UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-K

 

 

Commission File Number 000-33009

MedCath Corporation

(Exact name of registrant as specified in its charter)

 

 

10720 Sikes Place
Charlotte, North Carolina 28277
(Address of principal executive offices, including zip code)

 

(704) 815-7700

 

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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. (Check one):

 

(Do not check if a smaller reporting company)

 

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

 

As of December 10, 2009 there were 20,654,264 shares of the Registrant’s Common Stock outstanding. The aggregate market value of the Registrant’s common stock held by non-affiliates as of March 31, 2009 was approximately $115.8 million (computed by reference to the closing sales price of such stock on the Nasdaq Global Market^® on such date).

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s proxy statement for its annual meeting of stockholders to be held on March 3, 2010 are incorporated by reference into Part III of this Report.

 

 

MEDCATH CORPORATION

 

FORM 10-K

 

TABLE OF CONTENTS

 

 

FORWARD-LOOKING STATEMENTS

 

Some of the statements and matters discussed in this report and in exhibits to this report constitute forward-looking statements. Words such as “expects,” “anticipates,” “approximates,” “believes,” “estimates,” “intends” and “hopes” and variations of such words and similar expressions are intended to identify such forward-looking statements. We have based these statements on our current expectations and projections about future events. These forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. The forward-looking statements contained in this report include, among others, statements about the following:

 

 

Although these statements are made in good faith based upon assumptions our management believes are reasonable on the date they are made, we cannot assure you that we will achieve our goals. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report and its exhibits might not occur. Our forward-looking statements speak only as of the date of this report or the date they were otherwise made. Other than as may be required by federal securities laws to disclose material developments related to previously disclosed information, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We urge you to review carefully all of the information in this report and the discussion of risk factors before making an investment decision with respect to our debt and equity securities.

 

Unless otherwise noted, the following references in this report will have the meanings below:

 

 

 

Overview

 

We were incorporated in Delaware in 2001 as a healthcare provider and are focused primarily on providing high acuity services, including the diagnosis and treatment of cardiovascular disease. We own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence. We opened our first hospital in 1996 and currently have ownership interests in and operate ten hospitals, including eight in which we own a majority interest. Each of our majority-owned hospitals is a freestanding, licensed general acute care hospital that provides a wide range of health services with a majority focus on cardiovascular care. Each of our hospitals has a 24-hour emergency room staffed by emergency department physicians. The hospitals in which we have ownership interests have a total of 825 licensed beds and are located in predominantly high growth markets in seven states: Arizona, Arkansas, California, Louisiana, New Mexico, South Dakota, and Texas. During May 2009 we completed our 79 licensed bed expansion at Louisiana Medical Center and Heart Hospital and built space for an additional 40 beds at that hospital. During October 2009 we opened a new acute care hospital in Kingman, Arizona. This hospital is designed to accommodate a total of 106 licensed beds, with an initial opening of 70 of its licensed beds.

 

In addition to our hospitals, we currently own and/or manage 16 cardiac diagnostic and therapeutic facilities. Ten of these facilities are located at hospitals operated by other parties. These facilities offer invasive diagnostic and, in some cases, therapeutic procedures. The remaining six facilities are not located at hospitals and offer only diagnostic procedures. We refer to our diagnostics division as “MedCath Partners.” For financial data and other information of this and other segments of our business see Note 19 to our consolidated financial statements for financial information by segment.

 

We are subject to the informational requirements of the Securities Exchange Act of 1934 (the “Exchange Act”) and therefore, we file reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Such reports may be read and copied at the Public Reference Room of the SEC at 100 F Street NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at (800) SEC-0330. In addition, the SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file electronically.

 

We maintain a website at www.medcath.com that investors and interested parties can access and obtain copies, free-of-charge, of all reports, proxy and information statements and other information that the Company submits to the SEC as soon as reasonably practicable after we electronically submit such material to the SEC. This information includes copies of our proxy statements, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to the Exchange Act.

 

Investors and interested parties can also submit electronic requests for information directly to the Company at the following e-mail address: ir@medcath.com. Alternatively, communications can be mailed to the attention of “Investor Relations” at the Company’s executive offices.

 

Information on our website is not incorporated into this Form 10-K or our other securities filings and is not a part of this or them.

 

Our Strengths

 

Leading Local Market Positions in Growing Markets.  We believe all of our seven majority-owned hospitals that have been open for at least three years are ranked number one or two in the local market based on procedures performed in our core cardiovascular diagnosis-related group (“DRG”), based on the latest data available for each market at time of publication as reported by Thomson Reuters, a leading source of healthcare business information. For Arizona, California, and Texas, the original source is state-collected data through all or part of 2008. For Louisiana, Arkansas, New Mexico, and San Diego, the latest original source data available to us is 2007 Medicare Provider Analysis and Review data. Historically, 75% of patients treated in our hospitals reside in markets where the

population of those 55 years and older, the primary recipients of cardiac care services, is anticipated to increase on average by 18.6%, from 2009 to 2013, versus the national average of 16.1%, according to Thomson Reuters.

 

Efficient Quality Care Delivery Model.  Our hospitals have innovative facility designs and operating characteristics that we believe enhance the quality of patient care and service and improve physician and staff productivity. The innovative characteristics of our hospital designs include:

 

 

We believe our care delivery model leads to a high level of patient satisfaction and quality care. We selected NRC Picker to administer our inpatient satisfaction surveys beginning January 1, 2006. We have performed well when compared to NRC Picker’s national database. For the most recent available calendar year, 2008, our hospitals had an overall satisfaction score of 83.7% compared to 60.3% for the NRC Picker national comparison group. Our most recently reported overall satisfaction score, for the second quarter of 2009, was 82.9% compared to 61.1% for the national comparison group.

 

Proven Ability to Partner with Physicians and Community Hospital Systems.  We partner with physicians and share capital commitments in all of our hospitals and many of our cardiac diagnostic and therapeutic facilities. We also have management and partnership arrangements with community hospital systems both in the hospitals operated by these community hospitals and in certain of our hospitals. Physicians practicing at our hospitals participate in shared governance where decisions are made on a wide range of strategic and operational matters, such as development of clinical care protocols, patient procedure scheduling, development of hospital formularies, selection of vendors for high-cost supplies and devices, review of annual operating budgets and significant capital expenditures. The opportunity to have a role in how our hospitals are managed empowers physicians and encourages them to share new ideas, concepts and practices. We attribute our success in partnering with physicians to our ability to develop and effectively manage facilities in a manner that promotes physician productivity, satisfaction and professional success while enhancing the quality and efficiency of patient care services that we provide.

 

Strong Management Team.  Our management team has extensive experience and relationships in the healthcare industry. Our president and chief executive officer, O. Edwin French, was appointed to this position in February 2006 and has over 40 years of experience in the healthcare industry, most recently serving as president of the Acute Care Hospital Division for Universal Health Services. On September 1, 2009 David Bussone was named executive vice president and president overseeing the Hospital Division and Service Center departments in Charlotte and Dallas that support operations, such as physician recruiting, management engineering, supply chain management and marketing. Mr. Bussone has over 30 years of experience in the healthcare industry, most recently serving as a senior vice president for Universal Health Services, Inc.’s acute division. On September 22, 2009 Art Parker was appointed executive vice president and chief financial officer. Mr. Parker has been with the Company for over 8 years serving as interim chief financial officer since June 2009, as senior vice president finance and development, and as senior vice president and treasurer. Prior to joining the Company, Mr. Parker worked for Bank of America for 14 years holding posts related to the management of commercial banking relationships and serving as a high yield bond research analyst covering the healthcare and other industries.

 

Our Strategy

 

Key components of our strategy include:

 

Diversify the Business Through Expanded Services at Existing Hospitals.  While we continue to grow our core business lines, we recognize that the continued diversification of healthcare services performed at our hospitals is necessary for long-term earnings growth. We invested in certain of our facilities to build out existing capacity and

broaden the scope of services provided based on the needs of the communities we serve. While we continue to operate some of our facilities with a primary focus on serving the unique needs of patients suffering from cardiovascular disease, we have expanded our service offerings to improve the performance of some of our facilities by utilizing our expertise in partnering with physicians and operating hospitals and by broadening our services to include other high acuity surgical and medical services.

 

Selectively Evaluate General Acute Care Acquisitions.  We may selectively evaluate acquisitions of general acute care facilities in attractive markets throughout the United States. We may consider acquisitions of facilities where we believe we can improve clinical outcomes and operating performance. Acquiring such facilities would continue to add to a more diverse offering of services and we believe will contribute to achieving earnings stability and growth. Any acquisition opportunity will be carefully evaluated to ensure it meets our overall long-term strategic objectives.

 

Maximize Return by Evaluating the Long-term Prospects of our Assets.  We also may consider opportunistic dispositions of hospitals or other facilities where a motivated buyer emerges or the facility does not meet our overall growth or financial return objectives to maximize the long-term return of our assets. We will employ a disciplined approach to evaluating and qualifying disposition opportunities and will look to redeploy capital from divested assets into new assets.

 

Continue to Improve Operating Performance at Our Existing Facilities.  In markets where we have well-established hospitals and cardiac diagnostic and therapeutic facilities, we intend to continue to focus on strengthening management processes and systems in an effort to improve operating performance. We will continue to:

 

 

Develop New Relationships with Physicians in Our Existing Markets.  We intend to develop new relationships with physicians to strengthen our competitive position in certain of our existing markets. We believe that our relationships with physicians who have a reputation for clinical excellence give us important insights into the operation and management of our facilities and provide further resources to provide quality, cost-effective healthcare. Further, as we strengthen our market position, we believe we will improve our ability to develop favorable managed care relationships with, and market the quality of our services to, the communities we serve.

 

Pursue Growth Opportunities in New Markets with Physicians and Community Hospital Systems.  We intend to pursue growth opportunities in new markets by partnering with physicians and community hospital systems if the opportunity is in line with our long-term strategy. These opportunities are expected to support our diversification strategy by broadening our services to include other high acuity surgical and medical services. We completed the development of our 106 licensed bed general acute care hospital in Kingman, Arizona, which opened with 70 of its licensed beds in October 2009. The hospital is jointly owned by us and local physician investors.

Our Hospitals

 

We currently have ownership interests in and operate ten hospitals. The following table identifies key characteristics of these hospitals.

 

 

 

 

Diagnostic and Therapeutic Facilities

 

We have participated in the development of or have acquired interests in, and provide management services to, facilities where physicians diagnose and treat cardiovascular disease and manage hospital-based cardiac catheterization laboratories. We also own and operate mobile cardiac catheterization laboratories serving hospital networks and maintain a number of mobile and modular cardiac catheterization laboratories that we lease on a short-term basis. These diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories are equipped to allow the physicians using them to employ a range of diagnostic and treatment options for patients suffering from cardiovascular disease.

Managed Diagnostic and Therapeutic Facilities.  Currently we own and/or manage the operations of 16 cardiac diagnostic and therapeutic facilities. The following table provides information about these facilities.

 

 

 

 

Except when the requirements of applicable law require us to modify our services or when physicians have an ownership interest in a joint venture providing management services to hospitals, our management services generally include providing all non-physician personnel required to deliver patient care and the administrative, management and support functions required in the operation of the facility. The physicians who supervise or perform diagnostic and therapeutic procedures at these facilities have complete control over the delivery of cardiovascular healthcare services. In some cases, the management agreements for these centers have an extended initial term and several renewal options ranging from one to 10 years each. The physicians and hospitals with which we have contracts to operate these centers may terminate the agreements under certain circumstances. Either party may terminate most of these agreements for cause or upon the occurrence of specified material adverse changes in the business of the facilities. We intend to develop with hospitals and physician groups, or acquire contracts to manage, additional diagnostic and therapeutic facilities in the future.

 

Interim Mobile Catheterization Labs.  We maintain a rental fleet of mobile and modular cardiac catheterization laboratories. We lease these laboratories on a short-term basis to hospitals while they are either adding capacity to their existing facilities or replacing or upgrading their equipment. We also lease these laboratories to hospitals that experience a higher demand for cardiac catheterization procedures during a particular season of the

year and choose not to expand their own facilities to meet peak period demand. Our rental and modular laboratories are manufactured by leading original equipment manufacturers and have advanced technology and enable cardiologists to perform both diagnostic and interventional therapeutic procedures. Each of our rental units is generally in service for an average of nine months of the year. These units enable us to be responsive to immediate demand and create flexibility in our operations.

 

Major Procedures Performed at Our Facilities

 

Our hospitals offer a wide range of inpatient and outpatient medical services. These services can include cardiology, surgery, orthopedics, diagnostic and emergency room services, laboratory, radiology, respiratory, nutrition/dietary, intensive care units and pharmacy.

 

The following is a brief description of the major cardiovascular procedures physicians perform at our hospitals and other facilities.

 

Invasive Procedures

 

Cardiac catheterization:  percutaneous intravascular insertion of a catheter into any chamber of the heart or great vessels for diagnosis, assessment of abnormalities, interventional treatment and evaluation of the effects of pathology on the heart and great vessels.

 

Percutaneous cardiac intervention, including the following:

 

 

Electrophysiology study:  a diagnostic study of the electrical system of the heart. Procedures include the following:

 

 

Coronary artery bypass graft surgery:  a surgical establishment of a shunt that permits blood to travel from the aorta to a branch of the coronary artery at a point past the obstruction.

 

Valve Replacement Surgery:  an open-heart surgical procedure involving the replacement of valves that regulate the flow of blood between chambers in the heart, which have become narrowed or ineffective due to the build-up of calcium or scar tissue or the presence of some other physical damage.

Non-Invasive Procedures

 

Cardiac magnetic resonance imaging:  a test using a powerful magnet to produce highly detailed, accurate and reproducible images of the heart and surrounding structures as well as the blood vessels in the body without the need for contrast agents.

 

Echocardiogram with color flow doppler, or ultrasound test:  a test which produces real time images of the interior of the heart muscle and valves, which are used to accurately evaluate heart valve and muscle problems and measure heart muscle damage.

 

Nuclear treadmill exercise test or nuclear angiogram:  a test which involves the injection of a low level radioactive tracer isotope into the patient’s bloodstream during exercise on a motorized treadmill, which is frequently used to screen patients who may need cardiac catheterization and to evaluate the results in patients who have undergone angioplasty or cardiac surgery.

 

Standard treadmill exercise test:  a test which involves a patient exercising on a motorized treadmill while the electrical activity of the patient’s heart is measured, which is frequently used to screen for heart disease.

 

Ultrafast computerized tomography:  a test which can detect the buildup of calcified plaque in coronary arteries before the patient experiences any symptoms.

 

Employees

 

As of September 30, 2009, we employed 3,299 persons, including 2,472 full-time and 827 part-time employees. None of our employees is a party to a collective bargaining agreement and we consider our relationships with our employees to be good. There currently is a nationwide shortage of nurses and other medical support personnel, which makes recruiting and retaining these employees difficult. We believe we offer our employees competitive wages and benefits and offer a professional work environment that we believe helps us recruit and retain the staff we need to operate our hospitals and other facilities.

 

Our hospitals are staffed by licensed physicians who have been admitted to the medical staffs of individual hospitals. Any licensed physician — not just our physician partners — may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by the hospital’s medical staff and governing board in accordance with established credentialing criteria, and policies and procedures.

 

Environmental Matters

 

We are subject to various federal, state and local laws and regulations governing the use, storage, discharge and disposal of hazardous materials, including medical waste products. We believe that all of our facilities and practices comply with these laws and regulations and we do not anticipate that any of these laws will have a material adverse effect on our operations. We cannot predict, however, whether environmental issues may arise in the future.

 

Insurance

 

Like most healthcare providers, we are subject to claims and legal actions in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts and with deductibles and levels of self-insured retention that we believe are sufficient for our operations. We also maintain umbrella liability coverage to cover claims not covered by our professional malpractice liability or general liability insurance policies. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies — General and Professional Liability Risk.”

