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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
 
 
 
 
 
FORM 10-Q
 
 
 
 
 
 
(Mark one)
ý    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014.
OR
¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to __________
Commission file number: 001-33930
 
 
 
 
 
IPC THE HOSPITALIST COMPANY, INC.
(Exact name of registrant as specified in its charter) 
 
 
 
 
 
Delaware
95-4562058
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
 
4605 Lankershim Boulevard, Suite 617
North Hollywood, California
91602
(Address of principal executive offices)
(Zip code)
Registrant’s telephone number, including area code: (888) 447-2362 
 
 
 
 
 
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  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
ý
Accelerated filer
 
¨
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  ý
As of October 20, 2014, there were 17,222,466 shares of the registrant’s common stock, $0.001 par value, outstanding.
 



IPC The Hospitalist Company, Inc.
FORM 10-Q
QUARTERLY REPORT
TABLE OF CONTENTS
 
Note: Items 1A, 2, 3, 4 and 5 of Part II are omitted because they are not applicable.
 

2


PART I – FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

IPC The Hospitalist Company, Inc.
Consolidated Balance Sheets
(dollars in thousands, except for share data)
 
 
September 30,
2014
 
December 31,
2013
 
(Unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
25,470

 
$
25,010

Accounts receivable, net
110,664

 
103,585

Insurance receivable for malpractice claims, current portion
13,311

 
11,653

Prepaid expenses and other current assets
9,515

 
19,378

Total current assets
158,960

 
159,626

Property and equipment, net
7,217

 
6,343

Goodwill
388,194

 
357,387

Other intangible assets, net
5,161

 
5,857

Insurance receivable for malpractice claims, less current portion
23,512

 
20,599

Total assets
$
583,044

 
$
549,812

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued liabilities
$
9,446

 
$
5,486

Accrued compensation
42,281

 
35,639

Payable for practice acquisitions, current portion
28,904

 
32,430

Medical malpractice and self-insurance reserves, current portion
13,900

 
12,211

Deferred tax liabilities, current portion
969

 
969

Total current liabilities
95,500

 
86,735

Long-term debt
70,000

 
90,000

Medical malpractice and self-insurance reserves, less current portion
48,990

 
44,044

Payable for practice acquisitions, less current portion
6,955

 
8,289

Deferred tax liabilities, less current portion
5,762

 
5,762

Total liabilities
227,207

 
234,830

Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value, 15,000,000 shares authorized, none issued

 

Common stock. $0.001 par value, 50,000,000 shares authorized, 17,215,224 and 17,015,580 shares issued and outstanding at September 30, 2014 and December 31, 2013, respectively
17

 
17

Additional paid-in capital
179,291

 
167,926

Retained earnings
176,529

 
147,039

Total stockholders’ equity
355,837

 
314,982

Total liabilities and stockholders’ equity
$
583,044

 
$
549,812

The accompanying notes are an integral part of these consolidated financial statements.


3


IPC The Hospitalist Company, Inc.
Consolidated Statements of Income
(dollars in thousands, except for per share data)
(unaudited)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Net revenue
$
169,757

 
$
149,073

 
$
514,751

 
$
447,917

Operating expenses:
 
 
 
 
 
 
 
Cost of services—physician practice salaries, benefits and other
123,551

 
108,221

 
376,511

 
326,873

General and administrative
28,134

 
24,631

 
84,075

 
71,693

Net change in fair value of contingent consideration
2,390

 
282

 
1,312

 
(6,073
)
Depreciation and amortization
1,375

 
1,148

 
4,006

 
3,462

Total operating expenses
155,450

 
134,282

 
465,904

 
395,955

Income from operations
14,307

 
14,791

 
48,847

 
51,962

Investment income
2

 
7

 
4

 
12

Interest expense
(361
)
 
(109
)
 
(1,057
)
 
(323
)
Income before income taxes
13,948

 
14,689

 
47,794

 
51,651

Income tax provision
5,341

 
5,626

 
18,304

 
19,782

Net income
$
8,607

 
$
9,063

 
$
29,490

 
$
31,869

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.50

 
$
0.54

 
$
1.72

 
$
1.90

Diluted
$
0.49

 
$
0.52

 
$
1.68

 
$
1.85

 
The accompanying notes are an integral part of these consolidated financial statements.


4


IPC The Hospitalist Company, Inc.
Consolidated Statements of Cash Flows
(dollars in thousands)
(unaudited)
 
 
Nine Months Ended September 30,
 
2014
 
2013
Operating activities
 
 
 
Net income
$
29,490

 
$
31,869

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
4,006

 
3,462

Stock-based compensation expense
6,118

 
5,467

Changes in assets and liabilities:
 
 
 
Accounts receivable
(7,079
)
 
(10,755
)
Prepaid expenses and other current assets
9,645

 
9,788

Accounts payable and accrued liabilities
3,960

 
3,515

Accrued compensation
6,642

 
7,423

Medical malpractice and self-insurance reserves, net
2,064

 
1,973

Accrued contingent consideration
(1,023
)
 
(6,116
)
Net cash provided by operating activities
53,823

 
46,626

Investing activities
 
 
 
Acquisitions of physician practices
(35,138
)
 
(68,044
)
Purchase of property and equipment
(3,690
)
 
(3,032
)
Net cash used in investing activities
(38,828
)
 
(71,076
)
Financing activities
 
 
 
Proceeds from long-term debt

 
45,000

Repayments of long-term debt
(20,000
)
 
(20,000
)
Net proceeds from issuance of common stock
4,787

 
4,062

Excess tax benefits from stock-based compensation
678

 
1,653

Net cash (used in) provided by financing activities
(14,535
)
 
30,715

Net increase in cash and cash equivalents
460

 
6,265

Cash and cash equivalents, beginning of period
25,010

 
16,214

Cash and cash equivalents, end of period
$
25,470

 
$
22,479

Supplemental disclosure of cash flow information
 
 
 
Cash paid for:
 
 
 
Interest
$
1,061

 
$
324

Income taxes
$
14,453

 
$
13,579

 
The accompanying notes are an integral part of these consolidated financial statements.


5


IPC The Hospitalist Company, Inc.
Notes to the Consolidated Financial Statements
(Unaudited)
September 30, 2014

Note 1. Basis of Presentation and Significant Accounting Policies
Basis of Presentation
IPC The Hospitalist Company, Inc. and its wholly-owned subsidiaries (the “Company,” “IPC,” “we,” “us,” and “our”) is a national physician group practice company that operates and manages full-time hospitalist practices. We prepared the accompanying unaudited consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) on the same basis as our audited annual financial statements. The consolidated financial statements include all accounts of IPC The Hospitalist Company, Inc. and its wholly owned subsidiaries and consolidated professional medical corporations (Professional Medical Corporations) managed under long-term management agreements.

Through the management agreements and our relationship with the stockholders of the Professional Medical Corporations, we have exclusive authority over all non-medical decision making related to the ongoing business operations of the Professional Medical Corporations. Further, our rights under the management agreements are unilaterally salable or transferable. Based on the provisions of the agreements, we have determined that the Professional Medical Corporations are variable interest entities (VIE’s), and that we are the primary beneficiary because we have control over the operations of these VIE’s, provide full financial and management support to them, and take all residual benefits and bear all residual losses from their operations. Consequently, we consolidate the revenue and expenses of the Professional Medical Corporations from the date of execution of the agreements. All intercompany balances and transactions have been eliminated in consolidation.

