USMD Holdings, Inc. - FORM 10-Q

USMD Holdings, Inc. - FORM 10-Q - August 11, 2016

Attached files

Attached files

USMD Holdings, Inc. Reports

file	filename
EX-32.2 - EX-32.2 - USMD Holdings, Inc.	d386957dex322.htm
EX-32.1 - EX-32.1 - USMD Holdings, Inc.	d386957dex321.htm
EX-31.2 - EX-31.2 - USMD Holdings, Inc.	d386957dex312.htm
EX-31.1 - EX-31.1 - USMD Holdings, Inc.	d386957dex311.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2016

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-35639

USMD Holdings, Inc.

(Exact name of registrant as specified in its charter)


Delaware		27-2866866
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

6333 North State Highway 161, Suite 200 Irving, Texas		75038
(Address of principal executive offices)		(zip code)

(214) 493-4000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

The registrant had 11,393,942 shares of common stock outstanding as of August 5, 2016.

USMD HOLDINGS, INC.

TABLE OF CONTENTS


		Page
PART I - FINANCIAL INFORMATION			3

Item 1.	Financial Statements (Unaudited)

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		23

Item 4.	Controls and Procedures		37

PART II - OTHER INFORMATION			39

Item 1.	Legal Proceedings		39

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		39

Item 3.	Defaults Upon Senior Securities		39

Item 4.	Mine Safety Disclosures		39

Item 5.	Other Information		39

Item 6.	Exhibits		40

SIGNATURES			41

PART 1 – FINANCIAL INFORMATION

USMD HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)


	June 30, 2016			December 31, 2015
	(unaudited)
ASSETS⁽¹⁾
Current assets:
Cash and cash equivalents	$	19,203		$	29,593
Restricted cash		8,730			9,727
Accounts receivable, net of allowance for doubtful accounts of $4,276 and $2,920 at June 30, 2016 and December 31, 2015, respectively		28,429			23,176
Inventories		2,182			2,345
Deferred tax assets, net		6,404			6,343
Prepaid expenses and other current assets		7,083			5,086

Total current assets		72,031			76,270
Property and equipment, net		26,560			28,981
Investments in nonconsolidated affiliates		68,176			68,851
Goodwill		89,856			89,856
Intangible assets, net		13,595			14,592

Total assets	$	270,218		$	278,550

LIABILITIES⁽²⁾ AND EQUITY
Current liabilities:
Accounts payable	$	11,555		$	7,614
Accrued payroll		8,303			11,336
Other accrued liabilities		17,508			21,388
Other current liabilities		1,018			604
Current portion of long-term debt		6,960			7,121
Current portion of related party long-term debt		1,863			—
Current portion of capital lease obligations		2,030			1,486

Total current liabilities		49,237			49,549
Other long-term liabilities		10,469			10,120
Deferred compensation payable		3,947			4,275
Long-term debt, less current portion		27,055			26,741
Related party long-term debt, less current portion		13,599			15,421
Capital lease obligations, less current portion		5,387			6,049
Deferred tax liabilities, net		15,245			15,281

Total liabilities		124,939			127,436
Commitments and contingencies
Equity:
USMD Holdings, Inc. stockholders’ equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized; none issued		—			—
Common stock, $0.01 par value, 49,000,000 shares authorized; 11,393,086 and 11,333,838 shares issued and outstanding at June 30, 2016 and December 31, 2015, respectively		114			113
Additional paid-in capital		172,104			171,269
Accumulated deficit		(27,037	)		(20,366	)
Accumulated other comprehensive loss		(2	)		(2	)

Total USMD Holdings, Inc. stockholders’ equity		145,179			151,014
Noncontrolling interests in subsidiaries		100			100

Total equity		145,279			151,114

Total liabilities and equity	$	270,218		$	278,550

See accompanying notes to consolidated financial statements

USMD HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS - (Continued)

(In thousands, except share data)


	June 30, 2016		December 31, 2015
	(unaudited)
(1) Assets of consolidated variable interest entity (“VIE”) included in the consolidated balance sheets above (after elimination of intercompany transactions and balances) consist of:
Cash and cash equivalents	$	14,024	$	13,254
Accounts receivable		6,713		2,353
Prepaid expenses		424		22
Deferred tax asset		4,153		4,568

Total current assets	$	25,314	$	20,197


The assets of the consolidated VIE can only be used to settle the obligations of the VIE.

(2) Liabilities of consolidated VIE included in the consolidated balance sheets above (after elimination of intercompany transactions and balances) consist of:
Accounts payable	$	5,104	$	2,517
Other accrued liabilities		12,893		14,141

Total current liabilities	$	17,997	$	16,658

The liabilities of the consolidated VIE are obligations of the VIE and the creditors have no recourse to USMD Holdings, Inc.

See accompanying notes to consolidated financial statements

USMD HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	Three Months Ended June 30,						Six Months Ended June 30,
	2016			2015			2016			2015
Revenue:
Patient service revenue	$	48,598		$	48,367		$	98,966		$	93,518
Provision for doubtful accounts related to patient service revenue		(1,307	)		(1,138	)		(3,564	)		(2,338	)

Net patient service revenue		47,291			47,229			95,402			91,180
Capitated revenue		28,557			24,020			56,832			47,091
Management and other services revenue		5,925			5,181			10,929			10,249
Lithotripsy revenue		—			5,411			—			10,267

Net operating revenue		81,773			81,841			163,163			158,787

Operating expenses:
Salaries, wages and employee benefits		41,319			42,429			83,232			83,938
Medical services and supplies expense		30,384			25,972			56,643			51,016
Rent expense		4,245			4,108			8,698			8,164
Provision for doubtful accounts		(1	)		14			105			(119	)
Other operating expenses		10,809			10,201			21,615			20,055
Depreciation and amortization		2,360			2,024			4,616			4,251

Total operating expenses		89,116			84,748			174,909			167,305

Loss from operations		(7,343	)		(2,907	)		(11,746	)		(8,518	)
Other income (expense):
Interest expense, net		(1,120	)		(750	)		(2,056	)		(1,493	)
Equity in income of nonconsolidated affiliates, net		3,148			2,757			4,799			4,513
Other gain (loss)		(144	)		51			(76	)		51

Total other income, net		1,884			2,058			2,667			3,071

Loss before income taxes		(5,459	)		(849	)		(9,079	)		(5,447	)
Benefit for income taxes		(1,424	)		(1,184	)		(2,408	)		(3,203	)

Net income (loss)		(4,035	)		335			(6,671	)		(2,244	)
Less: net income attributable to noncontrolling interests		—			(2,444	)		—			(4,526	)

Net loss attributable to USMD Holdings, Inc.	$	(4,035	)	$	(2,109	)	$	(6,671	)	$	(6,770	)


Loss per share attributable to USMD Holdings, Inc.
Basic	$	(0.35	)	$	(0.20	)	$	(0.59	)	$	(0.66	)
Diluted	$	(0.35	)	$	(0.20	)	$	(0.59	)	$	(0.66	)
Weighted average common shares outstanding
Basic		11,394			10,355			11,394			10,300
Diluted		11,394			10,355			11,394			10,300

See accompanying notes to consolidated financial statements

USMD HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(In thousands)

(Unaudited)


	USMD Holdings, Inc. Common Stockholders’ Equity
	Common Stock				Additional		Accumulated Other			Accumulated Deficit			Total USMD			Noncontrolling
	Shares Outstanding		Par Value		Paid-in Capital		Comprehensive Loss			Accumulated Deficit			Holdings, Inc.			Interests in Subsidiaries		Total Equity
Balance at December 31, 2015		11,334	$	113	$	171,269	$	(2	)	$	(20,366	)	$	151,014		$	100	$	151,114
Net loss		—		—		—		—			(6,671	)		(6,671	)		—		(6,671	)
Share-based payment expense - stock options		—		—		364		—			—			364			—		364
Common stock issued in business combinations		27		—		200		—			—			200			—		200
Common stock issued for payment of 2015 accrued compensation		26		—		211		—			—			211			—		211
Common stock issued for payment of accrued liabilities		7		1		60		—			—			61			—		61

Balance at June 30, 2016		11,394	$	114	$	172,104	$	(2	)	$	(27,037	)	$	145,179		$	100	$	145,279

See accompanying notes to consolidated financial statements

USMD HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Six Months Ended June 30,
	2016			2015
Cash flows from operating activities:
Net loss	$	(6,671	)	$	(2,244	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Provision for doubtful accounts		3,669			2,219
Depreciation and amortization		4,616			4,251
Accretion of debt discount and amortization of debt issuance costs		418			364
(Gain) loss on sale or disposal of assets, net		42			(18	)
(Gain) loss on sale of ownership interests in nonconsolidated affiliates		75			(51	)
Equity in income of nonconsolidated affiliates, net		(4,799	)		(4,513	)
Distributions from nonconsolidated affiliates		5,474			5,017
Share-based payment expense		364			1,109
Deferred income tax benefit		(97	)		(1,194	)
Change in operating assets and liabilities, net of effects of business combinations:
Accounts receivable		(9,859	)		(8,169	)
Inventories		163			324
Prepaid expenses and other assets		(1,836	)		(2,822	)
Current liabilities		(2,187	)		7,693
Other noncurrent liabilities		21			440

Net cash provided by (used in) operating activities		(10,607	)		2,406

Cash flows from investing activities:
Capital expenditures		(549	)		(2,070	)
Payments received for the sale of ownership interests in nonconsolidated affiliates		141			210
Payments received for the sale of lithotripsy services business		721			—
Proceeds from sale of property and equipment		13			18

Net cash provided by (used in) investing activities		326			(1,842	)

Cash flows from financing activities:
Proceeds from issuance of long-term debt		—			4,350
Payments on long-term debt and capital lease obligations		(1,106	)		(1,279	)
Proceeds from issuance of related party long-term debt		—			700
Principal payments on related party long-term debt		—			(347	)
Payment of debt issuance costs		—			(18	)
Release of restricted cash		997			—
Distributions to noncontrolling interests		—			(4,441	)