 

We can offer no assurances that our professional liability and general liability insurance, nor our recorded reserves for self-insured retention, will cover all claims against us or continue to be available at reasonable costs for us to maintain adequate levels of insurance in the future.

Competition

 

In executing our business strategy, we compete primarily with other cardiovascular care providers, principally for-profit and not-for-profit general acute care hospitals. We also compete with other companies pursuing strategies similar to ours, and with not-for-profit general acute care hospitals that may elect to develop a hospital. In most of our markets we compete for market share of cardiovascular procedures with two to three hospitals. Some of the hospitals that compete with our hospitals are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Some of our competitors are larger and are more established than we are and, have greater geographic coverage, offer a wider range of services or have more capital or other resources than we do. If our competitors are able to finance capital improvements, recruit physicians, expand services or obtain favorable managed care contracts at their facilities, we may experience a decline in market share. In operating our hospitals, particularly in performing outpatient procedures, we compete with free-standing diagnostic and therapeutic facilities located in the same markets.

 

Reimbursement

 

Medicare.  Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease. Under the Medicare program, we are paid for certain inpatient and outpatient services performed by our hospitals and also for services provided at our diagnostic and therapeutic facilities.

 

Medicare payments for inpatient acute services are generally made pursuant to a prospective payment system (“PPS”). Under this system, hospitals are paid a prospectively determined fixed amount for each hospital discharge based on the patient’s diagnosis. Specifically, each discharge is assigned to a DRG. Based upon the patient’s condition and treatment during the relevant inpatient stay, each DRG is assigned a fixed payment rate that is prospectively set using national average costs per case for treating a patient for a particular diagnosis. The DRG rates are adjusted by an update factor each federal fiscal year, which begins on October 1. The update factor is determined, in part, by the projected increase in the cost of goods and services that are purchased by hospitals, referred to as the market basket index. DRG payments do not consider the actual costs incurred by a hospital in providing a particular inpatient service; however, such payments are adjusted by a predetermined geographic adjustment factor assigned to the geographic area in which the hospital is located.

 

While hospitals generally do not receive direct payments in addition to a DRG payment, hospitals may qualify for an outlier payment when the relevant patient’s treatment costs are extraordinarily high and exceed a specified threshold. Outlier payments, which were established by Congress as part of the DRG prospective payment system, are additional payments made to hospitals for treating patients who are costlier to treat than the average patient. In general, a hospital receives outlier payments when its costs, as determined by using gross charges adjusted by the hospital’s cost-to-charge ratio, exceed a certain threshold established annually by the Centers for Medicare and Medicaid Services (“CMS”). Outlier payments are currently subject to multiple factors including but not limited to: (1) the hospital’s estimated operating costs based on its historical ratio of costs to gross charges; (2) the patient’s case acuity; (3) the CMS established threshold; and, (4) the hospital’s geographic location. CMS is required by law to limit total outlier payments to between five and six percent of total DRG payments. CMS periodically changes the threshold in order to bring expected outlier payments within the mandated limit. An increase to the cost threshold reduces total outlier payments by (1) reducing the number of cases that qualify for outlier payments and (2) reducing the dollar amount hospitals receive for those cases that qualify. CMS historically has used a hospital’s most recently settled cost report to set the hospital’s cost-to-charge ratios. Those cost reports are typically two to three years old.

 

On August 22, 2007, CMS issued its final inpatient hospital prospective payment system rule for fiscal year 2008, which began October 1, 2007. The final rule continues major DRG reforms designed to improve the accuracy of hospital payments. As introduced in the fiscal year 2007 final rule, CMS will continue to use hospital costs rather than charges to set payment rates. For fiscal year 2008, hospitals were paid based upon a blend of 1/3 charge-based weights and 2/3 hospital cost-based weights for DRGs. Additionally, CMS adopted its proposal to restructure the current 538 DRGs to 745 MS-DRGs (severity-adjusted DRGs) to better recognize severity of patient illness. These MS-DRGs are being phased in over a two-year period.

CMS published the inpatient prospective payment system rule (“IPPS”) for 2009 on August 19, 2008. In addition to provisions which relate to IPPS payments, the 2009 IPPS final rule also contained provisions related to the Emergency Medical Treatment and Active Labor Act (“EMTALA”) and the Section 1877 of the Social Security Act, commonly known as the Stark Law, which will be discussed under the applicable EMTALA and Stark sections of this document. CMS also expanded the list of codes of hospital-acquired conditions for which CMS will not pay as secondary diagnoses unless the condition was present on admission. Due to the late enactment of the Medicare Improvements for Patient and Providers Act (“MIPPA”), CMS was unable to publish final rates in the 2009 IPPS final rule.

 

CMS issued the IPPS rule for 2010 on July 31, 2009. The Final IPPS rule for 2010 provides acute care hospitals with an inflation update of 2.1 percent in their 2010 payment rates. The Final IPPS rule also adds four new measures for which hospitals must submit data under the Reporting Hospital Quality Data for Annual Payment Update (“RHQDAPU”) program to receive the full market basket update.

 

Outpatient services are also subject to a prospective payment system. Services provided at our freestanding diagnostic facilities are typically reimbursed on the basis of the physician fee schedule, which is revised periodically, and bases payment on various factors including resource-based practice expense relative value units and geographic practice cost indices.

 

Future legislation may modify Medicare reimbursement for inpatient and outpatient services provided at our hospitals or services provided at our diagnostic and therapeutic facilities, but we are not able to predict the method or amount of any such reimbursement changes or the effect that such changes will have on us.

 

Medicaid.  Medicaid is a health insurance program for low-income individuals, which is funded jointly by the federal and individual state governments and administered locally by each state. Most state Medicaid payments for hospitals are made under a prospective payment system or under programs that negotiate payment levels with individual hospitals. Medicaid reimbursement is often less than a hospital’s cost of services. States periodically consider significantly reducing Medicaid funding, while at the same time in some cases expanding Medicaid benefits. This could adversely affect future levels of Medicaid payments received by our hospitals. We are unable to predict what impact, if any, future Medicaid managed care systems might have on our operations.

 

The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, court decisions, executive orders and freezes and funding reductions, all of which may adversely affect our business. There can be no assurance that payments for hospital services and cardiac diagnostic and other procedures under the Medicare and Medicaid programs will continue to be based on current methodologies or remain comparable to present levels. In this regard, we may be subject to rate reductions as a result of federal budgetary or other legislation related to the Medicare and Medicaid programs. In addition, various state Medicaid programs periodically experience budgetary shortfalls, which may result in Medicaid payment reductions and delays in payment to us.

 

Utilization Review.  Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of DRG classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department of Health and Human Services (HHS) that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review. As noted above, the Final IPPS rule also adds four new measures for which hospitals must submit data under the RHQDAPU program to receive the full market basket update.

 

Annual Cost Reports.  Hospitals participating in the Medicare and some Medicaid programs, whether paid on a reasonable cost basis or under a prospective payment system, are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require submission of annual cost reports identifying

medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients.

 

Annual cost reports required under the Medicare and some Medicaid programs are subject to routine governmental audits. These audits may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs and result in a recoupment of monies paid. Finalization of these audits and determination of amounts earned under these programs often takes several years. Providers can appeal any final determination made in connection with an audit.

 

Program Adjustments.  The Medicare, Medicaid and other federal healthcare programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations, and requirements for utilization review and new governmental funding restrictions, all of which may materially increase or decrease program payments as well as affect the cost of providing services and the timing of payment to facilities. The final determination of amounts earned under the programs often requires many years, because of audits by the program representatives, providers’ rights of appeal and the application of numerous technical reimbursement provisions. We believe that we have made adequate provision for such adjustments. Until final adjustment, however, previously determined allowances could become either inadequate or more than ultimately required.

 

Managed Care.  The percentage of admissions and net revenue attributable at our hospitals and other facilities to managed care plans has increased as a result of pressures to control the cost of healthcare services. We expect that the trend toward increasing percentages of patient admissions paid for by managed care plans will continue in the future. Generally, we receive lower payments from managed care plans than from traditional commercial/indemnity insurers; however, as part of our business strategy, we intend to take steps to improve our managed care position.

 

Commercial Insurance.  Our hospitals provide services to individuals covered by private healthcare insurance. Private insurance carriers pay our hospitals or in some cases reimburse their policyholders based upon the hospital’s established charges and the coverage provided in the insurance policy. Commercial insurers are trying to limit the costs of hospital services by negotiating discounts, and including the use of prospective payment systems, which would reduce payments by commercial insurers to our hospitals. Reductions in payments for services provided by our hospitals to individuals covered by commercial insurers could adversely affect us. We cannot predict whether or how payment by third party payors for the services provided by all hospitals and other facilities may change. Modifications in methodology or reductions in payment could adversely affect us.

 

Regulation

 

Overview.  The healthcare industry is required to comply with extensive government regulation at the federal, state and local levels. Under these laws and regulations, hospitals must meet requirements to be licensed under state law and be certified to participate in government programs, including the Medicare and Medicaid programs. These requirements relate to matters such as the adequacy of medical care, equipment, personnel, operating policies and procedures, emergency medical care, maintenance of records, relationships with physicians, cost reporting and claim submission, rate-setting, compliance with building codes and environmental protection. There are also extensive government regulations that apply to our owned and managed facilities and the physician practices that we manage. If we fail to comply with applicable laws and regulations, we could be subject to criminal penalties and civil sanctions and our hospitals and other facilities could lose their licenses and their ability to participate in the Medicare, Medicaid and other federal and state healthcare programs. In addition, government laws and regulations, or the interpretation of such laws and regulations, may change. If that happens, we may have to make changes in our facilities, equipment, personnel, services or business structures so that our hospitals and other healthcare facilities remain qualified to participate in these programs. We believe that our hospitals and other healthcare facilities are in substantial compliance with current federal, state, and local regulations and standards.

 

The Medicare Modernization Act and Other Healthcare Reform Initiatives

 

The Medicare Prescription Drug Improvement and Modernization Act of 2003 (the “Medicare Modernization Act”) made significant changes to the Medicare program, particularly with respect to the coverage of prescription

drugs. These modifications also include provisions affecting Medicare coverage and reimbursement to general acute care hospitals, as well as other types of providers.

 

The healthcare industry continues to attract much legislative interest and public attention. In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that, like the Medicare Modernization Act, would effect major changes in the healthcare system. Proposals that have been considered include changes in Medicare, Medicaid, and other state and federal programs, cost controls on hospitals and mandatory health insurance coverage for individuals. The U.S. Senate is currently debating the Patient Protection and Affordable Care Act, which proposes significant changes to the healthcare payment system. We cannot predict the course of this or other future healthcare legislation or other changes in the administration or interpretation of governmental healthcare programs and the effect that any legislation, interpretation, or change may have on us. Such effects may include material and adverse changes to the amounts of reimbursement received by our facilities.

 

Licensure and Certification

 

Licensure and Accreditation.  Our hospitals are subject to state and local licensing requirements. In order to verify compliance with these requirements, our hospitals are subject to periodic inspection by state and local authorities. All of our majority-owned hospitals are licensed as general acute care hospitals under applicable state law. In addition, our hospitals are accredited by The Joint Commission, a nationwide commission which establishes standards relating to physical plant, administration, quality of patient care and operation of hospital medical staffs.

 

Certification.  In order to participate in the Medicare and Medicaid programs, each provider must meet applicable regulations of the HHS and similar state entities relating to, among other things, the type of facility, equipment, personnel, standards of medical care and compliance with applicable federal, state and local laws. As part of such participation requirements and effective October 1, 2007, all physician-owned hospitals are required to provide written notice to patients that the hospital is physician-owned. Additionally, as part of a patient safety measure, all Medicare-participating hospitals must provide written notice to patients if a doctor is not present in the hospital 24 hours per day, 7 days a week. All our hospitals and our freestanding diagnostic and therapeutic facilities are certified to participate or are enrolled in the Medicare and Medicaid programs.

 

Emergency Medical Treatment and Active Labor Act.  The Emergency Medical Treatment and Active Labor Act impose requirements as to the care that must be provided to anyone who seeks care at facilities providing emergency medical services. In addition, CMS issued final regulations clarifying those areas within a hospital system that must provide emergency treatment, procedures to meet on-call requirements, as well as other requirements under EMTALA. CMS clarified the requirements related to the availability of on call physicians and obligations of recipient hospitals with specialized capabilities in the 2009 IPPS Final Rule. Sanctions for failing to fulfill these requirements include exclusion from participation in the Medicare and Medicaid programs and civil monetary penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law to sue the offending hospital for damages and equitable relief. A hospital that suffers a financial loss as a direct result of another participating hospital’s violation of the law also has a similar right. Although we believe that our emergency care practices are in compliance with the law and applicable regulations, we cannot assure you that governmental officials responsible for enforcing the law or others will not assert that we are in violation of these laws nor what obligations may be imposed by regulations to be issued in the future.

 

Certificate of Need Laws.  In some states, the construction of new facilities, the acquisition of existing facilities or the addition of new beds, equipment, or services may be subject to review by state regulatory agencies under a certificate of need program. These laws generally require appropriate state agency determination of public need and approval prior to the addition of equipment, beds or services. Currently, we do not operate any hospitals in states that have adopted certificate of need laws. However, these laws may limit our ability to acquire or develop new facilities or acquire or expand existing facilities in states that have such laws. We operate diagnostic facilities in some states with certificate of need laws and we believe they are operated in compliance with applicable requirements or are exempt from such requirements. However, we cannot assure you that government officials will agree with our interpretation of these laws.

Professional Licensure.  Healthcare professionals who perform services at our hospitals and diagnostic and therapeutic facilities are required to be individually licensed or certified under applicable state law. Our facilities are required to have by-laws relating to the credentialing process, or otherwise document appropriate medical staff credentialing. We take steps to ensure that our employees and agents and physicians on each hospital’s medical staff have all necessary licenses and certifications, and we believe that the medical staff members, as well as our employees and agents comply with all applicable state licensure laws as well as any hospital by-laws applicable to credentialing activities. However, we cannot assure you that government officials will agree with our position.

 

Corporate Practice of Medicine and Fee-Splitting.  Some states have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians. Some states also have adopted laws that prohibit physician ownership in healthcare facilities or otherwise restrict direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties, and rescission of the business arrangements. These laws vary from state to state, are often vague, and in most states have seldom been interpreted by the courts or regulatory agencies. We have attempted to structure our arrangements with healthcare providers to comply with the relevant state law. However, we cannot assure you that governmental officials charged with responsibility for enforcing these laws will not assert that we, or the transactions in which we are involved, are in violation of these laws. These laws may also be interpreted by the courts in a manner inconsistent with our interpretations.

 

Fraud and Abuse Laws

 

Overview.  Various federal and state laws govern financial and other arrangements among healthcare providers and prohibit the submission of false or fraudulent claims to the Medicare, Medicaid and other government healthcare programs. Penalties for violation of these laws include civil and criminal fines, imprisonment and exclusion from participation in federal and state healthcare programs. For example the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of certain fraud and abuse laws by adding several civil and criminal statutes that apply to all healthcare services, whether or not they are reimbursed under a federal healthcare program. Among other things, HIPAA established civil monetary penalties for certain conduct, including upcoding and billing for medically unnecessary goods or services. In addition, the federal False Claims Act allows an individual to bring a lawsuit on behalf of the government, in what are known as qui tam or whistleblower actions, alleging false Medicare or Medicaid claims or other violations of the statute. The use of these private enforcement actions against healthcare providers has increased dramatically in the recent past, in part because the individual filing the initial complaint may be entitled to share in a portion of any settlement or judgment.

 

Anti-Kickback Statute.  The federal anti-kickback statute prohibits providers of healthcare and others from soliciting, receiving, offering, or paying, directly or indirectly, any type of remuneration in connection with the referral of patients covered by the federal healthcare programs. Violations of the anti-kickback statute may be punished by a criminal fine of up to $25,000 or imprisonment for each violation, civil fines of up to $50,000, damages of up to three times the total dollar amount involved, and exclusion from federal healthcare programs, including Medicare and Medicaid.

