UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

For the quarterly period ended September 30, 2014

OR

For the transition period from              to             .

Commission file number: 001-36154

 

SURGICAL CARE AFFILIATES, INC.

(Exact name of registrant as specified in its charter)

 

 

(847) 236-0921

(Registrant’s telephone number, including area code)

 

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 such filing requirements for the past 90 days.    Yes  x    No  ¨

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  x    No  ¨

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.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No   x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

 

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SURGICAL CARE AFFILIATES, INC.

FORM 10-Q

INDEX

 

 

 

 

 

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GENERAL

Unless the context otherwise indicates or requires, references in this Quarterly Report on Form 10-Q to “Surgical Care Affiliates,” the “Company,” “we,” “us” and “our” refer to ASC Acquisition LLC and its consolidated affiliates prior to our conversion from a Delaware limited liability company to a Delaware corporation on October 30, 2013 (the “Conversion”), and to Surgical Care Affiliates, Inc. and its consolidated subsidiaries after the Conversion. In addition, unless the context otherwise indicates or requires, the term “SCA” refers to Surgical Care Affiliates, LLC, our direct operating subsidiary.

Pursuant to the Conversion, every 10.25 outstanding membership units of ASC Acquisition LLC were converted into one share of common stock of Surgical Care Affiliates, Inc., and options to purchase membership units of ASC Acquisition LLC were converted into options to purchase shares of common stock of Surgical Care Affiliates, Inc. at a ratio of 10.25 membership units of ASC Acquisition LLC underlying such options to each one share of common stock of Surgical Care Affiliates, Inc. underlying such converted options. In connection with the Conversion, the exercise prices of such converted options were adjusted accordingly. In addition, every 10.25 outstanding restricted equity units of ASC Acquisition LLC were converted into one restricted stock unit of Surgical Care Affiliates, Inc. For the convenience of the reader, except as the context otherwise requires, all information included in this Quarterly Report on Form 10-Q is presented giving effect to the Conversion.

On October 29, 2013, the Company’s Registration Statement on Form S-1 (File No. 333-190998) and the Company’s Registration Statement on Form 8-A (File No. 001-36154) each became effective, and the Company became subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements that reflect our current views with respect to, among other things, future events and financial performance, which involve substantial risks and uncertainties. Certain statements made in this Quarterly Report on Form 10-Q are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Exchange Act. Forward-looking statements include any statement that, without limitation, may predict, forecast, indicate or imply future results, performance or achievements instead of historical or current facts and may contain words like “anticipates,” “approximately,” “believes,” “budget,” “can,” “could,” “continues,” “contemplates,” “estimates,” “expects,” “forecast,” “intends,” “may,” “might,” “objective,” “outlook,” “predicts,” “probably,” “plans,” “potential,” “project,” “seeks,” “shall,” “should,” “target,” “will,” or the negative of these terms and other words, phrases, or expressions with similar meaning.

Any forward-looking statements contained in this Quarterly Report on Form 10-Q are based upon our historical performance and on our current plans, estimates and expectations in light of information currently available to us. The inclusion of forward-looking information should not be regarded as a representation by us that the future plans, estimates or expectations will be achieved. Such forward-looking statements are subject to various risks and uncertainties and assumptions relating to our operations, financial results, financial condition, business, prospects, growth strategy and liquidity. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from those projected in the forward-looking statements, and the Company cannot give assurances that such statements will prove to be correct. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information or otherwise. Given these uncertainties, the reader should not place undue reliance on forward-looking statements as a prediction of actual results. Factors that could cause actual results to differ materially from those projected or estimated by us include those that are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 under Part I, “Item 1A. Risk Factors.”

 

 

 

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PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value amount)

(Unaudited)

 

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See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

 

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SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands of U. S. dollars, except per share amounts)

(Unaudited)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

 

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SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands of U. S. dollars, except per share amounts)

(Unaudited)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

 

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SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands of U.S. dollars)

(Unaudited)

 

 

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

 

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SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

(In thousands)

(Unaudited)

 

 

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

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SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands of U. S. dollars)

(Unaudited)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

 

 

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SURGICAL CARE AFFILIATES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(In thousands of U. S. dollars)

(Unaudited)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

 

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SURGICAL CARE AFFILIATES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Amounts in tables are in thousands of U.S. dollars unless otherwise indicated)

 

NOTE 1 — DESCRIPTION OF BUSINESS

Nature of Operations and Ownership of the Company

Surgical Care Affiliates, Inc. (“Surgical Care Affiliates” or the “Company”), a Delaware corporation, was converted from a Delaware limited liability company, previously named ASC Acquisition LLC, to a Delaware corporation on October 30, 2013 (the “Conversion”). Pursuant to the Conversion, every 10.25 outstanding membership units of ASC Acquisition LLC were converted into one share of common stock of Surgical Care Affiliates, and options to purchase membership units of ASC Acquisition LLC were converted into options to purchase shares of common stock of Surgical Care Affiliates at a ratio of 10.25 membership units of ASC Acquisition LLC underlying such options to each one share of common stock of Surgical Care Affiliates underlying such converted options. In connection with the Conversion, the exercise prices of such converted options were adjusted accordingly. Upon conversion, every 10.25 outstanding restricted equity units of ASC Acquisition LLC were converted into one restricted stock unit of Surgical Care Affiliates. All share and per share amounts have been adjusted to reflect these conversion amounts throughout these financial statements.

We were formed primarily to own and operate a network of multi-specialty ambulatory surgery centers (“ASCs”) and surgical hospitals in the United States of America. We do this through our direct operating subsidiary, Surgical Care Affiliates, LLC (“SCA”). As of September 30, 2014, the Company operated in 33 states and had an interest in and/or operated 176 freestanding ASCs, five surgical hospitals and one sleep center with 11 locations, with a concentration of facilities in California, Indiana, Texas and Florida. Our ASCs and surgical hospitals primarily provide the facilities, equipment and medical support staff necessary for physicians to perform non-emergency surgical and other procedures in various specialties, including orthopedics, ophthalmology, gastroenterology, pain management, otolaryngology (ear, nose and throat, or “ENT”), urology and gynecology, as well as other general surgery procedures. At our ASCs, physicians perform same-day surgical procedures. At our surgical hospitals, physicians perform a broader range of surgical procedures, and patients may stay in the hospital for several days.

During the nine-months ended September 30, 2014, our portfolio of facilities changed as follows:

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Business Structure

We operate our facilities through strategic relationships with approximately 2,000 physician partners and, in many cases, with healthcare systems that have strong local market positions and that we believe have strong reputations for clinical excellence. The facilities in which we hold an ownership interest are owned by general partnerships, limited partnerships (“LP”), limited liability partnerships (“LLP”) or limited liability companies (“LLC”) in which a subsidiary of the Company typically serves as the general partner, limited partner, managing member or member. We account for our 182 facilities as follows:

 

In addition, at September 30, 2014 and December 31, 2013, we provided perioperative consulting services to 10 and 14 facilities, respectively, which are not included in the above facility count.

Basis of Presentation

The Company maintains its books and records on the accrual basis of accounting, and the accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”), the instructions for Form 10-Q, Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission (the “SEC”) and the SEC’s regulations for interim financial information. Such financial statements include the assets, liabilities, revenues and expenses of all wholly-owned subsidiaries, subsidiaries over which we exercise control and, when applicable, affiliates in which we have a controlling financial interest. These interim financial statements do not include all of the disclosures required by U.S. GAAP for complete financial statements. In the opinion of management, the accompanying unaudited financial statements of the Company reflect all adjustments (consisting only of normal, recurring items) necessary for a fair statement of the results for the interim periods presented. Operating results for the three- and nine-month periods ended September 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. The accompanying unaudited condensed consolidated financial statements and related notes should be read in conjunction with the Company’s audited December 31, 2013 consolidated financial statements included in our 2013 Annual Report on Form 10-K.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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NOTE 2 — TRANSACTIONS, DECONSOLIDATIONS AND CLOSURES

Acquisitions   

During the nine-months ended September 30, 2014, the Company acquired a controlling interest in twelve ASCs for total consideration of $104.0 million. Three of the twelve ASCs were acquired through the future JV (see Note 3) and are a VIE for which we are the primary beneficiary.  These acquisitions are described in further detail below.

 

In April 2014, the future JV (see Note 3) purchased a 51% controlling equity interest in Fort Worth Endoscopy Centers, LLC (“FWEC”), which owns and operates two ASCs in Fort Worth, Texas, for $24.8 million. In conjunction with the acquisition of such interest by the future JV, our promissory note due from the future JV was increased by $10.6 million. As with the other entities controlled by the future JV, we have determined that FWEC is a VIE for which we are the primary beneficiary. Accordingly, we consolidate FWEC. Prior to the transaction in 2014, these two ASCs were managed-only facilities. The amounts recognized as of the acquisition date for each major class of assets and liabilities assumed are as follows:

 

 

In August 2014, an indirect wholly-owned subsidiary of SCA purchased a 59% controlling interest in, as well as the management agreement rights of, the Surgery Center of Rockville, L.L.C., which owns and operates an ASC located in Rockville, Maryland, for $11.1 million. The amounts recognized as of the acquisition date for each major class of assets and liabilities assumed are as follows:

 

 

 

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In September 2014, two indirect wholly-owned subsidiaries of SCA purchased a 51% controlling interest in an ASC located in Marina del Rey, California (“Marina del Rey ASC”) for $20.4 million and a 51% controlling interest in an ASC located in Newport Beach, California (“Newport Beach ASC”) for $6.5 million.  In conjunction with the purchase of the two ASCs, SCA also purchased in September 2014 substantially all of the assets of two management entities for $5.3 million.  Prior to closing, the entities provided management and billing services to the Marina del Rey ASC and Newport Beach ASC, as well as to the two affiliated medical practices.  SCA now provides management services at the two ASCs and the two affiliated medical practices.  Both ASCs are consolidated facilities, and the medical practices are managed-only entities. The amounts recognized as of the acquisition date for each major class of assets and liabilities assumed are as follows:

 

 

The aggregate amounts recognized as of the acquisition date for each major class of assets and liabilities assumed in the remaining seven acquisitions closed in the nine-months ended September 30, 2014 are as follows:

 

The purchase price allocations above are preliminary and subject to adjustment.

During the nine-months ended September 30, 2014, we acquired a noncontrolling interest in five ASCs for a total consideration of $16.5 million. These acquisitions are accounted for as equity method investments.  Two of these ASCs were previously managed-only facilities.

 

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During the nine-months ended September 30, 2014, we contributed an existing equity method investment to another entity in which we have an equity method investment that is controlled by a health system partner. In conjunction with the contribution, we recognized a $1.9 million gain relating to the remeasurement of a portion of the investment to fair value. This gain is included in (Gain) loss on sale of investments in the accompanying condensed consolidated statements of operations.

 

Also during the nine-months ended September 30, 2014, a wholly-owned indirect subsidiary of SCA loaned a wholly-owned subsidiary of a health system partner (the “Counterparty”) $3.0 million in exchange for a promissory note that is convertible at the Counterparty’s option into a 49% ownership interest in the Counterparty. On April 1, 2014, the Counterparty used the proceeds of the loan and other funds to purchase 100% of the ownership interests in an ASC in Costa Mesa, California for $5.2 million. This ASC is currently a managed-only facility of SCA in which we provide management services to the facility but hold no equity interest.

Deconsolidations

During the nine-month period ended September 30, 2014, we completed one deconsolidation transaction. In this transaction, we sold a controlling equity interest in an ASC and transferred certain control rights to a partner in the entity. We retained a noncontrolling interest in this affiliate. We received cash proceeds of approximately $2.4 million and recorded a pre-tax loss of approximately $3.4 million, which was primarily related to the revaluation of our remaining investment in this affiliate to fair value. The loss on this transaction is recorded in (Gain) loss on sale of investments in the accompanying condensed consolidated statements of operations.