Net cash used in financing activities		(109	)		(1,035	)

Net decrease in cash and cash equivalents		(10,390	)		(471	)
Cash and cash equivalents at beginning of year		29,593			15,940

Cash and cash equivalents at end of period	$	19,203		$	15,469

Supplemental non-cash investing and financing information:
Accrued unissued share-based compensation	$	—		$	648
Liabilities paid in common stock	$	472		$	1,757
Property and equipment acquired through debt or capital lease financing	$	687		$	474
Property and equipment acquired on account	$	17		$	230
Finance sale of interest in nonconsolidated affiliate with note receivable	$	—		$	159
Fair value of common stock issued in business combinations	$	200		$	—
Supplemental cash flow information:
Cash paid for—
Interest, net of related parties	$	1,010		$	957
Interest to related parties	$	276		$	193
Income tax	$	588		$	771
Cash received for—
Income tax refund	$	241		$	—

See accompanying notes to consolidated financial statements

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

June 30, 2016

(Unaudited)

Note 1 – Description of Business, Basis of Presentation and Recently Issued Accounting Pronouncements

Description of Business:

USMD Holdings, Inc. (“USMD” or the “Company”) is an early-stage physician-led integrated health system. An integrated health system is considered early-stage when it has not yet established all the components necessary to be considered a fully integrated health system. Through its subsidiaries and affiliates, the Company provides healthcare services to patients and management and operational services to hospitals and other healthcare service providers. The Company provides healthcare services to patients in physician clinics, hospitals and other healthcare facilities, including cancer treatment centers and anatomical pathology and clinical laboratories. A wholly owned subsidiary of the Company is the sole member of a Texas Certified Non-Profit Health Organization that owns and operates a multi-specialty physician group practice (“USMD Physician Services”) in the Dallas-Fort Worth, Texas metropolitan area.

Through other wholly owned subsidiaries, the Company provides management and operational services to two general acute care hospitals in the Dallas-Fort Worth, Texas metropolitan area and provides management and/or operational services to three cancer treatment centers in three states. Of these managed entities, the Company has noncontrolling ownership interests in the two hospitals and one cancer treatment center. In addition, the Company wholly owns and operates one Independent Diagnostic Testing Facility (“IDTF”), two clinical laboratories, one anatomical pathology laboratory and one cancer treatment center in the Dallas-Fort Worth, Texas metropolitan area.

On December 18, 2015, as part of the Company’s strategic plan to build a fully integrated physician-led health system, the Company sold its lithotripsy services (“Lithotripsy Services”) business (see Note 2). The sale included the management services business as well as controlling and noncontrolling interests in the Company’s lithotripsy service provider entities. The Company retained a noncontrolling interest in one lithotripsy service provider entity. In its existing form, the lithotripsy business was not a core component of an integrated health system and, therefore, was not aligned with the strategic objectives of the Company.

Basis of Presentation:

The unaudited condensed consolidated financial statements and related notes of the Company have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”) for interim financial statements and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim reporting. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information in this report not misleading. These condensed consolidated financial statements reflect all adjustments that, in the opinion of the Company’s management, are necessary for fair presentation of the condensed consolidated financial statements. The December 31, 2015 condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by GAAP. The operating results for the interim periods are not necessarily indicative of results for the full fiscal year. These condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 filed with the SEC on April 14, 2016. Certain prior year amounts have been reclassified to conform to current year presentation.

The condensed consolidated financial statements include the accounts of the Company, entities controlled by the Company through its direct or indirect ownership of a majority interest and any other entities in which the Company has a controlling financial interest. The Company consolidates VIEs where the Company is the primary beneficiary. The primary beneficiary of a VIE is the party that has both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE. The Company consolidates entities in which it or its wholly owned subsidiary is the general partner or managing member and the limited partners or members, respectively, do not have sufficient rights to overcome the presumption of the Company’s control. The Company eliminates all significant intercompany accounts and transactions in consolidation.

The Company uses the equity method to account for investments in entities it or its wholly owned subsidiaries do not control, but over which it or its wholly owned subsidiaries have the ability to exercise significant influence. The Company does not consolidate equity method investments, but rather measures them at their initial cost and subsequently adjusts their carrying values through income for the Company’s respective share of earnings or losses during the period.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Recently Issued or Adopted Accounting Pronouncements:

In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). ASU 2014-09 requires revenue recognition to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 provides a single principles-based, five-step model to be applied to all contracts with customers. The five steps are to identify the contract(s) with the customer, identify the performance obligations in the contact, determine the transaction price, allocate the transaction price to the performance obligations in the contract and recognize revenue when each performance obligation is satisfied. The provisions of ASU 2014-09 may be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of the update recognized at the date of the initial application along with additional disclosures. ASU 2014-09 will be effective for the Company beginning January 1, 2018. Management is evaluating the impact that adoption of ASU 2014-09 will have on the Company’s consolidated financial statements.

In May 2016, the FASB issued ASU 2016-12, “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients” (“ASU 2016-12”). ASU 2016-12 addresses transition, collectibility, non-cash consideration and the presentation of sales and other similar taxes. ASU 2016-12 does not change the core principles of ASU 2014-09, but rather address implementation issues and is intended to result in more consistent application. ASU 2016-12 will be effective for the Company beginning January 1, 2018. Management is evaluating the impact that adoption of ASU 2016-12 will have on the Company’s consolidated financial statements.

In April 2016, the FASB issued ASU 2016-10, “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing” (“ASU 2016-10”). ASU 2016-10 clarifies guidance related to identifying performance obligations and licensing implementation guidance contained in the new revenue recognition standard. ASU 2016-10 will be effective for the Company beginning January 1, 2018. Management is evaluating the impact that adoption of ASU 2016-10 will have on the Company’s consolidated financial statements.

In March 2016, the FASB issued ASU 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations Reporting Revenue Gross versus Net)” (“ASU 2016-08”). ASU 2016-08 clarifies the implementation guidance on principal versus agent considerations. ASU 2016-08 will be effective for the Company beginning January 1, 2018. Management is evaluating the impact that adoption of ASU 2016-08 will have on the Company’s consolidated financial statements.

In March 2016, the FASB issued Accounting Standards Update (‘ASU”) No. 2016-09 “Compensation – Stock Compensation: Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”). ASU 2016-09 changes certain aspects of accounting for share-based payment awards to employees, including the accounting for income taxes, application of estimated rates of forfeiture and statutory tax withholding requirements. ASU 2016-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within those years. Early adoption is permitted. Management is evaluating the impact that adoption of ASU 2016-09 will have on the Company’s consolidated financial statements.

In February 2015, the FASB issued ASU No. 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis” (“ASU 2015-02”). ASU 2015-02 changes the analysis that a company must perform to determine whether it should consolidate certain legal entities. All legal entities are subject to reevaluation under the updated guidance. ASU 2015-02 eliminates the presumption that a general partner should consolidate a limited partnership, eliminates the consolidation model specific to limited partnerships, modifies the evaluation of whether limited partnerships and similar legal entities are VIEs or voting interest entities and affects the evaluation of fee arrangements in the VIE primary beneficiary determination. The Company adopted ASU 2015-02 effective January 1, 2016. Adoption of this guidance did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows. See Note 3 – Variable Interest Entities.

In April 2015, the FASB issued ASU No. 2015-03 “Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs” (“ASU 2015-03”). ASU 2015-03 requires that debt issuance costs be presented as a direct deduction from the carrying amount of the related debt liability, consistent with the presentation of debt discounts. Upon adoption, the

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

standard requires prior period financial statements to be retrospectively adjusted. Prior to the issuance of ASU 2015-03, debt issuance costs were required to be presented as deferred assets, separate from the related debt liability. ASU 2015-03 does not change the recognition and measurement requirements for debt issuance costs. The Company adopted ASU 2015-03 effective January 1, 2016. In accordance with the new guidance, the Company reclassified debt issuance costs previously included in other assets to long-term debt in the first quarter of 2016 and conformed prior periods. Adoption of this guidance did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In April 2015, the FASB issued ASU No. 2015-05 “Intangibles – Goodwill and Other – Internal Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in Cloud Computing Arrangement” (“ASU 2015-05”). ASU 2015-05 addresses accounting for fees paid by a customer in cloud computing arrangements such as (i) software as a service, (ii) platform as a service (iii) infrastructure as a service and (iv) other similar hosting arrangements. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The Company adopted ASU 2015-05 effective January 1, 2016. Adoption of this guidance did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

Note 2 – Sale of Lithotripsy Services Business

On December 18, 2015, in line with the Company’s strategic plan to build an integrated physician-led health system, the Company sold its Lithotripsy Services business. The Lithotripsy Services business was engaged in the formation, promotion and management of partnerships and other entities that provide the technical portion of lithotripsy procedures to hospitals, surgery centers, physician practices and other healthcare facilities. At the time of the sale, the Lithotripsy Services business provided management and/or operational services to 21 lithotripsy service providers located primarily in the South Central United States. Of those managed entities, the Lithotripsy Services business had minority ownership interests in 19 of the lithotripsy service providers. In addition, the Lithotripsy Services business wholly owned and operated two lithotripsy service providers in North Texas. The sale included the management services business as well as controlling and noncontrolling interests in the Company’s lithotripsy service provider entities. The Company retained a noncontrolling interest in one lithotripsy service provider entity. Except as noted in the preceding sentence, all ownership interests in and held by the Company were sold. As a result of the sale, the Company no longer provides management or operational services to or serves as the general partner of any lithotripsy service provider. In its existing form, the Lithotripsy Services business was not a core component of an integrated health system and, therefore, was not aligned with the strategic objectives of the Company.

The Lithotripsy Services business was sold for $19.8 million in cash subject to working capital and other adjustments and before purchase price adjustments for indebtedness and transaction costs. The Company received proceeds of $10.3 million after adjustments for indebtedness, transaction costs and amounts placed into escrow. At June 30, 2016, $2.0 million remains in escrow to satisfy indemnification obligations, which is recorded as restricted cash on the Company’s consolidated balance sheet. The Company resolved working capital true-ups in the second quarter of 2016. For the six months ended June 30, 2015, the pre-tax profit of the Lithotripsy Services business was $6.4 million, inclusive of amounts attributable to noncontrolling interests. For the six months ended June 30, 2015, the pre-tax profit of the Lithotripsy Services business attributable to USMD Holdings, Inc. was $1.6 million.