 

As authorized by Congress, the Office of Inspector General of the Department of HHS (“OIG”) has published safe harbor regulations that describe activities and business relationships that are deemed protected from prosecution under the anti-kickback statute. However, the failure of a particular activity to comply with the safe harbor regulations does not mean that the activity violates the anti-kickback statute. There are safe harbors for various types of arrangements, including those for personal services and management contracts and others for investment interests, such as stock ownership in companies with more than $50 million in undepreciated net tangible assets related to healthcare items and services. This publicly traded company safe harbor contains additional criteria, including that the stock must be obtained on terms and at a price equally available to the public when trading on a registered securities exchange.

 

The OIG is primarily responsible for enforcing the anti-kickback statute and generally for identifying fraud and abuse activities affecting government programs. In order to fulfill its duties, the OIG performs audits and investigations. In addition, the agency provides guidance to healthcare providers by issuing Special Fraud Alerts

and Bulletins that identify types of activities that could violate the anti-kickback statute and other fraud and abuse laws. The OIG has identified the following arrangements with physicians as potential violations of the statute:

 

 

We have a variety of financial relationships with physicians who refer patients to our hospitals and other facilities. Physicians own interests in each of our hospitals, some of our cardiac catheterization laboratories and in entities that provide only management services to certain non-affiliated hospitals. Physicians may also own MedCath Corporation common stock. We also have contracts with physicians providing for a variety of financial arrangements, including leases, management agreements, independent contractor agreements, right of first refusal agreements, medical director and professional service agreements. Although we believe that our arrangements with physicians have been structured to comply with the current law and available interpretations, some of our arrangements do not expressly meet the requirements for safe harbor protection. We cannot assure you that regulatory authorities will not determine that these arrangements violate the anti-kickback statute or other applicable laws. Also, most of the states in which we operate have adopted anti-kickback laws, some of which apply more broadly to all payors, not just to federal healthcare programs. Many of these state laws do not have safe harbor regulations comparable to the federal anti-kickback law and have only rarely been interpreted by the courts or other government agencies. If our arrangements were found to violate any of these federal or state anti-kickback laws we could be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid, or other governmental healthcare programs.

 

Physician Self-Referral Law.  Section 1877 of the Social Security Act, commonly known as the Stark Law, prohibits physicians from referring Medicare and Medicaid patients for certain designated health services to entities in which physicians or any of their immediate family members have a direct or indirect ownership or compensation arrangement unless an exception applies. The term “designated health services,” includes inpatient and outpatient hospital services, and some radiology services. Sanctions for violating the Stark Law include civil monetary penalties, including up to $15,000 for each improper claim and $100,000 for any circumvention scheme, and exclusion from the Medicare or Medicaid programs. There are various ownership and compensation arrangement exceptions to the self-referral prohibition, including an exception for a physician’s ownership in an entire hospital — as opposed to an ownership interest in a hospital department — if the physician is authorized to perform services at the hospital. This exception is commonly referred to as the “whole hospital exception.” There is also an exception for ownership of publicly traded securities in a company that has stockholder equity exceeding $75 million at the end of its most recent fiscal year or on average during the three previous fiscal years, as long as the physician acquired the securities on terms generally available to the public and the securities are traded on one of the major exchanges. Additionally, there is an exception for certain indirect ownership and compensation arrangements. Exceptions are also provided for many of the customary financial arrangements between physicians and providers, including employment contracts, personal service arrangements, isolated financial transactions, payments by physicians, leases, and recruitment agreements, as long as these arrangements meet certain conditions.

As discussed, there are various ownership and compensation arrangement exceptions to the Stark Law. In addressing the whole hospital exception, the Stark regulations specifically reiterate the statutory requirements for the exception. Additionally, the exception requires that the hospital qualify as a “hospital” under the Medicare program. The Stark Law and the Stark Regulations may also apply to certain compensation arrangements between hospitals and physicians.

 

The Deficit Reduction Act of 2005 (“DRA”) required the Secretary of HHS to develop a plan addressing several issues concerning physician investment in specialty hospitals. In August 2006, HHS submitted its required final report to Congress addressing: (1) proportionality of investment return; (2) bona fide investment; (3) annual disclosure of investment; (4) provision of care to Medicaid beneficiaries; (5) charity care; and (6) appropriate enforcement. The report reaffirms HHS’ intention to implement reforms to increase Medicare payment accuracy in the hospital inpatient prospective and ambulatory surgical center payment systems. HHS also has implemented certain “gainsharing” demonstrations are required by the DRA and other value-based payment approaches designed to align physician and hospital incentives while achieving measurable improvements in quality to care. In addition, HHS now requires transparency in hospital financial arrangements with physicians. Currently, all hospitals are required to provide HHS information concerning physician investment and compensation arrangements that potentially implicate the physician self-referral statute, and to disclose to patients whether they have physician investors. Hospitals that do not comply in a timely manner with this new disclosure requirement may face civil penalties of $10,000 per day that they are in violation. HHS also announced its position that non-proportional returns on investments and non-bona fide investments may violate the physician self-referral statute and are suspect under the anti-kickback statute. Other components of the plan include providing further guidance concerning what is expected of hospitals that do not have emergency departments under EMTALA and changes in the Medicare enrollment form to identify specialty hospitals. Issuance of the strategic plan coincided with the sunset of a DRA provision suspending enrollment of new specialty hospitals into the Medicare program.

 

In July 2007 as part of proposed revisions to the Medicare physician fee schedule for fiscal year 2008, CMS proposed certain additional changes to the Stark Law. In particular, the proposed rule would revise the Stark Law exception for space and equipment rentals. In instances where a physician leases space or equipment to an entity who accepts patients referred by that physician, the CMS proposal would no longer allow unit-of-service or “per click” payments for such leases. Additionally, the proposed rule would no longer treat “under arrangements” between hospitals and physician-owned entities as compensation instead of ownership relationships. CMS finalized these proposed changes to the Stark Law in the 2009 IPPS final rule published on August 19, 2008. These changes are effective October 1, 2009. Specifically, the 2009 IPPS final rule limits the ability of hospitals to enter into under arrangements with physicians and physician-owned entities and thus, physician-owned joint venture entities deemed to be “performing DHS” will have to comply with one of the more limited Stark Law “ownership” exceptions, rather than the previously acceptable Stark Law “compensation” exceptions. In addition, the 2009 IPPS final rule finalized the prohibition on per unit compensation in space and equipment lease transactions. Effective October 1, 2009, we restructured certain equipment lease transactions with physicians that include per unit or per use compensation as well as certain of our arrangements with community hospitals in order to comply with these new rules and regulations. While we believe that such restructured arrangements comply with applicable law, we cannot be assured, however, that if reviewed, government officials will agree with our interpretation of applicable law. We cannot yet know with certainty the full impact of this restructuring on the financial performance of the Company.

 

There have been few enforcement actions taken and relatively few cases interpreting the Stark Law to date. As a result, there is little indication as to how courts will interpret and apply the Stark Law; however, enforcement is expected to increase. We believe we have structured our financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and the Stark regulations. In particular, we believe that our physician ownership arrangements meet the whole hospital exception. In addition, we expect to meet the exception for publicly traded securities or indirect compensation arrangements, as appropriate. The freestanding diagnostic and other facilities that we own do not furnish any designated health services as defined under the Stark Law, and thus referrals to them are not subject to the Stark Law’s prohibitions. Similarly, our consulting and management services to physician group practices are not subject to the Stark Law’s prohibitions.

Possible amendments to the Stark Law, including any modification or revocation of the whole hospital exception upon which we rely in establishing many of our relationships with physicians, could require us to change or adversely impact the manner in which we establish relationships with physicians to develop and operate a facility, as well as our other business relationships such as joint ventures and physician practice management arrangements. We note that legislation has been introduced in Congress recently and in the past seeking to limit or restrict the whole hospital exception. Specifically, the Patient Protection and Affordable Care Act now under debate in the U.S. Senate, provides that the whole hospital exception would only be available to hospitals having physician ownership and a Medicare provider number as of February 1, 2010 and that meet certain other specified requirements. One such requirement is that physician owners could not own more than the percentage of the value of the physician ownership as of the date of the enactment of the bill. The proposed legislation would also restrict expansion of hospitals that meet the requirements referred to above. There can be no assurance that future legislation will not seek to modify, limit, restrict, or revoke the whole hospital exception. There also can be no assurance the CMS will not promulgate additional regulations under the Stark Law that may change or adversely impact our arrangements with referring physicians.

 

Moreover, as noted above, states in which we operate also have physician self-referral laws, which may prohibit certain physician referrals or require certain disclosures. Some of these state laws would apply regardless of the source of payment for care. These statutes typically provide criminal and civil penalties as well as loss of licensure and may have broader prohibitions than the Stark Law or more limited exceptions. While there is little precedent for the interpretation or enforcement of these state laws, we believe we have structured our financial relationships with physicians and others to comply with applicable state laws. In addition, existing state self-referral laws may be amended. We cannot predict whether new state self-referral laws or amendments to existing laws will be enacted or, once enacted, their effect on us, and we have not researched pending legislation in all the states in which our hospitals are located.

 

Civil Monetary Penalties.  The Social Security Act contains provisions imposing civil monetary penalties for various fraudulent and/or abusive practices, including, among others, hospitals which knowingly make payments to a physician as an inducement to reduce or limit medically necessary care or services provided to Medicare or Medicaid beneficiaries. In July 1999, the OIG issued a Special Advisory Bulletin on gainsharing arrangements. The bulletin warns that clinical joint ventures between hospitals and physicians may implicate these provisions as well as the anti-kickback statute, and specifically refers to specialty hospitals, which are marketed to physicians in a position to refer patients to the hospital, and structured to take advantage of the whole hospital exception. Hospitals specializing in heart, orthopedic, and maternity care are mentioned, and the bulletin states that these hospitals may induce investor-physicians to reduce services to patients through participation in profits generated by cost savings, in violation of a civil monetary penalty provision. Despite this initial broad interpretation of this civil monetary penalty law, since 2005 the OIG has issued nine advisory opinions which declined to sanction a particular gainsharing arrangement under this civil monetary penalty provision, or the anti-kickback statute, because of the specific circumstances and safeguards built into the arrangement. We believe that the ownership distributions paid to physicians by our hospitals do not constitute payments made to physicians under gainsharing arrangements. We cannot assure you, however, that government officials will agree with our interpretation of applicable law.

 

False Claims Prohibitions.  False claims are prohibited by various federal criminal and civil statutes. In addition, the federal False Claims Act prohibits the submission of false or fraudulent claims to the Medicare, Medicaid, and other government healthcare programs. Penalties for violation of the False Claims Act include substantial civil and criminal fines, including treble damages, imprisonment, and exclusion from participation in federal healthcare programs. In addition, the False Claims Act allows an individual to bring lawsuits on behalf of the government, in what are known as qui tam or whistleblower actions, alleging false Medicare or Medicaid claims or other violations of the statute.

 

A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. In fact, the DRA contains provisions which create incentives for states to enact anti-fraud legislation modeled after the federal False Claims Act.

Healthcare Industry Investigations

 

The federal government, private insurers and various state enforcement agencies have increased their scrutiny of providers’ business arrangements and claims in an effort to identify and prosecute fraudulent and abusive practices. There are ongoing federal and state investigations in the healthcare industry regarding multiple issues including cost reporting, billing and charge-setting practices, unnecessary utilization, physician recruitment practices, physician ownership of healthcare providers and joint ventures with hospitals. Certain of these investigations have targeted hospitals and physicians. We have substantial Medicare, Medicaid and other governmental billings, which could result in heightened scrutiny of our operations. We continue to monitor these and all other aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices are consistent with both legal requirements and current industry standards. However, because the federal and state fraud and abuse laws are complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations that are inconsistent with industry practices, including ours. Evolving interpretations of current or the adoption of new federal or state laws or regulations could affect many of the arrangements entered into by each of our hospitals. In public statements surrounding current investigations, governmental authorities have taken positions on a number of issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some instances, government investigations that in the past have been conducted under the civil provisions of federal law may now be conducted as criminal investigations.

 

A number of healthcare investigations are national initiatives in which federal agencies target an entire segment of the healthcare industry. One example involved the federal government’s initiative regarding hospitals’ improper requests for separate payments for services rendered to a patient on an outpatient basis within three days prior to the patient’s admission to the hospital, where reimbursement for such services is included as part of the reimbursement for services furnished during an inpatient stay. The government targeted all hospital providers to ensure conformity with this reimbursement rule. Further, the federal government continues to investigate Medicare overpayments to prospective payment system hospitals that incorrectly report transfers of patients to other prospective payment system hospitals as discharges. Law enforcement authorities, including the OIG and the United States Department of Justice, are also increasing scrutiny of various types of arrangements between healthcare providers and potential referral sources, including so-called contractual joint ventures, to ensure that the arrangements are not designed as a mechanism to exchange remuneration for patient care referrals and business opportunities. Investigators have also demonstrated a willingness to look behind the formalities of a business transaction to determine the underlying purpose of payments between healthcare providers and potential referral sources. Recently, the OIG has also begun to investigate certain hospitals with a particularly high proportion of Medicare reimbursement resulting from outlier payments. The OIG’s workplan has indicated its intention to review hospital privileging activities within the context of Medicare conditions of participation.

 

It is possible that governmental or regulatory authorities could initiate investigations on these or other subjects at our facilities and such investigations could result in significant costs in responding to such investigations and penalties to us, as well as adverse publicity, declines in the value of our equity and debt securities and lawsuits brought by holders of those securities. It is also possible that our executives, managers and hospital board members, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. The positions taken by authorities in any investigations of us, our executives, managers, hospital board members or other healthcare providers, and the liabilities or penalties that may be imposed could have a material adverse effect on our business, financial condition and results of operations.

 

Clinical Trials at Hospitals

 

Our hospitals serve as research sites for physician clinical trials sponsored by pharmaceutical and device manufacturers and therefore may perform services on patients enrolled in those studies, including implantation of experimental devices. Only physicians who are members of the medical staff of the hospital may participate in such studies at the hospital. All trials are approved by an Institutional Review Board (“IRB”), which has the

responsibility to review and monitor each study pursuant to applicable law and regulations. Such clinical trials are subject to numerous regulatory requirements.

 

The industry standard for conducting preclinical testing is embodied in the investigational new drug regulations administered by the federal Food and Drug Administration (the “FDA”). Research conducted at institutions supported by funds from the National Institutes of Health must also comply with multiple project assurance agreements and with regulations and guidelines governing the conduct of clinical research that are administered by the National Institutes of Health, the HHS Office of Research Integrity, and the Office of Human Research Protection. Research funded by the National Institutes of Health must also comply with the federal financial reporting and record keeping requirements incorporated into any grant contract awarded. The requirements for facilities engaging in clinical trials are set forth in the code of federal regulations and published guidelines. Regulations related to good clinical practices and investigational new drugs have been mandated by the FDA and have been adopted by similar regulatory authorities in other countries. These regulations contain requirements for research, sponsors, investigators, IRBs, and personnel engaged in the conduct of studies to which these regulations apply. The regulations require that written protocols and standard operating procedures are followed during the conduct of studies and for the recording, reporting, and retention of study data and records. CMS also imposes certain requirements for billing of services provided in connection with clinical trials.

 

The FDA and other regulatory authorities require that study results and data submitted to such authorities are based on studies conducted in accordance with the provisions related to good clinical practices and investigational new drugs. These provisions include:

 

 

Records for clinical studies must be maintained for specific periods for inspection by the FDA or other authorities during audits. Non-compliance with the good clinical practices or investigational new drug requirements can result in the disqualification of data collected during the clinical trial. It may also lead to debarment of an investigator or institution or False Claims Act allegations if fraud or substantial non-compliance is detected, and subject a hospital to a recoupment of payments for services that are not covered by federal healthcare programs. Finally, non-compliance could lead to revocation or non-renewal of government research grants.

