mixes to continue until the U.S. economy experiences an economic recovery that includes job growth and declining unemployment.
Value-Based Reimbursement
There is a trend in the healthcare industry towards value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting and financial incentives tied to the quality and efficiency of care provided by facilities. The Health Reform Law recently enacted by Congress expands the use of value-based purchasing initiatives in federal healthcare programs. We expect programs of this type to become more common in the healthcare industry.
Medicare requires providers to report certain quality measures in order to receive full reimbursement increases that previously were awarded automatically. CMS has expanded, through a series of rulemakings, the number of patient care indicators that hospitals must report. CMS currently requires hospitals to report 46 quality measures in order to qualify for the full market basket update to the inpatient prospective payment system for fiscal year 2011 and will require hospitals to report 55 quality measures to qualify for the full market basket update for fiscal year 2012. CMS will require hospitals to report 57 quality measures in fiscal year 2011 to receive the full market basket update for fiscal year 2013. CMS also requires hospitals to submit quality data regarding eleven measures relating to outpatient care in order to receive the full market basket increase under the outpatient prospective payment system in calendar year 2011. In order to receive the full market basket update for calendar year 2012, CMS has proposed increasing the number of outpatient quality measures that must be reported to 17. We anticipate that CMS will continue to expand the number of inpatient and outpatient quality measures. We have invested significant capital and resources in the implementation of our advanced clinical system that assists us in monitoring and reporting these quality measures. CMS makes the data submitted by hospitals, including our hospitals, public on its website.

 

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Medicare no longer pays hospitals additional amounts for the treatment of certain preventable adverse events, also known as HACs, unless the condition was present at admission. Currently, there are ten categories of conditions on the list of HACs. On January 15, 2009, CMS announced three NCDs that prohibit Medicare reimbursement for erroneous surgical procedures performed on an inpatient or outpatient basis. These three erroneous surgical procedures are in addition to the HACs designated by CMS by regulation. DEFRA provides that CMS may revise the list of HACs from time to time. Effective July 1, 2011, the Health Reform Law will prohibit the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat HACs. Further, effective federal fiscal year 2013, hospitals with excessive readmissions for certain conditions designated by the Department will receive reduced payments for all inpatient discharges, not just discharges relating to the conditions subject to the excessive readmission standard. Beginning in federal fiscal year 2015, hospitals that fall into the highest 25% of national risk-adjusted HAC rates for all hospitals in the previous year will receive a 1% reduction in their total Medicare payments.
The Health Reform Law also requires the Department to implement a value-based purchasing program for inpatient hospital services. Beginning in federal fiscal year 2013, the Department will reduce inpatient hospital payments for all discharges by a percentage specified by statute ranging from 1% to 2% and pool the total amount collected from these reductions to fund payments to reward hospitals that meet or exceed certain quality performance standards established by the Department. The Department will determine the amount received by each hospital that meets or exceeds the quality performance standards from the pool of dollars created by these payment reductions.
Many large commercial payors currently require providers to report quality data. Several commercial payors have announced that they will stop reimbursing hospitals for certain preventable adverse events. A number of state hospital associations have also announced policies addressing the waiver of patient bills for care related to a serious adverse event. In addition, managed care organizations may begin programs that condition payment on performance against specified measures. The quality measurement criteria used by commercial payors may be similar to or even more stringent than Medicare requirements.
We expect these trends towards value-based purchasing of healthcare services by Medicare and other payors to continue. Because of these trends, if we are unable to demonstrate quality of care in our facilities, our operating results could be significantly impacted in the future.
Physician Alignment and Integration
In an effort to meet community needs and address coverage issues, we continue to recruit and employ physicians with primary emphasis on family practice and internal medicine, general surgery, hospitalists, obstetrics and gynecology, cardiology, neurology and orthopedics. Our ability to attract and retain skilled physicians to our hospitals is critical to our success and is affected by the quality of care at our hospitals. This is one reason we have taken significant steps in implementing our expanded quality of care initiatives. We believe intense efforts focusing on quality of care will enhance our ability to recruit and retain the skilled physicians necessary to make our hospitals successful.
We experience certain risks associated with the integration of medical staffs at our hospitals. As we continue to focus on our physician employment strategy, we face significant competition for skilled physicians in certain of our markets as more hospital providers adopt a physician staffing model approach, coupled with a general shortage of physicians across most specialties. This increased competition has resulted in efforts by managed care organizations to align with certain provider networks in the markets in which we operate. For the year ended September 30, 2010, as we continue to execute our physician employment strategy, we have experienced a 35% increase in our employed physician base. While we expect that employing physicians should provide relief on cost pressures associated with on-call coverage and other professional fees, we anticipate incurring additional labor and other start-up related costs as we continue the integration of employed physicians.

 

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We also face risk from competition for outpatient business. We expect to mitigate this risk through continued focus on our physician employment strategy, our commitment to capital investment in our hospitals, including updated technology and equipment, and our commitment to our quality of care initiatives that some competitors, including individual physicians or physician groups, may not be equipped to implement.
Uncompensated Care
Like others in the hospital industry, we continue to experience high levels of uncompensated care, including charity care and bad debts. These elevated levels are driven by the number of uninsured patients seeking care at our hospitals, increasing healthcare costs and other factors beyond our control, such as increases in the amount of co-payments and deductibles as employers continue to pass more of these costs on to their employees. In addition, as a result of high unemployment and its impact on the economy, we believe that our hospitals may continue to experience high levels of or possibly growth in bad debts and charity care. During the year ended September 30, 2010, our uncompensated care as a percentage of acute care revenue was 13.2%, compared to 13.5% in the prior year.
We continue to monitor our self-pay admissions on a daily basis and continue to focus on the efficiency of our emergency rooms, point-of-service cash collections, Medicaid eligibility automation and process-flow improvements. While the volume of patients registered as uninsured remains high, we continue to be successful in qualifying many of these uninsured patients for Medicaid or other third-party coverage, which has helped to alleviate some of the pressure created from the growth in our uncompensated care.
Our level of uncompensated care continues to be affected by the volume of under-insured patients or patient balances after insurance. At September 30, 2010, self-pay balances after insurance were $35.9 million, compared to $37.3 million at September 30, 2009.
We anticipate that if we experience further growth in uninsured volume and revenue over the near-term, along with continued increases in co-payments and deductibles for insured patients, our uncompensated care will increase and our results of operations could be adversely affected.
The percentages of insured and uninsured hospital receivables (prior to allowances for contractual adjustments and doubtful accounts) are summarized as follows:
                 
    September 30,     September 30,  
    2010     2009  
Insured receivables
    61.8 %     62.0 %
Uninsured receivables
    38.2 %     38.0 %
 
           
 
               
Total
    100.0 %     100.0 %
 
           
The percentages in the table above are calculated using hospital receivable balances. Uninsured and insured receivables are net of discounts and contractual adjustments recorded at the time of billing. Included in insured receivables are accounts that are pending approval from Medicaid. These receivables were 3.0% and 3.2% of hospital receivables at September 30, 2010 and 2009, respectively.
The percentages of hospital receivables in summarized aging categories are as follows:
                 
    September 30,     September 30,  
    2010     2009  
0 to 90 days
    71.9 %     69.4 %
91 to 180 days
    17.8 %     18.1 %
Over 180 days
    10.3 %     12.5 %
 
           
 
               
Total
    100.0 %     100.0 %
 
           

 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. In preparing our financial statements, we make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates.
We have determined an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made and (2) changes in the estimate would have a material impact on our financial condition or results of operations. There are other items within our financial statements that require estimation but are not deemed critical as defined herein. Changes in estimates used in these and other items could have a material impact on our financial statements.
Allowance for Doubtful Accounts. Our ability to collect outstanding receivables from third-party payors and patients is critical to our operating performance and cash flows. The primary collection risk lies with uninsured patient accounts or patient accounts for which primary insurance has paid but a patient portion remains outstanding. The provision for bad debts and the allowance for doubtful accounts relate primarily to amounts due directly from patients. Our estimation of the allowance for doubtful accounts is based primarily upon the type and age of the patient accounts receivable and the effectiveness of our collection efforts. Our policy is to reserve a portion of all self-pay receivables, including amounts due from the uninsured and amounts related to co-payments and deductibles, as these charges are recorded. We monitor our accounts receivable balances and the effectiveness of our reserve policies on a monthly basis and review various analytics to support the basis for our estimates. These efforts primarily consist of reviewing the following:
   
Historical write-off and collection experience using a hindsight or look-back approach;
 
   
Revenue and volume trends by payor, particularly the self-pay components;
 
   
Changes in the aging and payor mix of accounts receivable, including increased focus on accounts due from the uninsured and accounts that represent co-payments and deductibles due from patients;
 
   
Cash collections as a percentage of net patient revenue less bad debt expense;
 
   
Trending of days revenue in accounts receivable; and
 
   
Various allowance coverage statistics.
We regularly perform hindsight procedures to evaluate historical write-off and collection experience throughout the year to assist in determining the reasonableness of our process for estimating the allowance for doubtful accounts. We do not pursue collection of amounts related to patients who qualify for charity care under our guidelines. Charity care accounts are deducted from gross revenue and do not affect the provision for bad debts.
At September 30, 2010, our self-pay receivables, including amounts due from uninsured patients and co-payment and deductible amounts due from insured patients, were $160.7 million and our allowance for doubtful accounts was $125.4 million. Excluding third-party settlement balances, days revenue in accounts receivable were 43 days at September 30, 2010, compared to 49 days at September 30, 2009. For the year ended September 30, 2010, the provision for bad debts was 11.4% of acute care revenue, compared to 11.5% in the prior year. Significant changes in payor mix or business office operations could have a significant impact on the provision for bad debts, as well as our results of operations and cash flows.
Allowance for Contractual Discounts and Settlement Estimates. We derive a significant portion of our net patient revenue from Medicare, Medicaid and managed care payors that receive discounts from our standard charges. For the years ended September 30, 2010, 2009 and 2008, Medicare, Medicaid and managed care revenue together accounted for 87.8%, 88.9% and 90.9%, respectively, of our hospitals’ net patient revenue.
We estimate contractual discounts and allowances based upon payment terms outlined in our managed care contracts, by federal and state regulations for the Medicare and various Medicaid programs, and in accordance with terms of our uninsured discount program. Contractual discounts for most of our patient revenue are determined by an automated process that establishes the discount on a patient-by-patient basis. The payment terms or fee schedules for most payors have been entered into our patient accounting systems. Automated (system-generated) contractual discounts are recorded, at the time a patient account is billed, based upon the system-loaded payment terms. In certain instances for payors that are not significant or who have not entered into a contract with us, we make manual estimates in determining contractual allowances based upon historical collection rates. At the end of each month, we estimate contractual allowances for all unbilled accounts based on payor-specific six-month average contractual discount rates.

 

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For governmental payors such as Medicare and Medicaid, we determine contractual discounts or allowances based upon the program’s reimbursement (payment) methodology (i.e. either prospectively determined or retrospectively determined based on costs as defined by the government payor). These contractual discounts are determined by an automated process in a manner similar to the process used for managed care revenue. Under prospective payment programs, we record contractual discounts based upon predetermined reimbursement rates. For retrospective cost-based revenues, which are less prevalent, we estimate contractual allowances based upon historical and current factors which are adjusted as necessary in future periods, when final settlements of filed cost reports are received. Net adjustments to estimated third-party payor settlements, also known as prior year contractuals, resulted in an increase in acute care revenue of $5.2 million, $3.2 million and $1.0 million for the years ended September 30, 2010, 2009 and 2008, respectively.
Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. All contractual adjustments, regardless of type of payor or method of calculation, are reviewed and compared to actual payment experience on an individual patient account basis. Discrepancies between expected and actual payments are reviewed, and as necessary, appropriate corrections to the patient accounts are made to reflect actual payments received. If a discrepancy exists between the payment terms loaded into the contract management system and the actual discount based on payments received, the system is updated accordingly to ensure appropriate discounting of future charges.
Additionally, we rely on other analytical tools to ensure our contractual discounts are reasonably estimated. These include, but are not limited to, monitoring of collection experience by payor, reviewing total patient collections as a percentage of net patient revenue (adjusted for the provision for bad debts) on a trailing twelve-month basis, gross to net patient revenue comparisons, contractual allowance metrics, etc. As well, patient accounts are continually reviewed to ensure all patient accounts reflect either system-generated discounts or estimated contractual allowances, as necessary.
Medicare and Medicaid regulations and various managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in our healthcare facilities, requiring complex calculations and assumptions which are subject to interpretation. Additionally, the services authorized and provided and resulting reimbursement are often subject to interpretation. These interpretations sometimes result in payments that differ from our estimates. Additionally, updates to regulations and contract renegotiations occur frequently, necessitating continual review and assessment of the estimation process by management. We have made significant investments in our patient accounting information systems, human resources and internal controls, which we believe greatly reduces the likelihood of a significant variance occurring between the recorded and estimated contractual discounts. Given that most of our contractual discounts are pre-defined or contractually based, and as a result of continual internal monitoring processes and our use of analytical tools, we believe the aggregate differences between amounts recorded for initial contractual discounts and final contractual discounts resulting from payments received are not significant. Finally, we believe that having a wide variety and large number of managed care contracts that are subject to review and administration on a hospital-by-hospital basis minimizes the impact on the Company’s net revenue of any imprecision in recorded contractual discounts caused by the system-load of payment terms of a particular payor. We believe that our systems and processes, as well as other items discussed, provide reasonable assurance that any change in estimate related to contractual discounts is immaterial to our financial position, results of operations and cash flows.
Insurance Reserves. Given the nature of our operating environment, we may become subject to medical malpractice or workers compensation claims or lawsuits. We maintain third-party insurance coverage for individual malpractice and workers compensation claims to mitigate a portion of this risk. In addition, we maintain excess coverage limiting our exposure to an aggregate annual amount for claims. We estimate our reserve for self-insured professional and general liability and workers compensation risks using historical claims data, demographic factors, severity factors, current incident logs and other actuarial analysis. At September 30, 2010 and 2009, our professional and general liability accrual for asserted and unasserted claims was $41.6 million and $41.7 million, respectively. For the year ended September 30, 2010, our total premiums and self-insured retention cost for professional and general liability insurance was $23.4 million, compared with $25.5 million in the prior year.

 

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The estimated accrual for medical malpractice and workers compensation claims could be significantly affected should current and future occurrences differ from historical claims trends. The estimation process is also complicated by the complexity and changing nature of tort reform in the states in which we operate. While we monitor current claims closely and consider outcomes when estimating our insurance accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in the estimates.
Valuations from our independent actuary for professional and general liability losses resulted in a change in related estimates for prior years which decreased professional and general liability expense by the following amounts (in millions):
         
Year ended September 30, 2010
  $ (2.6 )
Year ended September 30, 2009
  $ (1.2 )
Year ended September 30, 2008
  $ (6.8 )
Our estimate of the reserve for professional and general liability claims is based upon actuarial calculations that are completed semi-annually. The changes in estimates noted above were recognized in the periods in which the independent actuarial calculations were received. The key assumptions underlying the development of our estimate (loss development, trends and increased limits factors) have not changed materially, as they are largely based upon professional liability insurance industry data published by the Insurance Services Office (“ISO”), a leading provider of data, underwriting, risk management and legal/regulatory services. The reductions in professional and general liability expense related to changes in prior year estimates reflected above for the years ended September 30, 2010, 2009 and 2008, are the result of better than expected claims experience as compared to the industry benchmarks for loss development included in the original actuarial estimate.
Sensitivity in the estimate of our professional and general liability claims reserve is reflected in various actuarial confidence levels. We utilize a statistical confidence level of 50% in developing our best estimate of the reserve for professional and general liability claims. Higher statistical confidence levels, while not representative of our best estimate, provide a range of reasonably likely outcomes upon resolution of the related claims. The following table outlines our reported reserve amounts compared to reserve levels established at the higher statistical confidence levels.
         