Included in the sale of the Lithotripsy Services business was the sale of a controlling interest in one previously wholly owned, consolidated lithotripsy partnership. The Company retained a limited partnership interest in this partnership. As a result of the sale, the Company deconsolidated the partnership and began accounting for its remaining investment using the equity method. Effective on the date of deconsolidation, as an equity method investee, the partnership will be considered a related party. Except for its limited partner interest, the Company has no continuing involvement with the partnership. The partnership provides lithotripsy services to two equity method investees of the Company.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Note 3 – Variable Interest Entity

In connection with the adoption of ASU 2015-02, the Company evaluated all of its investments to determine the investments that meet the definition of a VIE and which of the VIE’s meet the primary beneficiary requirements for consolidation.

Non-Consolidated Variable Interest Entities:

Metro I Stone Management, Ltd. (“Metro”) is a limited partnership which provides lithotripsy services to the Company’s hospitals and other healthcare entities. The Company is a single limited partner in Metro with a 60% equity interest. The third party general partner owns the remaining 40% partnership interest and has the power to direct all activities of the entity. The Company does not have substantive kick-out rights or substantive participation rights.

The Company evaluated its equity interest in Metro to determine if the entity is a VIE. The Company evaluated whether Metro’s equity at risk, as defined by GAAP, is considered to be insufficient to finance its activities without additional support and, whether the holders of the equity lack the characteristics of a controlling financial interest. The Company concluded that Metro is a variable interest entity as our equity interests are non-substantive and therefore, lack the characteristics of a controlling financial interest.

In order to determine whether the Company is Metro’s primary beneficiary and therefore would consolidate the variable interest entity, the Company considered whether it has i) the power to direct the activities of Metro that most significantly impact its economic performance and ii) the obligation to absorb losses of Metro that could potentially be significant to it, or the right to receive benefits from Metro that could potentially be significant to it. The Company concluded that the limited partnership is structured such that the Company does not have the power to direct the activities of Metro that most significantly impact its economic performance, and therefore Metro is not consolidated.

The carrying value of this investment was $6.5 million as of June 30, 2016 and is included in the condensed consolidated balance sheets as investments in nonconsolidated affiliates. The Company’s maximum exposure to losses correlates to its 60% equity interest. In addition, the Company has not provided any financial support to Metro as of June 30, 2016.

Consolidated Variable Interest Entities:

The Company is an equal co-member of a Texas non-profit corporation that has been approved by the Texas Medical Board as a Certified Non-Profit Health Organization (WNI-DFW). WNI-DFW has a contractual arrangement to manage patient care by providing or arranging for the provision of all the necessary healthcare services for a health plan’s given Medicare Advantage patient population in the North Texas area served by WNI-DFW. Pursuant to the arrangement, WNI-DFW receives a fixed fee per patient under what is typically known as a “risk contract.” Risk contracting, or full risk capitation, refers to a model in which an entity receives from the third party payer a fixed payment per member per month for a defined patient population, and the entity is then responsible for arranging and/or providing all of the healthcare services required by that patient population. The entity accomplishes this by managing patient care and by contracting with healthcare providers to provide needed healthcare services for the patient population. In such a model, the contracting entity is then responsible for incurring or paying for the cost of healthcare services required by that patient population. The entity generates a net surplus if the cost of all healthcare services provided to the patient population is less than the payments received from the third party payer and it generates a net deficit if the cost of such services is higher than the payments received. WNI-DFW commenced operations on June 1, 2013.

The Company evaluated whether it has a variable interest in WNI-DFW, whether WNI-DFW is a VIE and whether the Company has a controlling financial interest in WNI-DFW. The Company concluded that it has a variable interest in WNI-DFW on the basis of its capital contribution to WNI-DFW and because WNI-DFW has entered into a Primary Care Physician Agreement (“PCP Agreement”) with USMD Physician Services. WNI-DFW’s equity at risk, as defined by GAAP, is considered to be insufficient to finance its activities without additional support, and, therefore, WNI-DFW is considered a VIE.

In order to determine whether the Company has a controlling financial interest in WNI-DFW and, thus, is WNI-DFW’s primary beneficiary, the Company considered whether it has i) the power to direct the activities of WNI-DFW that most significantly impact its economic performance and ii) the obligation to absorb losses of WNI-DFW that could potentially be significant to it or the right to receive benefits from WNI-DFW that could potentially be significant to it. The Company concluded that the members, the board of directors and the executive management team of WNI-DFW are structured in a way that neither member nor its designee has the

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

individual power to direct the activities of WNI-DFW that most significantly impact its economic performance. Management considered whether the various service and support agreements between WNI-DFW and its members (or their affiliates) provide either variable interest party with this power and concluded that the PCP Agreement between USMD Physician Services and WNI-DFW does provide to USMD Physician Services the power to direct such activities. Under the PCP Agreement, USMD Physician Services is responsible for providing many services related to the growth of the patient population of WNI-DFW, the management of that population’s healthcare needs, and the provision of required healthcare services to those patients. The Company has concluded that the success or failure of USMD Physician Services in conducting these activities will most significantly impact the economic performance of WNI-DFW. In addition, the Company’s variable interests in WNI-DFW obligate the Company to absorb deficits and provide it with the right to receive benefits that could potentially be significant to WNI-DFW. As a result of this analysis, the Company concluded that it is the primary beneficiary of WNI-DFW and therefore consolidates the balance sheets, results of operations and cash flows of WNI-DFW. The Company performs a qualitative assessment of WNI-DFW on an ongoing basis to determine if it continues to be the primary beneficiary.

The following table summarizes the carrying amounts of the assets and liabilities of WNI-DFW included in the Company’s consolidated balance sheets (after elimination of intercompany transactions and balances) (in thousands):


	June 30, 2016		December 31, 2015
	(unaudited)
Current assets:
Cash and cash equivalents	$	14,024	$	13,254
Accounts receivable		6,713		2,353
Prepaid expenses		424		22
Deferred tax asset		4,153		4,568

Total current assets	$	25,314	$	20,197


Current liabilities:
Accounts payable	$	5,104	$	2,517
Other accrued liabilities		12,893		14,141

Total current liabilities	$	17,997	$	16,658

The assets of WNI-DFW can only be used to settle obligations of WNI-DFW. The creditors of WNI-DFW have no recourse to the general credit of the Company. Upon notification from WNI-DFW, the Company is contractually obligated to fund certain cash requirements of WNI-DFW. Pursuant to such a notification, in January 2014, the Company advanced WNI-DFW $0.7 million. The results of operations and cash flows of WNI-DFW are included in the Company’s consolidated financial statements.

For the three and six months ended June 30, 2016, WNI-DFW contributed capitated revenue of $28.4 million and $56.7 million, respectively, and income before provision for income taxes of $3.9 million and $10.6 million (after elimination of intercompany transactions), respectively. For the three and six months ended June 30, 2015, WNI-DFW contributed capitated revenue of $24.0 million and $47.1 million, respectively, and income before provision for income taxes of $3.0 million and $6.0 million, respectively (after elimination of intercompany transactions).

Estimated Medical Claims Liability

In connection with the operations of WNI-DFW, the Company makes estimates related to incurred but not reported (“IBNR”) medical claims of WNI-DFW. The patient population to which WNI-DFW provides health services has limited medical claims activity from which claims-based actuarial judgments can be made. In addition, the full population is relatively small for precise actuarial determinations. Therefore, in addition to calculating IBNR claims using an actuarial estimate based on historical medical claims activity, management includes an adjustment factor based on broader patient populations deemed to be similar in risk profile to the WNI-DFW managed patient population. If actual results are not consistent with the Company’s estimate, the Company may be exposed to variances in medical services and supplies expense that may be material. At June 30, 2016 and December 31, 2015, the Company has recorded an estimated IBNR liability of $11.5 million and $13.1 million, respectively, which are included in other accrued liabilities.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Note 4 – Investments in Nonconsolidated Affiliates

The net carrying values and ownership percentages of nonconsolidated affiliates accounted for under the equity method are as follows (dollars in thousands):


	June 30, 2016				December 31, 2015
	Carrying Value		Ownership Percentage		Carrying Value		Ownership Percentage

USMD Hospital at Arlington, L.P.	$	51,033		46.40%	$	51,872		46.40%
USMD Hospital at Fort Worth, L.P.		10,577		30.88%		10,277		30.88%
Other		6,566		10%-60%		6,702		10%-60%

	$	68,176			$	68,851

At June 30, 2016, USMD Hospital at Arlington, L.P. (“USMD Arlington”) and USMD Hospital at Fort Worth, L.P. (“USMD Fort Worth”) were significant equity investees, as that term is defined by SEC Regulation S-X Rule 8-03(b)(3). Financial information for USMD Arlington and USMD Forth Worth is as follows (in thousands):


	Three Months Ended June 30,				Six Months Ended June 30,
	2016		2015		2016		2015
USMD Arlington:
Revenue	$	26,009	$	24,738	$	49,953	$	46,423
Income from operations	$	6,247	$	5,961	$	10,208	$	10,256
Net income	$	5,837	$	5,753	$	8,827	$	9,209

USMD Fort Worth:
Revenue	$	6,181	$	5,766	$	12,164	$	11,506
Income from operations	$	926	$	382	$	1,243	$	792
Net income	$	831	$	239	$	1,011	$	504

Note 5 – Patient Service Revenue

The Company’s patient service revenue by payer is summarized in the table that follows (dollars in thousands):