 

During the nine-month period ended September 30, 2013, we completed two separate deconsolidation transactions. In one of these transactions, we sold a controlling equity interest and transferred certain control rights to a health system. We retained a noncontrolling interest in this affiliate. We received cash proceeds of approximately $2.1 million and recorded a pre-tax loss of approximately $1.6 million, which was primarily related to the revaluation of our remaining investment in this affiliate to fair value. The loss on this transaction is recorded in (Gain) loss on sale of investments in the accompanying condensed consolidated statements of operations. In the other transaction, we transferred certain control rights to physician partners in the entity, and we retained a noncontrolling interest in the entity. We recorded a pre-tax loss of approximately $1.5 million, which was primarily related to the revaluation of our remaining investment in this affiliate to fair value. The loss on this transaction is recorded in Equity in net income of nonconsolidated affiliates in the accompanying condensed consolidated statements of operations.

Fair values for the retained noncontrolling interests are primarily estimated based on third-party valuations we have obtained in connection with such transactions and/or the amount of proceeds received for the controlling equity interest sold. Our continuing involvement as an equity method investor and manager of the facilities precludes classification of these transactions as discontinued operations.

Closures and Sales

During the nine-months ended September 30, 2014, we closed four facilities. Two consolidated facilities were closed in the first quarter of 2014, and their operations were absorbed into existing SCA consolidated facilities.  We impaired $0.5 million of property and equipment and intangible assets related to these two closed facilities in the first quarter.  One consolidated facility ceased operations in July 2014.  Also an impairment charge of $0.7 million was recorded during the nine-months ended September 30, 2014 for intangible and long-lived assets related to this one closed consolidated facility.  These impairments are recorded in Loss from discontinued operations, net of income tax expense on the Company’s condensed consolidated statements of operations.  One nonconsolidated facility was closed in the third quarter of 2014, and its operations were absorbed into an existing SCA nonconsolidated facility.

 

During the nine-month period ended September 30, 2013, we closed one facility. We recorded a pre-tax loss of approximately $1.5 million as a result of the closure. The loss on the transaction is recorded in Loss from discontinued operations, net of income tax in the accompanying condensed consolidated statements of operations.

During the nine-months ended September 30, 2014, we sold all of our interest in three ASCs. We recorded a pre-tax gain of approximately $0.4 million as a result of the sales. The gain on these transactions is recorded in (Gain) loss on sale of investments in the accompanying condensed consolidated statements of operations. We also wrote off approximately $0.8 million of goodwill related to one of these sales.

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Unaudited Pro Forma Financial Information

Summarized below are our consolidated results of operations for the three-months and nine-months ended September 30, 2014 and 2013, on an unaudited pro forma basis as if the consolidated acquisitions closed in the nine-months ended September 30, 2014 had occurred at the beginning of the earliest period presented. The pro forma information is based on the Company’s consolidated results of operations for the three-months and nine-months ended September 30, 2014 and 2013, and on other available information. These pro forma amounts include historical financial statement amounts with the following adjustments: we converted the sellers’ historical financial statements to GAAP and applied the Company’s accounting policies, and we adjusted for depreciation and amortization expense assuming the fair value adjustments to intangible assets had been applied beginning January 1, 2013. The pro forma financial information does not purport to be indicative of results of operations that would have occurred had the transactions occurred on the basis assumed above, nor are they indicative of results of the future operations of the combined enterprises.

 

 

Consolidated acquisitions closed during the three- and nine-months ended September 30, 2014 contributed Net operating revenues of $9.5 million and $13.3 million, respectively, and Income from continuing operations of $4.2 million and $5.9 million for the three- and nine-months ended September 30, 2014, respectively.

Nonconsolidated acquisitions closed during the three- and nine-months ended September 30, 2014 contributed $0.2 million and $0.1 million to Equity in net income of nonconsolidated affiliates for the three- and nine-months ended September 30, 2014, respectively.

 

NOTE 3 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company, its subsidiaries and VIEs for which we are the primary beneficiary. All significant intercompany transactions and accounts have been eliminated.

We evaluate partially owned subsidiaries and joint ventures held in partnership form using authoritative guidance, which includes a framework for evaluating whether a general partner(s) or managing member(s) controls an affiliate and therefore should consolidate it. The framework includes the presumption that general partner or managing member control would be overcome only when the limited partners or members have certain rights. Such rights include the right to dissolve or liquidate the LP, LLP or LLC or otherwise remove the general partner or managing member “without cause,” or the right to effectively participate in significant decisions made in the ordinary course of business of the LP, LLP or LLC. To the extent that any noncontrolling investor has rights that inhibit our ability to control the affiliate, including substantive veto rights, we do not consolidate the affiliate.

We use the equity method to account for our investments in affiliates with respect to which we do not have control rights but have the ability to exercise significant influence over operating and financial policies. Assets, liabilities, revenues and expenses are reported in the respective detailed line items on the consolidated financial statements for our consolidated affiliates. For our equity method affiliates, assets and liabilities are reported on a net basis in Investment in and advances to nonconsolidated affiliates in the condensed consolidated balance sheets, and revenues and expenses are reported on a net basis in Equity in net income of nonconsolidated affiliates in the condensed consolidated statements of operations. This difference in accounting treatment of equity method affiliates impacts certain financial ratios of the Company.

Variable Interest Entities

In order to determine if we are the primary beneficiary of a VIE for financial reporting purposes, we consider whether we have the power to direct the activities of the VIE that most significantly impact the economic performance of the VIE and whether we have the obligation to absorb losses or the right to receive returns that would be significant to the VIE. We consolidate a VIE when we are the primary beneficiary.

In 2012, the Company entered into a transaction whereby we transferred our interests in two consolidated facilities and cash to an entity (the “future JV”) wholly-owned by a health system in exchange for a promissory note. Concurrently, the health system transferred its interest in a facility it controlled to the future JV. The promissory note, which eliminates upon consolidation, has a fixed interest rate plus a variable component dependent on the earnings of the future JV. The promissory note contains a conversion feature

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that allows us to convert the promissory note into a 49% equity interest in the future JV at our option upon the occurrence of the renegotiation of certain contractual arrangements. We also entered into management services agreements with the facilities controlled by the future JV. As a result of the financial interest in the earnings of the future JV held by us via the promissory note and the powers granted us in the promissory note and the management services agreements, we have determined that the future JV is a VIE for which we are the primary beneficiary. Accordingly, we consolidate the future JV.

The carrying amounts and classifications of the assets and liabilities of the future JV, which are included in our September 30, 2014 and December 31, 2013 consolidated balance sheets, were as follows:

 

The assets of the consolidated VIE can only be used to settle the obligations of the VIE. The creditors of the VIE have no recourse to us, with the exception of $3.6 million and $4.0 million of debt guaranteed by us at September 30, 2014 and December 31, 2013, respectively. As of September 30, 2014, we consolidate the nine facilities controlled by the future JV as a VIE.

Investment in and Advances to Nonconsolidated Affiliates

Investments in entities we do not control, but for which we have the ability to exercise significant influence over the operating and financial policies, are accounted for under the equity method. Equity method investments are recorded at original cost and adjusted periodically to recognize our proportionate share of the entity’s net income or losses after the date of investment, additional contributions made and distributions received, amortization of definite-lived intangible assets attributable to equity method investments and impairment losses resulting from adjustments to the carrying value of the investment. We record equity method losses in excess of the carrying amount of an investment when we guarantee obligations or we are otherwise committed to provide further financial support to the affiliate.

Reclassifications and Revisions

Certain amounts in the condensed consolidated financial statements for prior periods have been reclassified to conform to the current period presentation. Such reclassifications primarily relate to facilities we closed or sold, which qualify for reporting as discontinued operations.

During the quarter ended March 31, 2014, we recorded corrections to increase Loss on sale of investments by $1.0 million related to the sale of our investment in a consolidated facility during the year ended December 31, 2013, as well as a correction to increase Equity in net income of nonconsolidated affiliates by $0.2 million relating to the sale of equity interests in a nonconsolidated facility during the year ended December 31, 2012. During the quarter ended September 30, 2014, we recorded corrections to increase Gain on sale of investments by approximately $2.8 million related to the sale of our interest in equity method facilities during prior years. We do not believe these corrections are material to either our current period financial statements or our previously issued financial statements. Additionally, we do not expect these corrections to be material to our 2014 annual financial statements.

The three- and nine-months ended September 30, 2013 condensed consolidated statements of operations include reclassifications totaling $0.2 million and $0.6 million, respectively, within Supplies and Other operating expenses to conform the September 30, 2013 presentation to the September 30, 2014 presentation.

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Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Earnings Per Share (“EPS”)

We report two earnings per share numbers, basic and diluted. These are computed by dividing net earnings by the weighted-average common shares outstanding (basic EPS) or weighted-average common shares outstanding assuming dilution (diluted EPS), as set forth below:

 

The numbers of shares used reflect the Company’s conversion to a Delaware corporation discussed in Note 1 for all periods. All dilutive share equivalents are reflected in our earnings per share calculations. Antidilutive share equivalents are not included in our EPS calculations. In periods of loss, shares that otherwise would have been included in our diluted weighted-average common shares outstanding computation are excluded. Accordingly, 989,000 shares and 686,000 shares were excluded for the three- and nine-months ended September 30, 2013, respectively.

Reportable Segments

We have six operating segments, which aggregate into one reportable segment. Our six operating segments are generally organized geographically. For reporting purposes, we have aggregated our operating segments into one reportable segment, because the nature of the services are similar and the businesses exhibit similar economic characteristics, processes, types and classes of customers, methods of service delivery and distribution and regulatory environments.

Net operating loss carryforwards (“NOLs”)

At September 30, 2014, we had federal net operating loss carryforwards of approximately $252.4 million. Such losses expire in various amounts at varying times beginning in 2027. These NOLs are subject to a valuation allowance. At this time, we do not believe the limitations imposed by Internal Revenue Code Section 382 will restrict our ability to use any NOLs before they expire. However, we cannot assure you that will be the case.

Recent Revisions to Authoritative Guidance

In April 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. This ASU changes the criteria for determining which disposals (both consolidated investments and equity method investments) can be presented as discontinued operations and modifies related disclosure requirements. Under the new criteria, a discontinued operation is defined as a disposal of a component or group of components, which may include equity method investments, that is disposed of or is classified as held for sale and “represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.” The ASU is effective for annual reporting periods beginning after December 15, 2014, and interim periods within those annual periods. The Company is in the process of evaluating the timing of implementation and the effect the new criteria will have on its results of operations and financial position.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The ASU is based on the principle that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to fulfill a contract. Entities have the option of using either a full retrospective or a modified

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retrospective approach for the adoption of the new standard. The ASU becomes effective for the Company at the beginning of its 2017 fiscal year; early adoption is not permitted. The Company is currently assessing the impact this ASU will have on its results of operations and financial position.

We do not believe any other recently issued, but not yet effective, revisions to authoritative guidance will have a material effect on our condensed consolidated financial position, results of operations or cash flows.

 

NOTE 4 — GOODWILL

Goodwill represents the unallocated excess of purchase price over the fair value of identifiable assets and liabilities acquired in business combinations. Goodwill also includes the unallocated excess of purchase price plus the fair value of any noncontrolling interest in the acquiree at the acquisition date over the fair value of identifiable assets and liabilities acquired in the business combination. The following table shows changes in the carrying amount of goodwill for the nine-months ended September 30, 2014:

 

 

NOTE 5 — RESULTS OF OPERATIONS OF NONCONSOLIDATED AFFILIATES

The following summarizes the combined results of operations of our equity method affiliates:

 

During the three- and nine-months ended September 30, 2014, we recorded $5.8 million and $17.4 million, respectively, of amortization expense for definite-lived intangible assets attributable to equity method investments. During the three- and nine-months ended September 30, 2013, we recorded $7.9 million and $17.9 million, respectively, of amortization expense for definite-lived intangible assets attributable to equity method investments. This expense was included in Equity in net income of nonconsolidated affiliates in our condensed consolidated statements of operations.