In our opinion, these consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial information set forth therein. Certain information and footnote disclosures normally included in complete financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to GAAP and SEC rules and regulations, which are applicable to interim financial statements. As a result, the following disclosures should be read in conjunction with our audited consolidated financial statements and notes thereto as of December 31, 2013 included in our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on February 26, 2014.

Revenue
Net revenue consists of fees for medical services provided by our affiliated hospitalists under fee-for-service, case rate and other professional fee arrangements with various payors including Medicare, Medicaid, managed care organizations, insurance companies and hospitals. Net revenue is reported in the period in which services are provided at amounts expected to be collected, which excludes contractual discounts and an estimate of uncollectible accounts.

Use of Estimates
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions of the fair value of certain reported amounts of assets, liabilities, revenues and expenses at the date and for the periods that the financial statements are prepared. Significant estimates include the estimated net realizable value of accounts receivable, medical malpractice insurance receivable and payable for known claims, liabilities for claims incurred but not reported (IBNR) related to medical malpractice, fair value of contingent consideration related to business combinations and the analysis of goodwill for impairment. The process of estimating these assets and liabilities involves judgment decisions, which are subject to an inherent degree of uncertainty. Actual results could differ from those estimates. The results of operations for the current interim period are not necessarily indicative of the results for the entire year ending December 31, 2014.

Fair Value of Financial Instruments
Our consolidated balance sheets as of September 30, 2014 and December 31, 2013 included the following financial instruments: cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, payable for practice acquisitions and long-term debt. We consider the carrying amounts of cash and cash equivalents, accounts receivable and accounts payable and accrued liabilities to approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization. The carrying amount of our long-term debt borrowed from our line of credit approximated its fair value at September 30, 2014 and December 31, 2013. Pursuant to GAAP, we determine

6


the fair value of our long-term borrowing using observable inputs, which are defined as Level 2 inputs under GAAP on fair value measures. See Note 3 for the definition of Level 2 inputs under GAAP.

Our payable for practice acquisitions consisted of accrued contingent consideration for practice acquisitions. The accrued contingent consideration is carried at fair value largely determined using the income approach with unobservable inputs defined as Level 3 inputs under GAAP. See Note 3 for the definition of Level 3 inputs under GAAP and more information.

Goodwill
The changes in the carrying amount of goodwill for the nine months ended September 30, 2014 are as follows (in thousands):
Goodwill - beginning balance at January 1, 2014
$
357,387

Goodwill acquired during 2014
32,668

Adjustment for prior year transactions
(1,861
)
Goodwill - ending balance at September 30, 2014
$
388,194


The valuation studies related to the practice acquisitions that occurred in the fourth quarter of 2013 were completed in early 2014, and as a result, the value of contingent consideration liability related to these acquisitions as of the acquisition dates was reduced by $1,861,000, along with a corresponding reduction in our goodwill.

Medical Malpractice Liability Insurance
We record our medical malpractice reserves, on an undiscounted basis, for claims incurred and reported and claims incurred but not reported (IBNR) during the policy period, based on actuarial loss projections using historical loss patterns. For claims incurred and reported, an insurance receivable from our carrier has been recorded pursuant to GAAP. Total accrued medical malpractice reserves and related insurance receivables were as follows (in thousands):
 
 
September 30, 2014
 
December 31, 2013
 
Assets
 
Liabilities
 
Assets
 
Liabilities
 
Insurance
Receivable
 
Claims
Reserve
 
IBNR
Reserve
 
Total
Liabilities
 
Insurance
Receivable
 
Claims
Reserve
 
IBNR
Reserve
 
Total
Liabilities
Current Portion
$
13,311

 
$
13,311

 
$
589

 
$
13,900

 
$
11,653

 
$
11,653

 
$
558

 
$
12,211

Long-term Portion
23,512

 
23,512

 
25,478

 
48,990

 
20,599

 
20,599

 
23,445

 
44,044

Total
$
36,823

 
$
36,823

 
$
26,067

 
$
62,890

 
$
32,252

 
$
32,252

 
$
24,003

 
$
56,255


New Accounting Principles
In May 2014, the Financial Accounting Standard Board issued a GAAP update "Revenue from Contracts with Customers". This GAAP update requires entities to recognize revenue when it transfers promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. This GAAP update also requires more detailed disclosures to enable users of the financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The GAAP update is effective for fiscal years (and interim reporting periods within fiscal years) beginning after December 15, 2016. We are currently evaluating the impact of the GAAP update on our consolidated financial position, results of operations and cash flows.

Note 2. Business Acquisitions

For practice acquisitions, we recognize all of the assets acquired, liabilities assumed and any contingent consideration at the acquisition-date fair value and expense all transaction related costs.

During the nine months ended September 30, 2014, we completed the acquisition of fifteen hospitalist physician practices. In connection with these acquisitions, we recorded goodwill and other identifiable intangible assets consisting of physician and hospital agreements.

Goodwill represents the potential business synergy from the combined operations of our existing and acquired practices through an expanded national network of providers, improved managed care contracting, improved collections, identification of

7


growth initiatives and cost savings based upon the significant infrastructure we have developed. Amounts recorded as goodwill and identifiable intangible assets with indefinite lives are not amortizable for GAAP financial reporting purposes but are amortized for tax purposes over 15 years.

In addition to the initial consideration paid at the close of each transaction, the asset purchase agreements for the fifteen acquisitions completed during the nine months ended September 30, 2014 provide for contingent consideration to be paid, which is generally based upon the achievement of certain operating results of the acquired practices as of certain measurement dates. These additional payments are not contingent upon the future employment of the sellers. The contingent consideration for the seven acquisitions completed during the three months ended September 30, 2014 was recorded on a provisional basis pending completion of the valuation studies as of the acquisition dates.

We estimate the fair value of contingent consideration to be paid based on discounted projected earnings of the acquired practices as of certain measurement dates. The discount rate that we use consists of a risk-free U.S. Treasury bond yield plus a Company specific credit spread which we believe is acceptable by willing market participants.

The following table summarizes the total amounts recorded during the nine months ended September 30, 2014 related to the acquisition of hospitalist practices (in thousands):
 
Acquired assets – paid and accrued:
 
Goodwill - 2014 transactions
$
32,668

Other intangible assets
494

Total acquired assets - 2014
33,162

Goodwill - adjustment for prior year transactions
(1,861
)
 
31,301

Cash paid for acquisitions:
 
2014 transactions
(20,429
)
Contingent consideration
(14,709
)
Total cash paid for acquisitions
(35,138
)
 
 
Change in accrued contingent consideration
(1,023
)
Net change in payable for practice acquisitions
(4,860
)
Payable for practice acquisitions, beginning of period
40,719

Payable for practice acquisitions, end of period
$
35,859


Note 3. Fair Value Measurement

Some of our liabilities are measured and recorded at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). The established fair value hierarchy distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (Levels 1 and 2) and the reporting entity’s own assumptions about market participant assumptions (Level 3). This hierarchy is used to measure fair value as follows:
 
Level 1 inputs utilize quoted prices in active markets for identical assets or liabilities.
Level 2 inputs include quoted prices for similar assets and liabilities in active markets; quoted prices in markets that are not active; and other inputs that are observable or can be corroborated by observable market data for the asset or liability.
Level 3 inputs are unobservable inputs for the asset or liability that are supported by little or no market activity.