	Three Months Ended June 30,												Six Months Ended June 30,
	2016						2015						2016						2015
	Amount			Ratio of Net Patient Service Revenue			Amount			Ratio of Net Patient Service Revenue			Amount			Ratio of Net Patient Service Revenue			Amount			Ratio of Net Patient Service Revenue
Medicare	$	15,510			32.8	%	$	14,888			31.5	%	$	32,420			34.0	%	$	28,419			31.2	%
Medicaid		789			1.7			705			1.5			1,562			1.6			1,477			1.6
Managed care and commercial payers		31,129			65.8			31,931			67.6			62,514			65.5			61,946			67.9
Self-pay		1,170			2.5			843			1.8			2,470			2.6			1,676			1.8

Patient service revenue before provision for doubtful accounts		48,598			102.8			48,367			102.4			98,966			103.7			93,518			102.6
Patient service revenue provision for doubtful accounts		(1,307	)		(2.8	)		(1,138	)		(2.4	)		(3,564	)		(3.7	)		(2,338	)		(2.6	)

Net patient service revenue	$	47,291			100.0	%	$	47,229			100.0	%	$	95,402			100.0	%	$	91,180			100.0	%

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on management’s assessment of the collectability of patient and customer accounts. The Company regularly reviews this allowance by considering factors such as historical experience, credit quality, the age of the accounts receivable balances and current economic conditions that may affect a patient’s or customer’s ability to pay. Uncollectible accounts are written off once collection efforts are exhausted. At June 30, 2016 and December 31, 2015, the allowance for doubtful accounts was 13.1% and 11.2%, respectively, of accounts receivable. A summary of the Company’s accounts receivable allowance for doubtful accounts activity is as follows (in thousands):


Balance at December 31, 2015		Provision for Doubtful Accounts Related to Patient Service Revenue		Provision for Doubtful Accounts		Write-offs, net of Recoveries			Balance at June 30, 2016

$	2,920		3,564		105		(2,313	)	$	4,276

Note 6 – Intangible Assets

The components of amortizable intangible assets consist of the following (in thousands):


	June 30, 2016							December 31, 2015
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Management agreements	$	5,246	$	(1,028	)	$	4,218	$	5,246	$	(931	)	$	4,315
Trade names		11,212		(9,643	)		1,569		11,212		(9,374	)		1,838
Customer relationships		767		(767	)		—		767		(767	)		—
Noncompete agreements		12,632		(4,824	)		7,808		12,632		(4,193	)		8,439

	$	29,857	$	(16,262	)	$	13,595	$	29,857	$	(15,265	)	$	14,592

For the three and six months ended June 30, 2016, aggregate amortization expense of intangible assets totaled $0.5 million and $1.0 million, respectively. For the three and six months ended June 30, 2015, aggregate amortization expense of intangible assets totaled $0.5 million and $1.1 million, respectively. Total estimated amortization expense for the Company’s intangible assets through the end of 2016 and during the next five years is as follows (in thousands):


July through December 2016	$	997
2017	$	1,993
2018	$	1,992
2019	$	1,679
2020	$	1,423
2021	$	1,417

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Note 7 – Other Accrued Liabilities

Other accrued liabilities consist of the following (in thousands):


	June 30, 2016		December 31, 2015
Accrued payables	$	2,789	$	4,502
Accrued bonus		1,017		1,949
Other accrued liabilities		733		757
IBNR claims payable		11,521		13,052
Medical claims payable		1,352		793
Income taxes payable		96		335

	$	17,508	$	21,388

Note 8 – Long-Term Debt and Capital Lease Obligations

Long-term debt and capital lease obligations consist of the following (in thousands):


	June 30, 2016			December 31, 2015
USMD Holdings, Inc.:
Credit Agreement:
Term loan, net of unamortized debt issuance of $36 and $74 at June 30, 2016 and December 31, 2015, respectively	$	6,714		$	6,676
Revolving credit facility		—			—
USMD Arlington related party advance, net of unamortized discount and debt issuance costs of $237 and $ 278 at June 30, 2016 and December 31, 2015, respectively		14,761			14,721
Convertible subordinated notes due 2019, net of unamortized discount and debt issuance costs of $2,061 and $2,398 at June 30, 2016 and December 31, 2015, respectively		22,281			21,944
Convertible subordinated notes due 2020 (including $700 related party notes), net of $15 and $17 debt issuance costs at June 30, 2016 and December 31, 2015, respectively		5,035			5,033
Other loans payable		686			909
Capital lease obligations		7,417			7,535

Total long-term debt and capital lease obligations		56,894			56,818
Less: current portion		(10,853	)		(8,607	)

Long-term debt and capital lease obligations, less current portion	$	46,041		$	48,211

Long-Term Debt Maturities

Maturities of the Company’s long-term debt at June 30, 2016, excluding unamortized debt discounts, are as follows for the years indicated (in thousands):


July through December 2016	$	6,926
2017		3,910
2018		3,872
2019		28,193
2020		8,891
Thereafter		36

Total	$	51,828

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Note 9 – Fair Value of Financial Instruments

Financial instruments consist mainly of cash and cash equivalents, accounts receivable, accounts payable, short-term borrowings and long-term debt. The carrying value of financial instruments with a short-term or variable-rate nature approximates fair value and are not presented in the table below. The carrying value and estimated fair value of the Company’s financial instruments that may not approximate fair value are set forth in the table below (in thousands):


	June 30, 2016				December 31, 2015
	Carrying Value		Fair Value		Carrying Value		Fair Value
Term loan	$	6,714	$	6,714	$	6,676	$	6,676
Convertible subordinated notes due 2019	$	22,281	$	21,127	$	21,944	$	17,805
Convertible subordinated notes due 2020	$	5,035	$	8,135	$	5,033	$	4,307
Other loans payable	$	686	$	624	$	909	$	898

At June 30, 2016 and December 31, 2015, the carrying value of the Company’s Term Loan approximates fair value due to recent amendment of the debt and its short-term nature. No events have occurred subsequent to issuance and amendment of the Term Loan to substantially impact the estimated borrowing rate applicable to the Term Loan.

The Company estimates the fair value of the convertible subordinated notes as the sum of the independently estimated fair values of the debt host instrument and embedded conversion option (Level 3 fair value measurement). The Company calculates the present value of future principal and interest payments of the debt host using estimated borrowing rates for similar subordinated debt or debt for which the Company could use to retire the existing debt. The convertible subordinated notes due 2020 issued in 2015 have effective interest rates that are higher than the effective interest rates of the convertible subordinated notes due 2019. Consequently, the estimated borrowing rate used in the calculation of 2015 fair value was increased commensurate with the borrowing rate of the convertible subordinated notes due 2020. The fair value of the embedded conversion option is valued using a Black-Scholes option pricing model. Quoted market prices are not available for the convertible subordinated notes.

The Company estimates current borrowing rates for its other loans payable by adjusting the discount factor of the obligations at the balance sheet date by the variance in borrowing rates between the issuance dates and balance sheet date (Level 2 fair value measurement). If the creditworthiness of the Company has significantly changed from the debt issuance date, management estimates the applicable borrowing rate based on the current facts and circumstances. Quoted market prices are not available for the Company’s long-term debt.

Note 10 – Share-Based Payment

Pursuant to the USMD Holdings, Inc. 2010 Equity Compensation Plan (the “Equity Compensation Plan”), the Company may issue up to 2.5 million equity awards to employees, nonemployee directors and nonemployee service providers in the form of stock options, stock and stock appreciation rights. Stock options may be granted with a contractual life of up to ten years. At June 30, 2016, the Company had 0.5 million shares available for grant under the Equity Compensation Plan.

Payments in Common Stock

For services rendered in 2015 as members of the Company’s Board of Directors, the Company elected to compensate directors in common stock of the Company in lieu of cash. Grant dates occur on the last day of each quarter for services rendered during that quarter. Shares granted are fully vested, non-forfeitable and granted pursuant to the Equity Compensation Plan. On February 21, 2016, in payment of Board of Directors’ compensation earned October 1, 2015 through December 31, 2015, the Company issued to members of the Company’s Board of Directors 21,522 previously granted shares of its common stock with an aggregate grant date fair value of $161,000.

Pursuant to the Equity Compensation Plan, on March 4, 2015, in payment of certain compensation accrued at December 31, 2015, the Company granted 4,447 shares of its common stock to a member of senior management. The shares had a grant date fair value of $35,000 and were issued on March 13, 2016.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Certain consultants to the Company have agreed to be partially compensated in common stock for services rendered. Shares granted are fully vested and non-forfeitable. Pursuant to the Equity Compensation Plan, during the year ended December 31, 2015, the Company granted to the consultants 6,613 shares of its common stock with a grant date fair value of $95,000, which were issued on March 13, 2016. On July 22, 2016, the Company issued to one of the consultants 856 previously granted shares of its common stock with an aggregate grant date fair value of $7,000.

The Company acquired certain assets of a general surgery practice in 2015 and elected to issue the former owners common stock equal to $200,000 divided by the closing price of the stock on the date of issuance, or 26,666 shares. Shares granted are fully vested and non-forfeitable. The shares were issued on February 5, 2016.

Note 11 – Earnings (loss) per Share

Basic earnings (loss) per share is computed by dividing net income (loss) attributable to the Company’s stockholders by the weighted-average number of common shares outstanding during the period, including fully vested common shares that have been granted, but not yet issued. Diluted earnings (loss) per share is based on the weighted-average number of common shares outstanding plus the number of additional shares that would have been outstanding had the potentially dilutive common shares been issued. Securities that are potentially dilutive to common shares include outstanding stock options and the convertible subordinated notes. Potential common shares are excluded from the computation of diluted earnings per common share when the effect would be antidilutive.

Dilutive potential common shares related to stock options are calculated in accordance with the treasury stock method, which assumes that proceeds from the exercise of stock options are used to purchase common shares at the average market price during the period. Proceeds from the exercise of stock options include the amount the employee must pay for exercising stock options, the amount of compensation cost for future services that the Company has not yet recognized and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible. The number of shares remaining represents the potentially dilutive effect of the securities. Stock options are only dilutive to the extent that the average market price of common stock during the period exceeds the exercise price of the options.