 

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NOTE 6 — LONG-TERM DEBT

Our long-term debt outstanding consists of the following:

 

Senior Secured Credit Facility (“Credit Facility”)

With respect to the Credit Facility, as of September 30, 2014, we had $597.9 million in principal amount of indebtedness outstanding under the senior secured term loan facility consisting of the following:

We must repay the principal amount of the Class B Term Loan and the Class C Term Loan in quarterly installments equal to 0.25% of the original principal amount, with the remaining principal amount payable in full on the maturity dates noted above.

Borrowings under each facility of the Credit Facility bear interest either at a base rate or at the London interbank market for the interest period relevant to such borrowings (“LIBOR”), as elected by SCA, plus an applicable margin. The base rate is determined by reference to the higher of (i) the prime rate of JPMorgan Chase Bank, N.A. and (ii) the federal funds effective rate plus 0.50%. The LIBOR rate is determined by reference to the interest rate for dollar deposits in the London interbank market for the interest period relevant to such borrowings. Interest payments, along with the installment payments of principal, are made at the end of each quarter. The following table outlines the applicable margin for each portion of the Credit Facility:

 

There was no outstanding balance under the senior secured revolving credit facility (the “Class B Revolving Credit Facility”) as of September 30, 2014 or December 31, 2013 other than $2.9 million and $1.7 million, respectively, of letters of credit. As of September 30, 2014 the Class B Revolving Credit Facility had a capacity of $132.3 million with a maturity date of June 30, 2016.

Any utilization of the Class B Revolving Credit Facility (other than issuances of up to an aggregate of $5.0 million of letters of credit) will be subject to compliance with a total leverage ratio test. At September 30, 2014, we had approximately $2.9 million in such letters of credit outstanding.

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2013 Amendment to the Credit Facility

In the second quarter of 2013, we entered into an amendment of our credit agreement (the “Amended Credit Agreement”). The Amended Credit Agreement provides for a Class C Term Loan Facility (“Class C Term Loan”) of $385.1 million ($384.6 million, net of discount) as of September 30, 2014. The Class C Term Loan will mature on June 30, 2018. We utilized the proceeds of the Class C Term Loan plus $8.7 million in cash to extinguish existing debt. The interest rate on the Class C Term Loan was 4.00% at September 30, 2014.

The Credit Facility is guaranteed by the Company and certain of SCA’s direct wholly-owned domestic subsidiaries (the “guarantors”), subject to certain exceptions, and borrowings under the Credit Facility are secured by a first priority security interest in all equity interests of SCA and of each wholly-owned domestic subsidiary directly held by SCA or a guarantor. Additionally, the Credit Facility contains various restrictive covenants that, subject to certain exceptions, prohibit us from prepaying certain subordinated indebtedness. The Credit Facility generally restricts SCA’s and SCA’s restricted subsidiaries’ ability to, among other things, incur indebtedness or liens, make investments or declare or pay dividends. The Company believes that it and SCA were in compliance with these covenants as of September 30, 2014. The Amended Credit Agreement contains a provision that could require prepayment of a portion of our indebtedness if SCA has excess cash flow, as defined by the Amended Credit Agreement. No such prepayment was required at September 30, 2014.

Interest Rate Swaps

The Company utilizes an interest rate risk management strategy that incorporates the use of derivative financial instruments to limit its exposure to interest rate risk. The swaps are “receive floating/pay fixed” instruments that define a fixed rate of interest on the economically hedged debt that the Company will pay, meaning we receive floating rate payments, which fluctuate based on LIBOR, from the counterparty and pay at a fixed rate to the counterparty, the result of which is to convert the interest rate of a portion of our floating rate debt into fixed rate debt, or to limit the variability of interest related payments caused by changes in LIBOR. At September 30, 2014, interest rate swaps of $190.0 million remained outstanding.  The remaining aggregate notional amount of $190.0 million in interest rate swaps will terminate on September 30, 2016. An interest rate swap with a notional amount of $50.0 million terminated on September 30, 2014.  As a result of the amendment to the Credit Facility in the second quarter of 2013, we de-designated the cash flow hedging instruments. The de-designation resulted in the reclassification of all amounts related to the cash flow hedges in Accumulated other comprehensive loss to Interest expense.

All derivative instruments are recognized on the balance sheet on a gross basis at fair value. The fair value of the interest rate swaps is recorded in the Company’s condensed consolidated balance sheets, either in Other current liabilities and Other long-term liabilities or Prepaids and other current assets and Other long-term assets, depending on the changes in the fair value of the swap and the payments or receipts expected within the next 12 months, with an offsetting adjustment reported as Interest expense in the condensed consolidated statements of operations. At September 30, 2014, $1.4 million was included in Other current liabilities in the condensed consolidated balance sheet based on the fair value of the derivative instruments and the amounts expected to be settled within the next 12 months. At September 30, 2014 and December 31, 2013, $1.0 million and $3.1 million, respectively, were included in Other long-term liabilities in the condensed consolidated balance sheet based on the fair value of the derivative instruments. Although all our derivative instruments are subject to master netting arrangements, no amounts have been netted against the gross liabilities previously detailed and no collateral has been posted with counterparties. During the nine-months ended September 30, 2014, the liability related to the swaps decreased by $0.7 million due to $1.2 million of swap settlements and a $0.5 million change in fair value. During the nine-months ended September 30, 2014, the Company recorded losses of approximately $0.3 million within Interest expense due to changes in fair value of derivative instruments.

The accounting for changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, cash flow hedge or a hedge related to foreign currency exposure. The Company previously designated its interest rate swaps as a cash flow hedge; however, as noted above, the interest rate swaps were de-designated as hedges in the second quarter of 2013.

Credit risk occurs when a counterparty to a derivative instrument fails to perform according to the terms of the agreement. Derivative instruments expose the Company to credit risk and could result in material changes from period to period. The Company minimizes its credit risk by entering into transactions with highly rated counterparties. In addition, at least quarterly, the Company evaluates its exposure to counterparties who have experienced or may likely experience significant threats to their ability to perform according to the terms of the derivative agreements to which we are a party. We have completed this review of the financial strength of the counterparties to our interest rate swaps using publicly available information, as well as qualitative inputs, as of September 30,

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2014. Based on this review, we do not believe there is a significant counterparty credit risk associated with these derivative instruments. However, no assurances can be provided regarding our potential exposure to counterparty credit risk in the future.

 

NOTE 7 — NONCONTROLLING INTERESTS

The following table shows the breakout of net income (loss) attributable to Surgical Care Affiliates between continuing operations and discontinued operations:

 

The following table shows the effects of changes to Surgical Care Affiliates’ ownership interest in its subsidiaries on Surgical Care Affiliates’ equity:

 

Certain of the Company’s noncontrolling interests have industry specific redemption features whereby the Company could be obligated, under the terms of certain of its operating subsidiaries’ partnership and operating agreements, to purchase some or all of the noncontrolling interests of the consolidated subsidiaries. As a result, these noncontrolling interests are not included as part of the Company’s equity and are carried as Noncontrolling interests-redeemable on the Company’s condensed consolidated balance sheets.

The activity relating to the Company’s noncontrolling interests-redeemable is summarized below:

 

 

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NOTE 8 — FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company follows the provisions of the authoritative guidance for fair value measurements, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under U.S. GAAP.

The fair value of an asset or liability is the amount at which the instrument could be exchanged in an orderly transaction between market participants to sell the asset or transfer the liability. As a basis for considering assumptions, the authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

Assets and liabilities measured at fair value are based on one or more of three valuation techniques, as follows:

The fair values of our assets and liabilities that are measured on a recurring basis are as follows (in millions):

 

 

 

 

 

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Disclosures for Recurring Measurements

Interest Rate Swaps

On a recurring basis, we measure our interest rate swaps at fair value. The fair value of our interest rate swaps is a Level 2 measurement derived from models based upon well recognized financial principles and reasonable estimates about relevant future market conditions and calculations of the present value of future cash flows, discounted using market rates of interest. Further, included in the fair value is approximately $0.1 million related to non-performance risk associated with the interest rate swaps at September 30, 2014 and December 31, 2013.

Contingent Consideration

In June 2013, we acquired 100% of the interests in Health Inventures, LLC (“HI”), a surgical and physician services company, for total consideration of $20.4 million. Of this amount, $9.6 million was paid to the sellers in cash, $8.9 million was placed into escrow as contingent consideration and $1.9 million was payable to certain individuals. The amount payable as contingent consideration depends in part upon the successful continuation and/or renewal of certain management agreement contracts held by HI and, in the case of renewals, will be determined by comparing the contract revenue prior to renewal against the expected contract revenue after renewal. The undiscounted range of amounts that could be paid as contingent consideration is zero to $8.9 million. As of the acquisition date, a $0.3 million contingent consideration asset was recorded. The fair value of the contingent consideration is a Level 3 measurement due to the lack of observable inputs.

 

The following table provides quantitative information associated with the fair value measurement of our recurring Level 3 inputs (in millions):

 

The following table provides a roll-forward of the recurring fair value balance that used Level 3 inputs (in millions):

 

Nonrecurring Measurements

Where applicable, on a nonrecurring basis, we measure property and equipment, goodwill, other intangible assets, investments in nonconsolidated affiliates and assets and liabilities of discontinued operations at fair value. The fair values of our property and equipment and other intangible assets are determined using discounted cash flows and significant unobservable inputs. The fair value of our investments in nonconsolidated affiliates is determined using discounted cash flows or earnings, or market multiples derived from a set of comparables. The fair value of our assets and liabilities of discontinued operations is determined using discounted cash flows and significant unobservable inputs unless there is an offer to purchase such assets and liabilities, which would be the basis for determining fair value. The fair value of our goodwill is determined using discounted cash flows, and, when available and as appropriate, we use comparative market multiples to corroborate discounted cash flow results. Goodwill is tested for impairment as of October 1 of each year, absent any interim impairment indicators.

An impairment charge of $1.5 million was recorded during the nine-months ended September 30, 2013 for an investment in a nonconsolidated affiliate. In conjunction with the deconsolidation of this affiliate (as described in Note 2), we adjusted the investment to fair value. The fair value of the investment in the nonconsolidated affiliate was determined based on the estimated fair value using valuations techniques that included recent market transactions.

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Also during the three- and nine- months ended September 30, 2013 an impairment charge of $1.2 million was recorded for an investment in a nonconsolidated affiliate due to the decline of future cash flows of such nonconsolidated affiliate that we judged to be other than temporary. This impairment is included in Equity in net income of nonconsolidated affiliates.

The investment in these nonconsolidated affiliates, measured at fair value on a nonrecurring basis, was as follows (in millions of U.S. dollars):

 

 

The inputs used by the Company in estimating the value of Level 3 Investment in nonconsolidated affiliates may include the weighted average cost of capital (“WACC”), revenue growth rates and exit price. Assumptions used by the Company due to the lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s results of operations. The following table includes information regarding the significant unobservable inputs used in the estimation of the Level 3 fair value measurement.

 

 

An impairment charge of $0.7 million was recorded during the nine-months ended September 30, 2014 for intangible and long-lived assets. The impairment is recorded in Loss from discontinued operations, net of income tax expense in the Company’s condensed consolidated statements of operations. A declining trend of earnings from operations at a facility and increased local competition resulted in the impairment charge recorded in 2014, as management determined its intent to sell or close the impacted facility. No impairment charges for intangible and long-lived assets were recorded during the three- and nine-months ended September 30, 2013. The fair value of the impaired long-lived assets was determined based on the assets’ estimated fair value using expected proceeds from the sale of the facility.

Assets related to discontinued operations measured at fair value on a nonrecurring basis are as follows (in millions of U.S. dollars):

 

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The inputs used by the Company in estimating the value of Level 3 Assets related to discontinued operations include the expected proceeds from the sale of the facility. Assumptions used by the Company due to the lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s results of operations. The following table includes information regarding significant unobservable inputs used in the estimation of Level 3 fair value measurement.