As reported at September 30, 2010
  $ 41.6  
75% Confidence Level
  $ 48.2  
90% Confidence Level
  $ 60.1  
Valuations from our independent actuary for workers’ compensation losses resulted in a change in related estimates for prior years which increased (decreased) workers’ compensation expense by the following amounts (in millions):
         
Year ended September 30, 2010
  $ 1.1  
Year ended September 30, 2009
  $ (0.5 )
Year ended September 30, 2008
  $ 0.8  
Medical Claims Payable. Medical claims expense, including claims paid to our hospitals, was $690.5 million, $602.1 million and $461.6 million, or 87.2%, 86.1% and 85.2% of premium revenue, for the years ended September 30, 2010, 2009 and 2008, respectively. For the years ended September 30, 2010, 2009 and 2008, $11.8 million, $9.3 million and $9.6 million, respectively, of health plan payments made to hospitals and other healthcare entities owned by us for services provided to our enrollees were eliminated in consolidation.

 

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The following table shows the components of the change in medical claims payable (in thousands):
                 
    Year Ended     Year Ended  
    September 30,     September 30,  
    2010     2009  
Medical claims payable as of October 1
  $ 113,519     $ 97,343  
Medical claims expense incurred during the year:
               
Related to current year
    697,052       620,153  
Related to prior years
    (6,596 )     (18,077 )
 
           
Total expenses
    690,456       602,076  
 
           
Medical claims payments during the year:
               
Related to current year
    (587,292 )     (508,299 )
Related to prior years
    (105,310 )     (77,601 )
 
           
Total payments
    (692,602 )     (585,900 )
 
           
Medical claims payable as of September 30
  $ 111,373     $ 113,519  
 
           
As reflected in the table above, medical claims expense for the year ended September 30, 2010, includes a $6.6 million reduction of medical costs related to prior years resulting from favorable development in the Medicaid and Medicare product lines of $6.4 million and $209,000, respectively. The favorable development is attributable to lower than anticipated medical costs. Medical claims expense for the year ended September 30, 2009, includes an $18.1 million reduction of medical costs related to prior years resulting from favorable development in the Medicaid and Medicare product lines of $15.5 million and $2.6 million, respectively. The favorable development is attributable to lower than anticipated medical costs and is offset, in part, by $10.8 million in reductions in premium revenue associated with settlements of various prior year program receivables.
We estimate our medical claims payable using historical claims experience (including severity and payment lag time) and other actuarial analysis including number of enrollees, age of enrollees and certain enrollee health indicators to predict the cost of healthcare services provided to enrollees during any given period. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from our estimates given changes in healthcare costs or adverse experience. For example, our medical claims payable is primarily composed of estimates related to the most recent three months and periods prior to the most recent three months. The claims trend factor, which is developed through a comprehensive analysis of claims incurred in prior months, is the most significant component used in developing the claims liability estimates for the most recent three months. The completion factor is an actuarial estimate, based upon historical experience, of the percentage of incurred claims during a given period that have been adjudicated as of the date of estimation. The completion factor is the most significant component used in developing the claims liability estimates for the periods prior to the most recent three months. The following table illustrates the sensitivity of our medical claims payable at September 30, 2010, and the estimated potential impact on our results of operations, to changes in these factors that management believes are reasonably likely based upon our historical experience and currently available information (dollars in thousands):
                             
Claims Trend Factor     Completion Factor  
        Increase (Decrease) in             Increase (Decrease) in  
Increase (Decrease) in     Medical Claims     Increase (Decrease) in     Medical Claims  
Factor     Payable     Factor     Payable  
  (3.0 )%   $ (4,363 )     1.0 %   $ (5,042 )
  (2.0 )     (2,908 )     0.5       (2,524 )
  (1.0 )     (1,454 )     (0.5 )     2,592  
  1.0       1,454       (1.0 )     5,190  
Goodwill and Other Intangibles. The accounting policies and estimates related to goodwill and other intangibles are considered critical because of the significant impact that impairment could have on our operating results. We record all assets and liabilities acquired in purchase acquisitions, including goodwill, indefinite-lived intangibles, and other intangibles, at fair value as required by Financial Accounting Standards Board (“FASB”) authoritative guidance regarding business combinations. Goodwill, which was $718.2 million at September 30, 2010, is not amortized but is subject to tests for impairment annually or more often if events or circumstances indicate it may be impaired. The initial recording of goodwill and other intangibles requires subjective judgments concerning estimates of the fair value of the acquired assets. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. We did not record an impairment loss during the year ended September 30, 2010. During the year ended September 30, 2009, we recorded a $64.6 million non-cash charge ($43.2 million after tax) related to the impairment of goodwill in our Florida market. Other identifiable intangible assets, net of accumulated amortization, were $27.0 million at September 30, 2010, compared to $30.0 million in the prior year. These are amortized over their estimated useful lives and are evaluated for impairment if events and circumstances indicate a possible impairment. Such evaluation of other intangible assets is based on undiscounted cash flow projections. Estimated cash flows may extend far into the future and, by their nature, are difficult to determine over an extended timeframe. Factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures and technology, and changes in discount rates and specific industry or market sector conditions. Other key judgments in accounting for intangibles include useful life and classification between goodwill and indefinite-lived intangibles or other intangibles which require amortization. See “Goodwill and Other Intangible Assets” in the Notes to Consolidated Financial Statements for additional information regarding intangible assets. To assist in assessing the impact of a goodwill or intangible asset impairment charge at September 30, 2010, we have $745.2 million of goodwill and intangible assets. The impact of a 5% impairment charge would result in a reduction in pre-tax income of $37.3 million.

 

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Income Taxes. We estimate and record a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized in future periods based on all relevant information. We believe that future income as well as the reversal of deferred tax liabilities will enable us to realize the deferred tax assets we have recorded, net of the valuation allowance we have established.
Certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. Significant judgment is required in determining and assessing the impact of such tax-related contingencies. Effective October 1, 2007, we adopted the provisions of FASB authoritative guidance regarding accounting for uncertainty in income taxes, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of all tax positions accounted for in accordance with provisions of FASB authoritative guidance regarding accounting for income taxes. In addition, the provisions related to accounting for uncertainty in income taxes provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We applied these provisions to all tax positions upon initial adoption of this guidance. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date, October 1, 2007, have been recognized in connection with these provisions.
The provisions regarding accounting for uncertainty in income taxes permits interest and penalties on underpayments of income taxes to be classified as interest expense, income tax expense, or another appropriate expense classification based on the accounting election of the company. Our policy is to classify interest and penalties as a component of income tax expense.
The estimates, judgments and assumptions used by us under “Allowance for Doubtful Accounts,” “Allowance for Contractual Discounts and Settlement Estimates,” “Insurance Reserves,” “Medical Claims Payable,” “Goodwill and Other Intangibles” and “Income Taxes” are, we believe, reasonable, but involve inherent uncertainties as described above, which may or may not be controllable by management. As a result, the accounting for such items could result in different amounts if management used different assumptions or if different conditions occur in future periods.

 

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RESULTS OF OPERATIONS SUMMARY
Consolidated
The following table sets forth, for the periods indicated, results of consolidated operations expressed in dollar terms and as a percentage of net revenue. Such information has been derived from our audited consolidated statements of operations.
                                                 
    Year Ended     Year Ended     Year Ended  
    September 30, 2010     September 30, 2009     September 30, 2008  
($ in thousands)   Amount     Percentage     Amount     Percentage     Amount     Percentage  
 
                                               
Net revenue:
                                               
 
                                               
Acute care revenue
  $ 1,729,344       68.6 %   $ 1,662,469       70.4 %   $ 1,523,790       73.8 %
Premium revenue
    792,062       31.4 %     699,503       29.6 %     541,746       26.2 %
 
                                   
Total net revenue
    2,521,406       100.0 %     2,361,972       100.0 %     2,065,536       100.0 %
 
                                               
Costs and expenses:
                                               
Salaries and benefits
    686,303       27.2 %     660,921       28.0 %     632,109       30.6 %
Supplies
    266,545       10.6 %     250,573       10.6 %     231,259       11.2 %
Medical claims
    678,651       26.9 %     592,760       25.1 %     452,055       21.9 %
Other operating expenses
    363,916       14.4 %     325,735       13.8 %     283,123       13.7 %
Provision for bad debts
    197,680       7.9 %     192,563       8.2 %     161,936       7.8 %
Rentals and leases
    39,955       1.6 %     39,127       1.7 %     36,633       1.8 %
Interest expense, net
    66,810       2.6 %     67,890       2.9 %     75,665       3.7 %
Depreciation and amortization
    96,106       3.8 %     97,462       4.1 %     96,741       4.7 %
Management fees
    5,000       0.2 %     5,000       0.2 %     5,000       0.2 %
Impairment of goodwill
                64,639       2.7 %            
Hurricane-related property damage
                938       0.0 %     3,589       0.2 %
 
                                   
Total costs and expenses
    2,400,966       95.2 %     2,297,608       97.3 %     1,978,110       95.8 %
 
                                               
Earnings from continuing operations before gain (loss) on disposal of assets and income taxes
    120,440       4.8 %     64,364       2.7 %     87,426       4.2 %
 
                                               
Gain (loss) on disposal of assets, net
    108       0.0 %     1,465       0.1 %     (75 )     (0.0 )%
 
                                   
 
                                               
Earnings from continuing operations before income taxes
    120,548       4.8 %     65,829       2.8 %     87,351       4.2 %
 
                                               
Income tax expense
    44,715       1.8 %     27,576       1.2 %     35,325       1.7 %
 
                                   
Net earnings from continuing operations
    75,833       3.0 %     38,253       1.6 %     52,026       2.5 %
Loss from discontinued operations, net of income taxes
    (1,087 )     (0.1 )%     (176 )     (0.0 )%     (11,275 )     (0.5 )%
 
                                   
 
                                               
Net earnings
    74,746       2.9 %     38,077       1.6 %     40,751       2.0 %
Net earnings attributable to non-controlling interests
    (8,279 )     (0.3 )%     (9,987 )     (0.4 )%     (4,437 )     (0.2 )%
 
                                   
 
                                               
Net earnings attributable to IASIS Healthcare LLC
  $ 66,467       2.6 %   $ 28,090       1.2 %   $ 36,314       1.8 %
 
                                   

 

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Acute Care
The following table sets forth, for the periods indicated, results of our acute care operations expressed in dollar terms and as a percentage of acute care revenue. Such information has been derived from our audited consolidated statements of operations.
                                                 
    Year Ended     Year Ended     Year Ended  
    September 30, 2010     September 30, 2009     September 30, 2008  
($ in thousands)   Amount     Percentage     Amount     Percentage     Amount     Percentage  
 
                                               
Net revenue:
                                               
Acute care revenue
  $ 1,729,344       99.3 %   $ 1,662,469       99.4 %   $ 1,523,790       99.4 %
Revenue between segments
    11,805       0.7 %     9,316       0.6 %     9,594       0.6 %
 
                                   
Total acute care revenue (1)
    1,741,149       100.0 %     1,671,785       100.0 %     1,533,384       100.0 %
 
                                               
Costs and expenses:
                                               
Salaries and benefits
    667,154       38.3 %     641,893       38.4 %     614,442       40.1 %
Supplies
    266,347       15.3 %     250,310       15.0 %     231,001       15.1 %
Other operating expenses
    339,304       19.5 %     302,804       18.1 %     264,814       17.3 %
Provision for bad debts
    197,680       11.4 %     192,563       11.5 %     161,936       10.6 %
Rentals and leases
    38,409       2.2 %     37,563       2.2 %     35,466       2.3 %
Interest expense, net
    66,810       3.8 %     67,890       4.1 %     75,665       4.9 %
Depreciation and amortization
    92,544       5.3 %     94,014       5.6 %     93,003       6.0 %
Management fees
    5,000       0.3 %     5,000       0.3 %     5,000       0.3 %
Impairment of goodwill
                64,639       3.9 %            
Hurricane-related property damage
                938       0.1 %     3,589       0.2 %
 
                                   
 
                                               
Total costs and expenses
    1,673,248       96.1 %     1,657,614       99.2 %     1,484,916       96.8 %
 
                                               
Earnings from continuing operations before gain (loss) on disposal of assets and income taxes
    67,901       3.9 %     14,171       0.8 %     48,468       3.2 %
 
                                               
Gain (loss) on disposal of assets, net
    108       0.0 %     1,616       0.1 %     (75 )     (0.0 )%
 
                                   
Earnings from continuing operations before income taxes
  $ 68,009       3.9 %   $ 15,787       0.9 %   $ 48,393       3.2 %
 
                                   
 
     
(1)  
Revenue between segments is eliminated in our consolidated results.
Years Ended September 30, 2010 and 2009
Acute care revenue — Acute care revenue from our hospital operations for the year ended September 30, 2010, was $1.7 billion, an increase of $69.4 million, or 4.1%, compared to $1.7 billion in the prior year. The increase in acute care revenue is comprised of an increase in adjusted admissions of 0.6% and an increase in net patient revenue per adjusted admission of 3.8%.
Salaries and benefits — Salaries and benefits expense from our hospital operations for the year ended September 30, 2010, was $667.2 million, or 38.3% of acute care revenue, compared to $641.9 million, or 38.4% of acute care revenue in the prior year.
Supplies — Supplies expense from our hospital operations for the year ended September 30, 2010, was $266.3 million, or 15.3% of acute care revenue, compared to $250.3 million, or 15.0% of acute care revenue, in the prior year. The increase in supplies as a percentage of acute care revenue is primarily the result of a shift in the mix of our surgical volume to cases with more costly implant utilization, such as certain cardiology and orthopedic procedures.
Other operating expenses — Other operating expenses from our hospital operations for the year ended September 30, 2010, were $339.3 million, or 19.5% of acute care revenue, compared to $302.8 million, or 18.1% of acute care revenue in the prior year. Included in the current year were increased professional fees associated with our participation in the indigent care affiliation agreements in our Texas market. Excluding the impact of these indigent care affiliation agreements, other operating expenses as a percentage of acute care revenue were 16.7% for the year ended September 30, 2010, compared to 16.1% in the prior year. The remaining increase in other operating expenses as a percentage of acute care revenue in the current year period is impacted by a 0.3% increase in non-income related taxes, and a 0.4% increase in purchased services related to information technology costs and collection agency fees.