Dilutive common shares related to the convertible subordinated notes are calculated in accordance with the if-converted method. Under the if-converted method, if dilutive, net income (loss) attributable to the Company’s stockholders is adjusted to add back the amount of after-tax interest charges recognized in the period, including any deemed interest from a beneficial conversion feature, and the convertible subordinated notes are assumed to have been converted with the resulting common shares added to weighted average shares outstanding. These securities are only dilutive to the extent that the after-tax interest charges per common share exceed basic earnings per share.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings (loss) per share and the computation of basic and diluted earnings (loss) per share (in thousands, except per share data):


	Three Months Ended June 30,						Six Months Ended June 30,
	2016			2015			2016			2015
Numerator:
Net loss attributable to USMD Holdings, Inc. - basic	$	(4,035	)	$	(2,109	)	$	(6,671	)	$	(6,770	)
Effect of potentially dilutive securities:
Interest on convertible notes, net of tax		—			—			—			—

Net loss attributable to USMD Holdings, Inc. - diluted	$	(4,035	)	$	(2,109	)	$	(6,671	)	$	(6,770	)

Denominator:
Weighted-average common shares outstanding		11,394			10,355			11,394			10,300
Effect of potentially dilutive securities:
Stock options		—			—			—			—
Convertible subordinated notes due 2019		—			—			—			—
Convertible subordinated notes due 2020		—			—			—			—

Weighted-average common shares outstanding assuming dilution		11,394			10,355			11,394			10,300

Loss per share attributable to USMD Holdings, Inc.:
Basic	$	(0.35	)	$	(0.20	)	$	(0.59	)	$	(0.66	)
Diluted	$	(0.35	)	$	(0.20	)	$	(0.59	)	$	(0.66	)

The following table presents the potential shares excluded from the diluted earnings (loss) per share calculation because the effect of including theses potential shares would be antidilutive (in thousands):


	Three Months Ended June 30,				Six Months Ended June 30,
	2016		2015		2016		2015
Stock options		799		916		786		916
Convertible subordinated notes due 2019		1,042		1,042		1,042		1,042
Convertible subordinated notes due 2020		461		461		461		461

		2,302		2,419		2,289		2,419

Note 12 – Commitments and Contingencies

Financial Guarantees

As of June 30, 2016, the Company had issued guarantees to third parties of the indebtedness and other obligations of certain of its current and one former nonconsolidated investees. Should the investees fail to pay the obligations due, the Company could be required to make payments totaling an aggregate of $24.0 million. The guarantees provide for recourse against the investee; however, generally, if the Company was required to perform under the guarantees, recovery of any amount from investees would be unlikely. Included in the guarantee amount above is the Company’s guarantee of 46.4% of the obligations of USMD Arlington that were incurred to finance the Advance to the Company. If the Company was required to perform under that guarantee or record a liability for that guarantee, its obligations under the Advance would likely decrease by an equal amount. The remaining terms of these guarantees range from 23 to 143 months. The Company records a liability for performance under financial guarantees when, upon review of available financial information of the nonconsolidated affiliate and in consideration of pertinent factors, management determines that it is probable it will have to perform under the respective guarantee and the liability is reasonably estimable. The Company has not recorded a liability for these guarantees, as it believes it is not probable that it will have to perform under these agreements.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Purchase Commitments

In connection with arrangements to lease equipment for the new IDTF at USMD Arlington, the Company entered into service and maintenance agreements for the equipment. Future minimum payments due under these service agreements are as follows (in thousands):


2016	$	802
2017		885
2018		883
2019		883
2020		756
Thereafter		79

Total	$	4,288

Gain Contingency - Sale of Interest in Equity Method Investee

Effective January 31, 2015, a subsidiary of the Company sold for $1.6 million its interest in a cancer treatment center that it accounted for under the equity method of accounting. The investment had a carrying value of $159,000. The interest was sold to the other owner of the cancer treatment center. The buyer issued a promissory note to the Company for the $1.6 million sale price; however, the Company concluded that only $159,000 of the note was reasonably assured of collection and recorded a note receivable in that amount. Upon collection of the $159,000 note receivable, the Company began recognizing gain on the sale as additional payments are received. For the three and six months ended June 30, 2016, the Company recognized an aggregate gain on the sale of $31,000 and $100,000, respectively, which is recorded in other gain on the Company’s condensed consolidated statement of operations. The Company had provided management services to the cancer treatment center under a long term contract and the contract was terminated with the sale of its ownership interest.

Litigation

The Company is from time to time subject to litigation and related claims and arbitration matters arising in the ordinary course of business, including claims relating to contracts and financial obligations, partnership or joint venture entity disputes and, with respect to USMD Physician Services, claims arising from the provision of professional medical services to patients. In some cases, plaintiffs may seek damages, including punitive damages that may not be covered by insurance. In other cases, claims may not be covered by insurance at all. The Company maintains professional and general liability insurance through commercial insurance carriers for claims and in amounts that the Company believes to be sufficient for its operations, although, potentially, some claims may exceed the scope and amount of coverage in effect. The Company expenses as incurred legal costs associated with litigation or other loss contingencies.

The Company accrues for a contingent loss when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Significant judgment is required in both the determination of the probability of a loss and the determination as to whether a loss is reasonably estimable. These determinations are updated at least quarterly and are adjusted to reflect the effects of negotiations, settlements, rulings, advice of legal counsel and technical experts and other information and events pertaining to a particular matter. To the extent there is a reasonable possibility that probable losses could exceed amounts already accrued, if any, and the additional loss or range of loss is estimable, management discloses the additional loss or range of loss. For matters where the Company has evaluated that a loss is not probable, but is reasonably possible, the Company will disclose an estimate of the possible loss or range of loss or make a statement that such an estimate cannot be made.

For lawsuits and claims where the Company can reasonably estimate a range of loss, the Company estimates a reasonably possible range of loss of $0.1 million to $0.7 million. In the remaining lawsuits and the potential claims, the parties are in the early stages of discovery and/or the plaintiffs have not made specific demands for damages. Due to these circumstances, the Company is unable to estimate a reasonably possible range of loss related to these lawsuits and claims. The Company is insured against the claims described above and believes based on the facts known to date that any damage award related to such claims would be recoverable from its insurer.

The Company is subject to various additional claims and legal proceedings that have arisen in the ordinary course of its business activities. Management believes that any liability that may ultimately result from the resolution of these matters will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Arbitration Judgment

On February 16, 2016, an arbitrator awarded the Company $1.1 million including damages, fees and interest to date. The award will continue to accrue interest until paid. The arbitration hearing stemmed from the early termination of a long-term contract by an entity to which the Company was providing management services. An order confirming the final judgment was entered by the court on March 31, 2016. For the three and six months ended June 30, 2016, the Company recognized revenue of $0.8 million, which is recorded in management and other services revenue on the Company’s condensed consolidated statement of operations.

Financial Advisory Commitment

The Company has in place with an investment banking firm a financial advisory services agreement, as amended, (“FAS Agreement”). Under the FAS Agreement, the Company may be obligated to compensate the firm in cash for certain financial transactions, depending on the transaction type and size, in amounts generally equal to the greater of a minimum $1.0 million to $3.0 million, a percentage of the potential transaction value, or a fee to be determined in the future based on prevailing market rates for the services provided, subject to the review and restrictions imposed by the Financial Industry Regulatory Authority as further defined in the FAS Agreement. If the Company enters into a qualifying financial transaction during a one year to thirty month period subsequent to termination of the FAS Agreement, depending on the transaction type and size, the investment banking firm may be entitled to compensation under the terms of the FAS Agreement. The FAS Agreement remains in effect until terminated by either party. Pursuant to the FAS Agreement, $3.0 million of proceeds from the sale of the Lithotripsy Services business was paid to the investment banking firm. In connection with the fee for the sale of the Lithotripsy Services business, the FAS Agreement was amended to provide for a future credit of up to $1.0 million to be applied against fees incurred in future transactions. Except as noted above, the Company has not closed any transaction for which compensation is due or was paid to the investment banking firm.

Build-to-Suit Lease

For build-to-suit lease arrangements, the Company evaluates lease terms to assess whether, for accounting purposes, it should be the owner of the construction project. Under build-to-suit lease arrangements, to the extent the Company is involved in the construction of structural improvements or takes construction risk prior to commencement of a lease, the Company establishes assets and liabilities for the estimated construction costs of the shell facility. Improvements to the facility during the construction project are capitalized, and, to the extent funded by a tenant improvement allowance, the facility financing obligation is increased. Upon occupancy of facilities under build-to-suit leases, the Company assesses whether these arrangements qualify for sales recognition under the sale-leaseback accounting guidance. If the Company continues to be the deemed owner for accounting purposes, the facilities are accounted for as financing obligations. Payments the Company makes under leases in which it is considered the owner of the facility are allocated to land rental expense, based on the relative values of the land and building at the commencement of construction, reductions of the facility financing obligation and interest expense recognized on the outstanding obligation. To the extent gross future payments do not equal the recorded liability, the liability is settled upon return of the facility to the lessor. Any difference between the book value of the assets and remaining facility obligation are recorded in other income (expense), net.

The Company has entered into an arrangement to lease the majority of medical office building space in a shell facility that was under construction at the date of lease inception. In addition to its normal tenant improvements, the Company was required to install the heating, ventilation and cooling equipment and systems for its leased portion of the building. Additionally, the Company was at risk for any construction cost overruns associated with these specific structural and tenant improvements. As a result, the Company concluded that for accounting purposes, it was the deemed owner of the building during the construction period. The landlord incurred an estimated $4.4 million of construction costs and the Company incurred $0.1 million for tenant improvements. During construction, the Company recorded these amounts as construction in progress, with a corresponding build-to-suit construction financing obligation. Upon completion of the construction of the facility in December 2015, the Company evaluated derecognition of the asset and liability under the provisions for sale-leaseback transactions. The Company concluded that it had forms of continuing economic involvement in the facility, and therefore did not comply with the provisions for sale-leaseback accounting. Instead, the lease will be accounted for as a financing obligation and lease payments will be attributed to (1) a reduction of the principal financing obligation; (2) imputed interest expense; and (3) land lease expense representing an imputed cost to lease the underlying land of the facility, which is considered an operating lease. In addition, the Company recorded the underlying building asset and will depreciate it over the building’s estimated useful life of 40 years. At the conclusion of the lease term, the Company would de-recognize both the net book values of the asset and financing obligation. At June 30, 2016, the Company has recorded a $4.4 million financing obligation in other long-term liabilities in the accompanying condensed consolidated balance sheet.