 

Failure to comply with new or revised applicable federal, state, and international clinical trial laws existing laws and regulations could subject us and physician investigators to loss of the right to conduct research, civil fines, criminal penalties, and other enforcement actions.

 

Finally, the Administrative Simplification Subtitle of HIPAA and related privacy and security regulations also require healthcare entities engaged in clinical research to maintain the privacy of patient identifiable medical information. See “— Privacy and Security Requirements.” We have implemented policies in an attempt to comply with these rules as they apply to clinical research, including procedures to obtain all required patient authorizations. However, there is little or no guidance available as to how these rules will be enforced.

 

Privacy and Security Requirements

 

HIPAA requires the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce in the healthcare industry. HHS has adopted final regulations establishing electronic data transmission standards

that all healthcare providers must use when submitting or receiving certain healthcare transactions electronically. We believe we have complied in all material respects with these electronic data transmission standards.

 

HHS has also adopted final regulations containing privacy standards as required by HIPAA. The privacy regulations extensively regulate the use and disclosure of individually identifiable health-related information. We have taken measures to comply with the final privacy regulations, but since there is little guidance about how these regulations will be enforced by the government, we cannot predict whether the government will agree that our healthcare facilities are in compliance.

 

HHS has adopted final regulations regarding security standards. These security regulations require healthcare providers to implement organizational and technical practices to protect the security of electronically maintained or transmitted health-related information. We believe we have complied in all material respects with these security standards.

 

The Health Information Technology for Economic and Clinical Health Act (“HITECH Act”), which is part of the American Recovery and Reinvestment Act signed into law on February 17, 2009, included provisions that expand the scope of the privacy and security requirements of HIPAA. In addition, the HITECH Act contains enhanced enforcement provisions, including: (i) increased civil monetary penalties; (ii) allowing state attorneys general to bring civil actions for HIPAA violations; and (iii) requiring HHS to conduct audits of covered entities, such as the hospitals, to determine their compliance with HIPAA. The HITECH Act’s changes may require significant and costly changes for us, although the exact extent of the actions that will be required is not known at this time because the HITECH Act directs the Secretary of HHS (HHS Secretary) to amend existing privacy and security standards and issue new standards as necessary, and these regulations have not been issued to date.

 

In addition, our facilities continue to remain subject to state laws that may be more restrictive than the regulations issued under HIPAA. These statutes vary by state and could impose additional penalties.

 

Electronic health record technology

 

We are considering acquiring electronic health record (“EHR”) technology. The HITECH Act provides for incentive payments to eligible hospitals to encourage the acquisition and use of EHR systems. The amount of incentive payments a hospital may receive is based on a formula that considers the hospital’s share of Medicare patients and when the hospital satisfies all of the relevant requirements for the incentive payments. Hospitals will have to demonstrate compliance with a number of requirements in order to receive incentive payments, including without limitation, (i) meaningful use of certified EHR technology; (ii) connectivity of certified EHR technology in a manner that provides for the electronic exchange of information to improve the quality of healthcare; and (iii) submission of information to HHS on clinical quality and other measures determined by HHS. The HITECH Act directs the HHS Secretary to determine what constitutes meaningful use and connectivity, as well as to develop quality measures to be reported, and the HHS Secretary has not issued regulations or other guidance on these requirements to date. We do not know when or if EHR technology acquired by us would enable us to qualify for incentive payments under the HITECH Act, and if we did qualify for such payments, we do not know when such payments would be received or the amounts of such payments. Finally, the HITECH Act provides that hospitals that do not satisfy requirements related to EHR technology and submission of quality data by 2015 will be subject to reductions in reimbursement.

 

Compliance Program

 

The OIG has issued guidelines to promote voluntarily developed and implemented compliance programs for the healthcare industry. In response to these guidelines, we adopted a code of ethics, designated compliance officers at the parent company level and individual hospitals, established a toll-free compliance line, which permits anonymous reporting, implemented various compliance training programs, and developed a process for screening all employees through applicable federal and state databases.

 

We have established a reporting system, auditing and monitoring programs, and a disciplinary system to enforce the code of ethics, and other compliance policies. Auditing and monitoring activities include claims

preparation and submission, and cover numerous issues such as coding, billing, cost reporting, and financial arrangements with physicians and other referral sources. These areas are also the focus of training programs.

 

Our policy is to require our officers and all employees to participate in compliance training programs. The board of directors has established a compliance committee, which oversees implementation of the compliance program.

 

The committee consists of three outside directors, and is chaired by Galen Powers, a former chief counsel for the Health Care Financing Administration (now known as CMS), where he was responsible for providing legal advice on federal healthcare programs, particularly Medicare and Medicaid. The compliance committee of the board meets at least quarterly.

 

The Chief Clinical and Compliance Officer reports to the chief executive officer for day-to-day compliance matters and at least quarterly to the compliance committee of the board. Each hospital has its own compliance committee and compliance officer that reports to its governing board. The compliance committee of the board of directors assesses each hospital’s compliance program at least annually. The corporate compliance officer annually assesses the hospitals for compliance reviews, provides an audit guide to the hospitals to evaluate compliance with our policies and procedures and serves on the compliance committee of each hospital.

 

The objective of the program is to ensure that our operations at all levels are conducted in compliance with applicable federal and state laws regarding both public and private healthcare programs.

 

 

You should carefully consider and evaluate all of the information included in this report, including the risk factors set forth below before making an investment decision with respect to our securities. The following is not an exhaustive discussion of all of the risks facing our company. Additional risks not presently known to us or that we currently deem immaterial may impair our business operations and results of operations.

 

If the anti-kickback, physician self-referral or other fraud and abuse laws are modified, interpreted differently or if other regulatory restrictions become effective, we could incur significant civil or criminal penalties and loss of reimbursement or be required to revise or restructure aspects of our business arrangements.

 

The federal anti-kickback statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring items or services payable by Medicare, Medicaid or any other federal healthcare program. The anti-kickback statute also prohibits any form of remuneration in return for purchasing, leasing or ordering or arranging for or recommending the purchasing, leasing or ordering of items or services payable by these programs. The anti-kickback statute is very broad in scope and many of its provisions have not been uniformly or definitively interpreted by existing case law, regulations or advisory opinions.

 

Violations of the anti-kickback statute may result in substantial civil or criminal penalties, including criminal fines of up to $25,000 for each violation or imprisonment and civil penalties of up to $50,000 for each violation, plus three times the amount claimed and exclusion from participation in the Medicare, Medicaid and other federal healthcare reimbursement programs. Any exclusion of our hospitals or diagnostic and therapeutic facilities from these programs would result in significant reductions in revenue and would have a material adverse effect on our business.

 

The requirements of the physician self-referral statute, or Stark Law, are very complex and while federal regulations have been issued to implement all of its provisions, proper interpretation and application of the statute remains challenging. The Stark Law prohibits a physician who has a “financial relationship” with an entity from referring Medicare or Medicaid patients to that entity for certain “designated health services.” A “financial relationship” includes a direct or indirect ownership or investment interest in the entity, and a compensation arrangement between the physician and the entity. Designated health services include some radiology services and inpatient and outpatient services.

There are various ownership and compensation arrangement exceptions to this self-referral prohibition. Our hospitals rely upon the whole hospital exception to allow referrals from physician investors. Under this ownership exception, physicians may make referrals to a hospital in which he or she has an ownership interest if (1) the physician is authorized to perform services at the hospital and (2) the ownership interest is in the entire hospital, as opposed to a department or a subdivision of the hospital. Another exception for ownership of publicly traded securities permits physicians who own shares of our common stock to make referrals to our hospitals, provided our stockholders’ equity exceeded $75.0 million at the end of our most recent fiscal year or on average during the three previous fiscal years. This exception applies if, prior to the time the physician makes a referral for a designated health service to a hospital, the physician acquired the securities on terms generally available to the public and the securities are traded on one of the major exchanges.

 

In July 2007 as part of proposed revisions to the Medicare physician fee scheduled for fiscal year 2008, CMS proposed certain additional changes to the Stark Law. In particular, the proposed rule would revise the Stark Law exception for space and equipment rentals. In instances where a physician leases space or equipment to an entity who accepts patients referred by that physician, the CMS proposal would no longer allow unit-of-service or “per click” payments for such leases. Additionally, the proposed rule would no longer treat “under arrangements” between hospitals and physician-owned entities as compensation instead of ownership relationships. Specifically, the proposal would revise the definition of “entity” under the Stark Law to include not only the entity billing for the service but also the entity that has performed the designated health service CMS finalized these proposed changes to the Stark Law in the 2009 IPPS final rule published on August 19, 2008. These changes are effective October 1, 2009. Specifically, the 2009 IPPS final rule limits the ability of hospitals to enter into under arrangements with physicians and physician-owned entities and thus, physician-owned joint venture entities deemed to be “performing Designated Health Services (DHS)” will have to comply with one of the more limited Stark Law “ownership” exceptions, rather than the previously acceptable Stark Law “compensation” exceptions. In addition, the 2009 IPPS final rule finalized the prohibition on per unit compensation in space and equipment lease transactions. We have restructured certain space and equipment lease transactions with physicians that include per unit or per use compensation effective October 1, 2009 as well certain arrangements with community hospitals. We cannot yet predict the full impact of this restructuring on our financial performance. While we believe that such restructured arrangements comply with applicable law, we cannot be assured, however, that government officials will agree with our interpretation of applicable law.

 

Possible amendments to the Stark Law, including any modification or revocation of the whole hospital exception upon which we rely in establishing many of our relationships with physicians, could require us to change or adversely impact the manner in which we establish relationships with physicians to develop and operate a facility, as well as our other business relationships such as joint ventures and physician practice management arrangements. We note that legislation has been introduced in Congress recently and in the past seeking to limit or restrict the whole hospital exception. Specifically, the Patient Protection and Affordable Care Act now under debate in the U.S. Senate, provides that the whole hospital exception would only be available to hospitals having physician ownership and a Medicare provider number as of February 1, 2010 and that meet certain other specified requirements. One such requirement is that physician owners could not own more than the percentage of the value of the physician ownership as of the date of the enactment of the bill. The proposed legislation would also restrict expansion of hospitals that meet the requirements referred to above. There can be no assurance that future legislation will not seek to modify, limit, restrict, or revoke the whole hospital exception. There also can be no assurance the CMS will not promulgate additional regulations under the Stark Law that may change or adversely impact our arrangements with referring physicians.

 

Reductions or changes in reimbursement from government or third-party payors could adversely impact our operating results.

 

Historically, Congress and some state legislatures have, from time to time, proposed significant changes in the healthcare system. Many of these changes have resulted in limitations on, and in some cases, significant reductions in the levels of, payments to healthcare providers for services under many government reimbursement programs. In addition, many payors, including Medicare and other government payors, are increasingly developing payment policies that result in more procedures being performed on an outpatient basis rather than on an inpatient basis. Such

policies will result in decreased revenues for our hospitals, since outpatient procedures are generally reimbursed at a lower rate than inpatient procedures. Recent budget proposals, if enacted in their current form, would freeze and/or reduce reimbursement for inpatient and outpatient hospital services. The Medicare hospital inpatient prospective payment system is evaluated on an annual basis. On August 22, 2007, CMS issued its final inpatient hospital prospective payment system rule for fiscal year 2008, which begins October 1, 2007. The final rule continues major DRG reforms designed to improve the accuracy of hospital payments. As introduced in the fiscal year 2007 final rule, CMS will continue to use hospital costs rather than charges to set payment rates. For fiscal year 2008, hospitals will be paid based upon a blend of 1/3 charge-based weights and 2/3 hospital cost-based weights for DRGs. Additionally, CMS adopted its proposal to restructure the current 538 DRGs to 745 MS-DRGs (severity-adjusted DRGs) to better recognize severity of patient illness. These MS-DRGs were phased in over a two-year period. Effective fiscal year 2009, CMS has identified eight conditions that will not be paid at a higher rate unless they were present on admission, including three serious preventable events deemed “never events.” CMS published the inpatient prospective payment system rule for 2009 on August 19, 2008. Due to the late enactment of the Medicare Improvements for Patient and Providers Act (“MIPPA”), CMS did not publish the final wage indices and payment rates for the 2009 IPPS final rule until October 2008. CMS issued the IPPS rule for 2010 on July 31, 2009. The Final IPPS rule for 2010 provides acute care hospitals with an inflation update of 2.1 percent in their 2010 payment rates. The Final IPPS rule also adds four new measures for which hospitals must submit data under the RHQDAPU program to receive the full market basket update

 

During the fiscal years ended September 30, 2009 and 2008, we derived 55.4% and 55.6%, respectively, of our net revenue from the Medicare and Medicaid programs. Changes in laws or regulations governing the Medicare and Medicaid programs or changes in the manner in which government agencies interpret them could materially and adversely affect our operating results or financial position.

 

Our relationships with third-party payors are generally governed by negotiated agreements or out of network arrangements. These agreements set forth the amounts we are entitled to receive for our services. Third-party payors have undertaken cost-containment initiatives during the past several years, including different payment methods, monitoring healthcare expenditures and anti-fraud initiatives, that have made these relationships more difficult to establish and less profitable to maintain. We could be adversely affected in some of the markets where we operate if we are unable to establish favorable agreements with third-party payors or satisfactory out of network arrangements.

 

If we fail to comply with the extensive laws and government regulations applicable to us, we could suffer penalties or be required to make significant changes to our operations.

 

We are required to comply with extensive and complex laws and regulations at the federal, state and local government levels. These laws and regulations relate to, among other things:

 

 

 

Many of these laws and regulations are expansive, and we do not always have the benefit of significant regulatory or judicial interpretation of them. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.

 

If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including:

 

 

A number of initiatives have been proposed during the past several years to reform various aspects of the healthcare system at the federal level and in the states in which we operate. The U.S. Senate is currently debating the Patient Protection and Affordable Care Act, which proposes significant changes to the healthcare payment system. Current or future legislative initiatives, government regulations or other government actions may have a material adverse effect on us.

 

Companies within the healthcare industry continue to be the subject of federal and state investigations.

 

Both federal and state government agencies as well as private payors have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare organizations including hospital companies. Like others in the healthcare industry, we receive requests for information from these governmental agencies in connection with their regulatory or investigative authority which, if determined adversely to us, could have a material adverse effect on our financial condition or our results of operations.

 

In addition, the Office of Inspector General and the U.S. Department of Justice have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Moreover, healthcare providers are subject to civil and criminal false claims laws, including the federal False Claims Act, which allows private parties to bring what are called whistleblower lawsuits against private companies doing business with or receiving reimbursement under government programs. These are sometimes referred to as “qui tam” lawsuits.

 

Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware or which cannot be disclosed until the court lifts the seal from the case. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under a false claim case may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to a federal healthcare program. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law, have thereby submitted false claims under the False Claims Act. Thus, it is possible that we have liability exposure under the False Claims Act.

 

Some states have adopted similar state whistleblower and false claims provisions. Publicity associated with the substantial amounts paid by other healthcare providers to settle these lawsuits may encourage current and former employees of ours and other healthcare providers to seek to bring more whistleblower lawsuits. Some of our activities could become the subject of governmental investigations or inquiries. Any such investigations of us, our executives or managers could result in significant liabilities or penalties to us, as well as adverse publicity.