 

The following table presents the carrying amounts and estimated fair values of our financial instruments that are classified as long-term liabilities in our condensed consolidated balance sheets. The carrying value equals fair value for our financial instruments that are classified as current in our condensed consolidated balance sheets. The carrying amounts of a portion of our long-term debt approximate fair value due to various characteristics of those issues, including short-term maturities, call features and rates that are reflective of current market rates. For our long-term debt without such characteristics, we determined the fair market value by using quoted market prices, when available, or discounted cash flows to calculate their fair values. The fair values utilize inputs other than quoted prices in active markets, although the inputs are observable either directly or indirectly; accordingly, the fair values are in Level 2 of the fair value hierarchy.

 

 

NOTE 9 — EQUITY-BASED COMPENSATION

We have one active equity-based compensation plan, the 2013 Omnibus Long-Term Incentive Plan, and two legacy equity-based compensation plans, the Management Equity Incentive Plan and the Directors and Consultants Equity Incentive Plan, under which we are no longer issuing new awards (together, the “Plans”). The Plans provide or have provided for the granting of options to purchase our stock, as well as restricted stock units (“RSUs”), to key teammates, directors, service providers, consultants and affiliates.

Option awards are granted with an exercise price equal to at least the fair market value of the underlying shares at the date of grant. Vesting in the option awards varies based upon the passage of time, the attainment of certain performance conditions or the occurrence of a Liquidity Event (as defined in the applicable Plan) in which TPG Global LLC, our majority owner, and/or any of its affiliates (“TPG”) achieves a minimum cash return on its original investment. RSUs vest based upon the passage of time.

At September 30, 2014, 3,868,646 stock-based awards had been issued under the Plans (excluding forfeitures) and 1,578,870 stock-based awards were available for future equity grants.

In conjunction with the Conversion (see Note 1), every 10.25 outstanding membership units of ASC Acquisition LLC were converted into one share of common stock of Surgical Care Affiliates, Inc., and options to purchase membership units of ASC Acquisition LLC were converted into options to purchase shares of common stock of Surgical Care Affiliates, Inc., at a ratio of 10.25 membership units of ASC Acquisition LLC underlying such options to each one share of common stock of Surgical Care Affiliates, Inc. underlying such converted options. In connection with the Conversion, the exercise prices of such converted options were adjusted accordingly. In addition, every 10.25 outstanding restricted equity units of ASC Acquisition LLC were converted into one RSU of Surgical Care Affiliates, Inc. All information in this footnote is presented giving effect to the Conversion.

On September 16, 2013, our Board of Directors accelerated the vesting of all performance-based options. As a result of the acceleration, no unvested performance-based options existed at September 30, 2014.

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During the first nine months of 2014, we issued to certain members of our management team 306,898 RSU awards with fair values ranging from $28.35 to $31.24 per RSU award and 416,742 time-based stock options with exercise prices ranging from $28.35 to $31.24. The fair value of these RSU awards and options was determined using the policies described in Note 3, Summary of Significant Accounting Policies, and Note 11, Equity-Based Compensation, to the consolidated financial statements of our 2013 Annual Report on Form 10-K.

 

NOTE 10 — INCOME TAXES

The provision for income tax expense for the three-months ended September 30, 2014 includes the following: (1) current income tax expense of $0.3 million attributable to state income taxes of subsidiaries which have separate state tax filing requirements and (2) deferred income tax expense of $2.5 million attributable to the tax amortization of goodwill that is not amortized for book purposes, as well as write-offs of book and tax goodwill due to syndications of partnership interests.

The provision for income tax expense for the nine-months ended September 30, 2014 includes the following: (1) current income tax expense of $0.6 million attributable to state income taxes of subsidiaries which have separate state tax filing requirements and (2) deferred income tax expense of $5.4 million attributable to the tax amortization of goodwill that is not amortized for book purposes, as well as write-offs of book and tax goodwill due to syndications of partnership interests.

The provision for income tax expense for the three-months ended September 30, 2013 includes the following: (1) current income tax expense of $0.2 million attributable to state income taxes of subsidiaries which have separate state tax filing requirements and (2) deferred income tax expense of $5.5 million attributable to the tax amortization of goodwill that is not amortized for book purposes, as well as write-offs of book and tax goodwill due to syndications of partnership interests.

The provision for income tax expense for the nine-months ended September 30, 2013 includes the following: (1) current income tax expense of $0.5 million attributable to state income taxes of subsidiaries which have separate state tax filing requirements and (2) deferred income tax expense of $9.5 million attributable to the tax amortization of goodwill that is not amortized for book purposes, as well as write-offs of book and tax goodwill due to syndications of partnership interests.

We reduce our deferred income tax assets by a valuation allowance if, based on the weight of the available evidence, it is more likely than not that all or a portion of a deferred tax asset will not be realized. We currently have a full valuation allowance against net deferred tax assets, other than the deferred tax liability resulting from the amortization of goodwill, which is considered an indefinite-lived intangible. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our most recent operating performance, the scheduled reversal of temporary differences and our forecast of taxable income in future periods are important considerations in our assessment. Management has considered all positive and negative evidence available at this time and has concluded that a full valuation allowance continues to be appropriate as of September 30, 2014. We continue to closely monitor actual and forecasted earnings and, if there is a change in management’s assessment of the amount of deferred income tax assets that is realizable, adjustments to the valuation allowance will be made in future periods.

 

NOTE 11 — DISCONTINUED OPERATIONS

The Company has closed or sold certain facilities that qualify for reporting as discontinued operations. The assets and liabilities associated with these facilities are reflected in the accompanying condensed consolidated balance sheets as of September 30, 2014 and December 31, 2013 as Current assets related to discontinued operations, Assets related to discontinued operations, Current liabilities related to discontinued operations and Liabilities related to discontinued operations. Additionally, the accompanying condensed consolidated statements of operations and cash flows reflect the loss, net of income tax expense, and the net cash (used in) provided by operating, investing and financing activities, respectively, associated with these facilities as discontinued operations.

The operating results of discontinued operations are as follows:  

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The assets and liabilities related to discontinued operations consist of the following:

 

 

 

NOTE 12 — RELATED PARTY TRANSACTIONS

The Company paid management fees to TPG Capital Management, L.P., an affiliate of TPG, our majority owner, of $0.5 million and $1.5 million during the three- and nine-months ended September 30, 2013, respectively, pursuant to a management services agreement. In connection with the completion of our initial public offering in the fourth quarter of 2013, the agreement was terminated, and the Company no longer pays management fees to TPG Capital Management, L.P. or any other affiliate of TPG.

In connection with the amendment of our Amended Credit Agreement on May 8, 2013, TPG Capital BD, LLC, an affiliate of TPG, our majority owner, served as an arranger for purposes of the amendment and was paid an arrangement fee in the amount of $0.5 million during the nine-months ended September 30, 2013. In addition, TPG Capital BD, LLC participated as an underwriter underwriting the shares of our common stock in connection with our initial public offering of common stock and was paid an underwriting discount of approximately $0.7 million by us and the selling stockholders.

Certain directors of the Company have received options to purchase stock of the Company under the Directors and Consultants Equity Incentive Plan as part of their compensation for service on SCA’s Board of Directors and for consulting services provided to the Company. Total expense recognized by the Company related to these options was immaterial for the three- and nine-month periods ended September 30, 2014 and 2013.

The law firm of Bradley Arant Boult Cummings LLP provides certain legal services to us. We paid approximately $0.2 million and $0.4 million to this law firm during the three-months ended September 30, 2014 and 2013, and approximately $0.7 million and $1.0 million during the nine-months ended September 30, 2014 and 2013, respectively, for such legal services. The spouse of one of our executive officers, Richard L. Sharff, Jr., is a partner of this law firm.

 

NOTE 13 — COMMITMENTS AND CONTINGENT LIABILITIES

Legal Proceedings

The Company provides services in a highly regulated industry and is subject to various legal actions and regulatory and other governmental and internal audits and investigations from time to time. As a result, we expect that various lawsuits, claims and legal and regulatory proceedings may be instituted or asserted against us, including, without limitation, employment-related claims and medical negligence claims. Additionally, governmental agencies often possess a great deal of discretion to assess a wide range of monetary penalties and fines. We record accruals for contingencies to the extent that we conclude it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The outcome of any current or future litigation or governmental or internal investigations cannot be accurately predicted, nor can we predict any resulting penalties, fines or other sanctions that may be imposed at the discretion of federal or state regulatory authorities. Nevertheless, it is reasonably possible that any such penalties, fines or other sanctions could be substantial, and the outcome of these matters may have a material adverse effect on our results of operations, financial position and cash flows and may affect our reputation.

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Litigation

On May 5, 2006, Dr. Hansel DeBartolo filed a lawsuit captioned DeBartolo, et al. v. HealthSouth Corporation et al, in the United States District Court for the Northern District of Illinois, Eastern Division, against Joliet Surgery Center Limited Partnership (the “Partnership”), the general partner of that Partnership, Surgicare of Joliet, Inc., and its then-parent, HealthSouth Corporation, for a declaratory judgment and an injunction relating to the forced repurchase of his partnership interest (the “Federal Court Action”). We agreed to take responsibility from HealthSouth Corporation (our parent until SCA was purchased by ASC Acquisition LLC in 2007) regarding this matter. Dr. DeBartolo claimed that the partnership agreement’s requirement that an investor in a surgical center perform one-third of his surgical procedures at the center violates the federal Anti-Kickback Statute and its underlying federal policy, and he sought an order prohibiting the repurchase of his partnership interest. After the trial court dismissed the case by holding that no private cause of action exists under the Anti-Kickback Statute, Dr. DeBartolo appealed to the Seventh Circuit Court of Appeals, which directed the trial court to dismiss the case because the Federal courts did not have jurisdiction over the subject matter involved. On February 8, 2010, Dr. DeBartolo filed a lawsuit in the Twelfth Judicial Circuit Court, Will County, Illinois making the same claim and seeking the same relief as he sought in the Federal Court Action. On February 5, 2014, the Circuit Court entered an Order granting summary judgment in favor of the Defendants. On March 4, 2014, Plaintiff filed a Notice of Appeal in the Appellate Court of Illinois, Third District (the “Appellate Court”) seeking reversal of the Circuit Court’s Order. In June 2014, Plaintiff filed a motion to withdraw the Appeal and the Appellate Court accepted the motion and dismissed the appeal with prejudice.

Risk Insurance

Risk insurance for the Company and most of our facilities is provided through SCA’s risk insurance program. We insure our professional liability, general liability, property and workers’ compensation risks through commercial insurance plans placed with unrelated carriers.

Provisions for these risks are based upon market driven premiums and actuarially determined estimates for incurred but not reported exposure under claims-made policies. Provisions for losses within the policy deductibles represent the estimated ultimate net cost of all reported and unreported losses incurred through the consolidated balance sheet dates. Those estimates are subject to the effects of trends in loss severity and frequency. While we believe the provisions for losses are adequate, we cannot be sure the ultimate costs will not exceed our estimates.

Leases

We lease certain land, buildings and equipment under non-cancelable operating leases expiring at various dates through 2031. We also lease certain buildings and equipment under capital leases expiring at various dates through 2024. Operating leases generally have 3 to 22 year terms with one or more renewal options and with terms to be negotiated at the time of renewal.

 

 

NOTE 14 — SUBSEQUENT EVENTS

Effective October 1, 2014, through a joint venture entity, SCA and a health system partner purchased the management agreement rights and a 51% controlling interest in Glendale Endoscopy Center, LLC, which owns and operates an ASC in Glendale, California, for total consideration of $4.7 million.  This ASC is an equity method investment.

Effective November 1, 2014, through the future JV as further described in Note 3, SCA and a health system partner purchased a 51% controlling interest in Wilson Creek Surgery Center, LLC, which owns and operates an ASC in McKinney, Texas, for total cash consideration of $8.4 million.  This ASC is a consolidated facility.

Effective November 1, 2014, an indirect wholly-owned subsidiary of SCA contributed $1.6 million to Alliance Surgical Center, LLC, which owns and operates an ASC located in Lake Mary, Florida (“Lake Mary ASC”), in exchange for a 60% controlling interest in the Lake Mary ASC.  This ASC is a consolidated facility.