8


The following table presents our liabilities measured at fair value on a recurring basis as of September 30, 2014 (in thousands):
 
 
Quoted Price In
Active Markets for
Identical Instruments
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total Balance
Accrued contingent consideration for practice acquisitions (included in payable for practice acquisitions)
$

 
$

 
$
35,859

 
$
35,859

The following table presents a rollforward of our liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2014 (in thousands):
 
 
Three Months Ended 
 September 30, 2014
 
Nine Months Ended 
 September 30, 2014
Accrued contingent consideration for practice acquisitions
 
 
 
Beginning balance
$
29,360

 
$
40,719

Addition through acquisition transactions
6,207

 
12,733

Adjustment for prior year transactions

 
(1,861
)
Change in accrued contingent consideration
2,281

 
(1,023
)
Payments
(1,989
)
 
(14,709
)
Ending balance
$
35,859

 
$
35,859

The fair value of our accrued contingent consideration is determined using widely accepted valuation techniques, which include the income approach for estimating future consideration to be paid based on projected earnings of our acquired practices as of specified measurement dates. The income approach involves the use of a probability-weighted discounted cash flow model based on significant inputs not observable in the market. The significant inputs include discount rates of 1.93% to 2.60% and 10% to 100% probability of achieving the estimated projected earnings or the achievement of certain other objectives.
Because our accrued contingent consideration is generally based on a certain multiple of earnings of the acquired practices during a specified measurement period, a moderate change in such projected earnings may result in a material change to the fair value of such contingent consideration liability with a corresponding adjustment to income from operations. We reassess our projected earnings and the related fair value of our accrued contingent consideration for practice acquisitions on a quarterly basis.

Note 4. Debt

Our secured revolving credit agreement (Credit Facility) provides a revolving line of credit of $125.0 million and contains an “accordion” feature that allows an increase of up to $25.0 million to the Credit Facility with lender approval. The Credit Facility has a maturity date of August 4, 2016 and is available for working capital, practice acquisitions, capital expenditures and general business expenses. As of September 30, 2014, we had borrowings of $70.0 million and letters of credit of $0.3 million outstanding, and $54.7 million available under the Credit Facility.

The revolving line of credit is limited by a formula based on a certain multiple times the trailing twelve months of earnings before interest, taxes, depreciation, amortization and certain non-cash items. Interest rate options for each borrowing under the Credit Facility, to be selected by us at the time of each borrowing, include either LIBOR plus 0.75% to 1.75%, or the lender’s prime rate plus 0% to 0.75%, both based on a leverage ratio. We pay an unused commitment fee equal to 0.25% per annum on the difference between the revolving line capacity and the average balance outstanding during the year. Outstanding amounts advanced to us under the revolving line of credit are repayable on or before the maturity date. The interest rate for our borrowings under the Credit Facility at September 30, 2014 was 1.4375% per annum.

The Credit Facility is guaranteed by our subsidiaries and affiliated Professional Medical Corporations and limited liability companies, and is secured by substantially all of our and our guarantors’ tangible and intangible assets. The Credit

9


Facility includes various customary financial covenants and restrictions, as well as customary remedies for our lenders following an event of default. As of September 30, 2014, we were in compliance with such financial covenants and restrictions.

Note 5. Income Taxes

The following table sets forth our income tax provisions and effective tax rates for the three and nine months ended September 30, 2014 and 2013 (dollars in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Income tax provision
$
5,341

 
$
5,626

 
$
18,304

 
$
19,782

Effective tax rate
38.3
%
 
38.3
%
 
38.3
%
 
38.3
%

The effective tax rates differ from the statutory U.S. federal income tax rate of 35.0% due primarily to state income taxes.

Our accounting policy is to include interest and penalties related to income tax liabilities in income tax expense. As of September 30, 2014, we did not have any estimated interest and penalties related to uncertain tax positions.

The tax years 2009 to 2013 remain open to examination by the major taxing jurisdictions to which we are subject. The statute of limitations for tax years 1999 to 2008 has expired, except that the tax year 1999 is subject to adjustment of net operating losses by the Internal Revenue Service. We are subject to taxation in the United States and various state jurisdictions. We are currently subject to one state tax examination for the tax year of 2009. The outcome of the examination cannot be predicted with certainty; however, we believe that the ultimate resolution will not have a material effect on our consolidated financial position, results of operations, or cash flows.

We make our best estimate of the tax rate expected to be applicable for the full fiscal year. The rate so determined is used to compute our income tax expense for an interim period.

Note 6. Stock-Based Compensation

At September 30, 2014, we had a stock-based employee compensation program, for which we had reserved a total of 4,943,170 common shares for issuance. Under our 2012 Equity Participation Plan (Equity Plan), which was approved by our stockholders on June 7, 2012, a total of 1,422,130 shares of our common stock were available for issuance and no new awards will be issued under any previous equity participation plans. As of September 30, 2014, there were 927,912 shares of our common stock available for future grants under our Equity Plan, which included the canceled and forfeited shares issued under previous equity participation plans.

All option awards granted during the nine months ended September 30, 2014 were issued with exercise prices equal to the closing price of our common stock on the NASDAQ Global Select Market on the dates of the grant. The options under the Equity Plan generally vest over a four-year period from date of grant, and options terminate on the 10th anniversary of the agreement date for all grants issued before January 1, 2013 and on the 7th anniversary of the agreement date for all grants issued after December 31, 2012. Restricted stock awards generally vest over a four-year period from date of the award. Performance stock awards generally vest over two to three years from date of the award based on the expected level of achievement of certain operational goals that will be obtained and adjusted as appropriate to reflect actual shares issued.

Stock-based compensation expense is recognized over the period when the options, restricted stock awards, performance stock awards and our employee stock purchase plan shares vest, which is included in total general and administrative expenses as follows (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Total stock-based compensation expense
$
2,094

 
$
1,869

 
$
6,118

 
$
5,467

Tax benefit from stock-based compensation expense
(802
)
 
(716
)
 
(2,343
)
 
(2,094
)
Total stock-based compensation expense, net of tax
$
1,292

 
$
1,153

 
$
3,775

 
$
3,373



10


As of September 30, 2014, total unrecognized compensation costs related to non-vested stock-based compensation arrangements granted under our Equity Plan and previous equity participation plans and the weighted-average period of years expected to recognize those costs are as follows (dollars in thousands):
 
Total Unrecognized
Compensation
Cost
 
Weighted -average
Remaining Recognition
Period
 
 
 
(Years)
Stock option
$
2,507

 
1.48
Restricted/Performance stock
$
7,855

 
1.96

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model based on the following weighted-average assumptions:
 
Nine Months Ended September 30,
 
2014
 
2013
Risk-free interest rate
1.03
%
 
0.67
%
Expected volatility
37.05
%
 
40.07
%
Expected option life (in years)
4.39

 
4.40

Expected dividend yield
%
 
%

The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero coupon issues. The expected volatility is largely based on the volatility of our stock price. The expected option life of each award granted was calculated using the “simplified method” in accordance with GAAP.

The grant date fair value of each restricted stock award or performance stock award is based on the closing stock price on the grant date of the award as reported by NASDAQ Global Select Market.