 

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Provision for bad debts — Provision for bad debts from our hospital operations for the year ended September 30, 2010, was $197.7 million, or 11.4% of acute care revenue, compared to $192.6 million, or 11.5% of acute care revenue in the prior year.
Earnings from continuing operations before income taxes — Earnings from continuing operations before income taxes increased $52.2 million to $68.0 million for the year ended September 30, 2010, compared to $15.8 million in the prior year. Earnings from continuing operations before income taxes for the year ended September 30, 2009, included the impact of a $64.6 million non-cash charge related to the impairment of goodwill in our Florida market.
Years Ended September 30, 2009 and 2008
Acute care revenue — Acute care revenue from our hospital operations for the year ended September 30, 2009, was $1.7 billion, an increase of $138.4 million, or 9.0%, compared to $1.5 billion in the prior year. Approximately 2.1% of this increase is attributable to the increase in revenue associated with the supplemental Medicaid reimbursement programs in our Texas market. The remaining increase in acute care revenue of 6.9% is comprised of an increase in adjusted admissions of 2.4% and an increase in net patient revenue per adjusted admission of 4.4%, excluding the impact of supplemental Medicaid reimbursement.
Salaries and benefits — Salaries and benefits expense from our hospital operations for the year ended September 30, 2009, was $641.9 million, or 38.4% of acute care revenue, compared to $614.4 million, or 40.1% of acute care revenue in the prior year. The decline in salaries and benefits expense as a percentage of acute care revenue is attributable to a reduction in employee medical and pharmacy claims experience, primarily resulting from changes in our employee health plan design. Additionally, our nursing contract labor as a percentage of acute care revenue declined to 0.8% for the year ended September 30, 2009, compared to 1.2% in the prior year.
Other operating expenses — Other operating expenses from our hospital operations for the year ended September 30, 2009, were $302.8 million, or 18.1% of acute care revenue, compared to $264.8 million, or 17.3% of acute care revenue in the prior year. The increase in other operating expenses as a percentage of acute care revenue was the result of additional professional fees incurred at our Texas hospitals to provide indigent care services during the current year, compared to the prior year.
Provision for bad debts — Provision for bad debts from our hospital operations for the year ended September 30, 2009, was $192.6 million, or 11.5% of acute care revenue, compared to $161.9 million, or 10.6% of acute care revenue in the prior year. We believe, as a result of the prolonged economic recession and rising unemployment, we continue to experience an increase in self-pay volume and revenue, as well as increases in the amount of co-payments and deductibles passed on by employers to employees. For the year ended September 30, 2009, our self-pay admissions as a percentage of total admissions were 6.0%, compared to 5.2% in the prior year. These trends continue to be the main driver behind the increase in our provision for bad debts.
Interest expense, net — Interest expense, net of interest income, for the year ended September 30, 2009, was $67.9 million, compared to $75.7 million in the prior year. This decrease of $7.8 million was primarily due to the impact of lower LIBOR interest rates in the current year, compared to the prior year. The weighted average interest rate of outstanding borrowings under our senior secured credit facilities was 3.6% for the year ended September 30, 2009, compared to 5.6% in the prior year.
Impairment of goodwill — Impairment of goodwill for the year ended September 30, 2009, includes a $64.6 million non-cash charge related to our Florida market. We have experienced other than temporary changes in market conditions and the business mix of our Florida operations, which have negatively impacted operating results in this market. Accordingly, we have written off the goodwill associated with our Florida market.
Earnings from continuing operations before income taxes — Earnings from continuing operations before income taxes decreased $32.6 million to $15.8 million for the year ended September 30, 2009, compared to $48.4 million in the prior year. Earnings from continuing operations before income taxes for the year ended September 30, 2009, included the impact of a $64.6 million non-cash charge related to the impairment of goodwill in our Florida market.

 

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Health Choice
The following table sets forth, for the periods indicated, results of our Health Choice operations expressed in dollar terms and as a percentage of premium revenue. Such information has been derived from our audited consolidated statements of operations.
                                                 
    Year Ended     Year Ended     Year Ended  
    September 30, 2010     September 30, 2009     September 30, 2008  
($ in thousands)   Amount     Percentage     Amount     Percentage     Amount     Percentage  
Premium revenue:
                                               
Premium revenue
  $ 792,062       100.0 %   $ 699,503       100.0 %   $ 541,746       100.0 %
Costs and expenses:
                                               
Salaries and benefits
    19,149       2.4 %     19,028       2.7 %     17,667       3.3 %
Supplies
    198       0.0 %     263       0.0 %     258       0.0 %
Medical claims (1)
    690,456       87.2 %     602,076       86.1 %     461,649       85.2 %
Other operating expenses
    24,612       3.1 %     22,931       3.3 %     18,309       3.4 %
Rentals and leases
    1,546       0.2 %     1,564       0.2 %     1,167       0.2 %
Depreciation and amortization
    3,562       0.5 %     3,448       0.5 %     3,738       0.7 %
 
                                   
Total costs and expenses
    739,523       93.4 %     649,310       92.8 %     502,788       92.8 %
 
                                               
Earnings before loss on disposal of assets
    52,539       6.6 %     50,193       7.2 %     38,958       7.2 %
 
                                               
Loss on disposal of assets, net
                (151 )     (0.0 )%            
 
                                   
 
                                               
Earnings before income taxes
  $ 52,539       6.6 %   $ 50,042       7.2 %   $ 38,958       7.2 %
 
                                   
 
     
(1)  
Medical claims paid to our hospitals of $11.8 million, $9.3 million and $9.6 million for the years ended September 30, 2010, 2009 and 2008, respectively, are eliminated in our consolidated results.
Years Ended September 30, 2010 and 2009
Premium revenue Premium revenue from Health Choice was $792.1 million for the year ended September 30, 2010, an increase of $92.6 million or 13.2%, compared to $699.5 million in the prior year. The growth in premium revenue was due to a 14.4% increase in Medicaid member months resulting from increased enrollment in the state program, primarily attributable to the impact of high unemployment, partially offset by a 1.9% decline in Medicaid premium revenue on a per member per month basis.
Medical claims — Prior to eliminations, medical claims expense was $690.5 million for the year ended September 30, 2010, compared to $602.1 million in the prior year. Medical claims expense represents the amounts paid by Health Choice for healthcare services provided to its members. Medical claims expense as a percentage of premium revenue was 87.2% for the year ended September 30, 2010, compared to 86.1% in the prior year. The increase in our medical claims expense as a percentage of premium revenue is primarily the result of an overall increase in medical costs on a per member per month basis, compared to the prior year, coupled with a 1.6% decline in overall premium revenue on a per member per month basis.
Years Ended September 30, 2009 and 2008
Premium revenue Premium revenue from Health Choice was $699.5 million for the year ended September 30, 2009, an increase of $157.8 million or 29.1%, compared to $541.7 million in the prior year. The growth in premium revenue was attributable to a 31.6% increase in Medicaid enrollees, resulting from Health Choice’s new contract with AHCCCS and increased enrollment in the state program. In addition, Health Choice has implemented successful outreach efforts, especially in its new counties, which have helped to increase the number of covered lives.
Medical claims — Prior to eliminations, medical claims expense was $602.1 million for the year ended September 30, 2009, compared to $461.6 million in the prior year. Medical claims expense represents the amounts paid by Health Choice for healthcare services provided to its members. Medical claims expense as a percentage of premium revenue was 86.1% for the year ended September 30, 2009, compared to 85.2% in the prior year. The increase in medical claims expense as a percentage of premium revenue is the result of AHCCCS’ implementation of a new risk based payment methodology, which has negatively affected premium revenue on a per member per month basis in the current year.

 

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Income Taxes
The following discussion sets forth, for the periods indicated, the impact of income taxes on our consolidated results. Such information has been derived from our audited consolidated statements of operations.
Years Ended September 30, 2010 and 2009
Income tax expense — We recorded a provision for income taxes from continuing operations of $44.7 million, resulting in an effective tax rate of 37.1% for the year ended September 30, 2010, compared to $27.6 million, for an effective tax rate of 41.9% in the prior year. Our effective tax rate for the year ended September 30, 2009, was impacted by a non-deductible component of the $64.6 million non-cash charge related to the impairment of goodwill in our Florida market.
Years Ended September 30, 2009 and 2008
Income tax expense — We recorded a provision for income taxes from continuing operations of $27.6 million, resulting in an effective tax rate of 41.9% for the year ended September 30, 2009, compared to $35.3 million, for an effective tax rate of 40.4% in the prior year. The increase in our effective tax rate is the result of the impact of a non-deductible component of the $64.6 million non-cash charge related to the impairment of goodwill in our Florida market.
Summary of Operations by Quarter
The following table presents unaudited quarterly operating results for the years ended September 30, 2010 and 2009. We believe that all necessary adjustments have been included in the amounts stated below to present fairly the quarterly results when read in conjunction with the consolidated financial statements. Results of operations for any particular quarter are not necessarily indicative of results of operations for a full year or predictive of future periods.
                                 
    Quarter Ended  
    Sept. 30,     June 30,     March 31,     Dec. 31,  
    2010(1)     2010     2010(2)     2009  
    (in thousands)  
Net revenue
  $ 629,939     $ 637,988     $ 624,522     $ 628,957  
Earnings from continuing operations before income taxes
    20,800       34,410       35,410       29,928  
Net earnings from continuing operations
    12,629       21,727       22,140       19,337  
                                 
    Quarter Ended  
    Sept. 30,     June 30,     March 31,     Dec. 31,  
    2009(3)     2009     2009(4)     2008  
    (in thousands)  
Net revenue
  $ 620,056     $ 601,618     $ 578,674     $ 561,624  
Earnings (loss) from continuing operations before income taxes
    (38,699 )     36,943       44,816       22,769  
Net earnings (loss) from continuing operations
    (27,300 )     23,228       28,367       13,958  
 
     
(1)  
Results for the quarter ended September 30, 2010, include a $1.7 million property tax assessment related to prior periods, and a $723,000 reduction and a $273,000 increase in prior year estimates for professional and general liability losses and workers’ compensation claims, respectively, as a result of our semi-annual actuarial studies.
 
(2)  
Results for the quarter ended March 31, 2010, include $2.0 million of stock compensation expense related to the repurchase of certain equity by our parent company, and a $1.9 million reduction and an $801,000 increase in prior year estimates for professional and general liability losses and workers’ compensation claims, respectively, as a result of our semi-annual actuarial studies.
 
(3)  
Results for the quarter ended September 30, 2009, include a $64.6 million non-cash charge ($43.2 million after taxes) related to the impairment of goodwill in our Florida market, and a $2.0 million and a $326,000 increase in prior year estimates for professional and general liability losses and workers’ compensation claims, respectively, as a result of our semi-annual actuarial studies.
 
(4)  
Results for the quarter ended March 31, 2009, include a $3.2 million and an $852,000 reduction in prior year estimates for professional and general liability losses and workers’ compensation claims, respectively, as a result of our semi-annual actuarial studies. Results for the quarter ended March 31, 2009, also include $938,000 in costs associated with property damage sustained at The Medical Center of Southeast Texas, as a result of Hurricane Ike.

 

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LIQUIDITY AND CAPITAL RESOURCES
Overview of Cash Flow Activities for the Years Ended September 30, 2010 and 2009
For the years ended September 30, 2010 and 2009, our cash flows are summarized as follows (in thousands):
                 
    2010     2009  
Cash flows from operating activities
  $ 257,239     $ 271,971  
Cash flows from investing activities
    (176,473 )     (82,576 )
Cash flows from financing activities
    (142,783 )     (63,605 )
Operating Activities
Operating cash flows decreased $14.7 million for the year ended September 30, 2010, compared to the prior year, primarily as a result of an increase in cash taxes.
At September 30, 2010, we had $134.5 million in net working capital, compared to $264.5 million at September 30, 2009. Net accounts receivable decreased $21.0 million to $209.2 million at September 30, 2010, from $230.2 million at September 30, 2009. Our days revenue in accounts receivable at September 30, 2010, were 43, compared to 49 at September 30, 2009.
Investing Activities
Capital expenditures for the year ended September 30, 2010, were $81.3 million, compared to $87.7 million in the prior year. Included in the year ended September 30, 2009, was $25.8 million related to the construction of our two patient tower projects in our Utah market, which were completed during fiscal 2009.
Investing activities during the year ended September 30, 2010, include $97.9 million in funding for the acquisition of Brim.
Financing Activities
During the year ended September 30, 2010, we distributed $125.0 million, net of a $1.8 million income tax benefit, to IAS, our parent company, to fund the repurchase of certain shares of its outstanding preferred stock and cancel certain vested rollover options to purchase its common stock. The holder of the IAS preferred stock is represented by an investor group led by TPG, JLL Partners and Trimaran Fund Management. The repurchase of preferred stock, which included accrued and outstanding dividends, and the cancellation of rollover options were funded by our excess cash on hand. The cancellation of the rollover options, which were associated with our 2004 recapitalization, resulted in the recognition of $2.0 million in stock compensation expense during the year ended September 30, 2010.
During the year ended September 30, 2010, pursuant to the terms of our senior secured credit facilities, we made net payments totaling $5.9 million, compared to net payments of $53.7 million, including $47.8 million used to pay the outstanding balance of our revolving credit facility, in the prior year. Additionally, we made payments totaling $2.5 million on capital leases and other debt obligations during the year ended September 30, 2010, compared to $1.8 million in the prior year.

 

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Capital Resources
As of September 30, 2010, we had two separate debt arrangements:
   
$854.0 million in senior secured credit facilities; and
 
   
$475.0 million in 8 3/4% senior subordinated notes due 2014.
$854.0 Million Senior Secured Credit Facilities
The $854.0 million senior secured credit facilities include: (i) a senior secured term loan of $439.0 million; (ii) a senior secured delayed draw term loan of $150.0 million; (iii) a senior secured revolving credit facility of $225.0 million, with a $100.0 million sub-limit for letters of credit; and (iv) a senior secured synthetic letter of credit facility of $40.0 million. All facilities mature on March 15, 2014, except for the revolving credit facility, which matures on April 27, 2013. The term loans bear interest at an annual rate of LIBOR plus 2.00% or, at our option, the administrative agent’s base rate plus 1.00%. The revolving loans bear interest at an annual rate of LIBOR plus an applicable margin ranging from 1.25% to 1.75% or, at our option, the administrative agent’s base rate plus an applicable margin ranging from 0.25% to 0.75%, such rate in each case depending on our senior secured leverage ratio. A commitment fee ranging from 0.375% to 0.50% per annum is charged on the undrawn portion of the senior secured revolving credit facility and is payable in arrears.
Principal under the senior secured term loan is due in 24 consecutive equal quarterly installments in an aggregate annual amount equal to 1.0% of the original principal amount ($439.0 million) during the first six years thereof, with the balance payable in four equal installments in year seven. Principal under the senior secured delayed draw term loan is due in equal quarterly installments in an aggregate annual amount equal to 1.0% of the original principal amount ($150.0 million) until March 31, 2013, with the balance payable in four equal installments during the final year of the loan. Unless terminated earlier, the senior secured revolving credit facility has a single maturity of six years. The senior secured credit facilities are also subject to mandatory prepayment under specific circumstances, including a portion of excess cash flow, a portion of the net proceeds from an initial public offering, asset sales, debt issuances and specified casualty events, each subject to various exceptions.
The senior secured credit facilities are (i) secured by a first mortgage and lien on our real property and related personal and intellectual property and pledges of equity interests in the entities that own such properties and (ii) guaranteed by certain of our subsidiaries.
In addition, the senior secured credit facilities contain certain covenants which, among other things, limit the incurrence of additional indebtedness, investments, dividends, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, liens and encumbrances and other matters customarily restricted in such agreements. The senior secured credit facilities agreement contains a customary restricted payments covenant, which, among others restrictions, limits the amount of dividends or other cash payments to IAS. As of September 30, 2010, we have $192.0 million available to expend free of any such restrictions pursuant to the restricted payment basket provisions set forth in this covenant.
At September 30, 2010, amounts outstanding under our senior secured credit facilities consisted of a $423.6 million term loan and a $146.7 million delayed draw term loan. In addition, we had $39.9 million and $41.4 million in letters of credit outstanding under the synthetic letter of credit facility and the revolving credit facility, respectively. The weighted average interest rate of outstanding borrowings under the senior secured credit facilities was 3.4% for the year ended September 30, 2010.
$475.0 Million 8 3/4% Senior Subordinated Notes Due 2014
We and our wholly-owned subsidiary, IASIS Capital Corporation, a holding company with no assets or operations, as issuers, have outstanding $475.0 million aggregate principal amount of 8 3/4% notes. Our 8 3/4% notes are general unsecured senior subordinated obligations of the issuers, are subordinated in right of payment to their existing and future senior debt, are pari passu in right of payment with any of their future senior subordinated debt and are senior in right of payment to any of their future subordinated debt. Our existing domestic subsidiaries, other than certain non-guarantor subsidiaries, which include Health Choice and our non-wholly owned subsidiaries, are guarantors of our 8 3/4% notes. Our 8 3/4% notes are effectively subordinated to all of the issuers’ and the guarantors’ secured debt to the extent of the value of the assets securing the debt and are structurally subordinated to all liabilities and commitments (including trade payables and capital lease obligations) of our subsidiaries that are not guarantors of our 8 3/4% notes. Our 8 3/4% notes require semi-annual interest payments in June and December. The indenture related to the 8 3/4% notes contains a customary restricted payments covenant, which, among others restrictions, limits the amount of dividends or other cash payments to IAS, including payments to fund the interest on the Holdings Senior Paid-in-Kind (“PIK”) Loans, which becomes cash pay in June 2012. As of September 30, 2010, we have $105.0 million available to expend free of any such restrictions pursuant to the restricted payment basket provisions set forth in this covenant.