 

 

 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Amounts in tables are in millions of U.S. dollars unless otherwise indicated)

The following discussion and analysis of our financial condition and results of operations should be read together with our condensed consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, as well as our consolidated audited financial statements and related notes included in our 2013 Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from those contained in forward-looking statements as a result of many factors, including those discussed in the section of the 2013 Annual Report on Form 10-K entitled Part I, “Item 1A. Risk Factors.”

OVERVIEW

We are a leading provider of surgical solutions to physicians, health systems and payors, providing high quality, cost-effective surgical care. We were formed in 2007 with a focus on developing and operating a network of multi-specialty ASCs and surgical hospitals in the United States. During the nine-month period ended September 30, 2013, we were a Delaware limited liability company. However, on October 30, 2013, we converted from a Delaware limited liability company, previously named ASC Acquisition LLC, to a Delaware corporation. As of September 30, 2014, we operated in 33 states and had an interest in and/or operated 176 freestanding ASCs, five surgical hospitals and one sleep center with 11 locations. Of these 182 facilities, we consolidated the operations of 94 affiliated facilities, had 63 nonconsolidated affiliated facilities and held no ownership in 25 affiliated facilities that contract with us to provide management services only. In addition, at September 30, 2014, we provided perioperative consulting services to 10 facilities, which are not included in our facility count.

The entities that own our facilities are structured as general partnerships, LPs, LLPs or LLCs, and where we have an ownership interest in the facility, either one of our subsidiaries or a joint venture in which we have an ownership interest is an owner and serves as the general partner, limited partner, managing member or member. Our partners or co-members in these entities are generally licensed physicians and hospitals or health systems.

EXECUTIVE SUMMARY

Our growth strategy includes growing the profits at our existing facilities, entering into strategic relationships with hospitals and health systems and making selective acquisitions of existing surgical facilities and groups of facilities. We also periodically exit non-strategic facilities.

We took several steps during the first nine months of 2014 to optimize our portfolio by:

Our consolidated net operating revenues increased $25.5 million, or 13.1%, for the three-months ended September 30, 2014 compared to the three-months ended September 30, 2013. The main factors that contributed to this increase were revenues earned from acquisitions, higher acuity case mix and increased rates paid under certain payor contracts. This increase was partially offset by the deconsolidation of one facility since September 30, 2013. Consolidated net patient revenues per case grew by 7.6% to $1,794 per case for the three-months ended September 30, 2014 from $1,667 per case during the prior period, reflecting acquisitions with higher rates per case than the average rates at our consolidated facilities as well as higher acuity case mix. The number of cases at our consolidated facilities increased to 112,087 cases during the three-months ended September 30, 2014 from 106,164 cases during the

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three-months ended September 30, 2013, largely due to acquisitions since September 30, 2013. Also, our same site consolidated cases grew by 1.7% for the three-months ended September 30, 2014 as compared to the prior year period. Our number of consolidated facilities increased to 94 facilities as of September 30, 2014 from 86 facilities as of September 30, 2013.

We do not consolidate 63 of the facilities affiliated with us because we do not hold a controlling equity interest in the partnerships that own those facilities. To assist management in analyzing our results of operations, including at our nonconsolidated facilities, we prepare and disclose a “systemwide” case volume statistic and certain supplemental “systemwide” growth measures, each of which treats our equity method facilities as if they were consolidated. While the revenues earned at our equity method facilities are not recorded in our consolidated financial statements, we believe that systemwide net operating revenues growth and systemwide net patient revenues per case growth are important to understanding our financial performance because they are used by management to help interpret the sources of our growth and provide management with a growth metric incorporating the revenues earned by all of our affiliated facilities, regardless of the accounting treatment. “Systemwide” is a non-GAAP measure which includes the results of both our consolidated and nonconsolidated facilities (without adjustment based on our percentage of ownership). For more information, please see “Our Consolidated Results and Results of Nonconsolidated Affiliates” on page 38.

During the three-months ended September 30, 2014, systemwide net operating revenues grew by 10.5% as compared to the prior year period. Systemwide net patient revenues per case grew by 4.5% compared to the prior year period. These increases are due to acquisitions, coupled with changes in case mix and fee schedule increases.

Our consolidated net operating revenues increased $45.4 million, or 7.8%, for the nine-months ended September 30, 2014 compared to the nine-months ended September 30, 2013. The main factors that contributed to this increase were revenues earned from acquisitions, higher acuity case mix and increased rates paid under certain payor contracts. This increase was partially offset by the deconsolidation of one facility since September 30, 2013 and the disposition of two facilities during the first quarter of 2014. Consolidated net patient revenues per case grew by 3.7% to $1,767 per case for the nine-months ended September 30, 2014 from $1,704 per case during the prior period, reflecting acquisitions with higher rates per case than the average rates at our consolidated facilities as well as higher acuity case mix. The number of cases at our consolidated facilities increased to 324,371 cases during the nine-months ended September 30, 2014 from 320,171 cases during the nine-months ended September 30, 2013, largely due to acquisitions since the prior year period, partially offset by the impact of severe weather on a number of our facilities, including in the South, Midwest and Northeast, during the first quarter of 2014, the deconsolidation of one facility since September 30, 2013 and the disposition of two facilities during the first quarter of 2014. Our number of consolidated facilities increased to 94 facilities as of September 30, 2014 from 86 facilities as of September 30, 2013.

During the nine-months ended September 30, 2014, systemwide net operating revenues grew by 9.8% as compared to the prior year period. Systemwide net patient revenues per case grew by 4.9% compared to the prior year period. These increases are due to acquisitions since the prior year period, coupled with changes in case mix and fee schedule increases.

At September 30, 2014, we had 97 facilities in partnership with 41 health systems.   We held ownership interests in 11 consolidated and 55 nonconsolidated facilities and managed three facilities in partnership with 31 health systems.  We managed 19 facilities in partnership with another nine health systems. Additionally, there is one health system relationship where we consolidate nine facilities as a Variable Interest Entity (“VIE”), but do not currently hold an equity ownership interest in these facilities. Our health system relationships include local, regional and national health systems. We typically have co-development arrangements with our health system partners to jointly develop a network of outpatient surgery centers in a defined geographic area. These co-development arrangements are an important source of differentiation and potential growth of our business. We expect our co-development and acquisition activity to continue with a major focus on creating partnerships with not-for-profit health systems as we continue to position ourselves as a partner of choice to physician groups and health systems.

Our Consolidated Subsidiaries and Nonconsolidated Affiliates

At facilities where we serve as an owner and day-to-day manager, we have significant influence over the operations of such facilities. When we have control of the facility, we account for our investment in the facility as a consolidated subsidiary. When this influence does not represent control of the facility, but we have the ability to exercise significant influence over operating and financial policies, we account for our investment in the facility under the equity method, and treat the facility as a nonconsolidated affiliate. Our net earnings from a facility are the same under either method, but the classification of those earnings in our consolidated statements of operations differs.

For our consolidated subsidiaries, our financial statements reflect 100% of the revenues and expenses for these subsidiaries, after elimination of intercompany transactions and accounts. The net income attributable to owners of our consolidated subsidiaries, other than us, is classified within the line item Net income attributable to noncontrolling interests.

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As of September 30, 2014, we consolidated nine facilities into our financial results where we do not currently hold an equity ownership interest. All nine facilities are majority-owned and controlled by a common parent company (the “future JV”). We hold a promissory note from the future JV that is convertible into equity of the future JV at our option upon the occurrence of the renegotiation of certain contractual arrangements. The promissory note has a fixed interest rate of 4% plus a variable component that is dependent on the earnings of the future JV. We are also party to management services agreements with the facilities controlled by the future JV. As a result of the financial interest in the earnings of the future JV held by us via the promissory note and the powers granted to us in the promissory note and the management services agreements, we have determined, under Accounting Standards Codification Section 810, that the future JV is a VIE for which we are the primary beneficiary and, accordingly, we consolidate these facilities into our financial results.

For our nonconsolidated affiliates, our consolidated statements of operations reflect our earnings from such facilities in two line items:

Our equity in net income of nonconsolidated affiliates is primarily a function of the performance of our nonconsolidated affiliates and our percentage of ownership interest in those affiliates. However, our net patient revenues and associated expense line items only contain the results from our consolidated facilities. As a result of this incongruity in our reported results, management uses a variety of supplemental information to analyze our results of operations, including:

While revenues of our nonconsolidated affiliates are not recorded in our net operating revenues, we believe this information is important in understanding our financial performance because these revenues are typically the basis for calculating the line item Management fee revenues and, together with the expenses of our nonconsolidated affiliates, are the basis for deriving the line item Equity in net income of nonconsolidated affiliates. As we execute on our strategy of partnering with health systems, we expect the number of our facilities that we account for as equity method facilities will increase relative to our total number of facilities.

 

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key measures

Facilities

Changes in our ownership of individual facilities and related changes in how we account for such facilities drive changes in our consolidated results from period to period in several ways, including:

We took several steps during the nine-months ended September 30, 2014 to optimize our facility portfolio by acquiring, deconsolidating, selling and closing certain consolidated and nonconsolidated facilities.

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The following table presents a breakdown of the changes in the number of consolidated, nonconsolidated and managed-only facilities during the periods presented.

 

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Revenues

Our consolidated net operating revenues for the three-months ended September 30, 2014 and 2013 were $219.9 million and $194.4 million, respectively. Our consolidated net operating revenues for the nine-months ended September 30, 2014 and 2013 were $627.7 million and $582.3 million, respectively.

Given the increase in the number of our nonconsolidated facilities, driven by the success of our health system and physician partnership growth strategy, we review nonconsolidated facility revenues and also manage our facilities utilizing certain supplemental systemwide growth metrics.

The following table summarizes our systemwide net operating revenues growth, systemwide net patient revenues per case growth, same site systemwide net operating revenues growth and same site systemwide net patient revenues per case growth.

 

 

Three-Months Ended September 30, 2014 Compared to Three-Months Ended September 30, 2013

Our consolidated net operating revenues increased by $25.5 million, or 13.1%, for the three-months ended September 30, 2014 to $219.9 million from $194.4 million for the three-months ended September 30, 2013. Consolidated net patient revenues per case increased by 7.6% to $1,794 per case during the three-months ended September 30, 2014 from $1,667 per case during the three-months ended September 30, 2013.

For the three-months ended September 30, 2014, systemwide net operating revenues grew by 10.5% compared to the three-months ended September 30, 2013. In addition, for the three-months ended September 30, 2014, systemwide net patient revenues per case grew by 4.5% compared to the three-months ended September 30, 2013.

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The following table quantifies several significant items impacting our consolidated net operating revenues growth and net operating revenues growth of our nonconsolidated affiliates on a period-over-period basis:

 

 

Nine-Months Ended September 30, 2014 Compared to Nine-Months Ended September 30, 2013

Our consolidated net operating revenues increased by $45.4 million, or 7.8%, for the nine-months ended September 30, 2014 to $627.7 million from $582.3 million for the nine-months ended September 30, 2013. Consolidated net patient revenues per case increased by 3.7% to $1,767 per case during the nine-months ended September 30, 2014 from $1,704 per case during the nine-months ended September 30, 2013.

For the nine-months ended September 30, 2014, systemwide net operating revenues grew by 9.8% compared to the nine-months ended September 30, 2013. In addition, for the nine-months ended September 30, 2014, systemwide net patient revenues per case grew by 4.9% compared to the nine-months ended September 30, 2013.

The following table quantifies several significant items impacting our consolidated net operating revenues growth and net operating revenues growth of our nonconsolidated affiliates on a period-over-period basis:

 

 

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Summary of Key Line Items

Net Operating Revenues

The majority of our net operating revenues consist of net patient revenues from the facilities we consolidate for financial reporting purposes. Net patient revenues are derived from fees we collect from insurance companies, Medicare, Medicaid, state workers’ compensation programs, patients and other payors in exchange for providing the facility and related services and supplies a physician requires to perform a surgical procedure. Our Net operating revenues also includes the line item Management fee revenues, which includes fees we earn from managing the facilities that we do not consolidate for financial reporting purposes. The line item Other revenues is composed of other ancillary services and fees received for anesthesia services. The physicians who perform procedures at our facilities bill and collect from their patients and other payors directly for their professional services, and their revenues from such professional services are not included in our net operating revenues.