In October 2007, we reached an agreement with the DOJ and the United States Attorneys’ Office in Phoenix, Arizona regarding clinical trials at the Arizona Heart Hospital, one of the ten hospitals in which we own an interest. The settlement concerns Medicare claims submitted between June 1998 and October 2002 for physician services involving the implantation of certain endoluminal graft devices (utilized to treat aneurysms) that had not received final marketing approval from the FDA, and allegedly were either implanted without an approved investigational device exception (“IDE”) or were implanted outside of the approved IDE protocol. The DOJ allegations did not involve patient care and related solely to whether the procedures were properly reimbursable by Medicare. The parties reached a settlement of the allegations to avoid the delay, uncertainty, inconvenience, and expense of protracted litigation. Further, the hospital denies engagement in any wrongdoing or illegal conduct, and the settlement agreement does not contain any admission of liability. As disclosed in previous filings, the hospital agreed to pay approximately $5.8 million to settle and obtain a release from any civil or administrative monetary claims related to the DOJ’s investigation. Additionally, the hospital has entered into a five-year corporate integrity agreement with the OIG under which the hospital will continue to maintain its existing corporate compliance program and which relates to clinical trials conducted at the hospital. The $5.8 million was paid to the United States in November 2007.

 

During fiscal years 2009 and 2008 we refunded certain reimbursements to CMS related to carotid artery stent procedures performed during prior fiscal years at two of the Company’s consolidated subsidiary hospitals. The DOJ initiated an investigation related to our return of these reimbursements. As a result of the DOJ’s investigation, the Company began negotiating a settlement agreement during the third quarter of fiscal 2009 with the DOJ whereby we are expected to pay approximately $0.8 million to settle and obtain a release from any federal civil false claims liability related to the DOJ’s investigation. The DOJ allegations do not involve patient care, and relate solely to whether the procedures were properly reimbursable by Medicare. The settlement would not include any finding of wrong-doing or any admission of liability. As part of the settlement, we are also negotiating with the Department of Health and Human Services, Office of Inspector General (“OIG”), to obtain a release from any federal healthcare program permissive exclusion actions to be instituted by the OIG. As of September 30, 2009 we had reserved $0.8 million related to this matter.

 

Medicare Recovery Audit Contractor

 

In 2005, CMS began using Recovery Audit Contractors (“RAC”) to detect Medicare overpayments not identified through existing claims review mechanisms. The RAC program relies on private auditing firms to examine Medicare claims filed by healthcare providers. Fees to the RACs are paid on a contingency basis. The RAC program began as a demonstration project in 2005 in three states (New York, California and Florida) which was expanded into the three additional states of Arizona, Massachusetts and South Carolina in July 2007. No RAC audits, however, were initiated at our Arizona or California hospitals during the demonstration project. The program was made permanent by the Tax Relief and Health Care Act of 2006 enacted in December 2006. CMS announced in March 2008 the end of the demonstration project and the commencement of the permanent program by the expansion of the RAC program to additional states beginning in the summer and fall 2008 and its plans to have RACs in place in all 50 states by 2010.

 

RACs perform post-discharge audits of medical records to identify Medicare overpayments resulting from incorrect payment amounts, non-covered services, incorrectly coded services, and duplicate services. CMS has given RACs the authority to look back at claims up to three years old, provided that the claim was paid on or after October 1, 2007. Claims identified as overpayments will be subject to the Medicare appeals process.

 

Even though we believe the claims for reimbursement submitted to the Medicare program by our facilities have been accurate, we are unable to reasonably estimate what the potential result of future RAC audits or other reimbursement matters could be.

 

If laws governing the corporate practice of medicine change, we may be required to restructure some of our relationships.

 

The laws of various states in which we operate or may operate in the future do not permit business corporations to practice medicine, exercise control over physicians who practice medicine or engage in various business

practices, such as fee-splitting with physicians. The interpretation and enforcement of these laws vary significantly from state to state. We are not required to obtain a license to practice medicine in any jurisdiction in which we own or operate a hospital or other facility because our facilities are not engaged in the practice of medicine. The physicians who use our facilities to provide care to their patients are individually licensed to practice medicine. In most instances, the physicians and physician group practices are not affiliated with us other than through the physicians’ ownership interests in the facility or other joint ventures and through the service and lease agreements we have with some of these physicians. Should the interpretation, enforcement or laws of the states in which we operate or may operate change, we cannot assure you that such changes would not require us to restructure some of our physician relationships.

 

If government laws or regulations change or the enforcement or interpretation of them change, we may be obligated to purchase some or all of the ownership interests of the physicians associated with us.

 

Changes in government regulation or changes in the enforcement or interpretation of existing laws or regulations could obligate us to purchase at the then fair market value some or all of the ownership interests of the physicians who have invested in the ventures that own and operate our hospitals and other healthcare businesses. Regulatory changes that could create this obligation include changes that:

 

 

From time to time, we may voluntarily seek to increase our ownership interest in one or more of our hospitals and other healthcare businesses, in accordance with any applicable limitations. We may seek to use shares of our common stock to purchase physicians’ ownership interests instead of cash. If the use of our stock is not permitted or attractive to us or our physician partners, we may use cash or promissory notes to purchase the physicians’ ownership interests. Our existing capital resources may not be sufficient for the acquisition or the use of cash may limit our ability to use our capital resources elsewhere, limiting our growth and impairing our operations. The creation of these obligations and the possible adverse effect on our affiliation with these physicians could have a material adverse effect on us.

 

We may have fiduciary duties to our partners that may prevent us from acting solely in our best interests.

 

We hold our ownership interests in hospitals and other healthcare businesses through ventures organized as limited liability companies or limited partnerships. As general partner, manager or owner of the majority interest in these entities, we may have special legal responsibilities, known as fiduciary duties, to our partners who own an interest in a particular entity. Our fiduciary duties include not only a duty of care and a duty of full disclosure but also a duty to act in good faith at all times as manager or general partner of the limited liability company or limited partnership. This duty of good faith includes primarily an obligation to act in the best interest of each business, without being influenced by any conflict of interest we may have as a result of our own business interests.

 

We also have a duty to operate our business for the benefit of our stockholders. As a result, we may encounter conflicts between our fiduciary duties to our partners in our hospitals and other healthcare businesses, and our responsibility to our stockholders. For example, we have entered into management agreements to provide management services to our hospitals in exchange for a fee. Disputes may arise with our partners as to the nature of the services to be provided or the amount of the fee to be paid. In these cases, as manager or general partner we may be obligated to exercise reasonable, good faith judgment to resolve the disputes and may not be free to act solely in our own best interests or the interests of our stockholders. We cannot assure you that any dispute between us and our partners with respect to a particular business decision or regarding the interpretation of the provisions of the hospital operating agreement will be resolved or that, as a result of our fiduciary duties, any dispute resolution will be on terms favorable or satisfactory to us.

Material decisions regarding the operations of our facilities require consent of our physician and community hospital partners, and we may be unable as a result to take actions that we believe are in our best interest.

 

The physician and community hospital partners in our healthcare businesses participate in material strategic and operating decisions we make for these facilities. They may do so through their representatives on the governing board of the subsidiary that owns the facility or a requirement in the governing documents that we obtain the consent of their representatives before taking specified material actions. We generally must obtain the consent of our physician and other hospital partners or their representatives before making any material amendments to the operating or partnership agreement for the venture or admitting additional members or partners. Although they have not done so to date, these rights to approve material decisions could in the future limit our ability to take actions that we believe are in our best interest and the best interest of the venture. We may not be able to resolve favorably, or at all, any dispute regarding material decisions with our physician or other hospital partners.

 

We may experience difficulties in executing our growth strategy.

 

Our growth strategy depends on our ability to identify attractive markets in which to expand existing facilities and establish new business ventures and to identify attractive acquisition opportunities. We may have difficulty in identifying potential markets that satisfy our criteria for expansion, for acquisition, or for developing a new facility or for entering into other business arrangements. Identifying physician and community hospital partners and negotiating and implementing the terms of an agreement with them can be a lengthy and complex process. As a result, we may not be able to develop new business ventures at the rate we currently anticipate. Our growth strategy also involves the expansion of several of our hospitals. The success of these expansions is dependant on increased regional support in each respective market. If the market conditions in these regions deteriorate, these expansion costs may not be recoverable. If we acquire an existing facility, there is no assurance that we will be able to operate it profitably.

 

Our growth strategy will also increase demands on our management, operational and financial information systems and other resources. To accommodate our growth, we will need to continue to implement operational and financial information systems and controls, and expand, train, manage and motivate our employees. Our personnel, information systems, procedures or controls may not adequately support our operations in the future. Failure to recruit and retain strong management, implement operational and financial information systems and controls, or expand, train, manage or motivate our workforce, could lead to delays in developing and achieving expected operating results for new facilities.

 

Unfavorable or unexpected results at one of our hospitals or in one of our markets could significantly impact our consolidated operating results.

 

Each of our individual hospitals comprise a significant portion of our operating results and a majority of our hospitals are located in the southwestern United States. Any material change in the current demographic, economic, competitive or regulatory conditions in this region, a particular market in which one of our other hospitals operates or the United States in general could adversely affect our operating results. In particular, if economic conditions deteriorate in one or more of these markets, we may experience a shift in payor mix arising from patients’ loss of or changes in employer-provided health insurance resulting in higher co-payments and deductibles or an increased number of uninsured patients.

 

Growth of self-pay patients and a deterioration in the collectability of these accounts could adversely affect our results of operations.

 

We have experienced growth in our self-pay patients, which includes situations in which each patient is responsible for the entire bill, as well as cases where deductibles are due from insured patients after insurance pays. We may have greater amounts of uninsured receivables in the future and if the collectability of those uninsured receivables deteriorates, increases in our allowance for doubtful accounts may be required, which could materially adversely impact our operating results and financial condition.

Our hospitals and other facilities face competition for patients from other healthcare companies.

 

The healthcare industry is highly competitive. Our facilities face competition for patients from other providers in our markets. In most of our markets we compete for market share of cardiovascular and other healthcare procedures that are the focus of our facilities with two to three providers. As we expand the scope of hospital services at our hospitals we may face even greater levels of competition from other larger general acute care hospitals in our markets that also provide those services. Some of these providers are part of large for-profit or not-for-profit hospital systems with greater financial resources than we have available to us and have been operating in the markets they serve for many years. Some of the hospitals that we compete against in certain of our markets and elsewhere have attempted to use their market position and managed care networks to influence physicians not to enter into or to abandon joint ventures that own facilities such as ours by, for example, revoking the admission privileges of our physician partners at the competing hospital. These practices of “economic credentialing” appear to be on the increase. Although these practices have not been successful to date in either preventing us from developing new ventures with physicians or causing us to lose existing investors, the future inability to attract new investors or loss of a significant number of our physician partners in one or more of our existing ventures could have a material adverse effect on our business and operating results.

 

We depend on our relationships with the physicians who use our facilities.

 

Our business depends upon the efforts and success of the physicians who provide healthcare services at our facilities and the strength of our relationships with these physicians. Each member of the medical staffs at our hospitals may also serve on the medical staffs of, and practice at, hospitals not owned by us.

 

At each of our hospitals, our business could be adversely affected if a significant number of key physicians or a group of physicians:

 

 

Historically, the medical staff at each hospital ranges from approximately 150 to 400 physicians depending upon the size of the hospital and the number of practicing physicians in the market. If we fail to maintain our relationships with the physicians in this group at a particular hospital, many of whom are investors in our hospitals, the revenues of that hospital would be reduced. None of the physicians practicing at our hospitals has a legal commitment, or any other obligation or arrangement that requires the physician to refer patients to any of our hospitals or other facilities.

 

From time to time physicians who are leaders of their medical groups and who use our hospitals may retire or otherwise cease practicing medicine or using our facilities for a variety of reasons. Those medical groups may not replace those physician leaders or may replace them with physicians who choose not to use our hospitals. Losing the utilization of our hospitals by those physicians and other physicians in their medical groups may result in material decreases in our revenue and financial performance.

 

A hospital system with which one of our established hospitals competes recently announced a collaboration with one of the leading cardiac services physician groups in that market, some of whose physicians have historically used our hospital and are investors in that hospital. It is possible this collaboration could result in a decrease in the use of our hospital by those physicians, with a resulting decrease in the revenue and financial performance of that hospital. Similar transactions in other markets may occur in the future and could have similar negative impacts on our other facilities and the Company.

A shortage of qualified nurses could affect our ability to grow and deliver quality, cost-effective care services.

 

We depend on qualified nurses to provide quality service to patients in our facilities. There is currently a shortage of qualified nurses in certain markets where we operate our facilities. This shortage of qualified nurses and the more stressful working conditions it creates for those remaining in the profession are increasingly viewed as a threat to patient safety and may trigger the adoption of state and federal laws and regulations intended to reduce that risk. For example, some states have adopted or are considering legislation that would prohibit forced overtime for nurses and/or establish mandatory staffing level requirements. Growing numbers of nurses are also joining unions that threaten and sometimes call work stoppages.

 

In response to the shortage of qualified nurses, we have increased and are likely to have to continue to increase our wages and benefits to recruit and retain nurses or to engage expensive contract nurses until we hire permanent staff nurses. We may not be able to increase the rates we charge to offset increased costs. The shortage of qualified nurses has in the past and may in the future delay our ability to achieve our operational goals at a hospital by limiting the number of patient beds available during the start-up phase of the hospital. The shortage of nurses also makes it difficult for us in some markets to reduce personnel expense at our facilities by implementing a reduction in the size of the nursing staff during periods of reduced patient admissions and procedure volumes.

 

We rely heavily on our information systems and if our access to this technology is impaired or interrupted, or if such technology does not perform as warranted by the vendor, our business could be harmed and we may not comply with applicable laws and regulations.

 

Increasingly, our business depends in large part upon our ability to store, retrieve, process and manage substantial amounts of information. To achieve our strategic objectives and to remain in compliance with various regulations, we must continue to develop and enhance our information systems, which may require the acquisition of equipment and third-party software. Our inability to implement and utilize, in a cost-effective manner, information systems that provide the capabilities necessary for us to operate effectively, or any interruption or loss of our information processing capabilities, for any reason including if such systems, or systems acquired in the future, do not perform appropriately, could harm our business, results of operations or financial condition.

 

We are considering acquiring EHR technology. The HITECH Act provides for incentive payments to eligible hospitals to encourage the acquisition and use of EHR systems. The amount of incentive payments a hospital may receive is based on a formula that considers the hospital’s share of Medicare patients and when the hospital satisfies all of the relevant requirements for the incentive payments. Hospitals will have to demonstrate compliance with a number of requirements in order to receive incentive payments, including without limitation, (i) meaningful use of certified EHR technology; (ii) connectivity of certified EHR technology in a manner that provides for the electronic exchange of information to improve the quality of healthcare; and (iii) submission of information to HHS on clinical quality and other measures determined by HHS. The HITECH Act directs the HHS Secretary to determine what constitutes meaningful use and connectivity, as well as to develop quality measures to be reported, and the HHS Secretary has not issued regulations or other guidance on these requirements to date. We do not know when or if EHR technology acquired by us would enable us to qualify for incentive payments under the HITECH Act, and if we did qualify for such payments, we do not know when such payments would be received or the amounts of such payments. Finally, the HITECH Act provides that hospitals that do not satisfy requirements related to EHR technology and submission of quality data by 2015 will be subject to reductions in reimbursement.

 

Uninsured risks from legal actions related to professional liability could adversely affect our cash flow and operating results.

 

In recent years, physicians, hospitals, diagnostic centers and other healthcare providers have become subject, in the normal course of business, to an increasing number of legal actions alleging negligence in performing services, negligence in allowing unqualified physicians to perform services or other legal theories as a basis for liability. Many of these actions involve large monetary claims and significant defense costs. We may be subject to such legal actions even though a particular physician at one of our hospitals or other facilities is not our employee and the governing documents for the medical staffs of each of our hospitals require physicians who provide services,

or conduct procedures, at our hospitals to meet all licensing and specialty credentialing requirements and to maintain their own professional liability insurance.

 

We have established a reserve for malpractice claims based on actuarial estimates using our historical experience with malpractice claims and assumptions about future events. Due to the considerable variability that is inherent in such estimates, including such factors as changes in medical costs and changes in actual experience, there is a reasonable possibility that the recorded estimates will change by a material amount in the near term. Also, there can be no assurance that the ultimate liability we experience under our self-insured retention for medical malpractice claims will not exceed our estimates. It is also possible that such claims could exceed the scope of coverage, or that coverage could be denied.