 

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Holdings Senior PIK Loans
IAS has outstanding Holdings Senior PIK Loans, which mature June 15, 2014. Proceeds were used to repurchase certain preferred equity from the stockholders of IAS. The Holdings Senior PIK Loans bear interest at an annual rate equal to LIBOR plus 5.25%. The Holdings Senior PIK Loans rank behind our existing debt and will convert to cash-pay in June 2012, at which time all accrued interest becomes payable. At September 30, 2010, the outstanding balance of the Holdings Senior PIK Loans was $389.8 million, which includes $89.8 million of interest that has accrued to the principal of these loans since the date of issuance, and is recorded in the financial statements of IAS. The credit agreement related to the Holdings Senior PIK Loans includes a restricted payment covenant, which, among other restrictions, limits the amount of dividends that can be paid to the stockholders of IAS. As of September 30, 2010, we have $43.0 million available to expend free of any such restrictions pursuant to the restricted payment basket provisions set forth in this covenant.
Other
We are a party to interest rate swap agreements with Citibank, N.A. (“Citibank”) and Wachovia Bank, N.A. (“Wachovia”), as counterparties, with notional amounts totaling $425.0 million, in an effort to manage exposure to floating interest rate risk on a portion of our variable rate debt. The arrangements with each counterparty include two interest rate swap agreements, one with a notional amount of $112.5 million maturing on February 28, 2011, and one with a notional amount of $100.0 million maturing on February 29, 2012. Under these agreements, we are required to make monthly interest payments to our counterparties at fixed annual interest rates ranging from 1.5% to 2.0%, depending upon the agreement. Our counterparties are obligated to make monthly interest payments to us based upon the one-month LIBOR rate in effect over the term of each agreement.
As of September 30, 2010, we provided a performance guaranty in the form of letters of credit totaling $48.3 million for the benefit of AHCCCS to support our obligations under the Health Choice contract to provide and pay for healthcare services. The amount of the performance guaranty is based in part upon the membership in the plan and the related capitation revenue paid to us.
Capital Expenditures
We plan to finance our proposed capital expenditures with cash generated from operations, borrowings under our senior secured credit facilities and other capital sources that may become available. We expect our capital expenditures for fiscal 2011 to be $120.0 million to $130.0 million, including the following significant expenditures:
   
$50.0 million to $55.0 million for growth and new business projects;
 
   
$40.0 million to $45.0 million in replacement or maintenance related projects at our hospitals;
 
   
$12.0 million related to our newly acquired facilities; and
 
   
$18.0 million in hardware and software costs related to information systems projects, including healthcare IT stimulus initiatives.
Liquidity
We rely on cash generated from our internal operations as our primary source of liquidity, as well as available credit facilities, project and bank financings and the issuance of long-term debt. From time to time, we have also utilized operating lease transactions that are sometimes referred to as off-balance sheet arrangements. We expect that our future funding for working capital needs, capital expenditures, long-term debt repayments and other financing activities will continue to be provided from some or all of these sources. Each of our existing and projected sources of cash is impacted by operational and financial risks that influence the overall amount of cash generated and the capital available to us. For example, cash generated by our business operations may be impacted by, among other things, economic downturns, weather-related catastrophes and adverse industry conditions. Our future liquidity will be impacted by our ability to access capital markets, which may be restricted due to our credit ratings, general market conditions, and by existing or future debt agreements. For a further discussion of risks that can impact our liquidity, see Item 1A., “Risk Factors,” beginning on page 34.

 

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Including our senior secured credit facilities at September 30, 2010, we had available liquidity as follows (in millions):
         
Available cash and cash equivalents
  $ 144.5  
Available capacity under our senior secured revolving credit facility
    183.6  
 
     
Net available liquidity at September 30, 2010
  $ 328.1  
 
     
Net available liquidity assumes 100% participation from all lenders currently participating in our senior secured revolving credit facility. On February 9, 2010, Barclays Capital assumed a $20.0 million position in our senior secured revolving credit facility, which represents 8.9% of the total capacity. This position was previously held by Lehman Brothers, which we had identified as a defaulting lender. At completion of this assumption, we had access to 100% of our total revolver capacity. In addition to our available liquidity, we expect to generate significant operating cash flow in fiscal 2011. We will also utilize proceeds from our financing activities as needed.
Based upon our current level of operations and anticipated growth, we believe we have sufficient liquidity to meet our cash requirements over the short-term (next 12 months) and over the next three years. In evaluating the sufficiency of our liquidity for both the short-term and long-term, we considered the expected cash flow to be generated by our operations, cash on hand and the available borrowings under our senior secured credit facilities compared to our anticipated cash requirements for debt service, working capital, capital expenditures and the payment of taxes, as well as funding requirements for long-term liabilities.
As a result of this evaluation, we believe that we will have sufficient liquidity for the next three years to fund the cash required for the payment of taxes and the capital expenditures required to maintain our facilities during this period of time. We are unable at this time to extend our evaluation of the sufficiency of our liquidity beyond three years. We cannot assure you, however, that our operating performance will generate sufficient cash flow from operations or that future borrowings will be available under our senior secured credit facilities, or otherwise, to enable us to grow our business, service our indebtedness, including the senior secured credit facilities and the 8 3/4% notes, or make anticipated capital expenditures. For more information, see Item 1A., “Risk Factors,” beginning on page 34.
One element of our business strategy is to selectively pursue acquisitions and strategic alliances in existing and new markets. Any acquisitions or strategic alliances may result in the incurrence of, or assumption by us, of additional indebtedness. We continually assess our capital needs and may seek additional financing, including debt or equity as considered necessary to fund capital expenditures and potential acquisitions or for other corporate purposes. Our future operating performance, ability to service or refinance our 8 3/4% notes and ability to service and extend or refinance the senior secured credit facilities will be subject to future economic conditions and to financial, business and other factors, many of which are beyond our control. For more information, see Item 1A., “Risk Factors,” beginning on page 34.

 

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We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
Tabular Disclosure of Contractual Obligations
The following table reflects a summary of obligations and commitments outstanding including both the principal and interest portions of long-term debt and capital lease obligations at September 30, 2010.
                                         
    Payments Due By Period  
    Less than                     More than        
    1 Year     1-3 Years     3-5 Years     5 Years     Total  
    (in millions)  
Contractual Cash Obligations:
                                       
Long-term debt, with interest (1)
  $ 67.8     $ 408.5     $ 787.7     $     $ 1,264.0  
Capital lease obligations, with interest
    0.9       1.2       1.1       4.7       7.9  
Medical claims
    111.4                         111.4  
Operating leases
    28.5       50.0       38.5       57.4       174.4  
Estimated self-insurance liabilities
    7.7       15.9       21.4             45.0  
Purchase obligations
    30.8       17.1       0.2             48.1  
 
                             
Subtotal
  $ 247.1     $ 492.7     $ 848.9     $ 62.1     $ 1,650.8  
 
                             
                                         
    Amount of Commitment Expiration Per Period  
    Less than                     More than        
    1 Year     1-3 Years     3-5 Years     5 Years     Total  
    (in millions)  
Other Commitments (2):
                                       
Guarantees of surety bonds
  $ 12.1     $     $     $     $ 12.1  
Letters of credit
          39.9       41.4             81.3  
Other commitments
    4.8                         4.8  
 
                             
Subtotal
    16.9       39.9       41.4             98.2  
 
                             
Total obligations and commitments
  $ 264.0     $ 532.6     $ 890.3     $ 62.1     $ 1,749.0  
 
                             
 
     
(1)  
We used 3.4%, the weighted average interest rate incurred on our senior secured credit facilities in fiscal 2010, which accrues actual interest at a variable rate. Actual interest will vary based on changes in interest rates. Included in the weighted average interest rate is the effect of our interest rate swap arrangements, which effectively converts $425.0 million of variable rate debt to fixed rate debt.
 
(2)  
Excludes $11.7 million of unrecognized tax benefits and related interest that could result in a cash settlement, of which $9.2 million relates to timing differences between book and taxable income that may be offset by a reduction of cash tax obligations in future periods. We have not included these amounts in the above table as we cannot reliably estimate the amount and timing of payments related to these liabilities.
Seasonality
The patient volumes and net revenue at our healthcare operations are subject to seasonal variations and generally are greater during the quarter ended March 31 than other quarters. These seasonal variations are caused by a number of factors, including seasonal cycles of illness, climate and weather conditions in our markets, vacation patterns of both patients and physicians and other factors relating to the timing of elective procedures.
RECENT ACCOUNTING PRONOUNCEMENTS
We have adopted the FASB authoritative guidance regarding business combinations, which applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. This guidance establishes principles and requirements for recognition and measurement of items acquired during a business combination, as well as certain disclosure requirements in the financial statements. The adoption of these provisions did not impact our results of operations or financial position; however, it is anticipated to have a material effect on our accounting for future acquisitions.

 

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We are subject to market risk from exposure to changes in interest rates based on our financing, investing, and cash management activities. The following components of our senior secured credit facilities bear interest at variable rates at specified margins above either the agent bank’s alternate base rate or the LIBOR rate: (i) a $439.0 million, seven-year term loan; (ii) a $150.0 million senior secured delayed draw term loan; and (iii) a $225.0 million, six-year senior secured revolving credit facility. As of September 30, 2010, we had outstanding variable rate debt of $570.3 million. We have managed our market exposure to changes in interest rates by converting $425.0 million of this variable rate debt to fixed rate debt through the use of interest rate swap agreements. Our interest rate swaps provide for $425.0 million of fixed rate debt under our senior secured credit facilities through February 28, 2011 and $200.0 million from March 1, 2011 through February 29, 2012, at rates ranging from 1.5% to 2.0% depending upon the terms of the specific agreement.
Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates on our remaining variable rate debt or our consolidated financial position, results of operations or cash flows would not be material. Holding other variables constant, including levels of indebtedness and interest rate swaps, a 0.125% increase in interest rates would have an estimated impact on pre-tax earnings and cash flows for the next twelve month period of $713,000.
Our interest rate swap agreements expose us to credit risk in the event of non-performance by our counterparties, Citibank and Wachovia. However, we do not anticipate non-performance by Citibank or Wachovia.
We have $475.0 million in senior subordinated notes due December 15, 2014, with interest payable semi-annually at the rate of 8 3/4% per annum. At September 30, 2010, the fair market value of the outstanding 8 3/4% notes was $485.7 million, based upon quoted market prices as of that date.
We currently believe we have adequate liquidity to fund operations during the near term through the generation of operating cash flows, cash on hand and access to our revolving credit facility. Our ability to borrow funds under our revolving credit facility is subject to the financial viability of the participating financial institutions. While we do not anticipate any of our current lenders defaulting on their obligations, we are unable to provide assurance that any particular lender will not default at a future date.

 

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Item 8. Financial Statements and Supplementary Data.
IASIS Healthcare LLC
Index to Consolidated Financial Statements

 

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Report of Independent Registered Public Accounting Firm
To the Board of Directors of
IASIS Healthcare Corporation, sole member of IASIS Healthcare LLC
We have audited the accompanying consolidated balance sheets of IASIS Healthcare LLC as of September 30, 2010 and 2009, and the related consolidated statements of operations, equity and cash flows for each of the three years in the period ended September 30, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of IASIS Healthcare LLC at September 30, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2010, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company changed its accounting and disclosure for noncontrolling interests with the adoption of the guidance originally issued in FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements (codified in FASB ASC Topic 810, Consolidation) effective October 1, 2009.
/s/ Ernst & Young LLP
Nashville, Tennessee
December 21, 2010

 

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IASIS HEALTHCARE LLC
CONSOLIDATED BALANCE SHEETS

(In thousands)
                 
    September 30,     September 30,  
    2010     2009  
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 144,511     $ 206,528  
Accounts receivable, less allowance for doubtful accounts of $125,406 and $126,132 at September 30, 2010 and 2009, respectively
    209,173       230,198  
Inventories
    53,842       50,492  
Deferred income taxes
    15,881       39,038  
Prepaid expenses and other current assets
    65,340       49,453  
 
           
Total current assets
    488,747       575,709  
 
               
Property and equipment, net
    985,291       997,353  
Goodwill
    718,243       717,920  
Other intangible assets, net
    27,000       30,000  
Deposit for acquisition
    97,891        
Other assets, net
    36,022       36,222  
 
           
Total assets
  $ 2,353,194     $ 2,357,204  
 
           
 
               
LIABILITIES AND EQUITY
               
 
               
Current liabilities:
               
Accounts payable
  $ 78,931     $ 68,552  
Salaries and benefits payable
    38,110       42,548  
Accrued interest payable
    12,536       12,511  
Medical claims payable
    111,373       113,519  
Other accrued expenses and other current liabilities
    106,614       65,701  
Current portion of long-term debt and capital lease obligations
    6,691       8,366  
 
           
Total current liabilities
    354,255       311,197  
 
               
Long-term debt and capital lease obligations
    1,044,887       1,051,471  
Deferred income taxes
    109,272       106,425  
Other long-term liabilities
    60,162       54,222  
 
               
Non-controlling interests with redemption rights
    72,112       72,527  
 
               
Equity:
               
Member’s equity
    702,135       750,932  
Non-controlling interests
    10,371       10,430  
 
           
Total equity
    712,506       761,362  
 
           
Total liabilities and equity
  $ 2,353,194     $ 2,357,204  
 
           
See accompanying notes.

 

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IASIS HEALTHCARE LLC
CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands)
                         
    Year Ended     Year Ended     Year Ended  
    September 30,     September 30,     September 30,  
    2010     2009     2008  
Net revenue:
                       
Acute care revenue
  $ 1,729,344     $ 1,662,469     $ 1,523,790  
Premium revenue
    792,062       699,503       541,746  
 
                 
Total net revenue
    2,521,406       2,361,972       2,065,536  
 
                       
Costs and expenses:
                       
Salaries and benefits
    686,303       660,921       632,109  
Supplies
    266,545       250,573       231,259  
Medical claims
    678,651       592,760       452,055  
Other operating expenses
    363,916       325,735       283,123  
Provision for bad debts
    197,680       192,563       161,936  
Rentals and leases
    39,955       39,127       36,633  
Interest expense, net
    66,810       67,890       75,665  
Depreciation and amortization
    96,106       97,462       96,741  
Management fees
    5,000       5,000       5,000  
Impairment of goodwill
          64,639        
Hurricane-related property damage
          938       3,589  
 
                 
Total costs and expenses
    2,400,966       2,297,608       1,978,110  
 
                       
Earnings from continuing operations before gain (loss) on disposal of assets and income taxes
    120,440       64,364       87,426  
Gain (loss) on disposal of assets, net
    108       1,465       (75 )
 
                 
 
                       
Earnings from continuing operations before income taxes
    120,548       65,829       87,351  
Income tax expense
    44,715       27,576       35,325  
 
                 
 
                       
Net earnings from continuing operations
    75,833       38,253       52,026  
Loss from discontinued operations, net of income taxes
    (1,087 )     (176 )     (11,275 )
 
                 
 
                       
Net earnings
    74,746       38,077       40,751  
Net earnings attributable to non-controlling interests
    (8,279 )     (9,987 )     (4,437 )
 
                 
 
                       
Net earnings attributable to IASIS Healthcare LLC
  $ 66,467     $ 28,090     $ 36,314  
 
                 
See accompanying notes.