 

Net Patient Revenues

Net patient revenues are recorded during the period in which the healthcare services are provided, based upon the estimated amounts due from insurance companies, patients and other government and third-party payors, including federal and state agencies (under the Medicare and Medicaid programs), state workers’ compensation programs and employers.

The following table presents a breakdown by payor source of the percentage of net patient revenues for the periods presented:

 

Consolidated Facilities

 

Nonconsolidated Facilities

 

The majority of our net patient revenues are related to patients with commercial health insurance coverage. Reimbursement rates have been relatively stable, on an average basis, across our portfolio.

Medicare accounted for 20% of our net patient revenues for the three- and nine-months ended September 30, 2014 and 21% of our net patient revenues for the three- and nine-months ended September 30, 2013. The Medicare program is subject to statutory and regulatory changes, possible retroactive and prospective rate adjustments, administrative rulings, freezes and funding reductions, all of which may adversely affect the level of payments to our facilities. Significant spending reductions mandated by the Budget Control Act of 2011 (the “BCA”) impacting the Medicare program went into effect on March 1, 2013. Under the BCA, the percentage reduction for Medicare may not be more than 2%, on a non-cumulative basis, for a federal fiscal year, with a uniform percentage reduction across all providers. The impact from these spending reductions has not been material to our results. In October 2014, the

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Centers for Medicare and Medicaid Services finalized the payment update of 1.4% for federal fiscal year 2015, consisting of 1.9% inflation minus a 0.5% productivity factor.  We do not expect this update to materially affect our results.

For the nine-months ended September 30, 2014, the net patient revenues from our consolidated facilities located in each of Texas, California and North Carolina represented approximately 15%, 14% and 13%, respectively, of our total net patient revenues. Additionally, the net patient revenues from our consolidated facilities located in each of Alabama, Connecticut and Florida represented more than 5% of our total net patient revenues for the nine-months ended September 30, 2014. As of September 30, 2014, 28 of our 63 nonconsolidated facilities accounted for as equity method investments were located in California and 13 of these 63 facilities were located in Indiana.

Management Fee Revenues

Management fee revenues consist of management fees that we receive from managing the day-to-day operations of the facilities that we do not consolidate for financial reporting purposes. Management fee revenues increased 12.9% and 65.3% for the three- and nine-months ended September 30, 2014, respectively, mainly due to the acquisitions, including the acquisition of Health Inventures, LLC, a surgical and physician services company, during the second quarter of 2013.

Operating Expenses

Salaries and Benefits

Salaries and benefits represent the most significant cost to us and include all amounts paid to full- and part-time teammates, including all related costs of benefits provided to such teammates. Salaries and benefits expense represented 34.6% and 38.3% of our net operating revenues for the three-months ended September 30, 2014 and 2013, respectively, and 35.3% and 34.4% of our net operating revenues for the nine-months ended September 30, 2014 and 2013, respectively.

Supplies

Supplies expense includes all costs associated with medical supplies used while providing patient care at our consolidated facilities. Our supply costs primarily include sterile disposables, pharmaceuticals, implants and other similar items. Supplies expense represented 20.6% and 21.7% of our net operating revenues for the three-months ended September 30, 2014 and 2013, respectively, and represented 21.0% and 21.8% of our net operating revenues for the nine-months ended September 30, 2014 and 2013, respectively. Supplies expense is typically closely related to case volume, the timing of purchases and case mix, as an increase in the acuity of cases and the use of implants in those cases tends to drive supplies expense higher.

Other Operating Expenses

Other operating expenses consists primarily of expenses related to insurance premiums, contract services, legal fees, repairs and maintenance, professional and licensure dues, office supplies and miscellaneous expenses. Other operating expenses do not generally correlate with changes in net patient revenues.

Occupancy Costs

Occupancy costs include facility rent and utility and maintenance expenses. Occupancy costs do not generally correlate with changes in net patient revenues.

Provision for Doubtful Accounts

We write off uncollectible accounts against the allowance for doubtful accounts after exhausting collection efforts and adding subsequent recoveries. Net accounts receivable includes only those amounts we estimate we will collect. We perform an analysis of our historical cash collection patterns and consider the impact of any known material events in determining the allowance for doubtful accounts. In performing our analysis, we consider the impact of any adverse changes in general economic conditions, business office operations, payor mix or trends in federal or state governmental healthcare coverage.

Provision for Income Tax Expense

Because we have a full valuation allowance booked against our net deferred tax assets, our tax expense is generated primarily from amortization of tax goodwill and write-offs of book and tax goodwill resulting from the syndication of partnership interests. Our tax expense therefore bears no relationship to pre-tax income, and our effective tax rate will fluctuate from period to period, depending upon the amount of tax expense from amortization and write-offs of goodwill. Since substantially all of our facilities are organized as general partnerships, LPs, LLPs or LLCs, which are not taxed at the entity level for federal income tax purposes and are only taxed at the entity level in five states for state income tax purposes, substantially all of our tax expense is attributable to Surgical Care Affiliates.

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Net Income (Loss) Attributable to Surgical Care Affiliates

Net income (loss) attributable to Surgical Care Affiliates is derived by subtracting net income attributable to noncontrolling interests from net income. Net income includes certain revenues and expenses that are incurred only through our wholly-owned subsidiaries and therefore do not impact net income attributable to noncontrolling interests. These revenues and expenses include management fee revenues, interest expense related to Surgical Care Affiliates’ debt, losses or gains on sales of investments and provision for income taxes. In periods where net income is negatively affected by these non-shared revenues and expenses, the deduction of net income attributable to noncontrolling interests from net income can result in a net loss attributable to Surgical Care Affiliates in periods where net income is positive.

 

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Summary Results of Operations

Three-Months Ended September 30, 2014 Compared to Three-Months Ended September 30, 2013

Our Consolidated Results and Results of Nonconsolidated Affiliates

The following table shows our results of operations and the results of operations of our nonconsolidated affiliates for the three-months ended September 30, 2014 and 2013:

 

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Net Operating Revenues

Our consolidated net operating revenues increased $25.5 million, or 13.1%, for the three-months ended September 30, 2014 compared to the three-months ended September 30, 2013. The main factors that contributed to this increase were revenues earned from acquisitions, higher acuity case mix and increased rates paid under certain payor contracts. This increase was partially offset by the deconsolidation of one facility since September 30, 2013. Consolidated net patient revenues per case grew by 7.6% to $1,794 per case for the three-months ended September 30, 2014 from $1,667 per case during the prior period, reflecting acquisitions with higher rates per case than the average rates at our consolidated facilities as well as higher acuity case mix. The number of cases at our consolidated facilities increased to 112,087 cases during the three-months ended September 30, 2014 from 106,164 cases during the three-months ended September 30, 2013, largely due to acquisitions since September 30, 2013. Also, our same site consolidated cases grew by 1.7% for the three-months ended September 30, 2014 as compared to the prior period. Our number of consolidated facilities increased to 94 facilities as of September 30, 2014 from 86 facilities as of September 30, 2013.

For the three-months ended September 30, 2014, systemwide net operating revenues grew by 10.5% compared to the three-months ended September 30, 2013. The growth in systemwide net operating revenues was largely due to the acquisition of fifteen consolidated affiliates, two of which were previously accounted for as managed-only facilities, and the acquisition of noncontrolling interests in six facilities accounted for as equity method investments, two of which were previously accounted for as managed only-facilities, since the prior period, as well as increased management fee revenues from acquisitions made subsequent to the prior period and increased rates earned under certain payor contracts. In addition, for the three-months ended September 30, 2014, systemwide net patient revenues per case grew by 4.5% compared to the three-months ended September 30, 2013 due to the acquisitions described above and higher acuity case mix.

Equity in Net Income of Nonconsolidated Affiliates

Equity in net income of nonconsolidated affiliates increased $3.3 million, or 80.5%, to $7.4 million during the three-months ended September 30, 2014 from $4.1 million during the three-months ended September 30, 2013. Equity in net income of nonconsolidated affiliates increased due to the acquisition of several noncontrolling interests in facilities since September 30, 2013 and the deconsolidation of one facility completed after September 30, 2013 (i.e., the facility became an equity method facility rather than a consolidated facility). After deconsolidation, the results of operations of the facility were reported net in Equity in net income of nonconsolidated affiliates, whereas prior to deconsolidation, those results were reported within the consolidated revenue and expense line items. This increase was primarily offset by $1.4 million of impairments to two equity method facilities during the third quarter of 2013 and the consolidation of one facility that was previously accounted for as an equity method investment in the fourth quarter of 2013.

Additionally, changes in our ownership amounts in equity method facilities and changes in the profitability of those equity method facilities also impacted Equity in net income of nonconsolidated affiliates.

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Salaries and Benefits

Salaries and benefits expense increased $1.6 million, or 2.2%, to $76.0 million for the three-months ended September 30, 2014 from $74.4 million for the three-months ended September 30, 2013 due to consolidated acquisitions and corporate investments related to operations and development.

Supplies

Supplies expense increased $3.0 million, or 7.1%, to $45.2 million for the three-months ended September 30, 2014 from $42.2 million for the three-months ended September 30, 2013. Supplies expense per case increased by 1.5% during the three-months ended September 30, 2014, as compared to the prior year period, primarily due to inflation and changes in case mix.

Other Operating Expenses

Other operating expenses increased $2.0 million, or 6.5%, to $33.0 million for the three-months ended September 30, 2014 from $31.0 million for the three-months ended September 30, 2013. This increase was primarily attributable to the incurrence of certain additional costs resulting from our organizational growth through acquisitions.

Depreciation and Amortization

Depreciation and amortization expense increased $2.9 million, or 26.4%, to $13.9 million for the three-months ended September 30, 2014 from $11.0 million for the three-months ended September 30, 2013, primarily due to consolidated acquisitions and the addition of new capitalized assets since September 30, 2013, partially offset by the conversion of one consolidated facility to an equity method investment.

Occupancy Costs

Occupancy costs increased $1.1 million, or 16.2%, to $7.9 million for the three-months ended September 30, 2014 from $6.8 million for the three-months ended September 30, 2013, primarily due to acquisitions after the prior period and organizational growth.

Provision for Doubtful Accounts

The provision for doubtful accounts increased slightly to $3.6 million for the three-months ended September 30, 2014 as compared to $3.4 million during the three-months ended September 30, 2013. However, it remained consistent as a percentage of net patient revenues at approximately 2.0% for each of the three-months ended September 30, 2014 and 2013.

Interest Expense

Interest expense decreased $6.3 million, or 43.4%, to $8.2 million for the three-months ended September 30, 2014 from $14.5 million for the three-months ended September 30, 2013, primarily due to the redemption of all of our outstanding senior subordinated notes.

Gain (Loss) on Sale of Investments

We recognized $6.3 million in gains on sale of investments for the three-months ended September 30, 2014 and a loss on sale of investments of $0.1 million for the three-months ended September 30, 2013. The gains recognized during the three-months ended September 30, 2014 were primarily due to the syndications of nonconsolidated affiliates, contributions of an equity method investment to a joint venture and the sale of the management rights to an equity method investment.  The losses for the three-months ended September 30, 2013 were primarily due to deconsolidation transactions.

Provision for Income Tax Expense

For the three-months ended September 30, 2014, income tax expense was $2.8 million, representing an effective tax rate of 6.2%, compared to an expense of $5.7 million, representing an effective tax rate of 38.1%, for the three-months ended September 30, 2013. The $2.8 million in expense for the three-months ended September 30, 2014 included $2.5 million attributable to the tax amortization of goodwill, an indefinite-lived intangible, as well as write-offs of book and tax goodwill, and $0.3 million of state income taxes accrued by subsidiaries with separate state tax filing requirements, including $0.2 million attributable to noncontrolling interests. The $5.7 million in expense for the three-months ended September 30, 2013 included $5.5 million attributable to the tax amortization of goodwill, an indefinite-lived intangible, as well as write-offs of book and tax goodwill, and $0.2 million of state income taxes accrued by subsidiaries with separate state tax filing requirements, including $0.1 million attributable to noncontrolling interests.