The following table summarizes the stock option activities in our Equity Plan during the nine months ended September 30, 2014:
 
Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
 
Weighted-
Average 
Fair
Value
 
 
 
 
 
(Years)
 
(in 000s)
 
 
Options outstanding as of December 31, 2013
1,380,425

 
$
30.12

 
 
 
 
 
$
12.56

Changes during period:
 
 
 
 
 
 
 
 
 
Granted
39,138

 
55.12

 
 
 
 
 
17.49

Exercised
(124,023
)
 
29.24

 
 
 
 
 
12.48

Cancelled
(39,188
)
 
42.36

 
 
 
 
 
17.90

Options outstanding as of September 30, 2014
1,256,352

 
$
30.60

 
5.39
 
$
18,542

 
$
12.56

Options exercisable as of September 30, 2014
1,102,773

 
$
28.96

 
5.20
 
$
17,897

 
$
12.02



11


The following table summarizes the restricted stock award and performance stock award activities in our Equity Plan during the nine months ended September 30, 2014:
 
Shares
 
Weighted-
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
 
Weighted-
Average
Fair
Value
 
 
 
(Years)
 
(in 000s)
 
 
Restricted/performance stock awards outstanding as of December 31, 2013
212,413

 
 
 
 
 
$
40.29

Changes during period:
 
 
 
 
 
 
 
Granted
113,376

 
 
 
 
 
52.33

Vested
(53,571
)
 
 
 
 
 
38.76

Forfeited
(9,301
)
 
 
 
 
 
42.82

Restricted/performance stock awards outstanding as of September 30, 2014
262,917

 
1.39
 
$
11,012

 
$
45.70


Note 7. Earnings Per Share

Basic net income per share is calculated by dividing net income for the period by the weighted-average number of common shares outstanding during the period. Diluted net income per share is calculated by dividing net income for the period by the weighted average number of shares outstanding during the period plus the dilutive effect of our outstanding stock awards and shares issuable under our employee stock purchase plan using the treasury stock method.

The calculations of basic and diluted net income per share for the three and nine months ended September 30, 2014 and 2013 are as follows (dollars in thousands, except for per share data):
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Basic:
 
 
 
 
 
 
 
Net income attributable to common stockholders
$
8,607

 
$
9,063

 
$
29,490

 
$
31,869

Weighted average number of common shares outstanding
17,187,819

 
16,839,069

 
17,122,574

 
16,769,085

Basic net income per share attributable to common stockholders
$
0.50

 
$
0.54

 
$
1.72

 
$
1.90

Diluted:
 
 
 
 
 
 
 
Net income attributable to common stockholders
$
8,607

 
$
9,063

 
$
29,490

 
$
31,869

Weighted average number of common shares outstanding
17,187,819

 
16,839,069

 
17,122,574

 
16,769,085

Weighted average number of dilutive common share equivalents from options to purchase common stock
465,073

 
529,357

 
469,302

 
470,211

Common shares and common share equivalents
17,652,892

 
17,368,426

 
17,591,876

 
17,239,296

Diluted net income per share
$
0.49

 
$
0.52

 
$
1.68

 
$
1.85

Outstanding stock options that have an above-market exercise price or that are anti-dilutive under the treasury stock method, are excluded from our diluted computation. As of September 30, 2014, the total number of excluded stock options was 77,576.

Note 8. Commitments and Contingencies

Legal

In the ordinary course of our business, we become involved in pending and threatened legal actions and proceedings, most of which involve claims of medical malpractice related to medical services provided by our affiliated hospitalists. We may also become subject to other lawsuits, which could involve significant claims and/or significant defense costs.


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We believe, based upon our review of pending actions and proceedings, that the outcome of such legal actions and proceedings will not have a material adverse effect on our business, financial condition, results of operations, or cash flows. The outcome of such actions and proceedings, however, cannot be predicted with certainty and an unfavorable resolution of one or more of them could have a material adverse effect on our business, financial condition, results of operations, or cash flows in a future period.

Government Claim

On June 7, 2010, we received a civil investigative demand (CID) issued by the Department of Justice (DOJ), U.S. Attorney’s Office for the Northern District of Illinois. The CID requested information concerning claims that we have submitted to Medicare and Medicaid. The CID covered the period from January 1, 2003, through June 4, 2010 and requested production of a range of documents relating to our Medicare and Medicaid participation, physician arrangements, operations, billings and compliance programs. We believe we have a strong compliance focus and that we operate with appropriate billing policies, procedures, provider training, and compliance programs and controls. We produced responsive documents and were in contact with representatives of the DOJ who informed us that the inquiry related to a qui tam whistleblower action filed under court seal in the U.S. District Court for the Northern District of Illinois (Chicago) (U.S. District Court). We also were informed that several state attorneys general were examining our Medicaid claims in coordination with the DOJ.

Though we cooperated with the government’s investigation and would welcome a resolution to this matter, we are now in active litigation with the federal government regarding this matter and intend to contest the case vigorously. On December 6, 2013, the U.S. District Court partially lifted the seal on the civil False Claims Act case related to this investigation. The unsealed portions of the Court docket include, among other documents, the whistleblower’s Complaint, which contains allegations of improper billing to Medicare and Medicaid, a Notice of Election to Intervene filed by the federal government and a Notice of Election to Decline Intervention filed by the State of Illinois and 12 other states that participated in the investigation. On June 16, 2014, the federal government filed its Complaint in Intervention against IPC and several of its subsidiaries in the U.S. District Court. The Complaint in Intervention contains allegations of improper billing to Medicare, Medicaid and other federal programs from January 1, 2003 to the present, seeks to recover treble damages and civil penalties under the civil False Claims Act, and seeks to recover damages under the common law theories of payment by mistake and unjust enrichment. On August 13, 2014, IPC and the IPC subsidiary defendants filed a joint motion to dismiss the Complaint in Intervention or, in the alternative, to sever claims against the defendants. The federal government filed its response on September 18, 2014, to which the defendants replied on September 25, 2014. The court’s decision regarding the joint motion to dismiss has not yet been issued.

It is not possible to predict when this matter may be resolved, the time or resources that we will need to devote to this litigation, or what impact, if any, the outcome of this matter might have on our consolidated financial position, results of operations, or cash flows.

Note 9. Subsequent Events

Subsequent to September 30, 2014, we acquired the assets of two hospitalist physician practices.
On October 20 and 24, 2014, shareholder derivative lawsuits were filed in the Court of Chancery of the State of Delaware against certain current and former directors and officers of IPC.  IPC is named as a nominal defendant in both suits.  The actions both assert alleged breaches of fiduciary duties related to IPC’s billing practices, and incorporate allegations from the False Claims Act case.  The lawsuits seek a variety of relief, including monetary damages and injunctive relief.  The litigation is in an early stage and the complaints have not yet been served. It is not possible to predict when these matters may be resolved, the time or resources that we will need to devote to this litigation, or what impact, if any, the outcome of these matters might have on our consolidated financial position, results of operations, or cash flows.


13



ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following management’s discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and the notes thereto included in this Quarterly Report. In addition, reference is made to our audited consolidated financial statements and notes thereto and related Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our most recent Annual Report on Form 10-K for the year ended December 31, 2013 filed with the Securities and Exchange Commission (SEC) on February 26, 2014.

The following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding future events and the future results of IPC that are based on management’s current expectations, estimates, projections, and assumptions about our business. Words such as “may,” “will,” “could,” “should,” “target,” “potential,” “project,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “sees,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements due to numerous factors, including, but not limited to, those discussed in our most recent Annual Report on Form 10-K, including the section entitled “Risk Factors,” as well as those discussed from time to time in the Company’s other SEC filings and reports. In addition, such statements could be affected by general industry and market conditions. Such forward-looking statements speak only as of the date of this Quarterly Report or, in the case of any document incorporated by reference, the date of that document, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Quarterly Report, or for changes made to this document by wire services or internet service providers. If we update or correct one or more forward-looking statements, investors and others should not conclude that we will make additional updates or corrections with respect to other forward-looking statements.