 

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IASIS HEALTHCARE LLC
CONSOLIDATED STATEMENTS OF EQUITY

(In thousands)
                                 
    Non-controlling                      
    Interests with             Non-        
    Redemption     Member’s     controlling        
    Rights     Equity     Interests     Total Equity  
 
                               
Balance at September 30, 2007 (as previously reported)
  $     $ 691,514     $     $ 691,514  
 
                               
Adjustment to non-controlling interests from adoption of FASB authoritative guidance
    44,134       (16,782 )     8,604       (8,178 )
 
                       
 
                               
Balance at September 30, 2007 (as adjusted)
    44,134       674,732       8,604       683,336  
Net earnings
    4,285       36,314       152       36,466  
Distributions to non-controlling interests
    (5,313 )           (172 )     (172 )
Proceeds from the sale of non-controlling interests
    15,872                    
Repurchases of non-controlling intersts
    (802 )                  
Non-controlling interests in acquisition of Ouachita
                1,897       1,897  
Tax effect of adoption of FASB income tax guidance
          (59 )           (59 )
Adjustment to redemption value of non-controlling interests with redemption rights
    (3,520 )     3,520             3,520  
 
                       
 
                               
Balance at September 30, 2008
    54,656       714,507       10,481       724,988  
Net earnings
    9,769       28,090       218       28,308  
Distributions to non-controlling interests
    (6,481 )           (269 )     (269 )
Repurchases of non-controlling interests
    (1,379 )                  
Conversion of non-controlling interests to note payable
    (691 )                  
Stock compensation
          561             561  
Other comprehensive loss
          (2,926 )           (2,926 )
Income tax benefit resulting from exercise of employee stock options
          9             9  
Contribution from parent company related to tax benefit from Holdings Senior PIK Loans interest
          27,344             27,344  
Adjustment to redemption value of non-controlling interests with redemption rights
    16,653       (16,653 )           (16,653 )
 
                       
 
                               
Balance at September 30, 2009
    72,527       750,932       10,430       761,362  
Net earnings
    8,144       66,467       135       66,602  
Distributions to non-controlling interests
    (8,790 )           (194 )     (194 )
Repurchases of non-controlling interests
    (459 )                  
Stock compensation
          2,487             2,487  
Other comprehensive loss
          (653 )           (653 )
Distribution to parent company in connection with the repurchase of equity, net
          (124,962 )           (124,962 )
Contribution from parent company related to tax benefit from Holdings Senior PIK Loans interest
          8,554             8,554  
Adjustment to redemption value of non-controlling interests with redemption rights
    690       (690 )           (690 )
 
                       
 
                               
Balance at September 30, 2010
  $ 72,112     $ 702,135     $ 10,371     $ 712,506  
 
                       
See accompanying notes.

 

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IASIS HEALTHCARE LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
                         
    Year Ended     Year Ended     Year Ended  
    September 30,     September 30,     September 30,  
    2010     2009     2008  
Cash flows from operating activities:
                       
Net earnings
  $ 74,746     $ 38,077     $ 40,751  
Adjustments to reconcile net earnings to net cash provided by operating activities:
                       
Depreciation and amortization
    96,106       97,462       96,741  
Amortization of loan costs
    3,163       3,029       2,913  
Stock compensation costs
    2,487       561        
Deferred income taxes
    30,473       (5,572 )     19,368  
Income tax benefit from stock compensation
    (1,770 )            
Income tax benefit from parent company interest
    8,554       27,344        
Loss (gain) on disposal of assets, net
    (108 )     (1,465 )     75  
Loss from discontinued operations
    1,087       176       11,275  
Impairment of goodwill
          64,639        
Hurricane-related property damage
          938       3,589  
Changes in operating assets and liabilities, net of the effect of acquisitions and dispositions:
                       
Accounts receivable, net
    21,279       (7,302 )     17,131  
Inventories, prepaid expenses and other current assets
    (19,227 )     6,728       (21,361 )
Accounts payable, other accrued expenses and other accrued liabilities
    41,957       45,884       (29,419 )
 
                 
Net cash provided by operating activities — continuing operations
    258,747       270,499       141,063  
Net cash provided by (used in) operating activities — discontinued operations
    (1,508 )     1,472       2,313  
 
                 
Net cash provided by operating activities
    257,239       271,971       143,376  
 
                 
 
                       
Cash flows from investing activities:
                       
Purchases of property and equipment
    (81,268 )     (87,720 )     (137,415 )
Cash paid for acquisitions
    (98,305 )     (1,941 )     (16,821 )
Proceeds from sale of assets
    57       5,252       360  
Change in other assets
    3,043       1,823       4,613  
 
                 
Net cash used in investing activities — continuing operations
    (176,473 )     (82,586 )     (149,263 )
Net cash provided by (used in) investing activities — discontinued operations
          10       (1,017 )
 
                 
Net cash used in investing activities
    (176,473 )     (82,576 )     (150,280 )
 
                 
 
                       
Cash flows from financing activities:
                       
Payment of debt and capital lease obligations
    (8,378 )     (55,476 )     (306,611 )
Proceeds from debt borrowings
                384,978  
Distribution to parent company in connection with the repurchase of equity, net
    (124,962 )            
Distributions to non-controlling interests
    (8,984 )     (6,750 )     (5,485 )
Proceeds received from sale (costs paid for repurchase) of non-controlling interests, net
    (459 )     (1,379 )     15,070  
Other
                192  
 
                 
Net cash provided by (used in) financing activities — continuing operations
    (142,783 )     (63,605 )     88,144  
Net cash used in financing activities — discontinued operations
                (502 )
 
                 
Net cash provided by (used in) financing activities
    (142,783 )     (63,605 )     87,642  
 
                 
Change in cash and cash equivalents
    (62,017 )     125,790       80,738  
Cash and cash equivalents at beginning of period
    206,528       80,738        
 
                 
Cash and cash equivalents at end of period
  $ 144,511     $ 206,528     $ 80,738  
 
                 
 
                       
Supplemental disclosure of cash flow information:
                       
Cash paid for interest
  $ 63,762     $ 66,136     $ 83,126  
 
                 
Cash paid (received) for income taxes, net
  $ 13,528     $ 4,104     $ (925 )
 
                 
 
                       
Supplemental schedule of noncash investing and financing activities:
                       
Capital lease obligations resulting from acquisitions
  $     $     $ 4,849  
 
                 
See accompanying notes.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION
Organization
IASIS Healthcare LLC (“IASIS” or the “Company”) owns and operates medium-sized acute care hospitals in high-growth urban and suburban markets. At September 30, 2010, the Company owned or leased 15 acute care hospital facilities and one behavioral health hospital facility, with a total of 3,185 licensed beds, located in six regions:
   
Salt Lake City, Utah;
   
Phoenix, Arizona;
   
Tampa-St. Petersburg, Florida;
   
three cities in Texas, including San Antonio;
   
Las Vegas, Nevada; and
   
West Monroe, Louisiana.
The Company also owns and operates Health Choice Arizona, Inc. (“Health Choice” or the “Plan”), a Medicaid and Medicare managed health plan in Phoenix.
Principles of Consolidation
The consolidated financial statements include all subsidiaries and entities under common control of the Company. Control is generally defined by the Company as ownership of a majority of the voting interest of an entity. In addition, control is demonstrated in instances when the Company is the sole general partner in a limited partnership. Significant intercompany transactions have been eliminated.
Use of Estimates
The preparation of the financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the accompanying audited consolidated financial statements and notes. Actual results could differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications have no impact on the Company’s total assets or total liabilities and equity.
General and Administrative
The majority of the Company’s expenses are “cost of revenue” items. Costs that could be classified as “general and administrative” by the Company would include the IASIS corporate office costs, which were $39.2 million, $45.6 million and $50.5 million, for the years ended September 30, 2010, 2009 and 2008, respectively.
Subsequent Events Consideration
The Company has evaluated its financial statements and disclosures for the impact of subsequent events up to the date of filing its annual report on Form 10-K with the Securities and Exchange Commission.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
2. SIGNIFICANT ACCOUNTING POLICIES
Net Revenue
Acute Care Revenue
The Company’s healthcare facilities have entered into agreements with third-party payors, including government programs and managed care health plans, under which the facilities are paid based upon established charges, the cost of providing services, predetermined rates per diagnosis, fixed per diem rates or discounts from established charges. Additionally, the Company offers discounts through its uninsured discount program to all uninsured patients receiving healthcare services who do not qualify for assistance under state Medicaid, other federal or state assistance plans, or charity care.
Net patient revenue is reported at the estimated net realizable amounts from third-party payors and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and are adjusted, if necessary, in future periods when final settlements are determined. Net adjustments to estimated third-party payor settlements (“prior year contractuals”) resulted in an increase in net revenue of $5.2 million, $3.2 million and $1.0 million for the years ended September 30, 2010, 2009 and 2008, respectively.
In the ordinary course of business, the Company provides care without charge to patients who are financially unable to pay for the healthcare services they receive. Because the Company does not pursue collection of amounts determined to qualify as charity care, they are not reported in net revenue. The Company currently records revenue deductions for patient accounts that meet its guidelines for charity care. The Company provides charity care to patients with income levels below 200% of the federal poverty level (“FPL”). Additionally, at all of the Company’s hospitals, a sliding scale of reduced rates is offered to uninsured patients, who are not covered through federal, state or private insurance, with incomes between 200% and 400% of the FPL. Charity care deductions based on gross charges for the years ended September 30, 2010, 2009 and 2008 were $37.9 million, $38.6 million and $37.7 million, respectively.
Premium Revenue
Health Choice is a prepaid Medicaid and Medicare managed health plan that derives most of its revenue through a contract with the Arizona Health Care Cost Containment System (“AHCCCS”) to provide specified health services to qualified Medicaid enrollees through contracted providers. AHCCCS is the state agency that administers Arizona’s Medicaid program. The contract requires the Plan to arrange for healthcare services for enrolled Medicaid patients in exchange for fixed monthly premiums, based upon negotiated per capita member rates, and supplemental payments from AHCCCS. Capitation payments received by Health Choice are recognized as revenue in the month that members are entitled to healthcare services.
The Plan receives reinsurance and other supplemental payments from AHCCCS for healthcare costs that exceed stated amounts at a rate ranging from 75% to 100% of qualified healthcare costs in excess of stated levels of up to $35,000 per claim, depending on the eligibility classification of the member. Qualified costs must be incurred during the contract year and are the lesser of the amount paid by the Plan or the AHCCCS fee schedule. Reinsurance recoveries are recognized under the contract with AHCCCS when healthcare costs exceed stated amounts as provided under the contract, including estimates of such costs at the end of each accounting period.
Effective October 1, 2008, Health Choice began its current contract with AHCCCS, which provides for a three-year term, with AHCCCS having the option to renew for two additional one-year periods. The contract is terminable without cause on 90 days’ written notice or for cause upon written notice if the Company fails to comply with any term or condition of the contract or fails to take corrective action as required to comply with the terms of the contract. Additionally, AHCCCS can terminate the contract in the event of the unavailability of state or federal funding.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Health Choice also provides coverage as a Medicare Advantage Prescription Drug (“MAPD”) Special Needs Plan (“SNP”) provider pursuant to its contract with the Centers for Medicare and Medicaid Services (“CMS”). The SNP allows Health Choice to offer Medicare and Part D drug benefit coverage for new and existing dual-eligible members, or those that are eligible for Medicare and Medicaid. The contract with CMS includes successive one-year renewal options at the discretion of CMS and is terminable without cause on 90 days’ written notice or for cause upon written notice if the Company fails to comply with any term or condition of the contract or fails to take corrective action as required to comply with the terms of the contract. Health Choice has received notification that CMS is exercising its option to extend its contract through December 31, 2011.
The Plan subcontracts with hospitals, physicians and other medical providers within Arizona and surrounding states to provide services to its Medicaid enrollees in Apache, Coconino, Maricopa, Mohave, Navajo, Pima, Yuma, LaPaz and Santa Cruz counties, and to its Medicare enrollees in Maricopa, Pima, Pinal, Coconino, Apache and Navajo counties. These services are provided regardless of the actual costs incurred to provide these services.
Cash and Cash Equivalents
The Company considers highly liquid investments with original maturities of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents balances primarily with high credit quality financial institutions. The Company manages its credit exposure by placing its investments in United States Treasury securities or other high quality securities, and by periodically evaluating the relative credit standing of the financial institution.
Accounts Receivable
The Company receives payments for services rendered from federal and state agencies (under the Medicare, Medicaid and TRICARE programs), managed care health plans, including Medicare and Medicaid managed health plans, commercial insurance companies, employers and patients. During the years ended September 30, 2010, 2009 and 2008, 47.6%, 45.9% and 44.9%, respectively, of the Company’s net patient revenue related to patients participating in the Medicare and Medicaid programs, including Medicare and Medicaid managed health plans. The Company recognizes that revenue and receivables from government agencies are significant to its operations, but does not believe that there is significant credit risks associated with these government agencies. The Company believes that concentration of credit risk from other payors is limited due to the number of patients and payors.
Net Medicare settlement receivables estimated at September 30, 2010 and 2009, totaled $1.3 million and $6.3 million, respectively, are included in accounts receivable in the accompanying consolidated balance sheets.
Allowance for Doubtful Accounts
The Company’s estimation of the allowance for doubtful accounts is based primarily upon the type and age of the patient accounts receivable and the effectiveness of the Company’s collection efforts. The Company’s policy is to reserve a portion of all self-pay receivables, including amounts due from the uninsured and amounts related to co-payments and deductibles, as these charges are recorded. On a monthly basis, the Company reviews its accounts receivable balances, the effectiveness of the Company’s reserve policies and various analytics to support the basis for its estimates. These efforts primarily consist of reviewing the following:
   
Historical write-off and collection experience using a hindsight or look-back approach;
   
Revenue and volume trends by payor, particularly the self-pay components;
   
Changes in the aging and payor mix of accounts receivable, including increased focus on accounts due from the uninsured and accounts that represent co-payments and deductibles due from patients;
   
Cash collections as a percentage of net patient revenue less bad debt expense;
   