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Because we have a full valuation allowance booked against our net deferred tax assets, our tax expense is generated primarily from amortization of tax goodwill and write-offs of tax goodwill resulting from the syndication of partnership interests. Our tax expense therefore bears no relationship to pre-tax income, and our effective tax rate will fluctuate from period to period, depending upon the amount of tax expense from amortization and write-offs of goodwill.

On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our most recent operating performance, the scheduled reversal of temporary differences and our forecast of taxable income in future periods are important considerations in our assessment. Management has considered all positive and negative evidence available at this time and has concluded that a full valuation allowance continues to be appropriate as of September 30, 2014. We continue to closely monitor actual and forecasted earnings and, if there is a change in management’s assessment of the amount of deferred income tax assets that is realizable, adjustments to the valuation allowance will be made in future periods.

Net income attributable to noncontrolling interests

Net income attributable to noncontrolling interests increased $9.2 million, or 43.0%, to $30.6 million for the three-months ended September 30, 2014 from $21.4 million during the three-months ended September 30, 2013. The increase in our consolidated net operating revenues, as described above, drove an increase in consolidated facilities’ net income. Most of our consolidated facilities include noncontrolling owners. An increase in the earnings of these facilities resulted in an increase in net income attributable to noncontrolling interests. This increase was partially offset by the deconsolidation of one facility since September 30, 2013.

Net income (loss) attributable to Surgical Care Affiliates

Net income attributable to Surgical Care Affiliates increased $20.5 million to $7.8 million of net income for the three-months ended September 30, 2014 from $12.7 million of net loss for the three-months ended September 30, 2013. The increase was driven by growth in earnings from acquisitions and lower interest expense.

 

 

 

 

 

 

 

 

 

 

 

 

 

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Nine-Months Ended September 30, 2014 Compared to Nine-Months Ended September 30, 2013

Our Consolidated Results and Results of Nonconsolidated Affiliates

The following table shows our results of operations and the results of operations of our nonconsolidated affiliates for the nine-months ended September 30, 2014 and 2013:

 

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Net Operating Revenues

Our consolidated net operating revenues increased $45.4 million, or 7.8%, for the nine-months ended September 30, 2014 compared to the nine-months ended September 30, 2013. The main factors that contributed to this increase were revenues earned from acquisitions, higher acuity case mix and increased rates paid under certain payor contracts. This increase was partially offset by the deconsolidation of one facility since September 30, 2013 and the disposition of two facilities during the first quarter of 2014. Consolidated net patient revenues per case grew by 3.7% to $1,767 per case for the nine-months ended September 30, 2014 from $1,704 per case during the prior period, reflecting acquisitions with higher rates per case than the average rates at our consolidated facilities as well as higher acuity case mix. The number of cases at our consolidated facilities increased to 324,371 cases during the nine-months ended September 30, 2014 from 320,171 cases during the nine-months ended September 30, 2013, largely due to acquisitions since the prior period, partially offset by the impact of severe weather on a number of our facilities, including in the South, Midwest and Northeast, during the first quarter of 2014, the deconsolidation of one facility since September 30, 2013 and the disposition of two facilities during the first quarter of 2014. Our number of consolidated facilities increased to 94 facilities as of September 30, 2014 from 86 facilities as of September 30, 2013.

For the nine-months ended September 30, 2014, systemwide net operating revenues grew by 9.8% compared to the nine-months ended September 30, 2013. The growth in systemwide net operating revenues was largely due to the acquisition of fifteen consolidated affiliates, two of which were previously accounted for as managed-only facilities, and noncontrolling interests in six facilities accounted for as equity method investments, two of which were previously accounted for as managed only-facilities, since the prior period, as well as increased management fee revenues from acquisitions made subsequent to the prior period, changes in case mix and increased rates earned under certain payor contracts. In addition, for the nine-months ended September 30, 2014, systemwide net patient revenues per case grew by 4.9% compared to the nine-months ended September 30, 2013 due to similar factors as described above. These increases were partially offset by generally flat same-site volume due to highly inclement winter weather in certain of our markets during the first quarter of 2014, a reduction in Medicare rates due to sequestration and a reduction in North Carolina worker’s compensation rates.

Equity in Net Income of Nonconsolidated Affiliates

Equity in net income of nonconsolidated affiliates increased $4.9 million, or 30.4%, to $21.0 million during the nine-months ended September 30, 2014 from $16.1 million during the nine-months ended September 30, 2013. Equity in net income of nonconsolidated affiliates increased due to the acquisition of several noncontrolling interests in facilities since September 30, 2013 and the deconsolidation of one facility since September 30, 2013 (i.e., the facility became an equity method facility rather than a consolidated facility). After deconsolidation, the results of operations of the facility were reported net in Equity in net income of nonconsolidated affiliates, whereas prior to deconsolidation, the results were reported within the consolidated revenue and expense line items. This increase was primarily offset by $3.4 million in impairments related to three equity method facilities during the nine-months ended September 30, 2013 and by the consolidation of one facility that was previously accounted for as an equity method investment in the prior period.

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Additionally, changes in our ownership amounts in equity method facilities and changes in the profitability of those equity method facilities also impacted Equity in net income of nonconsolidated affiliates.

Salaries and Benefits

Salaries and benefits expense increased $20.7 million, or 10.3%, to $221.3 million for the nine-months ended September 30, 2014 from $200.6 million for the nine-months ended September 30, 2013. Acquisitions, including the acquisition of Health Inventures, LLC, largely drove the increase in salaries and benefits. Corporate investments related to operations and development also contributed to the increase.

Supplies

Supplies expense increased $4.5 million, or 3.5%, to $131.6 million for the nine-months ended September 30, 2014 from $127.1 million for the nine-months ended September 30, 2013. Supplies expense per case increased by 2.2% during the nine-months ended September 30, 2014, as compared to the prior year period, primarily due to inflation and changes in case mix.

Other Operating Expenses

Other operating expenses increased $4.7 million, or 5.3%, to $93.8 million for the nine-months ended September 30, 2014 from $89.1 million for the nine-months ended September 30, 2013. This increase was primarily attributable to the incurrence of certain additional costs resulting from our organizational growth through acquisitions.

Depreciation and Amortization

Depreciation and amortization expense increased $7.2 million, or 22.6%, to $39.0 million for the nine-months ended September 30, 2014 from $31.8 million for the nine-months ended September 30, 2013, primarily due to acquisitions and the addition of new capitalized assets since September 30, 2013, partially offset by the conversion of one consolidated facility to an equity method investment.

Occupancy Costs

Occupancy costs increased $2.5 million, or 12.4%, to $22.6 million for the nine-months ended September 30, 2014 from $20.1 million for the nine-months ended September 30, 2013, primarily due to acquisitions after the prior period and organizational growth.

Provision for Doubtful Accounts

The provision for doubtful accounts decreased $0.4 million, or 3.8%, to $10.0 million for the nine-months ended September 30, 2014 from $10.4 million during the nine-months ended September 30, 2013. However, it remained consistent as a percentage of net patient revenues at approximately 2.0% for the nine-months ended September 30, 2014 and 2013.

Interest Expense

Interest expense decreased $24.2 million, or 49.6%, to $24.6 million for the nine-months ended September 30, 2014 from $48.8 million for the nine-months ended September 30, 2013, primarily due to the refinancing of certain of our indebtedness in 2013, including the redemption of all of our outstanding senior notes and senior subordinated notes in the second half of 2013.

(Gain) Loss on Sale of Investments

We recognized gains on sale of investments of $1.9 million and losses on sale of investments of $1.1 million for the nine-months ended September 30, 2014 and 2013, respectively. The gains for the nine-months ended September 30, 2014 were primarily due to the syndications of nonconsolidated affiliates, contributions of an equity method investment to a joint venture and the sale of the management rights to an equity method investment, partially offset by losses due to a deconsolidation transaction.  The losses for the nine-months ended September 30, 2013 were primarily due to deconsolidation transactions.

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Provision for Income Tax Expense

For the nine-months ended September 30, 2014, income tax expense was $6.0 million, representing an effective tax rate of 5.6%, compared to $10.0 million, representing an effective tax rate of 15.3%, for the nine-months ended September 30, 2013. The $6.0 million in expense for the nine-months ended September 30, 2014 included $5.4 million attributable to the tax amortization of goodwill, an indefinite-lived intangible, as well as write-offs of book and tax goodwill, and $0.6 million of state income taxes accrued by subsidiaries with separate state tax filing requirements, including $0.4 million attributable to noncontrolling interests. The $10.0 million in expense for the nine-months ended September 30, 2013 included $9.5 million attributable to the tax amortization of goodwill, an indefinite-lived intangible, as well as write-offs of book and tax goodwill, and $0.5 million of state income taxes accrued by subsidiaries with separate state tax filing requirements, including $0.2 million attributable to noncontrolling interests.

Because we have a full valuation allowance booked against our net deferred tax assets, our tax expense is generated primarily from amortization of tax goodwill and write-offs of tax goodwill resulting from the syndication of partnership interests. Our tax expense therefore bears no relationship to pre-tax income, and our effective tax rate will fluctuate from period to period, depending upon the amount of tax expense from amortization and write-offs of goodwill.

On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our most recent operating performance, the scheduled reversal of temporary differences and our forecast of taxable income in future periods are important considerations in our assessment. Management has considered all positive and negative evidence available at this time and has concluded that a full valuation allowance continues to be appropriate as of September 30, 2014. We continue to closely monitor actual and forecasted earnings and, if there is a change in management’s assessment of the amount of deferred income tax assets that is realizable, adjustments to the valuation allowance will be made in future periods.

Net income attributable to noncontrolling interests

Net income attributable to noncontrolling interests increased $6.7 million, or 8.9%, to $81.6 million for the nine-months ended September 30, 2014 from $74.9 million for the nine-months ended September 30, 2013. The increase in our consolidated net operating revenues, as described above, drove an increase in consolidated facilities’ net income. Most of our consolidated facilities include noncontrolling owners. An increase in the earnings of these facilities resulted in an increase in net income attributable to noncontrolling interests. This increase was partially offset by the deconsolidation of one facility since September 30, 2013.

Net income (loss) attributable to Surgical Care Affiliates

Net income attributable to Surgical Care Affiliates increased $38.0 million to $14.1 million of net income for the nine-months ended September 30, 2014 from $23.9 million of net loss for the nine-months ended September 30, 2013. The increase was driven by growth in earnings from acquisitions and lower interest expense.

Results of Discontinued Operations

We have closed or sold certain facilities that qualify for reporting as discontinued operations. The operating results of discontinued operations were as follows:

 

Both the decline in net operating revenues and the decline in costs and expenses in each period were due to the timing of the sale or closure of the facilities identified as discontinued operations. The net loss from our discontinued operations is included in the line item Loss from discontinued operations, net of income tax expense in the condensed consolidated financial statements.

 

 

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Liquidity and Capital Resources

Our primary cash requirements are paying our operating expenses, servicing our existing debt, making capital expenditures on our existing properties, financing acquisitions of interests in ASCs and surgical hospitals and making distributions to noncontrolling interests. These continuing liquidity requirements have been and will continue to be significant, primarily due to financing costs relating to our indebtedness. The following chart shows the cash flows provided by or used in operating, investing and financing activities of continuing and discontinued operations (in the aggregate) for the nine-months ended September 30, 2014 and 2013:

 

Cash Flows Provided by Operating Activities

Cash flows provided by operating activities is primarily derived from net income before deducting non-cash charges for depreciation and amortization.

 

During the nine-months ended September 30, 2014, we generated $156.1 million of cash flows provided by operating activities compared to $130.8 million during the nine-months ended September 30, 2013. Cash flows from operating activities increased $25.3 million, or 19.3%, from the prior period, primarily due to a $51.9 million increase in net income before depreciation and amortization, partially offset by a $23.5 million decrease in other operating cash flows.