 

Our results of operations may be adversely affected from time to time by changes in treatment practice and new medical technologies.

 

One major element of our business model is to focus on the treatment of patients suffering from cardiovascular disease. Our commitment and that of our physician partners to treating cardiovascular disease often requires us to purchase newly approved pharmaceuticals and devices that have been developed by pharmaceutical and device manufacturers to treat cardiovascular disease. At times, these new technologies receive required regulatory approval and become widely available to the healthcare market prior to becoming eligible for reimbursement by government and other payors. In addition, the clinical application of existing technologies may expand, resulting in their increased utilization. We cannot predict when new technologies will be available to the marketplace, the rate of acceptance of the new technologies by physicians who practice at our facilities, and when or if, government and third-party payors will provide adequate reimbursement to compensate us for all or some of the additional cost required to purchase new technologies. As such, our results of operations may be adversely affected from time to time by the additional, unreimbursed cost of these new technologies.

 

In addition, advances in alternative cardiovascular treatments or in cardiovascular disease prevention techniques could reduce demand or eliminate the need for some of the services provided at our facilities, which could adversely affect our results of operations. Further, certain technologies may require significant capital investments or render existing capital obsolete which may adversely impact our cash flows or operations.

 

California state law may impact our operations.

 

Effective January 1, 2009, California licensed general acute hospitals are subject to increased administrative penalties associated with survey deficiencies impacting the health or safety of a patient, the unlawful or unauthorized access, use, or disclosure of a patient’s medical information and are required to screen specific patients for certain hospital-related infections and must maintain an infection control policy. Deficiencies constituting immediate jeopardy to the health or safety of a patient are subject to graduated penalties of up to a maximum $100,000 per violation (up from a maximum of $25,000 per violation). Deficiencies not constituting immediate jeopardy to the health or safety of a patient are subject to penalties up to a maximum of $25,000 per violation (up from a maximum of $17,500 per violation). Penalties for violation of the unlawful or unauthorized access are up to $25,000 per patient and a maximum of $17,500 for each subsequent access, use or disclosure of the patient’s medical information.

 

We believe we are or will be in compliance with this new California provisions, but there can be no assurance that applicable regulatory agencies or individuals may challenge that assertion.

 

On January 8, 2009, the California Supreme Court ruled in Prospect Medical Group, Inc., et al. v. Northridge Emergency Medical Group, et al. (2009) 45 Cal. 4^th 497, that under California’s Knox-Keene statute, healthcare providers may not bill patients for covered emergency out patient services for which health plans or capitated payors are invoiced by the provider but fail to pay the provider. The California Supreme Court held that the only recourse for healthcare providers is to pursue the payors directly. The Prospect decision does not apply to amounts that the health plan or capitated payor is not obligated to pay under the terms of the insured’s policy or plan. Although the decision only considered emergency providers and referred to HMOs and capitated payors, future court decisions on how the so-called “balance billing” statute is interpreted does pose a risk to healthcare providers that perform emergency or other out-patient services in the state of California.

A purported class action law suit was recently filed by an individual against the Bakersfield Heart Hospital. In the complaint the plaintiff alleges that under California law, and specifically under the Knox-Keene Healthcare Service Plan Act of 1975, and under the Health and Safety Code of California that California prohibits the practice of “balance billing” patients who are provided “emergency services” as defined under California law. A class has not been certified by the court in this case. We are currently evaluating the claims asserted in this cause as well as the defense we may assert in this matter.

 

 

None.

 

 

Our executive offices are located in Charlotte, North Carolina in approximately 32,580 square feet of leased commercial office space.

 

Each of the ventures we have formed to develop a hospital owns the land and buildings of the hospital, with the exception of the land underlying the Heart Hospital of Austin and the land and building at Harlingen Medical Center, which are leased. Each hospital has pledged its interest in the land and hospital building to secure the long-term debt incurred to develop the hospital, and substantially all the equipment located at these hospitals is pledged as collateral to secure long-term debt. Each entity formed to own and operate a diagnostic and therapeutic facility leases its facility.

 

 

We are involved in various litigation and proceedings in the ordinary course of our business. We do not believe, based on our experience with past litigation, and taking into account our applicable insurance coverage and the expectations of counsel with respect to the amount of our potential liability, the outcome of any such litigation, individually or in the aggregate, will have a material adverse effect upon our business, financial condition or results of operations.

 

 

No matters were submitted to a vote of security holders during the fourth quarter of 2009.

 

 

Our common stock trades on the Nasdaq Global Market^® under the symbol “MDTH.” At December 10, 2009, there were 20,654,264 shares of common stock outstanding, the sale price of our common stock per share was $6.95, and there were 44 holders of record. The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock as reported by the Nasdaq Global Market ^®:

 

 

 

We have not declared or paid any cash dividends on our common stock and do not anticipate paying cash dividends on our common stock for the foreseeable future. The terms of our credit agreement restricts our ability to pay and the amount of any cash dividends or other distributions to our stockholders, and limits the amounts and extent for which we can repurchase our common stock. Under the terms of our credit agreement, we may only pay dividends if there is no default or event of default and we are in compliance with the restricted payment covenant and the financial ratio covenant after giving effect to the dividend. See Note 9 to our consolidated financial statements contained elsewhere in this report. We anticipate that we will retain all earnings, if any, to develop and expand our business. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.” Payment of dividends in the future will be at the discretion of our board of directors and will depend upon our financial condition and operating results.

 

During August 2007, our board of directors approved a stock repurchase program of up to $59.0 million. The purchases will be made from time to time in the open market or in privately negotiated transactions in accordance with applicable federal and state securities laws and regulations. The extent to which we repurchase common shares and the timing of such repurchases will depend upon stock price, general economic and market conditions and other corporate considerations. The repurchase program may be discontinued at any time. Subsequent to the approval of the stock repurchase program, the Company has repurchased 1,885,461 shares of common stock at a total cost of $44.4 million, with a remaining $14.6 million available to be repurchased under the approved stock repurchase program. No shares were repurchased during fiscal 2009.

The following graph illustrates, for the period from September 30, 2004 through September 30, 2009, the cumulative total shareholder return of $100 invested (assuming that all dividends, if any, were reinvested) in (1) our common stock, (2) the NASDAQ Composite Stock Index and (3) the S&P Health Care Facilities Index.

 

The comparisons in this table are required by the rules of the Securities and Exchange Commission and, therefore, are not intended to forecast or be indicative of possible future performance of our common stock.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among MedCath Corporation, The NASDAQ Composite Index
And The S&P Health Care Facilities Index

 

 

 

Copyright ^© 2009 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.

 

The selected consolidated financial data have been derived from our audited consolidated financial statements. The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes, appearing elsewhere in this report.

 

The following table sets forth our selected consolidated financial data as of and for the years ended September 30, 2009, 2008, 2007, 2006 and 2005.

 

 

 

 

 

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.

 

Overview

 

We are a healthcare provider focused primarily on providing high acuity services, predominantly the diagnosis and treatment of cardiovascular disease. We own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence. We also have partnerships with community hospital systems, and we manage the cardiovascular program of various hospitals operated by other parties. We opened our first hospital in 1996 and currently have ownership interests in and operate ten hospitals, including eight in which we own a majority interest. Each of our majority-owned hospitals is a freestanding, licensed general acute care hospital that provides a wide range of health services with a focus on cardiovascular care. Each of our hospitals has a twenty-four hour emergency room staffed by emergency department physicians. The hospitals in which we have ownership interests have a total of 825 licensed beds and are located predominately in high growth markets in seven states: Arizona, Arkansas, California, Louisiana, New Mexico, South Dakota, and Texas. During May 2009 we completed our 79 bed expansion at Louisiana Medical Center and Heart Hospital, with remaining capacity for an additional 40 beds at that hospital. During October 2009 we opened a new acute care hospital in Kingman, Arizona. This hospital is designed to accommodate a total of 106 licensed beds, with an initial opening of 70 of its licensed beds.

 

In addition to our hospitals, we currently own and/or manage 16 cardiac diagnostic and therapeutic facilities or programs. Ten of these programs are located at hospitals operated by other parties. These facilities offer invasive diagnostic and, in some cases, therapeutic procedures. The remaining six facilities are not located at hospitals and offer only diagnostic procedures.

 

We believe our facilities provide superior clinical outcomes, which, together with our ability to provide management capabilities and capital resources, positions us to expand upon our relationships with physicians and community hospitals to increase our presence in existing and new markets.

 

Basis of Consolidation.  We have included in our consolidated financial statements hospitals and cardiac diagnostic and therapeutic facilities over which we exercise substantive control, including all entities in which we

own more than a 50% interest, as well as variable interest entities in which we are the primary beneficiary. We have used the equity method of accounting for entities, including variable interest entities, in which we hold less than a 50% interest and over which we do not exercise substantive control, and are not the primary beneficiary. Accordingly, the hospitals in which we hold a minority interest are excluded from the net revenue and operating results of our consolidated company and our consolidated hospital division. During the fourth quarter of fiscal 2007, we sold a portion of our equity interest in Harlingen Medical Center; therefore, beginning in July 2007, we began excluding this hospital from net revenue and operating results of our consolidated company and our consolidated hospital division. Similarly, a number of our diagnostic and therapeutic facilities are excluded from the net revenue and operating results of our consolidated company and our consolidated MedCath Partners division. Our minority interest in the results of operations for the periods discussed for these entities is recognized as part of the equity in net earnings of unconsolidated affiliates in our statements of income in accordance with the equity method of accounting.

 

We sold our equity interests in Heart Hospital of Lafayette and Cape Cod Cardiology Services LLC in fiscal 2008 and 2009, respectively, and the net assets of Dayton Heart Hospital and Sun City Cardiac Center Associates in fiscal 2008 and 2009, respectively. Accordingly, for all periods presented, the results of operations for these entities have been excluded from continuing operations and are reported in income (loss) from discontinued operations, net of taxes.

 

Same Facility Hospitals.  Our policy is to include, on a same facility basis, only those facilities that were open and operational during the full current and prior fiscal year comparable periods. For example, on a same facility basis for our consolidated hospital division for the fiscal year ended September 30, 2007, we exclude the results of operations of Harlingen Medical Center, which, during the fourth quarter of fiscal 2007 and the entire fiscal 2008 and 2009, ceased to be a consolidated subsidiary due to the sale of a portion of the hospital, as discussed in the Basis of Consolidation above.

 

Revenue Sources by Division.  The largest percentage of our net revenue is attributable to our hospital division. The following table sets forth the percentage contribution of each of our consolidating divisions to consolidated net revenue in the periods indicated below.

 

 

Revenue Sources by Payor.  We receive payments for our services rendered to patients from the Medicare and Medicaid programs, commercial insurers, health maintenance organizations, and our patients directly. Generally, our net revenue is determined by a number of factors, including the payor mix, the number and nature of procedures performed and the rate of payment for the procedures. Since cardiovascular disease disproportionately affects those age 55 and older, the proportion of net revenue we derive from the Medicare program is higher than that of most general acute care hospitals. The following table sets forth the percentage of consolidated net revenue we earned by category of payor in each of our last three fiscal years.

 

 

A significant portion of our net revenue is derived from federal and state governmental healthcare programs, including Medicare and Medicaid, and we expect the net revenue that we receive from the Medicare program as a

percentage of total consolidated net revenue will remain significant in future periods. Our payor mix may fluctuate in future periods due to changes in reimbursement, market and industry trends with self-pay patients and other similar factors.

 

The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, court decisions, executive orders and freezes and funding reductions, all of which may significantly affect our business. In addition, reimbursement is generally subject to adjustment following audit by third party payors, including the fiscal intermediaries who administer the Medicare program for CMS. Final determination of amounts due providers under the Medicare program often takes several years because of such audits, as well as resulting provider appeals and the application of technical reimbursement provisions. We believe that adequate provision has been made for any adjustments that might result from these programs; however, due to the complexity of laws and regulations governing the Medicare and Medicaid programs, the manner in which they are interpreted and the other complexities involved in estimating our net revenue, there is a possibility that recorded estimates will change by a material amount in the near term. See Item 1 Business and Item 1A Risk Factors.

 

Critical Accounting Policies and Estimates

 

General.  The discussion and analysis of our financial condition and results of operations are based on our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on a regular basis and make changes as experience develops or new information becomes known. Actual results may differ from these estimates under different assumptions or conditions.

 

We define critical accounting policies as those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine and (3) have the potential to result in materially different results under different assumptions and conditions. We believe that our critical accounting policies are those described below. For a detailed discussion of the application of these and other accounting policies, see Note 2 to the consolidated financial statements included elsewhere in this report.

 

Revenue Recognition.  Amounts we receive for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as commercial insurers, health maintenance organizations and preferred provider organizations are generally less than our established billing rates. Payment arrangements with third-party payors may include prospectively determined rates per discharge or per visit, a discount from established charges, per diem payments, reimbursed costs (subject to limits) and/or other similar contractual arrangements. As a result, net revenue for services rendered to patients is reported at the estimated net realizable amounts as services are rendered. We account for the difference between the estimated realizable rates under the reimbursement program and the standard billing rates as contractual adjustments.

 

The majority of our contractual adjustments are system-generated at the time of billing based on either government fee schedules or fee schedules contained in our managed care agreements with various insurance plans. Portions of our contractual adjustments are performed manually and these adjustments primarily relate to patients that have insurance plans with whom our hospitals do not have contracts containing discounted fee schedules, also referred to as non-contracted payors and patients that have secondary insurance plans following adjudication by the primary payor. Estimates of contractual adjustments are made on a payor-specific basis and based on the best information available regarding our interpretation of the applicable laws, regulations and contract terms. While subsequent adjustments to the systematic contractual allowances can arise due to denials, short payments deemed immaterial for continued collection effort and a variety of other reasons, such amounts have not historically been significant.

We continually review the contractual estimation process to consider and incorporate updates to the laws and regulations and any changes in the contractual terms of our programs. Final settlements under some of these programs are subject to adjustment based on administrative review and audit by third parties, which can take several years to determine. From a procedural standpoint, for government payors, primarily Medicare, we recognize estimated settlements in our consolidated financial statements based on filed cost reports. We subsequently adjust those settlements as we obtain new information from audits or reviews by the fiscal intermediary and, if the result of the fiscal intermediary audit or review impacts other unsettled and open cost reports, then we recognize the impact of those adjustments. We estimate current year settlements based on models designed to approximate our cost report filings and revise our estimates in February of each year upon completion of the actual cost report and tentative settlement. Due to the complexity of laws and regulations governing the Medicare and Medicaid programs, the manner in which they are interpreted, and the other complexities involved in estimating our net revenue, there is a reasonable possibility that recorded estimates will change by a material amount in the near term.

 

We provide care to patients who meet certain criteria under our charity care policy without charge or at amounts less than our established rates. Because we do not pursue collection of amounts determined to qualify as charity care, they are not reported as net revenue.

 

Our managed diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories operate under various contracts where management fee revenue is recognized under fixed-rate and percentage-of-income arrangements as services are rendered. In addition, certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories recognize additional revenue under cost reimbursement and equipment lease arrangements. Net revenue from our owned diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories is reported at the estimated net realizable amounts due from patients, third party payors, and others as services are rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors.

 

Allowance for Doubtful Accounts.  Accounts receivable primarily consist of amounts due from third-party payors and patients in our hospital division. The remainder of our accounts receivable principally consist of amounts due from billings to hospitals for various cardiovascular care services performed in our MedCath Partners Division and amounts due under consulting and management contracts. To provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. We estimate this allowance based on such factors as payor mix, aging and the historical collection experience and write-offs of our respective hospitals and other business units. Adverse changes in business office operations, payor mix, economic conditions or trends in federal and state governmental healthcare reimbursement could affect our collection of accounts receivable.