Trending of days revenue in accounts receivable; and
   
Various allowance coverage statistics.
The Company regularly performs hindsight procedures to evaluate historical write-off and collection experience throughout the year to assist in determing the reasonableness of its process for estimating the allowance for doubtful accounts.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Inventories
Inventories, principally medical supplies, implants and pharmaceuticals, are stated at the lower of average cost or market.
Long-lived Assets
The primary components of the Company’s long-lived assets are discussed below. When events, circumstances or operating results indicate that the carrying values of certain long-lived assets and related identifiable intangible assets (excluding goodwill) that are expected to be held and used might be impaired under the provisions of Financial Accounting Standards Board (“FASB”) authoritative guidance regarding accounting for the impairment or disposal of long-lived assets, the Company considers the recoverability of assets to be held and used by comparing the carrying amount of the assets to the undiscounted value of future net cash flows expected to be generated by the assets. If assets are identified as impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets as determined by independent appraisals or estimates of discounted future cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
Property and Equipment
Property and equipment are stated at cost. Routine maintenance and repairs are charged to expense as incurred. Expenditures that increase capacities or extend useful lives are capitalized. Buildings and improvements are depreciated over estimated useful lives ranging generally from 14 to 40 years. Estimated useful lives of equipment vary generally from 3 to 25 years. Leasehold improvements are amortized on a straight-line basis over the lesser of the terms of the respective leases or their estimated useful lives. Depreciation expense, including amortization of assets capitalized under capital leases, is computed using the straight-line method and was $93.1 million, $94.5 million and $93.7 million for the years ended September 30, 2010, 2009 and 2008, respectively. In connection with certain construction projects, the Company capitalized interest totaling $1.2 million and $1.4 million for the years ended September 30, 2009 and 2008, respectively. No amounts were capitalized in the year ended September 30, 2010.
Goodwill and Other Intangible Assets
See Note 10 for the values of goodwill and other intangible assets assigned to each business segment. Intangible assets are evaluated for impairment if events and circumstances indicate a possible impairment.
Goodwill is not amortized but is subject to annual tests for impairment or more often if events or circumstances indicate it may be impaired. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Company completed its annual impairment test of goodwill during fiscal 2010, noting no impairment. During fiscal 2009, the Company’s testing of goodwill indicated impairment of goodwill associated with its Florida market. See Note 10 for more details.
Other Assets
Other assets consist primarily of costs associated with the issuance of debt, which are amortized over the life of the related debt. Amortization of deferred financing costs is included in interest expense and totaled $3.2 million, $3.0 million and $2.9 million for the years ended September 30, 2010, 2009 and 2008, respectively. Deferred financing costs, net of accumulated amortization, totaled $12.0 million and $15.2 million at September 30, 2010 and 2009, respectively.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Insurance Reserves
The Company estimates its reserve for self-insured professional and general liability and workers compensation risks using historical claims data, demographic factors, severity factors, current incident logs and other actuarial analysis.
Income Taxes
The Company accounts for income taxes under the asset and liability method in accordance with FASB authoritative guidance regarding accounting for income taxes and its related uncertainty. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply when the temporary differences are expected to reverse. The Company assesses the likelihood that deferred tax assets will be recovered from future taxable income to determine whether a valuation allowance should be established.
Non-controlling Interests in Consolidated Entities
Effective October 1, 2009, the Company adopted the provisions of FASB authoritative guidance regarding non-controlling interests in consolidated financial statements. The guidance requires the Company to clearly identify and present ownership interests in subsidiaries held by parties other than the Company in the consolidated financial statements within the equity section. It also requires the amounts of consolidated net earnings attributable to the Company and to the non-controlling interests to be clearly identified and presented on the face of the consolidated statements of operations.
The Company consolidates seven subsidiaries with non-controlling interests that include third-party partners that own limited partnership units with certain redemption features. The redeemable limited partnership units require the Company to buy back the units upon the occurrence of certain events at the fair value of the units. In addition, the limited partnership agreements for all of the limited partnerships provide the limited partners with put rights which allow the units to be sold back to the Company, subject to certain limitations, at the fair value of the units. According to the limited partnership agreements, the fair value of the units is generally calculated as the product of the most current audited fiscal period’s EBITDA (earnings before interest, taxes, depreciation, amortization and management fees) and a fixed multiple, less any long-term debt of the entity. The majority of these put rights require an initial holding period of six years after purchase, at which point the holder of the redeemable limited partnership units may put back to the Company 20% of such holder’s units. Each succeeding year, the number of vested redeemable units will increase by 20% until the end of the tenth year after the initial investment, at which point 100% of the units may be put back to the Company. Under no circumstances shall the Company be required to repurchase more than 25% of the total vested redeemable limited partnership units in any fiscal year. The equity attributable to these interests has been classified as non-controlling interests with redemption rights in the accompanying consolidated balance sheets.
Medical Claims Payable
Monthly capitation payments made by Health Choice to physicians and other healthcare providers are expensed in the month services are contracted to be performed. Claims expense for non-capitated arrangements is accrued as services are rendered by hospitals, physicians and other healthcare providers during the year.
Medical claims payable related to Health Choice includes claims received but not paid and an estimate of claims incurred but not reported. Incurred but not reported claims are estimated using a combination of historical claims experience (including severity and payment lag time) and other actuarial analysis, including number of enrollees, age of enrollees and certain enrollee health indicators, to predict the cost of healthcare services provided to enrollees during any given period. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from estimates given changes in the healthcare cost structure or adverse experience.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The following table shows the components of the change in medical claims payable (in thousands):
                 
    Year Ended     Year Ended  
    September 30,     September 30,  
    2010     2009  
Medical claims payable as of October 1
  $ 113,519     $ 97,343  
Medical claims expense incurred during the year:
               
Related to current year
    697,052       620,153  
Related to prior years
    (6,596 )     (18,077 )
 
           
Total expenses
    690,456       602,076  
 
           
Medical claims payments during the year:
               
Related to current year
    (587,292 )     (508,299 )
Related to prior years
    (105,310 )     (77,601 )
 
           
Total payments
    (692,602 )     (585,900 )
 
           
Medical claims payable as of September 30
  $ 111,373     $ 113,519  
 
           
As reflected in the table above, medical claims expense for the year ended September 30, 2010, includes a $6.6 million reduction of medical costs related to prior years resulting from favorable development in the Medicaid and Medicare product lines of $6.4 million and $209,000, respectively. The favorable development is attributable to lower than anticipated medical costs. Medical claims expense for the year ended September 30, 2009, includes an $18.1 million reduction of medical costs related to prior years resulting from favorable development in the Medicaid and Medicare product lines of $15.5 million and $2.6 million, respectively. The favorable development is attributable to lower than anticipated medical costs and is offset, in part, by $10.8 million in reductions in premium revenue associated with settlements of various prior year program receivables. Additional adjustments to prior year estimates may be necessary in future periods as more information becomes available.
Health Choice has experienced an increase in the number of lives served by the plan. Enrollment in Health Choice at September 30, 2010 and 2009, was 198,393 and 190,763, respectively.
Stock Based Compensation
Although IASIS has no stock option plan or outstanding stock options, the Company, through its parent, IASIS Healthcare Corporation (“IAS”), grants stock options for a fixed number of common shares to employees. The Company accounts for this stock-based incentive plan under the measurement and recognition provisions of FASB authoritative guidance regarding share-based payments (“Share-Based Payments Guidance”). Accordingly, the Company has not recognized any compensation expense for the stock options granted prior to October 1, 2006, as the exercise price of the options equaled, or was greater than, the market value of the underlying stock on the date of grant.
For stock options granted on or after October 1, 2006, the Company applies the fair value recognition provisions of the Share-Based Payments Guidance, requiring all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. In accordance with the provisions of the Share-Based Payments Guidance, the Company uses the Black-Scholes-Merton model in determining the fair value of its share-based payments. The fair value of compensation costs will be amortized on a straight-line basis over the requisite service periods of the awards, generally equal to the awards’ vesting periods.
Fair Value of Financial Instruments
Cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities are reflected in the accompanying consolidated financial statements at amounts that approximate fair value because of the short-term nature of these instruments. The fair value of the Company’s capital lease obligations also approximate carrying value as they bear interest at current market rates. The estimated fair values of the Company’s 8 3/4% senior subordinated notes due 2014 (the “8 3/4% notes”) and senior secured credit facilities were $485.7 million and $570.3 million, respectively, at September 30, 2010, based upon quoted market prices at that date.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Management Services Agreement
The Company is party to a management services agreement with affiliates of TPG, JLL Partners and Trimaran Fund Management. The management services agreement provides that in exchange for consulting and management advisory services that will be provided to the Company by the investors, the Company will pay an aggregate monitoring fee of 0.25% of budgeted net revenue up to a maximum of $5.0 million per fiscal year to these parties (or certain of their respective affiliates) and reimburse them for their reasonable disbursements and out-of-pocket expenses. This monitoring fee is divided among the parties in proportion to their relative ownership percentages in IASIS Investment LLC, parent company and majority stockholder of IAS. The monitoring fee will be subordinated to the senior subordinated notes in the event of a bankruptcy of the Company. The management services agreement does not have a stated term. Pursuant to the provisions of the management services agreement, the Company has agreed to indemnify the investors (or certain of their respective affiliates) in certain situations arising from or relating to the agreement, the investors’ investment in the securities of IAS or any related transactions or the operations of the investors, except for losses that arise on account of the investors’ negligence or willful misconduct. For each of the three years ended September 30, 2010, 2009 and 2008, the Company paid $5.0 million in monitoring fees under the management services agreement.
Recently Issued Accounting Pronouncements
The Company has adopted the new FASB authoritative guidance regarding business combinations, which applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. This new guidance establishes principles and requirements for recognition and measurement of items acquired during a business combination, as well as certain disclosure requirements in the financial statements. The adoption of these provisions did not impact the Company’s results of operations or financial position; however, it is anticipated to have a material effect on the Company’s accounting for future acquisitions.
3. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Long-term debt and capital lease obligations consist of the following (in thousands):
                 
    September 30,     September 30,  
    2010     2009  
Senior secured credit facilities
  $ 570,260     $ 576,150  
Senior subordinated notes
    475,000       475,000  
Capital leases and other obligations
    6,318       8,687  
 
           
 
    1,051,578       1,059,837  
Less current maturities
    6,691       8,366  
 
           
 
  $ 1,044,887     $ 1,051,471  
 
           
Senior Secured Credit Facilities
The $854.0 million senior secured credit facilities include: (i) a senior secured term loan of $439.0 million; (ii) a senior secured delayed draw term loan of $150.0 million; (iii) a senior secured revolving credit facility of $225.0 million, which includes a $100.0 million sub-limit for letters of credit; and (iv) a senior secured synthetic letter of credit facility of $40.0 million. All facilities mature on March 15, 2014, except for the revolving credit facility, which matures on April 27, 2013. The term loans bear interest at an annual rate of LIBOR plus 2.00% or, at the Company’s option, the administrative agent’s base rate plus 1.00%. The revolving loans bear interest at an annual rate of LIBOR plus an applicable margin ranging from 1.25% to 1.75% or, at the Company’s option, the administrative agent’s base rate plus an applicable margin ranging from 0.25% to 0.75%, such rate in each case depending on the Company’s senior secured leverage ratio. A commitment fee ranging from 0.375% to 0.5% per annum is charged on the undrawn portion of the senior secured revolving credit facility and is payable in arrears.
Principal under the senior secured term loan is due in 24 consecutive equal quarterly installments in an aggregate annual amount equal to 1.0% of the original principal amount ($439.0 million) during the first six years thereof, with the balance payable in four equal installments in year seven. Principal under the senior secured delayed draw term loan is due in equal quarterly installments in an aggregate annual amount equal to 1.0% of the original principal amount ($150.0 million) until March 31, 2013, with the balance payable in four equal installments during the final year of the loan. Unless terminated earlier, the senior secured revolving credit facility has a single maturity of six years. The senior secured credit facilities are also subject to mandatory prepayment under specific circumstances, including a portion of excess cash flow, a portion of the net proceeds from an initial public offering, asset sales, debt issuances and specified casualty events, each subject to various exceptions.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The senior secured credit facilities are (i) secured by a first mortgage and lien on the real property and related personal and intellectual property of the Company and pledges of equity interests in the entities that own such properties and (ii) guaranteed by certain of the Company’s subsidiaries.
In addition, the senior secured credit facilities contain certain covenants which, among other things, limit the incurrence of additional indebtedness, investments, dividends, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, liens and encumbrances and other matters customarily restricted in such agreements.
At September 30, 2010, amounts outstanding under the Company’s senior secured credit facilities consisted of a $423.6 million term loan and a $146.7 million delayed draw term loan. In addition, the Company had $39.9 million and $41.4 million in letters of credit outstanding under the synthetic letter of credit facility and the revolving credit facility, respectively. The weighted average interest rate of outstanding borrowings under the senior secured credit facilities was 3.4% and 3.6% for the years ended September 30, 2010 and 2009, respectively.
8 3/4% Senior Subordinated Notes
The Company, together with its wholly-owned subsidiary, IASIS Capital Corporation, a holding company with no assets or operations, as issuers, have outstanding $475.0 million aggregate principal amount of 8 3/4% notes. The 8 3/4% notes are general unsecured senior subordinated obligations and are subordinated in right of payment to all existing and future senior debt of the Company. The Company’s existing domestic subsidiaries, other than certain non-guarantor subsidiaries, which include Health Choice and the Company’s non-wholly owned subsidiaries, are guarantors of the 8 3/4% notes. The 8 3/4% notes are effectively subordinated to all of the issuers’ and the guarantors’ secured debt to the extent of the value of the assets securing the debt and are structurally subordinated to all liabilities and commitments (including trade payables and capital lease obligations) of the Company’s subsidiaries that are not guarantors of the 8 3/4% notes.
Holdings Senior Paid-in-Kind Loans
IAS has outstanding unsecured Senior Paid-in-Kind (“PIK”) Loans, which were used to repurchase certain preferred equity from its stockholders in fiscal 2007. The Senior PIK Loans mature June 15, 2014, and bear interest at an annual rate equal to LIBOR plus 5.25%. At September 30, 2010, the outstanding balance of the Senior PIK Loans was $389.8 million, which includes $89.8 million of interest that has accrued to the principal of these loans since the date of issuance, and is recorded in the financial statements of IAS. In June 2012, the Senior PIK Loans, which rank behind the Company’s existing debt, will convert to cash-pay, at which time all accrued interest becomes payable. In the event the Senior PIK Loans are not refinanced before their maturity, it is anticipated that principle and interest will be funded by the cash flows of the Company.
4. INTEREST RATE SWAPS
Effective March 2, 2009, the Company executed interest rate swap transactions with Citibank, N.A. and Wachovia Bank, N.A., as counterparties, with notional amounts totaling $425.0 million. The arrangements with each counterparty include two interest rate swap agreements, one with a notional amount of $112.5 million maturing on February 28, 2011 and one with a notional amount of $100.0 million maturing on February 29, 2012. The Company entered into these interest rate swap arrangements to mitigate the floating interest rate risk on a portion of its outstanding variable rate debt. Under these agreements, the Company is required to make monthly fixed rate payments to the counterparties, as calculated on the applicable notional amounts, at annual fixed rates, which range from 1.5% to 2.0% depending upon the agreement. The counterparties are obligated to make monthly floating rate payments to the Company based on the one-month LIBOR rate for the same referenced notional amount.
         