Cash Flows Used in Investing Activities

During the nine-months ended September 30, 2014, our net cash used in investing activities was $122.5 million, consisting primarily of $89.0 million for business acquisitions, net of cash acquired, $25.4 million of capital expenditures and $17.7 million of purchases of equity interests in nonconsolidated affiliates, partially offset by a $6.9 million decrease in restricted cash, $2.7 million of proceeds from the sale of businesses and $2.4 million of proceeds from the sale of equity interests of consolidated affiliates in deconsolidation transactions. Cash flows used in investing activities increased $85.8 million, or 233.8%, from the prior period, primarily due to an increase in cash outflows for business acquisitions and for the purchase of equity interests in nonconsolidated affiliates.

Cash Flows Used in Financing Activities

Net cash used in financing activities for the nine-months ended September 30, 2014 was $66.1 million, consisting primarily of $81.8 million of distributions to noncontrolling interests, which primarily related to existing facilities, and $11.8 million for principal payments on long-term debt, partially offset by $19.6 million in long-term debt borrowings and $12.5 million of contributions from noncontrolling interests of consolidated affiliates, which primarily were used to fund business acquisitions.

Net cash used in financing activities decreased $58.1 million, or 46.8%, from the prior period, primarily due to lower net long-term debt borrowings and lower distributions to unit holders.

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Cash and cash equivalents were $53.4 million at September 30, 2014 as compared to $85.8 million at December 31, 2013. Cash and cash equivalents consist of cash on hand, demand deposits with financial institutions reduced by the amount of outstanding checks and drafts where the right of offset exists for such bank accounts and short-term, highly liquid investments. We consider all highly liquid investments with original maturities of 90 days or less, such as certificates of deposit, money market funds and commercial paper, to be cash equivalents. The overall working capital position at September 30, 2014 was $18.0 million compared to $37.3 million at December 31, 2013, a decrease of $19.3 million, or 51.7%. This decrease was primarily driven by a decrease in Cash and cash equivalents and an increase in the net payable to nonconsolidated affiliates.

Based on our current level of operations, we believe cash flow from operations and available cash, together with available borrowings under our Class B Revolving Credit Facility, will be adequate to meet our short-term (12 months or less) liquidity needs.

Debt

Our primary sources of funding have been the incurrence of debt and cash flows from operations. In the future, our primary sources of liquidity are expected to be cash flows from operations and additional funds available under the Class B Revolving Credit Facility.

The Credit Facility

Our Credit Facility consists of a $132.3 million Class B Revolving Credit Facility, which will mature on June 30, 2016 (the “Class B Revolving Credit Facility”); a $212.8 million Class B Term Loan, which will mature on December 30, 2017 (the “Class B Term Loan”); and a $385.1 million Class C Term Loan, which will mature on June 30, 2018 (the “Class C Term Loan” and, together with the Class B Revolving Credit Facility and the Class B Term Loan, the “Senior Secured Credit Facilities”).

The following table indicates the current maturity date for each of our credit facilities:

 

Due to the maturity dates reflected in the table above, we believe that we do not currently face a substantial near-term refinancing risk. However, upon the occurrence of certain events, such as a change of control or a violation of certain covenants in our Senior Secured Credit Facilities, we could be required to repay or refinance our indebtedness prior to maturity.

As of September 30, 2014, we had no outstanding balance under the Class B Revolving Credit Facility, and we had approximately $2.9 million in letters of credit outstanding. Utilization of the Class B Revolving Credit Facility is subject to compliance with a total leverage ratio test. No utilization of the Class B Revolving Credit Facility may be outstanding (other than issuances of up to an aggregate of $5.0 million of letters of credit) at the end of any fiscal quarter in which the total leverage ratio, which is the ratio of consolidated total debt to consolidated EBITDA (each as defined in the Amended Credit Agreement), as of the last day of such fiscal quarter, is greater than a specified ratio level.

Borrowings under each facility of the Senior Secured Credit Facilities bear interest at a base rate or at LIBOR, as elected by us, plus an applicable margin. The base rate is determined by reference to the higher of (i) the prime rate of JPMorgan Chase Bank, N.A. and (ii) the federal funds effective rate plus 0.50% (the “base rate”). The LIBOR rate is determined by reference to the interest rate for dollar deposits in the LIBOR. The following table outlines the applicable margin for each credit facility:

 

At September 30, 2014, the interest rate on the Class B Term Loan was 4.23%. At September 30, 2014, the interest rate on the Class C Term Loan was 4.00%. We must repay the principal amount of the Class B Term Loan and the Class C Term Loan in quarterly installments equal to 0.25% of the original principal amount of the respective loan. The remaining principal amount of each of the Class B Term Loan and the Class C Term Loan is due in full at maturity. Interest payments, along with the installment payments of principal, are made at the end of each quarter. We are also required to pay a commitment fee to the lenders under our

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Class B Revolving Credit Facility in respect of the unutilized commitments thereunder of between 0.375% or 0.50%, depending on the senior secured leverage ratio (as defined in the Amended Credit Agreement).

The Senior Secured Credit Facilities contain certain customary representations and warranties, affirmative covenants, events of default and various restrictive covenants, which are subject to certain significant exceptions. As of September 30, 2014, we believe that we and SCA were in compliance with these covenants.

Capital Expenditures

Capital expenditures totaled $7.2 million and $25.4 million for the three- and nine-months ended September 30, 2014, respectively, as compared to $8.9 million and $26.2 million for the three- and nine-months ended September 30, 2013, respectively. The capital expenditures made during the three- and nine-months ended September 30, 2014 consisted primarily of fixture improvements made at our leased facilities and our purchase of medical and other equipment. These capital expenditures were financed primarily through internally generated funds and bank or manufacturer financing. We believe that our capital expenditure program is adequate to improve and equip our existing facilities.

Capital Leases

We engage in a significant number of leasing transactions, including real estate, medical equipment, computer equipment and other equipment utilized in operations. Certain leases that meet the lease capitalization criteria in accordance with authoritative guidance for leases have been recorded as an asset and liability at the net present value of the minimum lease payments at the inception of the lease. Interest rates used in computing the net present value of the lease payments generally range from 2.2% to 12.2% based on the rate implied by the lease at the inception of the lease.

Inflation

For the past three years, inflation has not significantly affected our operating results or the geographic areas in which we operate.

 

 

Off-Balance Sheet Transactions

As a result of our strategy of partnering with physicians and health systems, we do not own controlling interests in many of our facilities. At September 30, 2014, we accounted for 63 of our 182 affiliated facilities under the equity method. Like our consolidated facilities, our nonconsolidated facilities have debts, including capitalized lease obligations, that are generally non-recourse to us. With respect to our equity method facilities, these debts are not included in our consolidated financial statements. At September 30, 2014, the total debt on the balance sheets of our nonconsolidated affiliates was approximately $56.2 million. Our average percentage of ownership of these nonconsolidated affiliates, weighted based on the individual affiliate’s amount of debt and our ownership of such affiliate, was approximately 24% at September 30, 2014. We or one of our wholly-owned subsidiaries collectively guaranteed $2.7 million of the $56.2 million in total debt of our nonconsolidated affiliates as of September 30, 2014. Additionally, our guarantees related to operating leases of nonconsolidated affiliates were $15.1 million at September 30, 2014.

As described above, our nonconsolidated affiliates are structured as general partnerships, LPs, LLPs or LLCs. None of these affiliates provide financing, liquidity, or market or credit risk support for us. They also do not engage in hedging or research and development services with us. Moreover, we do not believe that they expose us to any of their liabilities that are not otherwise reflected in our consolidated financial statements and related disclosures. Except as noted above with respect to guarantees, we are not obligated to fund losses or otherwise provide additional funding to these affiliates other than as we determine to be economically required in order to successfully implement our development plans.

Critical Accounting Policies

General

Our discussion and analysis of our financial condition, results of operations and liquidity and capital resources are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of consolidated financial statements under GAAP requires our management to make certain estimates and assumptions that impact the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements. These estimates and assumptions also impact the reported amount of net earnings during any period. Estimates are based on information available as of the date financial statements are prepared. Accordingly, actual results could differ from those estimates. Critical accounting policies and estimates are defined as those that are both most important to the portrayal of our financial condition and operating results and that require management’s most subjective judgments. Our critical accounting policies and estimates include our

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policies and estimates regarding consolidation, variable interest entities, revenue recognition, accounts receivable, noncontrolling interests in consolidated affiliates, equity-based compensation, valuation of our common stock, income taxes, goodwill and impairment of long-lived assets and other intangible assets. There were no material changes to our critical accounting policies during the nine-months ended September 30, 2014.

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our principal market risk is our exposure to variable interest rates. As of September 30, 2014, we had $662.8 million of indebtedness (excluding capital leases), of which $645.3 million is at variable interest rates and $17.5 million is at fixed interest rates. In seeking to reduce the risks and costs associated with such activities, we manage exposure to changes in interest rates primarily through the use of derivatives. We do not use financial instruments for trading or other speculative purposes, nor do we use leveraged financial instruments.

At September 30, 2014, we held interest rate swaps hedging interest rate risk on $190.0 million of our variable rate debt through two forward starting interest rate swaps with an aggregate notional amount of $190.0 million, which we entered into during 2011. These forward starting interest rate swaps, which are swaps that are entered into at a specified trade date but do not begin until a future start date, extend the interest rate swaps that we terminated in 2012 and on September 30, 2013. These swaps are “receive floating/pay fixed” instruments, meaning we receive floating rate payments, which fluctuate based upon LIBOR, from the counterparty and provide payments to the counterparty at a fixed rate, the result of which is to convert the interest rate of a portion of our floating rate debt into fixed rate debt in order to limit the variability of interest-related payments caused by changes in LIBOR. Forward starting interest rate swaps with an aggregate notional amount of $100.0 million became effective on September 30, 2012, and the remaining forward starting interest rate swap with a notional amount of $140.0 million became effective on September 30, 2013. A forward interest rate starting swap with a notional amount of $50.0 million terminated on September 30, 2014. The remaining aggregate notional amount of $190.0 million in forward starting interest rate swaps will terminate on September 30, 2016. Assuming a 100 basis point increase in LIBOR on our un-hedged debt at September 30, 2014, our annual interest expense would increase by approximately $4.1 million.

Counterparties to the interest rate swaps discussed above expose us to credit risks to the extent of their potential non-performance. The credit ratings of the counterparties, which consist of investment banks, are monitored at least quarterly. We have completed a review of the financial strength of the counterparties using publicly available information, as well as qualitative inputs, as of September 30, 2014. Based on this review, we do not believe there is a significant counterparty credit risk associated with these interest rate swaps. However, we cannot assure you that these actions will protect us against or limit our exposure to all counterparty or market risks.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2014, the Company’s disclosure controls and procedures are effective in ensuring that material information relating to the Company required to be disclosed in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods and is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.

Changes in Internal Control Over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended September 30, 2014, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II — OTHER INFORMATION

 

Item 1. Legal Proceedings

From time to time, we are party to various legal proceedings that have arisen in the normal course of conducting business. See Note 13, Commitments and Contingent Liabilities, to the condensed consolidated financial statements in this Quarterly Report on Form 10-Q for information regarding legal proceedings, which is incorporated herein by reference in response to this item.

 

 

Item 1A. Risk Factors

In addition to the other information contained in this Quarterly Report on Form 10-Q, the risks and uncertainties that we believe could materially affect our business, financial condition or future results and are most important for you to consider are discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013. Additional risks and uncertainties which are not presently known to us, which we currently deem immaterial or which are similar to those faced by other companies in our industry or business in general, may also materially and adversely affect any of our business, financial position or future results.

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

 

 

Item 3. Defaults Upon Senior Securities

None.

 

 

Item 4. Mine Safety Disclosure

Not applicable.

 

 

Item 5. Other Information

 

None.

 

 

 

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Item 6. Exhibits

 

 

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

 

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EXHIBIT INDEX

 

 

 

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