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Under the lease, after a five month rent abatement, the Company is required to pay an initial base rent of $36,000 per month, increasing 3% per year, as well as all its share of building operating expenses. The lease term expires March 31, 2026 and the Company has an option to extend the lease term for two consecutive terms of five years each.

At June 30, 2016, future minimum rent payments under the build-to-suit lease are as follows (in thousands):


2016	$	218
2017		448
2018		461
2019		475
2020		489
Thereafter		2,816

Total	$	4,907

Operating Lease Commitments

As part of its current initiatives, the Company has begun consolidating certain physician clinics into newly leased, larger clinic locations that more effectively centralize and align physicians and ancillary services. In connection with this initiative, the Company has entered into new leases and renewed existing leases of medical office building space. Generally, the Company enters into leases for existing medical office building space or for space in a completed building shell and then constructs normal tenant improvements to meet its needs, subject to landlord approval. The leases provide for tenant improvement allowances to fund the design and construction of the tenant improvements. The Company records improvements to the leased space as leasehold improvements, including the improvements financed by the landlord. Tenant improvement allowances financed by the landlord are also recorded to deferred rent and amortized as a reduction to rent expense over the term of the lease beginning at the asset in-service date.

Future minimum rental commitments under non-cancelable operating leases are as follows (in thousands):


July through December 2016	$	8,028
2017		13,488
2018		11,739
2019		10,555
2020		9,102
Thereafter		35,060

Total	$	87,972

USMD HOLDINGS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements-(Continued)

June 30, 2016

(Unaudited)

Note 13 – Related Party Transactions

The Company provides management, clinical and support services to various nonconsolidated affiliates in which it has limited partnership or ownership interests. Management and other services revenue and accounts receivable from these entities are as follows (in thousands):


	Management and Other Services Revenue
	Three Months Ended June 30,				Six Months Ended June 30,
	2016		2015		2016		2015
USMD Arlington	$	2,863	$	2,765	$	5,634	$	5,392
USMD Fort Worth		850		815		1,690		1,629
Other equity method investees		573		351		1,065		748

	$	4,286	$	3,931	$	8,389	$	7,769


	Accounts Receivable
	June 30, 2016		December 31, 2015
USMD Arlington	$	829	$	967
USMD Fort Worth		446		383
Other equity method investees		236		50

	$	1,511	$	1,400

One previously consolidated lithotripsy entity that was a component of the sale of the Lithotripsy Services business historically provided lithotripsy services to USMD Arlington and USMD Fort Worth. For the three and six months ended June 30, 2015, the Company recognized lithotripsy revenues from USMD Arlington and USMD Fort Worth totaling $0.5 million and $0.9 respectively.

The Company leases space from USMD Arlington for certain of its physicians and its Arlington-based cancer treatment center. For the three months ended June 30, 2016 and 2015, the Company recognized rent expense related to USMD Arlington totaling $0.7 million and $0.5 million, respectively. For the six months ended June 30, 2016 and 2015, the Company recognized rent expense related to USMD Arlington totaling $1.3 million and $1.0 million, respectively.

WNI-DFW, the Company’s consolidated VIE that operates under a population health management model, records medical services expense for its patients that are treated at USMD Arlington and USMD Fort Worth. Medical services expense incurred by WNI-DFW with these entities and its related accounts payable are as follows (in thousands:


	Medical Services Expense
	Three Months Ended June 30,				Six Months Ended June 30,
	2016		2015		2016		2015
USMD Arlington	$	491	$	720	$	781	$	1,145
USMD Fort Worth		138		132		245		206

	$	629	$	852	$	1,026	$	1,351


	Accounts Payable
	June 30, 2016		December 31, 2015
USMD Arlington	$	124	$	198
USMD Fort Worth		16		66

	$	140	$	264

Item 2.

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

As used in this Quarterly Report on Form 10-Q, the terms “USMD,” the “Company,” “we,” “us” and “our” refer to USMD Holdings, Inc. and its consolidated subsidiaries, unless otherwise stated or indicated by context.

The purpose of this section, Management’s Discussion and Analysis of Financial Condition and Results of Operations, is to provide a narrative explanation of our financial statements from the perspective of our management that enables investors to better understand our business, to enhance our overall financial disclosures, to provide the context within which our financial information may be analyzed and to provide information about the quality of, and potential variability of, our financial condition, results of operations and cash flows. This section should be read in conjunction with the accompanying condensed consolidated financial statements.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains, and from time to time management may make, statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts but instead represent management’s current expectations regarding future events, many of which, by their nature, are inherently uncertain and outside its control. The forward-looking statements contained in this Quarterly Report are based on information as of the date of this Quarterly Report on Form 10-Q. Many of these forward-looking statements relate to future industry trends, actions, future performance or results of current and anticipated initiatives and the outcome of contingencies and other uncertainties that may have a significant impact on our business, future operating results and liquidity. Whenever possible, we identify these statements by using words such as “anticipate,” “believe,” “estimate,” “continue,” “intend,” “expect,” “plan,” “forecast,” “project” and similar expressions for future-tense or we may use conditional constructions (“will,” “may,” “should,” “could,” etc.). We caution you that these statements are only predictions and are not guarantees of future performance. These forward-looking statements and our actual results, developments and business are subject to certain risks and uncertainties that could cause actual results and events to differ materially from those anticipated by these statements. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements. We assume no obligation to update or revise any forward-looking statements, whether as a result of new information or future events, except as required by law. Many factors that could cause actual results to differ from those in the forward-looking statements including, among others, those discussed under “Risk Factors,” in our Registration Statement on Form S-4 and those described elsewhere in this Quarterly Report on Form 10-Q and from time to time in our future reports filed with the Securities and Exchange Commission (the “SEC”).

Executive Overview

Background

We are an early-stage physician-led integrated health system committed to maintaining the vital doctor-patient relationship that we believe results in higher quality and more affordable patient care. An integrated health system is considered early-stage when it has not yet established all the components necessary to be considered a fully integrated health system. Our focus, and the focus of our healthcare providers, is to deliver higher quality, more convenient, cost effective healthcare to our patients. We believe that our model brings primary care and specialist physicians together and places them in their proper role as leaders of healthcare delivery and that this important shift brings quality and patient satisfaction back to the forefront by making our providers responsible for patient outcomes and the overall clinical experience.

Through our subsidiaries and affiliates, we provide healthcare services to patients and management and operational services to healthcare providers. We operate in one physician-led integrated health system segment. We provide healthcare services to patients in physician clinics, hospitals and other healthcare facilities, including cancer treatment centers and anatomical pathology and clinical laboratories. A wholly owned subsidiary of USMD is the sole member of a Texas Certified Non-Profit Health Organization that owns and operates a multi-specialty physician group practice (“USMD Physician Services”) in the Dallas-Fort Worth, Texas metropolitan area. We operate under a traditional fee-for-service model as well as a risk contracting model.

In April 2013, a subsidiary of USMD became an equal co-member of a Texas non-profit corporation that has been approved by the Texas Medical Board as a Certified Non-Profit Health Organization (“WNI-DFW”). WNI-DFW has a contractual arrangement to manage patient care by providing or arranging for the provision of all the necessary healthcare services for a health plan’s given Medicare Advantage patient population in the North Texas area served by WNI-DFW. Pursuant to the arrangement, WNI-DFW receives a fixed fee per patient under what is typically known as a “risk contract.” Risk contracting, or risk capitation, refers to a population health management model where we receive from the third party payer a fixed payment per member per month for a defined patient population to manage the healthcare of that population. In such a model, we are responsible for all cost of care of the population, subject to certain exceptions. WNI-DFW accomplishes this by managing patient care and by contracting with healthcare providers to provide needed healthcare services for the patient population. This population health management model differs from the traditional fee-for-service model where we are paid based on specific services performed. Under this model, USMD and the other member of WNI-DFW are entitled to any residual amounts and bear the risk of any deficits resulting from managing the healthcare of the population. Our WNI-DFW co-member is an industry leader in medical risk management and efficient healthcare delivery services. Under our arrangement, our co-member provides administrative services, including a utilization management function that works closely with our case management team. USMD Physician Services provides physician services to the managed patient population. We consolidate the operations of WNI-DFW into our financial statements. WNI-DFW commenced operations on June 1, 2013.

Through other wholly owned subsidiaries, we provide management and operational services to general acute care hospitals (in Arlington, Texas and Fort Worth, Texas) and provide management and/or operational services to four cancer treatment centers in four states. Of the managed entities, we have limited ownership interests in the two hospitals and one cancer treatment center. In addition, we wholly own and operate one Independent Diagnostic Testing Facility (“IDTF”), one cancer treatment center, two clinical laboratories and one anatomical pathology laboratory in the Dallas-Fort Worth, Texas metropolitan area. We have noncontrolling ownership interests in one cancer treatment center limited liability corporation and one lithotripsy service provider that we do not manage.

Historically, we have provided management and operational services to lithotripsy service providers (“Lithotripsy Services”). On December 18, 2015, we sold our Lithotripsy Services business. The sale included the management services business as well as controlling and noncontrolling interests in our lithotripsy service provider entities. We retained a noncontrolling interest in one lithotripsy service provider entity. In its existing form, the lithotripsy business was not a core component of an integrated health system and, therefore, was not aligned with the strategic objectives of the Company.