    Total Notional  
Date Range   Amounts  
    (in thousands)  
Expiring on February 28, 2011
  $ 225,000  
Expiring on February 29, 2012
  $ 200,000  

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Company accounts for its interest rate swaps in accordance with the provisions of FASB authoritative guidance regarding accounting for derivative instruments and hedging activities, which also includes enhanced disclosure requirements. In accordance with these provisions, the Company has designated its interest rate swaps as cash flow hedge instruments. The Company assesses the effectiveness of these cash flow hedges on a quarterly basis, with any ineffectiveness being measured using the hypothetical derivative method. The Company completed an assessment of its cash flow hedge instruments during the years ended September 30, 2010 and 2009, and determined its hedging instruments to be highly effective in all periods. Accordingly, no gain or loss resulting from hedging ineffectiveness is reflected in the Company’s accompanying consolidated statements of operations.
The Company applies the provisions of FASB authoritative guidance regarding fair value measurements, which provides a single definition of fair value, establishes a framework for measuring fair value, and expands disclosures concerning fair value measurements. The Company applies these provisions to the valuation and disclosure of its interest rate swaps. This authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: (i) Level 1, which is defined as quoted prices in active markets that can be accessed at the measurement date; (ii) Level 2, which is defined as inputs other than quoted prices in active markets that are observable, either directly or indirectly; and (iii) Level 3, which is defined as unobservable inputs resulting from the existence of little or no market data, therefore potentially requiring an entity to develop its own assumptions.
The Company determines the fair value of its interest rate swaps in a manner consistent with that used by market participants in pricing hedging instruments, which includes using a discounted cash flow analysis based upon the terms of the agreements, the impact of the one-month forward LIBOR curve and an evaluation of credit risk. Given the use of observable market assumptions and the consideration of credit risk, the Company has categorized the valuation of its interest rate swaps as Level 2.
The fair value of the Company’s interest rate swaps at September 30, 2010 and 2009, reflect liability balances of $5.7 million and $4.7 million, respectively, and are included in other long-term liabilities in the accompanying consolidated balance sheets. The fair value of the Company’s interest rate swaps reflects a liability because the effect of the forward LIBOR curve on future interest payments results in less interest due to the Company under the variable rate component included in the interest rate swap agreements, as compared to the amount due the Company’s counterparties under the fixed interest rate component. Any change in the fair value of the Company’s interest rate swaps, net of income taxes, is included in other comprehensive loss as a component of member’s equity in the accompanying consolidated balance sheets.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
5. COMPREHENSIVE INCOME
Comprehensive income consists of two components: net earnings and other comprehensive income. Other comprehensive income refers to revenues, expenses, gains and losses that under the FASB authoritative guidance related to accounting for comprehensive income are recorded as elements of equity, but are excluded from net earnings. The following table presents the components of comprehensive income, net of income taxes (in thousands):
                 
    Year Ended     Year Ended  
    September 30,     September 30,  
    2010     2009  
 
               
Net earnings
  $ 74,746     $ 38,077  
Change in fair value of interest rate swaps
    (1,045 )     (4,660 )
Change in income tax benefit
    392       1,734  
 
           
 
               
Comprehensive income
  $ 74,093     $ 35,151  
 
           
The components of accumulated other comprehensive loss, net of income taxes, are as follows (in thousands):
                 
    September 30,     September 30,  
    2010     2009  
 
               
Fair value of interest rate swaps
  $ (5,707 )   $ (4,662 )
Income tax benefit
    2,128       1,736  
 
           
 
               
Accumulated other comprehensive loss
  $ (3,579 )   $ (2,926 )
 
           
6. DISTRIBUTION TO PARENT
During the year ended September 30, 2010, the Company distributed $125.0 million, net of a $1.8 million income tax benefit, to IAS to fund the repurchase of certain shares of its outstanding preferred stock and cancel certain vested rollover options to purchase its common stock. The holder of the IAS preferred stock is represented by an investor group led by TPG, JLL Partners and Trimaran Fund Management. The repurchase of preferred stock, which included accrued and outstanding dividends, and the cancellation of rollover options were funded by the Company’s excess cash on hand.
7. ACQUISITIONS
Effective October 1, 2010, the Company purchased Brim Holdings, Inc. (“Brim”) in a cash-for-stock transaction valued at $95.0 million, subject to changes in net working capital. Brim operates Wadley Regional Medical Center, a 370 licensed bed acute care hospital facility located in Texarkana, Texas, and Pikes Peak Regional Hospital, a 15 licensed bed critical access acute care hospital facility, in Woodland Park, Colorado. In connection with the Company’s agreement to purchase Brim, the Company made an agent fund deposit of $97.9 million, which is included in long-term assets in the accompanying consolidated balance sheet as of September 30, 2010.
Effective February 1, 2008, IASIS Glenwood Regional Medical Center, LP, a wholly-owned subsidiary of the Company, purchased a majority ownership interest in Ouachita Community Hospital, a ten-bed surgical hospital located in West Monroe, Louisiana. The purchase price for the majority ownership interest included $16.8 million in cash.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
8. DISCONTINUED OPERATIONS
The Company’s lease agreements to operate Mesa General Hospital (“Mesa General”), located in Mesa, Arizona, and Biltmore Surgery Center (“Biltmore”), located in Phoenix, Arizona, expired by their terms on July 31, 2008 and September 30, 2008, respectively. The Company discontinued services at Mesa General on May 31, 2008, and Biltmore on April 30, 2008. The operating results of Mesa General and Biltmore are classified in the Company’s accompanying consolidated financial statements as discontinued operations. The following table sets forth the components of discontinued operations (in thousands):
                         
    Year ended     Year ended     Year ended  
    September 30,     September 30,     September 30,  
    2010     2009     2008  
 
                       
Total net revenue
  $ 77     $ 974     $ 49,974  
 
                       
Operating expenses
    1,814       1,256       64,648  
Loss on disposal of assets
                3,928  
Income tax benefit
    (650 )     (106 )     (7,327 )
 
                 
 
                       
Loss from discontinued operations, net of income taxes
  $ (1,087 )   $ (176 )   $ (11,275 )
 
                 
The Company allocated to discontinued operations interest expense of $2.5 million for the year ended September 30, 2008. The allocation of interest expense to discontinued operations was based on the ratio of disposed net assets of Mesa General and Biltmore to the sum of total net assets of the Company plus the Company’s total outstanding debt.
Income taxes allocated to the discontinued operations resulted in related effective tax rates of 37.4%, 37.6% and 39.4% for the years ended September 30, 2010, 2009 and 2008, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
9. PROPERTY AND EQUIPMENT
Property and equipment consist of the following (in thousands):
                 
    September 30,     September 30,  
    2010     2009  
Land
  $ 102,969     $ 102,499  
Buildings and improvements
    811,569       792,467  
Equipment
    556,353       500,450  
 
           
 
    1,470,891       1,395,416  
Less accumulated depreciation and amortization
    (501,952 )     (414,572 )
 
           
 
    968,939       980,844  
Construction-in-progress
    16,352       16,509  
 
           
 
  $ 985,291     $ 997,353  
 
           
Included in property and equipment are assets acquired under capital leases of $4.7 million and $4.6 million, net of accumulated amortization of $2.6 million and $3.4 million, at September 30, 2010 and 2009, respectively.
10. GOODWILL AND OTHER INTANGIBLE ASSETS
The following table presents the changes in the carrying amount of goodwill (in thousands):
                         
    Acute     Health        
    Care     Choice     Total  
Balance at September 30, 2008
  $ 774,842     $ 5,757     $ 780,599  
Impairment of Florida market goodwill
    (64,639 )           (64,639 )
Other acquisitions
    1,960             1,960  
 
                 
Balance at September 30, 2009
    712,163       5,757       717,920  
Other acquisitions
    323             323  
 
                 
Balance at September 30, 2010
  $ 712,486     $ 5,757     $ 718,243  
 
                 
For the year ended September 30, 2010, as a result of the Company’s annual impairment testing, the Company has determined all remaining goodwill and long-lived assets to be recoverable. For the year ended September 30, 2009, as a result of the Company’s annual impairment testing, the Company recorded a $64.6 million non-cash charge ($43.2 million after tax) for the impairment of goodwill related to its Florida market.
Other intangible assets consist solely of Health Choice’s contract with AHCCCS, which is amortized over a period of 15 years, the contract’s estimated useful life, including assumed renewal periods. The gross intangible value originally assigned to the contract was $45.0 million. The Company expects amortization expense for this intangible asset to be $3.0 million per year over the estimated life of the contract. Amortization of this intangible asset is included in depreciation and amortization expense in the accompanying consolidated statement of operations and totaled $3.0 million for each of the years ended September 30, 2010, 2009 and 2008. Net other intangible assets included in the accompanying consolidated balance sheets at September 30, 2010 and 2009, totaled $27.0 million and $30.0 million, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
11. MEMBER’S EQUITY
Common Interests of IASIS
As of September 30, 2010, all of the common interests of IASIS were owned by IAS, its sole member.
12. STOCK OPTIONS
Management Rollover Options
In 2004, an investor group led by TPG acquired IAS, the parent company of IASIS. Prior to the acquisition, IAS maintained the IASIS 2000 Stock Option Plan. In connection with the acquisition, certain holders of 299,900 of in-the-money common stock options elected to rollover and convert such options into fully vested options to purchase an aggregate 3,263 shares of preferred stock, with an exercise price of $437.48 per share, and an aggregate 163,150 shares of common stock, with an exercise price of $8.75 per share. All of the other outstanding options under the IASIS 2000 Stock Option Plan were cancelled upon consummation of the acquisition and the plan was terminated.
In connection with the issuance of the Senior PIK Loans in fiscal 2007, the preferred rollover options were cancelled in exchange for a cash payment equal to the excess of the accreted value of the preferred stock over the exercise price of $437.48 per share.
During the year ended September 30, 2010, the Company paid $4.9 million, net of a $1.8 million income tax benefit, to cancel the 163,150 vested rollover options to purchase its common stock. The cancellation of the rollover options resulted in the Company recognizing $2.0 million in stock compensation expense during the year ended September 30, 2010.
2004 Stock Option Plan
The IAS 2004 Stock Option Plan (the “2004 Stock Option Plan”) was established to promote the Company’s interests by providing additional incentives to its key employees, directors, service providers and consultants. The options granted under the plan represent the right to purchase IAS common stock upon exercise. Each option shall be identified as either an incentive stock option or a non-qualified stock option. The plan was adopted by the board of directors and majority stockholder of IAS in June 2004. The maximum number of shares of IAS common stock that may be issued pursuant to options granted under the 2004 Stock Option Plan is 2,625,975. The options become exercisable over a period not to exceed five years after the date of grant, subject to earlier vesting provisions as provided for in the 2004 Stock Option Plan. All options granted under the 2004 Stock Option Plan expire no later than 10 years from the respective dates of grant. At September 30, 2010, there were 939,646 options available for grant.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Information regarding the Company’s stock option activity is summarized below:
                                                 
    2004 Stock Option Plan     Rollover Options  
                    Weighted                     Weighted  
                    Average                     Average  
            Option Price     Exercise             Option Price     Exercise  
    Options     Per Share     Price     Options     Per Share     Price  
Options outstanding at September 30, 2007
    1,491,125     $ 20.00-$35.68     $ 22.09       163,150     $ 8.75     $ 8.75  
 
                                   
Granted
    1,080     $ 34.75     $ 34.75                    
Exercised
    (9,600 )   $ 20.00     $ 20.00                    
Cancelled/forfeited
    (80,720 )   $ 20.00-$35.68     $ 26.04                    
 
                                   
Options outstanding at September 30, 2008
    1,401,885     $ 20.00-$35.68     $ 21.82       163,150     $ 8.75     $ 8.75  
 
                                   
Granted
    477,700     $ 34.75     $ 34.75                    
Exercised
                                   
Cancelled/forfeited
    (119,410 )   $ 20.00-$35.68     $ 31.17                    
 
                                   
Options outstanding at September 30, 2009
    1,760,175     $ 20.00-$35.68     $ 24.70       163,150     $ 8.75     $ 8.75  
 
                                   
Granted
    45,000     $ 34.75-$45.66     $ 43.24                    
Exercised
                                   
Cancelled/forfeited
    (118,846 )   $ 20.00-$35.68     $ 33.38       (163,150 )     8.75       8.75  
 
                                   
Options outstanding at September 30, 2010
    1,686,329     $ 20.00-$45.66     $ 24.58                    
 
                                   
Options exercisable at September 30, 2010
    1,374,620     $ 20.00-$35.68     $ 21.98           $     $  
 
                                   
The following table provides information regarding assumptions used in the fair value measurement for options granted on or after October 1, 2006.
         
    Options Granted  
    On or After  
    October 1, 2006  
Risk-free interest
    3.1 %
Dividend yield
    0.0 %
Volatility
    35.0 %
Expected option life
    7.3 years  
For options granted on or after October 1, 2006, the Company used the Black-Scholes-Merton valuation model in determining the fair value measurement. Volatility for such options was estimated based on the historical stock price information of certain peer group companies for a period of time equal to the expected option life period.
13. INCOME TAXES
Income tax expense on earnings from continuing operations consists of the following (in thousands):
                         
    Year Ended     Year Ended     Year Ended  
    September 30,     September 30,     September 30,  
    2010     2009     2008  
Current:
                       
Federal
  $ 11,439     $ 28,220     $ 12,631  
State
    2,803       4,933       3,326  
Deferred:
                       
Federal
    26,750       (5,092 )     15,522  
State
    3,723       (485 )     3,846  
 
                 
 
  $ 44,715     $ 27,576     $ 35,325  
 
                 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
A reconciliation of the federal statutory rate to the effective income tax rate applied to earnings from continuing operations before income taxes is as follows (in thousands):
                         
    Year Ended     Year Ended     Year Ended  
    September 30,     September 30,     September 30,  
    2010     2009     2008  
Federal statutory rate
  $ 35.0 %   $ 35.0 %   $ 35.0 %
State income taxes, net of federal income tax benefit
    3.5       4.4       5.3  
Non-deductible goodwill impairment charges
          3.8        
Other non-deductible expenses
    0.2       0.8       0.5  
Income attributable to non-controlling interests
    (2.4 )     (5.3 )     (1.8 )
Change in valuation allowance charged to federal income tax expense
    0.4       2.4       1.1  
Other items, net
    0.4       0.8       0.3  
 
                 
Income tax expense
  $ 37.1 %   $ 41.9 %   $ 40.4 %
 
                 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
A summary of the items comprising deferred tax assets and liabilities is as follows (in thousands):
                                 
    September 30,     September 30,  
    2010     2009  
    Assets     Liabilities     Assets     Liabilities  
Depreciation and fixed asset basis differences
  $     $ 76,706     $     $ 77,743  
Amortization and intangible asset basis differences
          66,092             55,721  
Allowance for doubtful accounts
    8,424             30,769        
Professional liability
    15,350             15,561        
Accrued expenses and other liabilities
    18,617             14,625        
Deductible carryforwards and credits
    10,221             9,861        
Other, net
    6,325             3,841        
Valuation allowance
    (9,530 )           (8,580 )      
 
                       
Total
  $ 49,407     $ 142,798     $ 66,077     $ 133,464  
 
                       
Net current deferred tax assets of $15.9 million and $39.0 million and net non-current deferred tax liabilities of $109.3 million and $106.4 million are included in the accompanying consolidated balance sheets at September 30, 2010 and 2009, respectively. The Company had a net income tax receivable of $6.6 million included in other current assets at September 30, 2010, and a net income tax payable of $3.4 million included in other current liabilities at September 30, 2009.
The Company and some of its subsidiaries are included in IAS’ consolidated filing group for U.S. federal income tax purposes, as well as in certain state and local income tax returns that include IAS. With respect to tax returns for any taxable period in which the Company or any of its subsidiaries are included in a tax return filing with IAS, the amount of taxes to be paid by the Company is determined, subject to some adjustments, as if it and its subsidiaries filed their own tax returns excluding IAS. Member’s equity in the accompanying consolidated balance sheets as of September 30, 2010 and 2009, include $35.9 million and $27.3 million, respectively, in capital contributions representing cumulative tax benefits generated by IAS and utilized by the Company in the combined tax return filings, for which IAS did not require cash settlement from the Company.
The Company maintains a valuation allowance for deferred tax assets it believes may not be utilized. The valuation allowance increased by $900,000 and $2.9 million during the years ended September 30, 2010 and 2009, respectively. The increases in the valuation allowance for both years relate to the generation of net operating loss carryforwards by certain subsidiaries excluded from the IAS consolidated federal income tax return, as well as state net operating loss carryforwards that may not ultimately be utilized.
As of September 30, 2010, federal net operating loss carryforwards were available to offset $12.1 million of future taxable income generated by subsidiaries of the Company that are excluded from the IAS consolidated return. A valuation allowance has been established against $10.3 million of these carryforwards, which expire between 2026 and 2030. State net operating losses in the amount of $149.8 million were also available, but largely offset by a valuation allowance. The state net operating loss carryforwards expire between 2018 and 2030.
The Company adopted the provisions of FASB authoritative guidance regarding accounting for uncertainty in income taxes, on October 1, 2007. As a result, the Company recorded a liability for unrecognized tax benefits of $8.1 million, and reduced deferred tax assets for federal and state net operating losses generated by uncertain tax deductions by $9.9 million as of October 1, 2007.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The liability for unrecognized tax benefits included in the accompanying consolidated balance sheets was $11.7 million, including accrued interest of $319,000 at September 30, 2010, and $7.8 million, including accrued interest of $122,000 at September 30, 2009. An additional $6.2 million and $5.9 million of unrecognized tax benefits are reflected as a reduction to deferred tax assets for state net operating losses generated by uncertain tax deductions as of September 30, 2010 and 2009, respectively. Of the total unrecognized tax benefits at September 30, 2010, $2.3 million (net of the tax benefit on state taxes and interest) represents the amount of unrecognized tax and interest that, if recognized, would favorably impact the Company’s effective income tax rate. The remainder of the unrecognized tax positions consist of items for which the uncertainty relates only to the timing of the deductibility, and state net operating loss carryforwards for which ultimate recognition would result in the creation of an offsetting valuation allowance due to the unlikelihood of future taxable income in that state.
A summary of activity of the Company’s total amounts of unrecognized tax benefits is as follows (in thousands):
                         