Company Overview and Recent Developments
We are a leading provider of hospitalist services in the United States. Hospitalist medicine is organized around inpatient care and is primarily focused on providing, managing and coordinating the care of hospitalized patients. Hospitalists practice in inpatient facilities, including acute care hospitals, long-term care facilities, specialty hospitals, psychiatric facilities and post-acute care facilities. We believe we are the largest dedicated hospitalist company in the United States based on revenues, patient encounters and number of affiliated hospitalists. Our early entry into the emerging hospitalist industry has permitted us to establish a reputation and leadership position that we believe is closely identified with hospitalist medicine.

Business Acquisitions
During the nine months ended September 30, 2014, we acquired fifteen hospitalist physician practices for a total estimated purchase price of $33,162,000. In connection with these acquisitions, we recorded goodwill of $32,668,000 and identifiable intangible assets of $494,000. Total transaction costs of $141,000 for our acquisition activities during the nine months ended September 30, 2014 were expensed as incurred.

In connection with these fifteen acquisitions, we recorded liabilities of $12,733,000 representing the fair value of future contingent consideration to be paid based upon the estimated achievement of certain operating results of the acquired practices as of certain measurement dates. The contingent consideration for the seven acquisitions completed during the three months ended September 30, 2014 was recorded on a provisional basis pending completion of the valuation studies as of the acquisition dates. The finalized fair value of contingent considerations is re-evaluated on a quarterly basis based on changes in our estimate of the operating results of future periods. The changes in fair value, if any, are recognized in our results of operations. Because the fair value of contingent consideration is generally based on a certain multiple of operating results of the acquired practices during a measurement period, a moderate change in projected operating results can result in a large change to the fair value of such contingent consideration.

The net change in fair value of contingent consideration (“net change in fair value”) for acquisitions was an increase to expense of $2.4 million and $0.3 million for the three months ended September 30, 2014 and 2013, respectively. The net change in fair value for the nine months ended September 30, 2014 and 2013 was an increase to expense of $1.3 million and a reduction to expense of $6.1 million, respectively.


14


Income from operations, which includes the net change in fair value, and diluted earnings per share for the three months ended September 30, 2014 was $14.3 million (a decrease of 3.3%) and $0.49 diluted earnings per share, respectively, compared with $14.8 million and $0.52 diluted earnings per share, respectively, for the same period in the prior year. Excluding the net change in fair value, income from operations and diluted earnings per share for the three months ended September 30, 2014 was $16.7 million (an increase of 10.8%) and $0.57 diluted earnings per share, respectively, compared with $15.1 million and $0.53 diluted earnings per share, respectively, for the same period in the prior year.

Income from operations, which includes the net change in fair value, and diluted earnings per share for the nine months ended September 30, 2014 was $48.8 million (a decrease of 6.0%) and $1.68 diluted earnings per share, respectively, compared with $52.0 million and $1.85 diluted earnings per share, respectively, for the same period in the prior year. Excluding the net change in fair value, income from operations and diluted earnings per share for the nine months ended September 30, 2014 was $50.2 million (an increase of 9.3%) and $1.72 diluted earnings per share, respectively, compared with $45.9 million and $1.63 diluted earnings per share, respectively, for the same period in the prior year.
Rate Changes by Government Sponsored Programs
The Medicare program reimburses for our services based upon the rates set forth in the annually updated Medicare Physician Fee Schedule, which relies, in part, on a target-setting formula system called the Sustainable Growth Rate (SGR). Many private payors use the Medicare Physician Fee Schedule to determine their own reimbursement rates. On December 10, 2013, the Centers for Medicare and Medicaid Services (CMS) published its final Medicare Physician Fee Schedule for calendar year 2014. Effective January 1, 2014, the Medicare update resulted in a slight increase in our net patient revenue per encounter.

The annual Medicare Physician Fee Schedule update, based on the SGR, is adjusted to reflect the comparison of actual expenditures to target expenditures. Because one of the factors for calculating the SGR is linked to the growth in the U.S. gross domestic product (GDP), the SGR formula may result in a negative payment update if growth in Medicare beneficiaries’ use of services exceeds GDP growth, a situation which has occurred every year since 2002 and the reoccurrence of which we cannot predict.

Congress has repeatedly intervened to delay the implementation of the negative SGR payment update. For example, with the enactment of the Bipartisan Budget Act of 2013 on December 26, 2013, the 20.1 percent cut that was to occur was replaced with a 0.5 percent increase for services provided through March 31, 2014. On April 1, 2014, with the enactment of the Protecting Access to Medicare Act of 2014, Congress prevented the 24 percent cut that was to occur by continuing the previously implemented 0.5 percent payment increase through December 31, 2014 and maintaining a zero percent payment update from January 1, 2015 through March 31, 2015. There is, however, no guarantee that Congress will continue to postpone implementation of the negative SGR payment update in the future. Moreover, the existing methodology may result in significant yearly fluctuations in the Medicare Physician Fee Schedule amounts, which may be unrelated to changes in the actual costs of providing physician services. Unless Congress enacts a permanent change in the SGR methodology, the uncertainty regarding reimbursement rates and fluctuation will continue to exist.

Another provision that affects physician payments is an adjustment under the Medicare statute to reflect the geographic variation in the cost of delivering physician services, by comparing those costs to the national average. This concerns the “work” component of the Geographic Practice Cost Indices (GPCI). If Congress does not block this adjustment, payments would be decreased to any geographic area with an index of less than 1.0. Although Congress has delayed the GPCI payment adjustment several times, most recently in the Protecting Access to Medicare Act of 2014, which blocks the GPCI payment adjustment until April 1, 2015, there is no guarantee that Congress will block the adjustment in the future, which could result in a decrease in the payments we receive for physician services.

The Budget Control Act of 2011 (BCA) established a Joint Select Committee on Deficit Reduction, which was tasked with achieving a reduction in the federal debt level of at least $1.2 trillion. That Committee did not draft a proposal by the BCA’s deadline. As a result, automatic cuts (i.e., sequestration) in various federal programs were scheduled to take place, beginning in January 2013. The American Taxpayer Relief Act of 2012 delayed implementation of the BCA’s automatic cuts until March 1, 2013, but, on March 1, 2013, President Obama signed a sequestration order that triggered the BCA’s automatic cuts, including a two percent cut in Medicare payments to providers that was implemented, effective April 1, 2013 through 2021. Thus far, this 2.0 percent net reduction in Medicare reimbursement rates for the codes applicable to the services performed by our affiliated hospitalists reduced our net patient revenue per encounter by approximately 1.0 percent.

Additionally, the Bipartisan Budget Act of 2013 extended the 2% sequestration cut for Medicare through fiscal year 2023, and a bill signed by the President on February 15, 2014 further extended this cut for an additional year, through fiscal year

15


2024. The Protecting Access to Medicare Act of 2014 realigned the fiscal year 2024 Medicare sequestration amounts so that there will be a 4.0 percent sequester for the first six months and a zero percent sequester for the second six months, instead of a 2.0 percent sequester for the full twelve-month period. Moreover, the instability of the federal budget may lead to legislation that could result in further cuts in Medicare and Medicaid payments to providers. On September 19, 2014, President Obama signed into law an approximately $1 trillion Continuing Appropriations Resolution that funds the government through December 11, 2014, or until enactment of specified appropriations legislation. However, this new law is a temporary measure that does not resolve the debt-limit issue, and the Medicare program is frequently mentioned as a target for spending cuts.