We intend to expand our physician-led integrated health system in the North Texas service area, with a specific focus on expansion of our population health management business and ancillary service offerings. Our success is dependent upon our ability to i) increase the number of physicians and specialists in our system; ii) increase our risk services managed patient populations; iii) expand the service offerings within our physician-led integrated health system – to move from an early-stage integrated health system to a fully integrated health system; iv) reasonably estimate the risk profile of patient populations and accurately document and code patient conditions within those populations; and v) control costs of care. Our near term growth and success is dependent upon our ability to execute our expansion strategy and to organize and successfully assimilate those new components into our healthcare delivery model.

For the periods presented, we had the following operating statistics:


	As of June 30,
	2016		2015
Clinics and other healthcare facilities operated out of by USMD Physician Services		56		57
Primary care and pediatric physicians employed		131		129
Physician specialists employed		88		90


	Three Months Ended June 30,				Six Months Ended June 30,
	2016		2015		2016		2015
Patient encounters⁽ⁱ⁾		225,192		233,359		457,959		452,230
RVU’s⁽ⁱⁱ⁾		391,767		397,047		783,275		763,752
Lab tests⁽ⁱⁱⁱ⁾		334,620		335,214		684,609		654,659
Imaging procedures ⁽ⁱⁱⁱ⁾		12,851		7,781		24,739		16,289
Cancer treatment center fractions treated^(iv)		4,799		4,646		10,215		9,107
Lithotripsy cases ⁽ⁱⁱⁱ⁾		—		2,477		—		4,687
Capitated member months ^(v)		31,398		28,456		62,229		56,320


	June 30, 2016		March 31, 2016		December 31, 2015		September 30, 2015		June 30, 2015
Capitated membership^(vi)		10,489		10,296		9,844		9,707		9,534

i.	A patient encounter is registered when a patient sees his or her USMD healthcare provider.

ii.

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

iii.	Lab tests, imaging procedures and lithotripsy cases are all production metrics based on Current Procedural Terminology codes promulgated by the American Medical Association.

iv.	Cancer treatment center fractions are production metrics based on Current Procedural Terminology codes and include fractions from our wholly owned center.

v.	Capitated member months represent the aggregate number of months of healthcare services WNI-DFW has provided to capitated members.

vi.	Capitated membership represents the number of members under a capitation arrangement to which we provided healthcare services as of a specified date.

We use various evidence-based quality metrics such as specific cancer screenings to measure how well our physicians manage their patient panels. We believe our quality criteria have enabled us to reduce the total medical cost of care of our managed patients, including reductions in emergency room visits and hospital readmissions. We use these and other metrics to measure the performance of our business.

Results of Operations

Three Months Ended June 30, 2016 Compared to Three Months Ended June 30, 2015

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


	Three Months Ended June 30,												Three Month Variance
	2016						2015						2016 vs. 2015
	Amount			Ratio			Amount			Ratio			Amount			Ratio
Revenues:
Net patient service revenue	$	47,291			57.8	%	$	47,229			57.7	%	$	62			0.1	%
Capitated revenue		28,557			34.9	%		24,020			29.3	%		4,537			18.9	%
Management and other services revenue		5,925			7.2	%		5,181			6.3	%		744			14.4	%
Lithotripsy revenue		—			0.0	%		5,411			6.6	%		(5,411	)		-100.0	%

Net operating revenue		81,773			100.0	%		81,841			100.0	%		(68	)		-0.1	%

Operating expenses:
Salaries, wages and employee benefits		41,319			50.5	%		42,429			51.8	%		(1,110	)		-2.6	%
Medical services and supplies expense		30,384			37.2	%		25,972			31.7	%		4,412			17.0	%
Rent expense		4,245			5.2	%		4,108			5.0	%		137			3.3	%
Provision for doubtful accounts		(1	)		0.0	%		14			0.0	%		(15	)		-107.1	%
Other operating expenses		10,809			13.2	%		10,201			12.5	%		608			6.0	%
Depreciation and amortization		2,360			2.9	%		2,024			2.5	%		336			16.6	%

		89,116			109.0	%		84,748			103.6	%		4,368			5.2	%

Loss from operations		(7,343	)		-9.0	%		(2,907	)		-3.6	%		(4,436	)		152.6	%
Other income, net		1,884			2.3	%		2,058			2.5	%		(174	)		-8.5	%

Loss before income taxes		(5,459	)		-6.7	%		(849	)		-1.0	%		(4,610	)		543.0	%
Benefit for income taxes		(1,424	)		-1.7	%		(1,184	)		-1.4	%		(240	)		20.3	%

Net income (loss)		(4,035	)		-4.9	%		335			0.4	%		(4,370	)		-1304.5	%
Less: net income attributable to noncontrolling interests		—			0.0	%		(2,444	)		-3.0	%		2,444			-100.0	%

Net loss attributable to USMD Holdings, Inc.	$	(4,035	)		-4.9	%	$	(2,109	)		-2.6	%	$	(1,926	)		91.3	%

Revenues

The following table summarizes our net operating revenues for the periods indicated and is used in the revenue discussions that follow (dollars in thousands):


	Three Months Ended June 30,										Three Month Variance
	2016					2015					2016 vs. 2015
	Amount		Ratio			Amount		Ratio			Amount			Ratio

Net patient service revenue:
Physician clinics	$	37,767		46.2	%	$	38,726		47.3	%	$	(959	)		-2.5	%
Imaging		2,116		2.6	%		1,125		1.4	%		991			88.1	%
Diagnostic laboratories		3,885		4.8	%		3,986		4.9	%		(101	)		-2.5	%
Cancer treatment center		2,347		2.9	%		2,565		3.1	%		(218	)		-8.5	%

Total patient encounter based clinic net patient service revenue		46,115		56.4	%		46,402		56.7	%		(287	)		-0.6	%
Other physician revenue		1,176		1.4	%		827		1.0	%		349			42.2	%

		47,291		57.8	%		47,229		57.7	%		62			0.1	%


Capitated revenue		28,557		34.9	%		24,020		29.3	%		4,537			18.9	%


Management and other services revenue:
Hospital management revenue		3,712		4.5	%		3,579		4.4	%		133			3.7	%
Lithotripsy management revenue		—		0.0	%		357		0.4	%		(357	)		-100.0	%
Cancer treatment center management revenue		701		0.9	%		550		0.7	%		151			27.5	%
Other services revenue		1,512		1.8	%		695		0.8	%		817			117.6	%

		5,925		7.2	%		5,181		6.3	%		744			14.4	%


Lithotripsy revenue		—		0.0	%		5,411		6.6	%		(5,411	)		-100.0	%



Net operating revenue	$	81,773		100.0	%	$	81,841		100.0	%	$	(68	)		-0.1	%

Net Patient Service Revenue

Our net patient service revenue (“NPSR”) is driven by a patient encounter at one of our physician clinics. A patient sees the physician at one of our clinics and the physician may prescribe services that may be performed at one of our imaging centers, diagnostic laboratories, cancer treatment center or other affiliated healthcare facilities. The NPSR earned at our imaging centers, diagnostic laboratories and cancer treatment center are almost exclusively derived from the physician clinic patient encounter. Our imaging centers, diagnostic laboratories and cancer treatment center only nominally serve patients or conduct tests not derived from our physician clinic patient encounter. For these reasons, we utilize the overall NPSR per patient encounter metric.

Patient encounter based clinic NPSR decreased $0.3 million or 0.6%, net of a $0.2 million increase in the provision for doubtful accounts. Patient encounters and RVUs decreased 3.5% and 1.3%, respectively, for the three months ended June 30, 2016 as compared to the same period in 2015. NPSR per patient encounter increased 3.0% due to a favorable change in case mix offset by an unfavorable shift in payer mix. The shift in payer mix was a result of an increase in utilization by beneficiaries enrolled in government program payer sources from 41% to 42% of gross charges. The $0.2 million decrease at the cancer treatment center is primarily due to a decline in certain commercial payer reimbursement rates. We anticipate downward pricing pressure to continue to negatively impact NPSR at the cancer treatment center during 2016.

Other physician revenue represents non-clinic physician premium payments for quality measures, on-call pay and physician recruitment agreement revenues and increased to $1.2 million for the three months ended June 30, 2016 from $0.8 million during the same period in 2015. The increase is primarily attributable to a $0.3 million increase in premium payments for quality measures.

Capitated Revenue

We record capitated revenue associated with the consolidated operations of WNI-DFW. Capitated revenue is correlated to capitated membership counts as well as the health risk of the patient population being managed; the population risk impacts the “per member per month” rate earned. Capitated revenue increased $4.5 million to $28.6 million for the three months ended June 30, 2016 from $24.0 million in 2015. The growth in membership counts at WNI-DFW accounted for $2.5 million of the increase and a rise in the aggregate risk score assigned to our managed Medicare Advantage population accounted for $2.0 million of the increase. We anticipate expanding our capitated member counts through WNI-DFW and other entities focused on the Medicare Advantage market as we execute our strategy to move from an early-stage integrated health system to a fully integrated health system. During 2014, we invested in systems to train and monitor our physicians and staff with the intent to improve the accuracy of physician documentation and coding of patient conditions. We believe these efforts have resulted in a more accurate assessment by CMS of the risk score of our managed Medicare Advantage population.

Management and Other Services Revenue

Management services revenue includes revenue earned through the provision of management and support services to our nonconsolidated managed entities and is generated through our management of hospitals, cancer treatment centers and, prior to the sale of our Lithotripsy Services business, lithotripsy centers. Management and other services revenue increased 14.4% to $5.9 million for the three months ended June 30, 2016 from $5.2 million in 2015 for the reasons noted below.

Hospital management revenue earned from USMD Hospital at Arlington, L.P. (“USMD Arlington”) and USMD Hospital at Fort Worth, L.P. (“USMD Fort Worth”) increased $0.1 million or 3.7% in 2016 as compared to 2015. An increase in surgical case volume and in the contractual inflation adjustment to reimbursable support costs contributed $0.2 million to the increase in hospital management revenue and was offset by a $0.1 million decrease related to an unfavorable shift to a lower acuity surgical case mix at the hospitals and an unfavorable change in commercial versus government payer mix.