    Year Ended     Year Ended     Year Ended  
    September 30,     September 30,     September 30,  
    2010     2009     2008  
Unrecognized tax benefits at October 1
  $ 13,638     $ 15,550       17,942  
Additions resulting from tax positions taken in a prior period
          14       937  
Reductions resulting from tax positions taken in a prior period
    (1,700 )     (3,171 )     (6,258 )
Additions resulting from tax positions taken in the current period
    5,596       1,965       2,929  
Reductions resulting from lapse of statute of limitations
          (720 )      
 
                 
Unrecognized tax benefits at September 30
  $ 17,534     $ 13,638     $ 15,550  
 
                 
The Company’s policy is to classify interest and penalties as a component of income tax expense. Interest expense totaling $129,000 and $146,000 (net of related tax benefits) is included in income tax expense for the years ended September 30, 2010 and 2008, respectively. Income tax expense for the year ended September 30, 2009, has been reduced by $122,000 due to a decrease in accrued interest payable in connection with uncertain tax positions (net of related tax benefits).
The Company’s tax years 2007 and beyond remain open to examination by U.S. federal and state taxing authorities. It is reasonably possible that unrecognized tax benefits could significantly increase or decrease within the next twelve months. However, the Company is currently unable to estimate the range of any possible change.
14. COMMITMENTS AND CONTINGENCIES
Net Revenue
The calculation of appropriate payments from the Medicare and Medicaid programs, including supplemental Medicaid reimbursement, as well as terms governing agreements with other third-party payors are complex and subject to interpretation. Final determination of amounts earned under the Medicare and Medicaid programs often occurs subsequent to the year in which services are rendered because of audits by the programs, rights of appeal and the application of numerous technical provisions. In the opinion of management, adequate provision has been made for adjustments that may result from such routine audits and appeals.
Professional, General and Workers’ Compensation Liability Risks
The Company is subject to claims and legal actions in the ordinary course of business, including claims relating to patient treatment and personal injuries. To cover these types of claims, the Company maintains professional and general liability insurance in excess of self-insured retentions through a commercial insurance carrier in amounts that the Company believes to be sufficient for its operations, although, potentially, some claims may exceed the scope of coverage in effect. Plaintiffs in these matters may request punitive or other damages that may not be covered by insurance. The Company is currently not a party to any such proceedings that, in the Company’s opinion, would have a material adverse effect on the Company’s business, financial condition or results of operations. The Company expenses an estimate of the costs it expects to incur under the self-insured retention exposure for professional and general liability claims using historical claims data, demographic factors, severity factors, current incident logs and other actuarial analysis. At September 30, 2010 and 2009, the Company’s professional and general liability accrual for asserted and unasserted claims totaled $41.6 million and $41.7 million, respectively. The semi-annual valuations from the Company’s independent actuary for professional and general liability losses resulted in a change related to estimates for prior years which decreased professional and general liability expense by $2.6 million, $1.2 million and $6.8 million during the years ended September 30, 2010, 2009 and 2008, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Company is subject to claims and legal actions in the ordinary course of business relative to workers’ compensation. To cover these types of claims, the Company maintains workers’ compensation insurance coverage with a self-insured retention. The Company accrues costs of workers’ compensation claims based upon estimates derived from its claims experience. The semi-annual valuations from the Company’s independent actuary for workers’ compensation losses resulted in a change related to estimates for prior years which increased workers’ compensation expense by $1.1 million during the year ended September 30, 2010, decreased workers’ compensation expense by $526,000, during the year ended September 30, 2009, and increased workers’ compensation expense by $759,000 during the year ended September 30, 2008.
Health Choice
Health Choice has entered into capitated contracts whereby the Plan provides healthcare services in exchange for fixed periodic and supplemental payments from the AHCCCS and CMS. These services are provided regardless of the actual costs incurred to provide these services. The Company receives reinsurance and other supplemental payments from AHCCCS to cover certain costs of healthcare services that exceed certain thresholds. The Company believes the capitated payments, together with reinsurance and other supplemental payments are sufficient to pay for the services Health Choice is obligated to deliver. As of September 30, 2010, the Company has provided a performance guaranty in the form of letters of credit totaling $48.3 million for the benefit of AHCCCS to support its obligations under the Health Choice contract to provide and pay for the healthcare services. The amount of the performance guaranty is generally based in part upon the membership in the Plan and the related capitation revenue paid to Health Choice.
Acquisitions
The Company has acquired and in the future may choose to acquire businesses with prior operating histories. Such businesses may have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-referral laws. Although the Company has procedures designed to conform business practices to its policies following the completion of any acquisition, there can be no assurance that the Company will not become liable for previous activities of prior owners that may later be asserted to be improper by private plaintiffs or government agencies. Although the Company generally seeks to obtain indemnification from prospective sellers covering such matters, there can be no assurance that any such matter will be covered by indemnification, or if covered, that such indemnification will be adequate to cover potential losses and fines.
Other
On March 31, 2008, the United States District Court for the District of Arizona (the “District Court”) dismissed with prejudice the qui tam complaint against IAS. The qui tam action sought monetary damages and civil penalties under the federal False Claims Act (“FCA”) and included allegations that certain business practices related to physician relationships and the medical necessity of certain procedures resulted in the submission of claims for reimbursement in violation of the FCA. The case dates back to March 2005 and became the subject of a subpoena by the Office of Inspector General (“OIG”) in September 2005. In August 2007, the case was unsealed and the U.S. Department of Justice declined to intervene. The District Court dismissed the case from the bench at the conclusion of oral arguments on IAS’ motion to dismiss. On April 21, 2008, the District Court issued a written order dismissing the case with prejudice and entering formal judgment for IAS and denying as moot IAS’ motions related to the relator’s misappropriation of information subject to a claim of attorney-client privilege by IAS. Both parties appealed. On August 12, 2010, United States Court of Appeals for the Ninth Circuit reversed the District Court’s dismissal of the qui tam complaint and the District Court’s denial of IAS’ motions concerning relator’s misappropriation of documents and ordered that the qui tam relator be allowed leave to file a Third Amended Complaint and for the District Court to consider IAS’ motions concerning relator’s misappropriation of documents. The District Court ordered the qui tam relator to file his Third Amended Complaint by November 22, 2010, and set a schedule for the filing of motions related to the relator’s misappropriation of documents. On October 20, 2010, the qui tam relator filed a motion to transfer this action to the United States District Court for the Eastern District of Texas. That motion remains pending. On November 22, 2010, the relator filed his Third Amended Complaint. IAS anticipates filing a motion to dismiss the Third Amended Complaint and motions concerning the relator’s misappropriation of documents. If the qui tam action was to be resolved in a manner unfavorable to us, it could have a material adverse effect on our business, financial condition and results of operations, including exclusion from the Medicare and Medicaid programs. In addition, we may incur material fees, costs and expenses in connection with defending the qui tam action.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
15. LEASES
The Company leases various buildings, office space and equipment under capital and operating lease agreements. These leases expire at various times and have various renewal options.
The Company is a party to an amended facility lease with a 15 year term that expires in January 31, 2019, and includes options to extend the term of the lease through January 31, 2039. The annual cost under this agreement is $6.4 million, payable in monthly installments. Future minimum lease payments at September 30, 2010, are as follows (in thousands):
                 
    Capital     Operating  
    Leases     Leases  
2011
  $ 933     $ 28,525  
2012
    652       25,766  
2013
    562       24,254  
2014
    562       20,769  
2015
    562       17,713  
Thereafter
    4,679       57,380  
 
           
Total minimum lease payments
  $ 7,950     $ 174,407  
 
             
Amount representing interest (at rates ranging from 4.4% to 11.0%)
    3,374          
 
             
Present value of net minimum lease payments (including $649 classified as current)
  $ 4,576          
 
             
Aggregate future minimum rentals to be received under noncancellable subleases as of September 30, 2010, were $6.8 million.
16. RETIREMENT PLANS
Substantially all employees who are employed by the Company or its subsidiaries, upon qualification, are eligible to participate in a defined contribution 401(k) plan (the “Retirement Plan”). Employees who elect to participate generally make contributions from 1% to 20% of their eligible compensation, and the Company matches, at its discretion, such contributions up to a maximum percentage. Generally, employees immediately vest 100% in their own contributions and vest in the employer portion of contributions over a period not to exceed five years. Company contributions to the Retirement Plan were $6.7 million, $5.7 million and $5.0 million for the years ended September 30, 2010, 2009 and 2008, respectively.

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
17. SEGMENT AND GEOGRAPHIC INFORMATION
The Company’s acute care hospitals and related healthcare businesses are similar in their activities and the economic environments in which they operate (i.e., urban and suburban markets). Accordingly, the Company’s reportable operating segments consist of (1) acute care hospitals and related healthcare businesses, collectively, and (2) Health Choice. The following is a financial summary by business segment for the periods indicated (in thousands):
                                 
    For the Year Ended September 30, 2010  
    Acute Care     Health Choice     Eliminations     Consolidated  
Acute care revenue
  $ 1,729,344     $     $     $ 1,729,344  
Premium revenue
          792,062             792,062  
Revenue between segments
    11,805             (11,805 )      
 
                       
Total net revenue
    1,741,149       792,062       (11,805 )     2,521,406  
 
                               
Salaries and benefits (excludes stock compensation)
    664,667       19,149             683,816  
Supplies
    266,347       198             266,545  
Medical claims
          690,456       (11,805 )     678,651  
Other operating expenses
    339,304       24,612             363,916  
Provision for bad debts
    197,680                   197,680  
Rentals and leases
    38,409       1,546             39,955  
 
                       
Adjusted EBITDA(1)
    234,742       56,101             290,843  
 
                               
Interest expense, net
    66,810                   66,810  
Depreciation and amortization
    92,544       3,562             96,106  
Stock compensation
    2,487                   2,487  
Management fees
    5,000                   5,000  
 
                       
Earnings from continuing operations before gain on disposal of assets and income taxes
    67,901       52,539             120,440  
Gain on disposal of assets, net
    108                   108  
 
                       
Earnings from continuing operations before income taxes
  $ 68,009     $ 52,539     $     $ 120,548  
 
                       
Segment assets
  $ 2,032,246     $ 320,948             $ 2,353,194  
 
                         
Capital expenditures
  $ 80,966     $ 302             $ 81,268  
 
                         
Goodwill
  $ 712,486     $ 5,757             $ 718,243  
 
                         

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                 
    For the Year Ended September 30, 2009  
    Acute Care     Health Choice     Eliminations     Consolidated  
Acute care revenue
  $ 1,662,469     $     $     $ 1,662,469  
Premium revenue
          699,503             699,503  
Revenue between segments
    9,316             (9,316 )      
 
                       
Total net revenue
    1,671,785       699,503       (9,316 )     2,361,972  
 
                               
Salaries and benefits (excludes stock compensation)
    641,332       19,028             660,360  
Supplies
    250,310       263             250,573  
Medical claims
          602,076       (9,316 )     592,760  
Other operating expenses
    302,804       22,931             325,735  
Provision for bad debts
    192,563                   192,563  
Rentals and leases
    37,563       1,564             39,127  
Hurricane-related property damage
    938                   938  
 
                       
Adjusted EBITDA(1)
    246,275       53,641             299,916  
 
                               
Interest expense, net
    67,890                   67,890  
Depreciation and amortization
    94,014       3,448             97,462  
Stock compensation
    561                   561  
Impairment of goodwill
    64,639                   64,639  
Management fees
    5,000                   5,000  
 
                       
Earnings from continuing operations before gain (loss) on disposal of assets and income taxes
    14,171       50,193             64,364  
Gain (loss) on disposal of assets, net
    1,616       (151 )           1,465  
 
                       
Earnings from continuing operations before income taxes
  $ 15,787     $ 50,042     $     $ 65,829  
 
                       
Segment assets
  $ 2,109,422     $ 247,782             $ 2,357,204  
 
                         
Capital expenditures
  $ 86,875     $ 845             $ 87,720  
 
                         
Goodwill
  $ 712,163     $ 5,757             $ 717,920  
 
                         

 

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IASIS HEALTHCARE LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                 
    For the Year Ended September 30, 2008  
    Acute Care     Health Choice     Eliminations     Consolidated  
Acute care revenue
  $ 1,523,790     $     $     $ 1,523,790  
Premium revenue
          541,746             541,746  
Revenue between segments
    9,594             (9,594 )      
 
                       
Total net revenue
    1,533,384       541,746       (9,594 )     2,065,536  
 
                               
Salaries and benefits
    614,442       17,667             632,109  
Supplies
    231,001       258             231,259  
Medical claims
          461,649       (9,594 )     452,055  
Other operating expenses
    264,814       18,309             283,123  
Provision for bad debts
    161,936                   161,936  
Rentals and leases
    35,466       1,167             36,633  
Hurricane-related property damage
    3,589                   3,589  
 
                       
Adjusted EBITDA(1)
    222,136       42,696             264,832  
 
                               
Interest expense, net
    75,665                   75,665  
Depreciation and amortization
    93,003       3,738             96,741  
Management fees
    5,000                   5,000  
 
                       
Earnings from continuing operations before loss on disposal of assets and income taxes
    48,468       38,958             87,426  
Loss on disposal of assets, net
    (75 )                 (75 )
 
                       
Earnings from continuing operations before income taxes
  $ 48,393     $ 38,958     $     $ 87,351  
 
                       
Segment assets
  $ 2,123,069     $ 185,078             $ 2,308,147  
 
                         
Capital expenditures
  $ 136,425     $ 990             $ 137,415  
 
                         
Goodwill
  $ 774,842     $ 5,757             $ 780,599  
 
                         
     
(1)  
Adjusted EBITDA represents net earnings from continuing operations before interest expense, income tax expense, depreciation and amortization, stock compensation, impairment of goodwill, gain (loss) on disposal of assets and management fees. Management fees represent monitoring and advisory fees paid to TPG, the Company’s majority financial sponsor, and certain other members of IASIS Investment LLC. Management routinely calculates and communicates adjusted EBITDA and believes that it is useful to investors because it is commonly used as an analytical indicator within the healthcare industry to evaluate hospital performance, allocate resources and measure leverage capacity and debt service ability. In addition, the Company uses adjusted EBITDA as a measure of performance for its business segments and for incentive compensation purposes. Adjusted EBITDA should not be considered as a measure of financial performance under GAAP, and the items excluded from adjusted EBITDA are significant components in understanding and assessing financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to net earnings, cash flows generated by operating, investing, or financing activities or other financial statement data presented in the consolidated financial statements as an indicator of financial performance or liquidity. Adjusted EBITDA, as presented, differs from what is defined under the Company’s senior secured credit facilities and may not be comparable to similarly titled measures of other companies.
18. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
A summary of accrued expenses and other current liabilities consists of the following (in thousands):
                 
    September 30,     September 30,  
    2010     2009  
Employee health insurance payable
  $ 8,265     $ 9,183  
Accrued property taxes
    11,645       10,496  
Health Choice program settlements payable
    56,487       13,720  
Other
    30,217       32,302  
 
           
 
  $ 106,614     $ 65,701  
 
           

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
19. ALLOWANCE FOR DOUBTFUL ACCOUNTS
A summary of activity in the Company’s allowance for doubtful accounts is as follows (in thousands):
                                         
                            Accounts        
                            Written Off,        
    Beginning     Provision for             Net of     Ending  
    Balance     Bad Debts     Other (1)     Recoveries     Balance  
Year Ended September 30, 2008
  $ 97,829       161,936       6,782       (158,092 )   $ 108,455  
Year Ended September 30, 2009
  $ 108,455       192,563       641       (175,527 )   $ 126,132  
Year Ended September 30, 2010
  $ 126,132       197,680