 

When possible, we will attempt to collect co-payments from patients prior to admission for inpatient services as a part of the pre-registration and registration processes. If unsuccessful, we will also attempt to reach a mutually agreed-upon payment arrangement at that time. To the extent possible, the estimated amount of the patient’s financial responsibility is determined based on the services to be performed, the patient’s applicable co-payment amount or percentage and any identified remaining deductible and co-insurance percentages. If payment arrangements are not provided upon admission or only a partial payment is obtained, we will attempt to collect any estimated remaining patient balance upon discharge. We also comply with the requirements under applicable law concerning collection of Medicare co-payments and deductibles. Patients who come to our hospitals for outpatient services are expected to make payment or adequate financial arrangements before receiving services. Patients who come to the emergency room are screened and stabilized to the extent of the hospital’s capability for any emergency medical condition in accordance with applicable laws, rules and other regulations in order that financial arrangements do not delay such screening, stabilization, and appropriate disposition.

 

General and Professional Liability Risk.  We are self-insured for medical malpractice, workers’ compensation healthcare and dental coverage up to certain maximum liability amounts. Although the amounts accrued are actuarially determined based on analysis of historical trends of losses, settlements, litigation costs and other factors, the amounts we will ultimately disburse could differ from such accrued amounts.

 

Goodwill.  Goodwill represents the excess of cost over the fair value of net assets acquired. Goodwill is required to be evaluated for impairment at the same time every year and when an event occurs or circumstances

change that, more likely than not, reduce the fair value of the reporting unit below its carrying value. A two-step method is used for determining if goodwill is impaired. Step one is to compare the fair value of the reporting unit with the unit’s carrying value, including goodwill. If this test indicates the fair value is less than the carrying value, then step two is required to compare the implied fair value of the reporting unit’s goodwill with the carrying value of the reporting unit’s goodwill. We have selected September 30th as our annual testing date.

 

Due to overall market conditions during the first quarter of fiscal 2009 resulting in a decline in our market capitalization, we performed an interim impairment test of goodwill as of December 31, 2008. The fair value of the reporting unit (our Hospital Division) was determined using a combination of a discounted cash flow, market multiple and comparable transaction methods. These methods are based on our best estimate of future revenues and operating costs, comparable transactions that have taken place in the market place and are reconciled to our market capitalization. The results of our interim analysis concluded that the fair value of the reporting unit was in excess of its carrying value.

 

We performed our annual impairment analysis of goodwill as of September 30, 2009 utilizing the same historical methods as discussed above. Initially our analysis resulted in a fair value for which we could not satisfactorily reconcile to our market capitalization. During the fourth quarter of fiscal 2009, our stock price underperformed comparable companies as well as the broader markets, and we also experienced a decline in our fourth quarter operating results. As a result of these events we placed greater weight on the discounted cash flow method, which resulted in a fair value that was below the carrying value of the reporting unit at September 30, 2009.

 

The second step of the impairment testing process involved the allocation of the fair value of the reporting unit derived in the first step of the impairment test to the fair value of the reporting unit’s assets and liabilities. This process requires significant management estimates and judgments, and is used to determine the implied fair value of the reporting unit’s goodwill. The fair value in excess of amounts allocated to such net assets represented the implied fair value of goodwill for the reporting unit. As a result goodwill was written down to its implied fair value of zero, derived in the second step, causing the entire balance of $60.2 million of goodwill to be impaired during the fourth quarter of fiscal 2009. The non-cash impairment expense did not affect our operations, cash flow, cash position or access to our bank facility.

 

Long-Lived Assets.  Long-lived assets, which include finite lived intangible assets, are evaluated for impairment when events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of an asset and its eventual disposition are less than its carrying amount. The determination of whether or not long-lived assets have become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the estimated future cash flows expected to result from the use of those assets. Changes in our strategy, assumptions and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of long-lived assets.

 

Earnings Allocated to Minority Interests.  Earnings allocated to minority interests represent the allocation of profits and losses to minority owners in our consolidated subsidiaries. Because our hospitals are owned as joint ventures, each hospital’s earnings and losses are generally allocated for accounting purposes to us and our physician and community hospital partners on a pro-rata basis in accordance with the respective ownership percentages in the hospital. If, however, the cumulative net losses of a hospital exceed its initial capitalization and committed capital obligations of our partners, then we recognize a disproportionately higher share, up to 100%, of the hospital’s losses, instead of the smaller pro-rata share of the losses that normally would be allocated to us based upon our percentage ownership. The disproportionate allocation to us of a hospital’s losses would reduce our consolidated net income in that reporting period. When the same hospital has earnings in a subsequent period, a disproportionately higher share, up to 100%, of the hospital’s earnings will be allocated to us to the extent we have previously recognized a disproportionate share of that hospital’s losses. The disproportionate allocation to us of a hospital’s earnings would increase our consolidated net income in that reporting period.

 

The determination of disproportionate losses to be allocated is based on the specific terms of each hospital’s operating agreement, including each partner’s contributed capital, obligation to contribute additional capital to provide working capital loans, or to guarantee the outstanding obligations of the hospital. During each of our fiscal

years 2009, 2008 and 2007, our disproportionate recognition of earnings and losses in our hospitals had a net positive/(negative) impact of $(2.2) million, $0.6 million, and $(0.2) million, respectively, on our reported income from continuing operations before income taxes and discontinued operations.

 

We expect our earnings allocated to minority interests to fluctuate in future periods as we either recognize disproportionate losses and/or recoveries thereof through disproportionate profits of our hospitals. As of September 30, 2009, we have $2.0 million of cumulative disproportionate losses allocated to us. We could also be required to recognize disproportionate losses at our other hospitals not currently in a disproportionate allocation position depending on their results of operations in future periods.

 

Income Taxes.  Income taxes are computed on the pretax income based on current tax law. Deferred income taxes are recognized for the expected future tax consequences or benefits of differences between the tax bases of assets or liabilities and their carrying amounts in the consolidated financial statements. A valuation allowance is provided for deferred tax assets if it is more likely than not that these items will either expire before we are able to realize their benefit or their future deductibility is uncertain.

 

Developing the provision for income taxes requires significant judgment and expertise in federal and state income tax laws, regulations and strategies, including the determination of deferred tax assets and liabilities and, if necessary, any valuation allowances that may be required for deferred tax assets. Our judgments and tax strategies are subject to audit by various taxing authorities. While we believe we have provided adequately for our income tax liabilities in our consolidated financial statements, adverse determinations by these taxing authorities could have a material adverse effect on our consolidated financial condition and results of operations.

 

Share-Based Compensation — Compensation expense for share-based awards made to employees and directors are recognized based on the estimated fair value of each award over the awards’ vesting period. We estimate the fair value of share-based payment awards on the date of grant using, either an option-pricing model for stock options or the closing market value of our stock for restricted stock and restricted stock units, and expense the value of the portion of the award that is ultimately expected to vest over the requisite service period in the Company’s statement of operations.

 

We calculated the share-based compensation expense for each stock option on the date of grant by using a Black-Scholes option pricing model. The key assumptions used in the Black-Scholes option pricing model are the expected life of the stock option, the risk free interest rate and expected volatility. The expected volatility used in the Black-Scholes option pricing model incorporates historical share-price volatility and was based on an analysis of historical prices of our stock. The expected volatility reflects the historical volatility for a duration consistent with the contractual life of the options. The expected life of the stock options granted represents the period of time that the options are expected to be outstanding. The risk-free interest rates are based on zero-coupon United States Treasury yields in effect at the date of grant consistent with the expected exercise timeframes.

 

Stock options awarded to employees are fully vested at the time of grant, with the condition that the optionee is prohibited from selling the share of stock acquired upon exercise of the option for a specified period of time. As a result, total share-based compensation is recorded for stock options on the option grant date.

 

During fiscal 2009 we granted shares of restricted stock and restricted stock units to employees and directors, respectively. Restricted stock granted to employees, excluding executives of the Company, vest in equal annual installments over a three year period. Executives of the Company (defined by us as vice president or higher) received two restricted stock grants. The first grant of restricted stock vests in equal annual installments over a three year period. The second grant of restricted stock vests over a three year period based on established performance conditions. Restricted stock units granted to directors are fully vested at the date of grant and are paid in the form of common stock upon each applicable director’s termination of service on the board.

 

Recent Accounting Pronouncements:  See Note 2 of our consolidated financial statements included elsewhere in this report for additional disclosures.

Results of Operations

 

Fiscal Year 2009 Compared to Fiscal Year 2008

 

Statement of Operations Data.  The following table presents our results of operations in dollars and as a percentage of net revenue:

 

 

Net revenue.  Below is selected procedural and net revenue data for the fiscal years ended September 30, 2009 and 2008.

 

 

 

 

 

 

Net revenue increased 1.8% to $602.0 million for our fiscal year ended September 30, 2009 from $591.6 million for our fiscal year ended September 30, 2008. Of this $10.4 million increase in net revenue, our Hospital Division generated a $12.1 million increase, our MedCath Partners Division generated a $1.6 million decrease and our Corporate and other Division generated a $0.1 million decrease. The Hospital Division increase was comprised of an $11.0 million increase in net patient revenue and a $1.1 million increase in other operating revenue.

 

We continued to experience a shift in inpatient to outpatient procedures in our Hospital Division during fiscal 2009. Our inpatient admissions were down 8.3% for the 2009 fiscal year compared to the 2008 fiscal year; however our outpatient procedures, taking into consideration outpatient visits excluding emergency department visits, increased 11.7% as a result of the shift from inpatient to outpatient procedures. Our emergency department visits increased 11.2% during fiscal 2009 compared to fiscal 2008, driven primarily by our expansion and marketing efforts. Total outpatient net patient revenue excluding emergency department and our Heart Saver program net revenue increased from 19.1% of total hospital net revenue for fiscal 2008 to 24.4% for fiscal 2009.

 

During 2009 we established a consolidated primary care physician group at one of our hospitals. Net revenue for fiscal 2009 includes $1.0 million related to this new group. The related expenses are also reported as a component of income from operations.

 

Our net revenue was positively impacted by an overall decrease in deductions for uncompensated care of 57.6% or $8.4 million. We commonly refer to these deductions as charity care. Charity care was $6.1 million for

fiscal 2009 compared to $14.4 million for fiscal 2008. Charity care is recorded for patients that meet certain federal poverty guidelines and request charity consideration in line with our policy. The number of patients that qualified for charity care decreased during fiscal 2009 compared to fiscal 2008.

 

During fiscal 2009 and 2008, we recognized net negative contractual adjustments to our net revenue of $4.5 million and $1.4 million, respectively, related to the filing of prior years Medicare cost reports as well as other Medicare and Medicaid settlement adjustments. Therefore, these adjustments had a year over year negative impact of $3.1 million to net revenue.

 

Personnel expense.  Personnel expense increased 1.6% to $200.9 million for fiscal 2009 from $197.9 million for fiscal 2008. As a percentage of net revenue, personnel expense remained flat at 33.4% for the comparable periods.

 

We recognized share-based compensation expense of $2.4 million and $5.0 million for the fiscal years ended September 2009 and 2008, respectively. The $2.6 million decrease in share-based compensation expense was offset by an increase in personnel expense related to cost of living wage adjustments made during the first quarter of fiscal 2009 and an increase in our Hospital Division benefit costs related to our self-insured medical plan due to an increase in employee related medical claims during fiscal 2009.

 

Medical supplies expense.  Medical supplies expense increased 5.9% to $171.5 million, or 28.5% of net revenue, for fiscal 2009 from $161.9 million, or 27.4% of net revenue, for fiscal 2008. We experienced an increase in expense related to AICD’s, heart valves, drug-eluting stents and vascular graft supplies during fiscal 2009 offset by a reduction in expense for bare metal stents, orthopedic and chargeable medical supplies. The increase in AICD’s, heart valves, drug-eluting stents and vascular graft supplies was directly related to a combination of a higher utilization of supplies per procedure, an increase in the number of procedures performed or the use of higher cost supplies for these procedures. Conversely, the reduction in bare metal stents and orthopedic supplies is the direct result of lower utilization of supplies per procedure and lower cost for the units used per procedure.

 

Bad debt expense.  Bad debt expense increased 13.2% to $49.4 million for fiscal 2009 from $43.7 million for fiscal 2008. Total uncompensated care, which includes charity care deductions recorded as a reduction to patient revenue and bad debt expense, was $55.4 million for fiscal 2009, or 9.6% of Hospital Division net patient revenue, compared to $58.0 million, or 10.1% of Hospital Division net patient revenue for fiscal 2008. We have experienced an increase in bad debt expense primarily related to an increase in the uncollectibility of the self-pay balance after insurance and a reduction in patients that qualify for charity care and/or government assistance. The reduction in total uncompensated care to net revenue is due to improved collections during fiscal 2009. Our days sales outstanding were 43 for fiscal 2009 compared to 46 for fiscal 2008 (same facility basis).

 

Other operating expenses.  Other operating expenses increased 7.3% to $127.0 million for fiscal 2009 from $118.4 million for fiscal 2008. This increase is mainly driven by clinical and non-clinical contract services due to the growth in volume at several of our facilities, particularly emergency department visits, as well as increased maintenance costs at our hospitals as machinery warranties have expired at several of our facilities. These increases have been offset by a decline in administrative contract services and collection agency fees as these services are brought in-house to control costs and gain efficiencies. In addition, we incurred a $1.3 million increase in costs related to a new primary care physician group at one of our hospitals.

 

We also incurred $0.8 million in penalty expense for the anticipated settlement of regulatory claims at two of our hospitals related to the identification, return and self-reporting of $0.7 million in reimbursement for certain procedures performed at those hospitals in prior fiscal years, $1.1 million in professional fees associated with an internal assessment of certain controls and procedures completed during the quarter and $0.4 million in severance fees for fiscal 2009. However, these expenses were offset by lower Corporate and other and Partner Division costs for medical claims and decreased salaries and wages related to a reduction of employees in the Partners Division.

 

Pre-opening expenses.  We incurred approximately $3.6 million and $0.8 million in pre-opening expenses during fiscal 2009 and 2008. Pre-opening expenses represent costs specifically related to projects under development. As of September 30, 2009 and 2008, we had one hospital under development, Hualapai Medical Center in Kingman, Arizona, which opened on October 15, 2009. The amount of pre-opening expenses, if any, we incur in future periods will depend on the nature, timing and size of our development activities.

Depreciation.  Depreciation increased 5.7% to $31.8 million for the fiscal year ended September 30, 2009 as compared to $30.0 million for the fiscal year ended September 30, 2008. The increase in depreciation is the direct result of expansion at several of our facilities as well as the purchase of newer computer equipment to replace outdated hardware.

 

Interest expense.  Interest expense decreased 52.5% to $6.8 million for fiscal 2009 compared to $14.3 million for fiscal 2008. This $7.5 million decrease in interest expense is primarily attributable to the overall reduction in our outstanding debt, a decrease in the interest rate on our outstanding debt, and the capitalization of interest on our capital expansion projects. Capitalized interest was $2.7 million for fiscal 2009 compared to $1.3 million for fiscal 2008.

 

Loss on early extinguishment of debt.  During December 2008, we redeemed all of our outstanding 97/8% Senior Notes for $111.2 million, which included the payment of a repurchase premium of $5.0 million and accrued interest of $4.2 million. The Senior Notes were redeemed through borrowings under the Senior Secured Credit Facility and available cash on hand. In addition, we incurred $2.0 million in expenses related to the write-off of previously incurred financing costs associated with the Senior Notes. There was no loss on early extinguishment of debt for fiscal 2008.

 

Interest and other income, net.  Interest and other income, net decreased 88.3% to $0.2 million for fiscal 2009 compared to $2.0 million for fiscal 2008. The decrease is a result of the decrease in cash balances and the decrease in interest earned on cash balances during fiscal 2009.