Healthcare Reform
In March 2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, ACA) was enacted. The ACA includes a number of provisions that may affect our Company, although the impact of many of the changes will be unknown until they are fully implemented, which in some cases will not occur for a couple of years. The impact of some of these provisions have already proven to be positive, such as the Primary Care Incentive Payment Program (PCIP), which makes a ten percent Medicare bonus payment for primary care services (including outpatient and nursing home visits) furnished on or after January 1, 2011 and before January 1, 2016 to primary care practitioners for whom primary care services represented a minimum of 60 percent of Medicare allowed charges in a prior period, and the increase in Medicaid rates up to the level of Medicare rates (Medicaid parity) in 2013 and 2014 for primary care services. Another positive provision is the expansion in the number of individuals with health insurance, which started in January 2014.

The impact of other provisions is unknown at this time, such as the establishment of an Independent Payment Advisory Board (the “IPA Board”)-a fifteen-member board which is tasked with making proposals to Congress and the U.S. Department of Health and Human Services (HHS) to reduce the per capita rate of growth in Medicare spending in years when that growth exceeds established targets. HHS generally will be required to implement these proposals unless Congress enacts superseding legislation. Pursuant to statute, the IPA Board’s first set of recommendations were due on January 15, 2014. However, as of late 2014, the President had yet to nominate anyone to serve on the IPA Board.

Fraud and abuse penalty increases and the expansion in the scope of the reach of the federal False Claims Act and other government enforcement tools may adversely impact entities in the healthcare industry, including our Company.

The impact of certain provisions will depend upon the ultimate method of implementation. For example, the ACA requires HHS to develop a budget neutral, value-based payment modifier that provides for differential payment under the Medicare Physician Fee Schedule for physicians or groups of physicians that is linked to quality of care furnished compared to cost. CMS has continued to implement the modifier through the Medicare Physician Fee Schedule rulemaking for 2014, by, among other things, finalizing its proposal to apply the value-based payment modifier to groups of physicians with 10 or more eligible professionals in calendar year 2016 and to expand the modifier to all physicians in calendar year 2017. The impact of this payment modifier cannot be determined at this time.

In addition, certain provisions of the ACA authorize voluntary demonstration projects, which include the development of bundling payments for acute, inpatient hospital services, physician services, and post-acute services for episodes of hospital care. The Medicare Bundled Payments for Care Improvement Initiative is currently underway and assesses four models of care linking payments for multiple services provided to beneficiaries during an episode of care. The impact of these projects on our Company cannot be determined at this time.

Seasonality and Quarterly Fluctuations
We have historically experienced and expect to continue to experience quarterly fluctuations in net revenue and income from operations. Absent the impact and timing of acquisitions, our net revenue has historically been higher in the first and fourth quarters of the year primarily due to the following factors:
 
the number of physicians we have on staff during the quarter, which may fluctuate based upon the timing of hires due to the end of the academic year for graduating resident physicians, the schedule of the Internal Medicine Board exams and terminations in our existing practices; and

fluctuations in patient encounters, which are impacted by hospital census, which can be volatile, and physician productivity and often reflect seasonality due to the higher occurrence of illnesses such as flu and pneumonia in patient populations in the first quarter.


16


We have significant fixed operating costs, including physician practice salaries and benefits and, as a result, are highly dependent on patient encounters and the productivity of our affiliated hospitalists to sustain profitability. Additionally, quarterly results may be affected by the timing of practice acquisitions and the hiring and termination of our affiliated hospitalists.

Results of Operations and Operating Data
The following table sets forth operating data and selected consolidated statement of income information stated as a percentage of net revenue:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Operating data – patient encounters
1,749,000

 
1,509,000

 
5,240,000

 
4,598,000

 
 
 
 
 
 
 
 
Net revenue
100.0
 %
 
100.0
%
 
100.0
%
 
100.0
 %
Operating expenses:
 
 
 
 
 
 
 
Cost of services—physician practice salaries, benefits and other
72.8
 %
 
72.6
%
 
73.1
%
 
73.0
 %
General and administrative
16.6
 %
 
16.5
%
 
16.3
%
 
16.0
 %
Net change in fair value of contingent consideration
1.4
 %
 
0.2
%
 
0.3
%
 
(1.4
)%
Depreciation and amortization
0.8
 %
 
0.8
%
 
0.8
%
 
0.8
 %
Total operating expenses
91.6
 %
 
90.1
%
 
90.5
%
 
88.4
 %
Income from operations
8.4
 %
 
9.9
%
 
9.5
%
 
11.6
 %
Investment income
                  –

 
%
 
                  –

 
 %
Interest expense
(0.2
)%
 
%
 
          (0.2%)

 
(0.1
)%
Income before income taxes
8.2
 %
 
9.9
%
 
9.3
%
 
11.5
 %
Income tax provision
3.1
 %
 
3.8
%
 
3.6
%
 
4.4
 %
Net income
5.1
 %
 
6.1
%
 
5.7
%
 
7.1
 %


Three months ended September 30, 2014 compared with three months ended September 30, 2013

Our patient encounters for the three months ended September 30, 2014 increased by 240,000 encounters or 15.9% to 1,749,000, compared with 1,509,000 for the same period in the prior year. Net revenue for the three months ended September 30, 2014 was $169.8 million, an increase of $20.7 million, or 13.9%, from $149.1 million for the same period in the prior year. Of this $20.7 million increase, 62.0% was attributable to same-market area growth, including tuck-in acquisitions and new hires, and 38.0% was attributable to revenue generated from operations in new markets. Same-market net revenue increased 8.7% and same-market encounters increased 9.9%. Same-market areas are those geographic areas in which we have had operations for the entire current period and the entire comparable prior period. Because in-market area acquisitions are often small practice groups which become subsumed within our existing practice groups and are managed by our existing regional management staff, we consider these as part of our same-market area growth.

Physician practice salaries, benefits and other expenses increased by $15.3 million or 14.2% to $123.6 million, or 72.8% of net revenue, for the three months ended September 30, 2014, as compared with $108.2 million, or 72.6% of net revenue, for the same period in the prior year. The dollar increase in cost of services is largely related to the increase in the number of hospitalists added through hiring and acquisitions during the period. Same-market area physician costs increased a total of $9.7 million, which was primarily the result of increased costs related to our new hires or acquired physician practices. In addition, $5.6 million of the $15.3 million overall cost increase is attributable to physician costs associated with our entrance into new markets.

General and administrative expenses include all salaries, benefits and operating expenses not specifically related to the day-to-day operations of our physician group practices, including billing and collections functions, our regional and market-area administrative offices and our corporate management and overhead. General and administrative expenses increased $3.5 million, or 14.2%, to $28.1 million, or 16.6% of net revenue, for the three months ended September 30, 2014, as compared with

17


$24.6 million, or 16.5% of net revenue, for the same period in the prior year. The 10 basis point increase as a percentage of revenue is primarily related to our expansion of our corporate business development and recruiting resources. The dollar increase in expense was primarily the result of increased costs to support the continuing growth of our operations and acquisitions, including new regional office costs, incremental costs of supporting our post-acute business, expansion of our corporate business development and recruiting resources and other expenses. Excluding stock based compensation, general and administrative expenses were 15.3% of net revenue for the three months ended September 30, 2014 and 2013.