 

Equity in net earnings of unconsolidated affiliates.  Equity in net earnings of unconsolidated affiliates increased $1.2 million to $9.1 million in fiscal 2009 from $7.9 million in fiscal 2008. The increase is attributable to a $1.6 million growth in earnings for our unconsolidated affiliates related to our Partners Division offset by a reduction of $0.4 million related to the Hospital Division. The increase for our Partners Division is the result of a new minority owned venture that had a full year of operations in fiscal 2009. The decline for our Hospital Division is the result of an overall net decrease in income from our two minority owned hospitals.

 

Minority interest share of earnings of consolidated subsidiaries.  Minority interest share of earnings of consolidated subsidiaries decreased $3.2 million in fiscal 2009 compared to fiscal 2008. The decline is the result of an overall net decrease in income before minority interest of certain of our established hospitals. We expect our earnings allocated to minority interests to fluctuate in future periods as we either recognize disproportionate losses and/or recoveries thereof through disproportionate profit recognition.

 

Income tax expense.  Income tax expense was $1.2 million for fiscal 2009 compared to $9.4 million for fiscal 2008, which represented an effective tax rate of 2.1% and 43.1%, respectively. The fiscal 2009 effective rate is below our federal statutory rate of 35% primarily due to the non-deductibility for income tax purposes of a majority of the $60.2 million impairment expense related to goodwill.

 

Income (loss) from discontinued operations, net of taxes.  Income from discontinued operations, net of taxes, reflects the results of Dayton Heart Hospital, Cape Cod Cardiology Services LLC, Sun City Cardiac Center Associates and the Heart Hospital of Lafayette for fiscal 2008 and fiscal 2009. Net income from discontinued operations was $8.1 million for fiscal 2009 compared to $8.6 million for fiscal 2008. Income from discontinued operations, net of taxes, includes the gains on the sale of Cape Cod Cardiology Services LLC and Sun City Cardiac Center Associates for fiscal 2009 offset by operating losses of other discontinued entities. Income from discontinued operations, net of taxes, for fiscal 2008 includes the gain recorded as a result of the sale of certain assets of Dayton Heart Hospital offset by operating losses of Dayton Heart Hospital prior to the sale.

Fiscal Year 2008 Compared to Fiscal Year 2007

 

Statement of Operations Data.  The following table presents our results of operations in dollars and as a percentage of net revenue:

 

 

During the fourth quarter of fiscal 2007, we completed a recapitalization of Harlingen Medical Center. As part of the recapitalization, our ownership in Harlingen Medical Center was reduced from a majority ownership of 51.0% to a minority ownership of 35.6%. Due to this change in ownership, we began accounting for Harlingen Medical Center as an equity investment at the beginning of the fiscal quarter ended September 30, 2007 as opposed to including Harlingen Medical Center in our consolidated results of operations. As such, our fiscal year 2008 and our fourth quarter of fiscal 2007 consolidated results exclude the financials results of Harlingen Medical Center. The following management discussion and analysis focuses on same facility results of operations and, therefore, excludes Harlingen Medical Center from the results of both fiscal 2008 and fiscal 2007 when appropriate.

Net revenue.  Net revenue decreased 7.1% to $591.6 million for our fiscal year ended September 30, 2008 from $636.5 million for our fiscal year ended September 30, 2007. Of this $44.9 million decrease in net revenue, our hospitals generated a $41.4 million decrease, our MedCath Partners division generated a $3.7 million decrease, our cardiology consulting and management operations generated a $0.3 million increase, and our corporate and other division generated a $0.1 million decrease.

 

On a same facility basis our net revenue increased $16.1 million, or 2.8% from the prior fiscal year.

 

We experienced a shift in inpatient to outpatient procedures during fiscal 2008. On a same facility basis our admissions were down 1.8% for the 2008 fiscal year compared to the 2007 fiscal year, however our adjusted admissions, which take into consideration outpatient visits, increased 3.8% as a result of the shift from inpatient to outpatient procedures. During fiscal 2008 we experienced an increase in net revenues of 66% and 67% from outpatient drug-eluting stents and bare metal stents, respectively, when compared to fiscal 2007. Net revenue from inpatient drug-eluting stents and bare metal stents were down 4.8% and 6.9%, respectively, on a same facility basis in fiscal 2008 compared to fiscal 2007.

 

Our net revenue has been negatively impacted by an overall increase in deductions for uncompensated care. We commonly refer to these deductions as charity care. Charity care was $14.5 million for fiscal 2008 compared to $4.9 million for fiscal 2007. Charity care is recorded for patients that meet certain federal poverty guidelines. The number of patients that qualified for charity care increased during fiscal 2008 compared to fiscal 2007.

 

During fiscal 2007, we recognized net negative contractual adjustments to our net revenue of $0.7 million related to the filing of our 2006 Medicare cost reports as well as other Medicare and Medicaid settlement adjustments. Further, the fiscal year ended September 30, 2007 was negatively impacted as a result of recording a $5.8 million reduction in net revenue for a portion of certain federal healthcare billings reimbursed in prior years. See Note 12 — Contingencies and Commitments of our consolidated financial statements. In contrast, we recognized negative contractual adjustments to our net revenue of $2.0 million during fiscal 2008 related to our Medicare cost reports and other Medicare and Medicaid settlement adjustments for prior fiscal periods.

 

Personnel expense.  Personnel expense decreased 3.8% to $197.9 million for fiscal 2008 from $205.6 million for fiscal 2007. As a percentage of net revenue, personnel expense increased to 33.4% from 32.3% for the comparable periods.

 

On a same facility basis, personnel expense increased to 33.4% of net revenue for the fiscal year ended September 30, 2008 from 32.3% for the fiscal year ended September 30, 2007. This increase is mainly due to cost of living wage adjustments made during the first quarter of fiscal 2008 and an increase in labor costs due to the continued demand for nurses and other technicians in several of our markets.

 

We recognized share-based compensation of $5.0 million and $4.3 million for the fiscal year ended September 2008 and 2007, respectively.

 

Medical supplies expense.  Medical supplies expense decreased 2.9% to $161.9 million for fiscal 2008 from $166.6 million for fiscal 2007.

 

Medical supplies expense on a same facility basis increased slightly to 27.4% from 27.3% as a percentage of net revenue for the fiscal year ending September 30, 2008 compared to the fiscal year ending September 30, 2007. Medical supplies expense as a percentage of adjusted admission has remained flat on a same facility basis year over year.

 

Bad debt expense.  Bad debt expense decreased 14.9% to $43.7 million for fiscal 2008 from $51.3 million for fiscal 2007. Same facility bad debt expense increased 12.9% to $43.7 million for fiscal 2008 compared to $38.7 million for fiscal 2007. Same facility bad debt expense also increased to 7.4% of net revenue for the fiscal year ending September 30, 2008 compared to 6.7% for the fiscal year ended September 30, 2007 due to a decrease in payments and write-offs as a percentage of patient billings. We have experienced an unfavorable trend regarding the collection of the portion of the amount due from patients after insurance and a decrease in the number of patients that qualify for Medicaid.

Other operating expenses.  Other operating expenses decreased 7.5% to $118.4 million for fiscal 2008 from $127.9 million for fiscal 2007. Same facility other operating expenses increased 3.2% to $118.4 million for fiscal 2008 compared to $115.0 million for fiscal 2007. We continue to see an increase in contract services due to the growth in volume at several of our facilities as well as increased maintenance costs at our hospitals as machinery warranties have expired at several of our facilities.

 

Pre-opening expenses.  We incurred approximately $0.8 million and $0.6 million in pre-opening expenses during fiscal 2008 and 2007. Pre-opening expenses represent costs specifically related to projects under development, primarily new hospitals. As of September 30, 2008 and 2007, we have one hospital under development, Hualapai Medical Center in Kingman, Arizona. The amount of pre-opening expenses, if any, we incur in future periods will depend on the nature, timing and size of our development activities.

 

Depreciation.  Depreciation decreased 2.9% to $30.0 million for the fiscal year ended September 30, 2008 as compared to $31.0 million for the fiscal year ended September 30, 2007.

 

On a same facility basis, depreciation increased 10.9% to $30.0 million for fiscal 2008 compared to $27.1 million for fiscal 2007. The depreciation increase is a result of the expansion and the investment in support software at several of our facilities.

 

Loss (gain) on disposal of property, equipment and other assets.  We incurred a loss on the disposal of property, equipment and other assets of $1.5 million in fiscal 2007 compared to a loss of $0.2 million in fiscal 2008. The 2007 loss was higher as a result of assets that were disposed and replaced with improved technology to ensure the highest state of the art care for our patients. The loss for fiscal 2008 is also due to the replacement of aged assets offset by a $0.2 gain on the sale of equipment by one of our managed ventures.

 

Interest expense.  Interest expense decreased 35.2% to $14.3 million for fiscal 2008 compared to $22.1 million for fiscal 2007. This $7.8 million decrease in interest expense is primarily attributable to the overall reduction in our outstanding debt as we repurchased approximately $36.2 million of our senior notes, repaid $21.2 million of our REIT loan at one of our facilities, repaid $11.1 million of our equipment loan at another of our facilities, and repaid $39.9 million of our senior secured credit facility during the fiscal year ended September 30, 2007.

 

Loss on early extinguishment of debt.  Loss on early extinguishment of debt for fiscal 2007 was $9.9 million for fiscal 2007. During the fiscal year ended September 30, 2007, this loss consisted of a $3.5 million repurchase premium and the write off of approximately $1.0 million of deferred loan acquisition costs related to the prepayment of a portion of our senior notes in December 2006. We also wrote off $0.5 million in deferred loan acquisition costs during fiscal 2007 related to the prepayment of $39.9 million of our senior secured credit facility. Further, upon early repayment of $11.1 million of our equipment loan at one of our facilities, we expensed approximately $0.2 million of deferred loan acquisition costs, and as part of the Harlingen Medical Center recapitalization transaction, we incurred a $3.5 million repurchase premium and expensed approximately $1.2 million of deferred loan acquisition costs. There was no loss on early extinguishment of debt for fiscal 2008.

 

Interest and other income, net.  Interest and other income, net decreased 74.0% to $2.0 million for fiscal 2008 compared to $7.8 million for fiscal 2007. The decrease is a result of the decrease in cash and the decrease in interest earned on cash balances during fiscal 2008.

 

Equity in net earnings of unconsolidated affiliates.  Equity in net earnings of unconsolidated affiliates increased to $7.9 million in fiscal 2008 from $5.7 million in fiscal 2007. The increase is attributable to growth in earnings for our unconsolidated affiliates related to our Hospital Division of $0.7 million and an increase in earnings for several new ventures in our MedCath Partners division. Equity in net earnings of unconsolidated affiliates related to our MedCath Partners division was $0.3 million for fiscal 2007 compared to $2.2 million for fiscal 2008.

 

Minority interest share of earnings of consolidated subsidiaries.  Minority interest share of earnings of consolidated subsidiaries decreased $2.1 million in fiscal 2008 compared to fiscal 2007. Our minority interest share of earnings can fluctuate as a result of our disproportionate share accounting for our partnership interests. Our partnership operating agreements may call for the recognition of losses or profits at amounts that are disproportionate to our partnership interest.

Income tax expense.  Income tax expense was $9.4 million for fiscal 2008 compared to $10.3 million for fiscal 2007, which represented an effective tax rate of approximately 43.1% and 44.8%, respectively. The decrease in the effective tax rate is due to the reduced impact of one-time permanent adjustments to derive taxable income.

 

Income (loss) from discontinued operations, net of taxes.  Income from discontinued operations, net of taxes, reflects the results of Dayton Heart Hospital, Heart Hospital of Lafayette, Cape Cod Cardiology Services and Sun City Cardiac Center Associates for fiscal 2007, fiscal 2008 and fiscal 2009. Net income from discontinued operations was $8.6 million for fiscal 2008 compared to a loss of $1.2 million for fiscal 2007. The Company evaluated the carrying value of the long-lived assets related to Heart Hospital of Lafayette during fiscal 2007 and determined that the carrying value was in excess of the fair value. Accordingly, an impairment charge of $4.1 million was recorded during the first quarter of fiscal 2007. The $4.1 million impairment charge was offset by net income related to Dayton Heart Hospital for fiscal 2007. Income from discontinued operations, net of taxes, for fiscal 2008 includes the gain recorded as a result of the sale of certain assets of Dayton Heart Hospital offset by operating losses of Dayton Heart Hospital prior to the sale.

Selected Quarterly Results of Operations

 

The following table sets forth quarterly consolidated operating results for each of our last five quarters. We have prepared this information on a basis consistent with our audited consolidated financial statements and included all adjustments that we consider necessary for a fair presentation of the data. These quarterly results are not necessarily indicative of future results of operations. This information should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report.

 

 

Our results of operations historically have fluctuated on a quarterly basis and can be expected to continue to be subject to quarterly fluctuations. Cardiovascular procedures can often be scheduled ahead of time, permitting some

patients to choose to undergo the procedure at a time and location of their preference. Some of the types of trends that we have experienced in the past and may experience again in the future include:

 

 

To the extent these types of events occur in the future, as in the past, we expect they will affect the quarterly results of operations of our hospitals.

 

Liquidity and Capital Resources

 

Working Capital and Cash Flow Activities.  Our consolidated working capital was $60.2 million at September 30, 2009 and $115.1 million at September 30, 2008. The decrease of $54.9 million in working capital primarily resulted from cash outflows for capital expenditures as a result of our hospital expansions, the repurchase of our Senior Notes, and the payment of federal and state income taxes offset by cash flows from operations.

 

At September 30, 2008 $3.2 million of cash was restricted and held in escrow as required by the city of Kingman, Arizona in conjunction with the Company’s development of the Hualapai Mountain Medical Center. The escrowed funds were released during the fourth quarter of fiscal 2009 upon our completion of the common infrastructure construction projects affecting the city of Kingman.

 

During the second quarter of fiscal 2007, we were informed by one of our Medicare fiscal intermediaries that outlier payments received prior to January 1, 2004 would not be disputed; therefore, we reversed $2.2 million that was originally recorded to account for outlier payments that had been received in 2003. At September 30, 2009 and 2008, we carried a reserve of $9.6 million and $9.1 million, respectively, for the outlier payments received in 2004.

 

The cash provided by operating activities from continuing operations was $64.8 million and $43.2 million for the years ending September 30, 2009 and 2008, respectively. The $21.6 million increase is primarily attributed to the decrease in federal and state income tax payments made during fiscal 2009 compared to fiscal 2008, offset by cash flows from operations.

 

Our investing activities from continuing operations used net cash of $89.0 million for fiscal 2009 compared to net cash used of $82.0 million for fiscal 2008. Net cash used by investing activities for fiscal 2009 and 2008 was primarily capital expenditures for the development of our hospital in Kingman, Arizona and expansion projects at two of our existing hospitals.

 

Our financing activities from continuing operations used net cash of $45.6 million during fiscal 2009 compared to net cash used of $60.2 million during fiscal 2008. The $14.6 decrease of net cash used for financing activities is due to the repurchase of common stock under our repurchase program during fiscal 2008 and a decrease in minority interest distributions; offset by an increase in overall long-term debt payments in fiscal 2009 related to the repurchase of our outstanding Senior Notes as further discussed in Note 9 of the consolidated financial statements included elsewhere in this report.

 

Capital Expenditures.  Cash paid for property and equipment for fiscal years 2009 and 2008 was $94.0 million and $66.7 million, respectively, primarily related to the development of our hospital in Kingman, Arizona and the expansion projects at two of our existing hospitals, which began during the year ended September 30, 2007. All expansion projects were completed during fiscal 2009, and our hospital in Kingman, Arizona opened in October 2009.

Obligations, Commitments and Availability of Financing.  As described more fully in the notes to our consolidated financial statements included elsewhere in this report, we had certain cash obligations at September 30, 2009, which are due as follows (in thousands):