The net change in fair value of contingent consideration (“net change in fair value”) for acquisitions was an increase to expense of $2.4 million and $0.3 million for the three months ended September 30, 2014 and 2013, respectively. Because the fair value of contingent consideration is generally based on a certain multiple of operating results of the acquired practices during a measurement period, a moderate change in projected operating results can result in a large change to the fair value of such contingent consideration.

Income from operations for the three months ended September 30, 2014 decreased $0.5 million, or 3.3%, to $14.3 million from $14.8 million for the same period in the prior year. Our operating margin was 8.4% and 9.9% for the three months ended September 30, 2014 and 2013, respectively. Excluding the net change in fair value, income from operations for the three months ended September 30, 2014 increased 10.8% to $16.7 million, or an operating margin of 9.8%, compared with income from operations of $15.1 million, or an operating margin of 10.1% for the same period in the prior year.

Our effective tax rate for the three months ended September 30, 2014 and 2013 was 38.3%. The effective tax rate differs from the statutory U.S. federal rate of 35.0% due primarily to state income taxes.

Net income for the three months ended September 30, 2014 decreased 5.0% to $8.6 million from $9.1 million for the same period in the prior year, and our net income margin was 5.1% for the three months ended September 30, 2014, compared with 6.1% for the same period in the prior year. Diluted earnings per share for the three months ended September 30, 2014 was $0.49, compared with $0.52 for the same period in the prior year. Excluding the net change in fair value, net income for the three months ended September 30, 2014 increased 9.1% to $10.1 million, or $0.57 diluted earnings per share, compared with net income of $9.2 million, or $0.53 diluted earnings per share for the same period in the prior year.

Nine months ended September 30, 2014 compared with nine months ended September 30, 2013

Our patient encounters for the nine months ended September 30, 2014 increased by 642,000 encounters or 14.0% to 5,240,000, compared with 4,598,000 for the same period in the prior year. Net revenue for the nine months ended September 30, 2014 was $514.8 million, an increase of $66.8 million, or 14.9%, from $447.9 million for the same period in the prior year. Of this $66.8 million increase, 67.0% was attributable to same-market area growth, including tuck-in acquisitions and new hires, and 33.0% was attributable to revenue generated from operations in new markets. Same-market net revenue increased 10.1% and same-market encounters increased 8.4%. The difference between revenue growth and encounter growth is attributable to an increase in hospital stipends, medical directorship revenues, meaningful use incentives and a true-up to previously estimated parity rates.

Physician practice salaries, benefits and other expenses increased by $49.6 million or 15.2% to $376.5 million, or 73.1% of net revenue, for the nine months ended September 30, 2014 as compared with $326.9 million, or 73.0% of net revenue, for the same period in the prior year. The dollar increase in cost of services is largely related to the increase in the number of hospitalists added through hiring and acquisitions during the period. Same-market area physician costs increased a total of $34.0 million, which was primarily the result of increased costs related to our new hires or acquired physician practices. In addition, $15.6 million of the $49.6 million overall cost increase is attributable to physician costs associated with our entrance into new markets.

General and administrative expenses increased $12.4 million, or 17.3%, to $84.1 million, or 16.3% of net revenue, for the nine months ended September 30, 2014, as compared with $71.7 million, or 16.0% of net revenue, for the same period in the prior year. The 30 basis point increase as a percentage of revenue is primarily related to our expansion of our corporate business development and recruiting resources. The dollar increase in expense was primarily the result of increased costs to support the continuing growth of our operations and acquisitions, including new regional office costs, incremental costs of supporting our post-acute business, expansion of our corporate business development and recruiting resources and other expenses. Excluding stock based compensation, general and administrative expenses were 15.1% and 14.8% of revenue for the nine months ended September 30, 2014 and 2013, respectively.
    
The net change in fair value for acquisitions was an increase to expense of $1.3 million and a reduction to expense of $6.1 million for the nine months ended September 30, 2014 and 2013, respectively.

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Income from operations for the nine months ended September 30, 2014 decreased $3.1 million, or 6.0%, to $48.8 million from $52.0 million for the same period in the prior year. Our operating margin was 9.5% and 11.6% for the nine months ended September 30, 2014 and 2013, respectively. Excluding the net change in fair value, income from operations for the nine months ended September 30, 2014 increased 9.3% to $50.2 million, or an operating margin of 9.7%, compared with income from operations of $45.9 million, or an operating margin of 10.2% for the same period in the prior year.

Our effective tax rate for the nine months ended September 30, 2014 and 2013 was 38.3%. The effective tax rate differs from the statutory U.S. federal rate of 35.0% due primarily to state income taxes.

Net income for the nine months ended September 30, 2014 decreased 7.5% to $29.5 million from $31.9 million for the same period in the prior year, and our net income margin was 5.7% for the nine months ended September 30, 2014, compared with 7.1% for the same period in the prior year. Diluted earnings per share for the nine months ended September 30, 2014 was $1.68, compared with $1.85 for the same period in the prior year. Excluding the net change in fair value, net income for the nine months ended September 30, 2014 increased 7.7% to $30.3 million, or $1.72 diluted earnings per share, compared with net income of $28.1 million, or $1.63 diluted earnings per share for the same period in the prior year.

Liquidity and Capital Resources
As of September 30, 2014, we had approximately $80.2 million in liquidity, which is composed of $25.5 million in cash and cash equivalents and an available line of credit of $54.7 million. We had borrowings of $70.0 million from our revolving line of credit outstanding at September 30, 2014, which was used to fund our practice acquisitions.

Net cash provided by operating activities was $53.8 million and $46.6 million for the nine months ended September 30, 2014 and 2013, respectively. The changes in working capital during the nine months ended September 30, 2014 was largely related to an increase in accounts receivable of $7.1 million, a decrease in prepaid expenses and other current assets of $9.6 million, an increase in accounts payable and accrued liabilities of $4.0 million and an increase in accrued compensation of $6.6 million primarily related to timing of payrolls and physician bonus payments.

Our days sales outstanding (DSO), which we use to measure the effectiveness of our collections, was 55 DSO and 56 DSO as of September 30, 2014 and December 31, 2013, respectively. We calculate our DSO using a three-month rolling average of net revenues.

Net cash used in investing activities was $38.8 million for the nine months ended September 30, 2014, compared with $71.1 million for the same period in the prior year. Cash of $35.1 million was used in the nine months ended September 30, 2014 for physician practice acquisitions and contingent consideration payments on prior acquisitions, compared with $68.0 million for the same period in the prior year. The remainder of cash used in investing activities was for purchases of computer hardware and software, and office furnishings.

For the nine months ended September 30, 2014, net cash used in financing activities was $14.5 million, compared with $30.7 million of cash provided by financing activities for the same period in 2013. During the nine months ended September 30, 2014, we repaid $20.0 million of our outstanding revolving line of credit. During the nine months ended September 30, 2013, we repaid $20.0 million of our outstanding revolving line of credit and borrowed $45.0 million under the revolving line of credit to fund our practice acquisitions towards the end of such period.

Credit Facility and Liquidity
Our secured revolving credit agreement (Credit Facility) provides a revolving line of credit of $125.0 million and contains an “accordion” feature that allows an increase of up to $25.0 million to the Credit Facility with lender approval. The Credit Facility has a maturity date of August 4, 2016 and is available for working capital, practice acquisitions, capital expenditures and general business expenses. As of September 30, 2014, we had borrowings of $70.0 million and letters of credit of $0.3 million outstanding, and $54.7 million available under the Credit Facility.

The revolving line of credit is limited by a formula based on a certain multiple times the trailing twelve months of earnings before interest, taxes, depreciation, amortization and certain non-cash items. Interest rate options for each borrowing under the Credit Facility, to be selected by us at the time of each borrowing, include either LIBOR plus 0.75% to 1.75%, or the lender’s prime rate plus 0% to 0.75%, both based on a leverage ratio. We pay an unused commitment fee equal to 0.25% per annum on the difference between the revolving line capacity and the average balance outstanding during the year. Outstanding amounts advanced to us under the revolving line of credit are repayable on or before the maturity date. The interest rate for our borrowings under the Credit Facility at September 30, 2014 was 1.4375% per annum.

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The Credit Facility is guaranteed by our subsidiaries and affiliated Professional Medical Corporations and limited liability companies, and is secured by substantially all of our and our guarantors’ tangible and intangible assets. The Credit Facility includes various customary financial covenants and restrictions, as well as customary remedies for our lenders following an event of default. As of September 30, 2014, we were in compliance with such financial covenants and restrictions.

We anticipate that funds generated from operations, together with our current cash on hand and funds available under our Credit Facility will be sufficient to finance our working capital requirements and fund anticipated acquisitions, contingent acquisition consideration and capital expenditures.

Off Balance Sheet Arrangements
As of September 30, 2014, we had no off-balance sheet arrangements.

ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to changes in interest rate as a result of our Credit Facility. At our option, the interest rate on outstanding borrowings under our Credit Facility is either LIBOR plus 0.75% to 1.75% or the lender’s prime rate plus 0% to 0.75%, both based on a leverage ratio. The lender’s prime rate is a daily floating rate most recently announced by our lender, whether or not such announced rate is the lowest rate available from our lender. LIBOR is either the 30, 60, 90 or 180 day LIBOR. Historically, we have chosen not to use interest rate derivatives to manage our exposure to changes in interest rates. We had long-term borrowings of $70.0 million bearing an annual interest of 1.4375% under our Credit Facility at September 30, 2014. A 1.0% change in interest rate on our borrowings of $70.0 million would result in an impact to income before income taxes of approximately $700,000 on an annual basis.

Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities with shorter maturities may produce less income if interest rates fall. As of September 30, 2014, all of our short-term investments were invested in money market funds with less than 90-day maturities and are classified as cash equivalents.

ITEM 4.    CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures
We maintain controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the SEC, and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has conducted an evaluation of the design and operation of our “disclosure controls and procedures” as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting during the three months ended September 30, 2014 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.


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PART II – OTHER INFORMATION

ITEM 1.    LEGAL PROCEEDINGS

Legal
In the ordinary course of our business, we become involved in pending and threatened legal actions and proceedings, most of which involve claims of medical malpractice related to medical services provided by our affiliated hospitalists. We may also become subject to other lawsuits, which could involve significant claims and/or significant defense costs.

We believe, based upon our review of pending actions and proceedings that the outcome of such legal actions and proceedings will not have a material adverse effect on our business, financial condition, results of operations, or cash flows. The outcome of such actions and proceedings, however, cannot be predicted with certainty and an unfavorable resolution of one or more of them could have a material adverse effect on our business, financial condition, results of operations, or cash flows in a future period.

Government Claim
On June 7, 2010, we received a civil investigative demand (CID) issued by the Department of Justice (DOJ), U.S. Attorney’s Office for the Northern District of Illinois. The CID requested information concerning claims that we have submitted to Medicare and Medicaid. The CID covered the period from January 1, 2003, through June 4, 2010 and requested production of a range of documents relating to our Medicare and Medicaid participation, physician arrangements, operations, billings and compliance programs. We believe we have a strong compliance focus and that we operate with appropriate billing policies, procedures, provider training, and compliance programs and controls. We produced responsive documents and were in contact with representatives of the DOJ who informed us that the inquiry related to a qui tam whistleblower action filed under court seal in the U.S. District Court for the Northern District of Illinois (Chicago) (U.S. District Court). We also were informed that several state attorneys general were examining our Medicaid claims in coordination with the DOJ.

Though we cooperated with the government’s investigation and would welcome a resolution to this matter, we are now in active litigation with the federal government regarding this matter and intend to contest the case vigorously. On December 6, 2013, the U.S. District Court partially lifted the seal on the civil False Claims Act case related to this investigation. The unsealed portions of the Court docket include, among other documents, the whistleblower’s Complaint, which contains allegations of improper billing to Medicare and Medicaid, a Notice of Election to Intervene filed by the federal government and a Notice of Election to Decline Intervention filed by the State of Illinois and 12 other states that participated in the investigation. On June 16, 2014, the federal government filed its Complaint in Intervention against IPC and several of its subsidiaries in the U.S. District Court. The Complaint in Intervention contains allegations of improper billing to Medicare, Medicaid and other federal programs from January 1, 2003 to the present, seeks to recover treble damages and civil penalties under the civil False Claims Act, and seeks to recover damages under the common law theories of payment by mistake and unjust enrichment. On August 13, 2014, IPC and the IPC subsidiary defendants filed a joint motion to dismiss the Complaint in Intervention or, in the alternative, to sever claims against the defendants. The federal government filed its response on September 18, 2014, to which the defendants replied on September 25, 2014. The court’s decision regarding the joint motion to dismiss has not yet been issued.

It is not possible to predict when this matter may be resolved, the time or resources that we will need to devote to this litigation, or what impact, if any, the outcome of this matter might have on our consolidated financial position, results of operations, or cash flows.

Derivative Lawsuits
On October 20 and 24, 2014, shareholder derivative lawsuits were filed in the Court of Chancery of the State of Delaware against certain current and former directors and officers of IPC.  IPC is named as a nominal defendant in both suits.  The actions both assert alleged breaches of fiduciary duties related to IPC’s billing practices, and incorporate allegations from the False Claims Act case.  The lawsuits seek a variety of relief, including monetary damages and injunctive relief.  The litigation is in an early stage and the complaints have not yet been served.

It is not possible to predict when these matters may be resolved, the time or resources that we will need to devote to this litigation, or what impact, if any, the outcome of these matters might have on our consolidated financial position, results of operations, or cash flows.



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ITEMS 1A, 2, 3, 4 AND 5 ARE NOT APPLICABLE
 
ITEM 6.    EXHIBITS
(a) Exhibits
Exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index on page 24 of this report.


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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on October 28, 2014.
 
 
 
 
IPC THE HOSPITALIST COMPANY, INC.
 
 
By:
 
/s/ ADAM D. SINGER, M.D.
 
 
Adam D. Singer, M.D.
Chief Executive Officer
 
 
By:
 
/s/ RICK KLINE
 
 
Rick Kline
Chief Financial Officer


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EXHIBIT INDEX
 
 
 
 
Exhibit
Number
  
Description of Document
 
 
3.1
 
Fourth Amended and Restated By-laws.
 
 
3.2
 
Fourth Amended and Restated Certificate of Incorporation.
 
 
31.1
  
Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes Oxley Act.
 
 
31.2
  
Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes Oxley Act.
 
 
32.1
  
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act.
 
 
32.2
  
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act.
 
 
101.INS
  
XBRL Instance Document
 
 
101.SCH
  
XBRL Taxonomy Extension Schema Document
 
 
101.CAL
  
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF
  
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB
  
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE
  
XBRL Taxonomy Extension Presentation Linkbase Document


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