Cancer treatment center management revenue increased $0.2 million or 27.5% in 2016 as compared to 2015. We earn cancer treatment center management revenue by charging the cancer treatment center a contracted management fee that is based on a percentage of the managed entity’s account collections, net income, a combination of collections and net income, or a fixed monthly fee and reimbursement of variable support costs. We negotiate the management fee with each cancer treatment center and the fee differs between managed entities. Shifts in the level of activity between managed entities affect the price mix of cancer treatment center management revenue. The opening of a new cancer treatment center during the first quarter of 2016 resulted in a $0.2 million increase in consolidated cancer treatment center management revenue in 2016 as compared to 2015. Same facility cancer treatment center management revenue remained flat in 2016 as compared to 2015. Same facility year over year individual entity contractual rates did not change in 2016 as compared to 2015 rates.

Other services revenue primarily consists of healthcare information technology consulting services provided to third parties and income related to the early termination of management agreements. Other services revenue increased $0.8 million to $1.5 million for the three months ended June 30, 2016 from $0.7 million in 2015. In the second quarter of 2016, we entered into a settlement agreement and recognized $0.8 million as a result of the early termination of a management agreement.

Operating Expenses

Salaries, wages and employee benefits decreased $1.1 million to $41.3 million for the three months ended June 30, 2016 from $42.4 million in 2015. Physician and physician extenders salary expense decreased $2.0 million primarily due to the new physician compensation model and a decline in RVUs offset by a $0.2 million increase related to salaried physician costs. Effective July 2015, we completed implementation of many of the key components of the model. As a result of the implementation, physician salaries decreased during the three months ended June 30, 2016 relative to the run rate experienced since the plan became effective. In addition, during the three months ended June 30, 2016, physician and extender salary expense incurred per RVU generated and as a percent of NPSR declined as compared to salary expense incurred prior to July 2015. We anticipate continued reduction in the relative run rate in 2016 and future years. Non-physician salary and wages expense decreased $0.1 million, primarily related to a decline in headcount. Employee benefit costs increased $0.7 million primarily due to increases in health benefits expense and retirement benefits expense. Contract labor costs increased $0.1 million.

Medical services and supplies expense includes external medical claims costs associated with population health management (WNI-DFW) as well as medical services and supplies associated with all patients, such as drugs, medications and general medical supplies. Medical services and supplies expense increased $4.4 million to $30.4 million for the three months ended June 30, 2016 from $26.0 million in 2015. Drug supplies expense increased $1.0 million for the three months ended June 30, 2016 as compared to 2015, commensurate with the increase in drug supplies revenue. WNI-DFW medical services expense increased $3.3 million to $21.7 million for the three months ended June 30, 2016 from $18.4 million in 2015. Medical services expense of WNI-DFW includes the direct medical cost of caring for the patient population including incurred but not reported (“IBNR”) medical claims.

Rent expense increased $0.1 million to $4.2 million for the three months ended June 30, 2016 from $4.1 million in 2015 primarily due to an increase in leased square footage.

Other operating expenses consist primarily of management fees, consulting and professional fees, purchased services, repairs and maintenance, utilities and other expense. Other operating expenses increased $0.6 to $10.8 million for the three months ended June 30, 2016 from $10.2 million in 2015. The increase is primarily related to an increase of $1.0 in purchased services, professional fees and insurance offset by a decrease of $0.4 million in repairs and maintenance.

Depreciation and amortization increased $0.3 million for the three months ended June 30, 2016 as compared to the same period in 2015, primarily due to asset additions.

Other Income, net

Other income, net decreased $0.2 million to $1.9 million for the three months ended June 30, 2016 from $2.1 million in 2015 due primarily to a $0.4 million increase in net interest expense and a $0.2 expense related to the sale of our Lithotripsy Services business, offset by $0.4 net increase in equity in income of nonconsolidated affiliates. The increase in equity in income of nonconsolidated entities was the result of a $0.3 million increase in the equity in income of USMD Arlington and USMD Fort Worth and a $0.1 million increase in comparative equity in income of the remaining nonconsolidated affiliates.

Income Tax Benefit

Our effective tax rates were 26.7% and 139.6% for the three months ended June 30, 2016 and 2015, respectively. The 2016 variance from the statutory rate is primarily due to nondeductible interest expense related to our convertible debt. The 2015 variance from the statutory rate is primarily due to the impact that net income attributable to noncontrolling interests has on a tax rate when a pretax loss exists.

Net Income Attributable to Noncontrolling Interests

As of the date of sale of our Lithotripsy Services business, we no longer eliminate income or loss attributable to non-USMD ownership interests.

Six Months Ended June 30, 2016 Compared to Six Months Ended June 30, 2015

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


	Six Months Ended June 30,												Six Month Variance
	2016						2015						2016 vs. 2015
	Amount			Ratio			Amount			Ratio			Amount			Ratio
Revenues:
Net patient service revenue	$	95,402			58.5	%	$	91,180			57.4	%	$	4,222			4.6	%
Capitated revenue		56,832			34.8	%		47,091			29.7	%		9,741			20.7	%
Management and other services revenue		10,929			6.7	%		10,249			6.5	%		680			6.6	%
Lithotripsy revenue		—			0.0	%		10,267			6.5	%		(10,267	)		-100.0	%

Net operating revenue		163,163			100.0	%		158,787			100.0	%		4,376			2.8	%

Operating expenses:
Salaries, wages and employee benefits		83,232			51.0	%		83,938			52.9	%		(706	)		-0.8	%
Medical services and supplies expense		56,643			34.7	%		51,016			32.1	%		5,627			11.0	%
Rent expense		8,698			5.3	%		8,164			5.1	%		534			6.5	%
Provision for doubtful accounts		105			0.1	%		(119	)		-0.1	%		224			-188.2	%
Other operating expenses		21,615			13.2	%		20,055			12.6	%		1,560			7.8	%
Depreciation and amortization		4,616			2.8	%		4,251			2.7	%		365			8.6	%

		174,909			107.2	%		167,305			105.4	%		7,604			4.5	%

Loss from operations		(11,746	)		-7.2	%		(8,518	)		-5.4	%		(3,228	)		37.9	%
Other income, net		2,667			1.6	%		3,071			1.9	%		(404	)		-13.2	%

Loss before income taxes		(9,079	)		-5.6	%		(5,447	)		-3.4	%		(3,632	)		66.7	%
Benefit for income taxes		(2,408	)		-1.5	%		(3,203	)		-2.0	%		795			-24.8	%

Net loss		(6,671	)		-4.1	%		(2,244	)		-1.4	%		(4,427	)		197.3	%
Less: net income attributable to noncontrolling interests		—			0.0	%		(4,526	)		-2.9	%		4,526			-100.0	%

Net loss attributable to USMD Holdings, Inc.	$	(6,671	)		-4.1	%	$	(6,770	)		-4.3	%	$	99			-1.5	%

Revenues

The following table summarizes our net operating revenues for the periods indicated and is used in the revenue discussions that follow (dollars in thousands):


	Six Months Ended June 30,										Six Month Variance
	2016					2015					2016 vs. 2015
	Amount		Ratio			Amount		Ratio			Amount			Ratio

Net patient service revenue:
Physician clinics	$	76,388		46.8	%	$	73,965		46.6	%	$	2,423			3.3	%
Imaging		4,114		2.5	%		2,431		1.5	%		1,683			69.2	%
Diagnostic laboratories		7,821		4.8	%		7,900		5.0	%		(79	)		-1.0	%
Cancer treatment center		5,124		3.1	%		5,079		3.2	%		45			0.9	%

Total patient encounter based clinic net patient service revenue		93,447		57.3	%		89,375		56.3	%		4,072			4.6	%
Other physician revenue		1,955		1.2	%		1,805		1.1	%		150			8.3	%

		95,402		58.5	%		91,180		57.4	%		4,222			4.6	%


Capitated revenue		56,832		34.8	%		47,091		29.7	%		9,741			20.7	%


Management and other services revenue:
Hospital management revenue		7,323		4.5	%		7,021		4.4	%		302			4.3	%
Lithotripsy management revenue		—		0.0	%		694		0.4	%		(694	)		-100.0	%
Cancer treatment center management revenue		1,348		0.8	%		1,085		0.7	%		263			24.2	%
Other services revenue		2,258		1.4	%		1,449		0.9	%		809			55.8	%

		10,929		6.7	%		10,249		6.5	%		680			6.6	%


Lithotripsy revenue		—		0.0	%		10,267		6.5	%		(10,267	)		-100.0	%



Net operating revenue	$	163,163		100.0	%	$	158,787		100.0	%	$	4,376			2.8	%

Net Patient Service Revenue

Patient encounter based clinic NPSR increased $4.1 million or 4.6%, net of a $1.2 million increase in the provision for doubtful accounts. Patient encounters and RVUs increased by 1.3% and 2.6%, respectively for the six months ended June 30, 2016 as compared to the same period in 2015. NPSR per patient encounter increased 3.2%, due to a change in case mix offset by an unfavorable shift in payer mix. The shift in payer mix was reflected by an increase in utilization by beneficiaries enrolled in government program payer sources from 41% to 42% of gross charges. Cancer treatment center revenue remained flat in 2016 as compared to 2015. A $0.5 million increase related to an increase in fractions treated at the cancer treatment center was offset by a $0.5 million decrease related to a decline in certain commercial payer reimbursement rates.

The provision for doubtful accounts related to patient service revenue increased $1.2 million during the six months ended June 30, 2016 as compared to the same period in 2015. Year over year comparative overall collections have slowed resulting in an increase in gross patient accounts receivable, further aging of accounts receivable and an increase in the provision for doubtful accounts. We believe the slowed collection rate is temporary and partially attributable to an information technology system conversion.

Other physician revenue represents non-clinic physician premium payments for quality measures, on-call pay and physician recruitment agreement revenues and increased to $2.0 million for the six months ended June 30, 2016 from $1.8 million during the same period in 2015. The increase is primarily attributable to a $0.3 million increase in on-call pay offset by a $0.1 million decline in premium payments for quality measures.

Capitated Revenue

Capitated revenue increased $9.7 million to $56.8 million for the six months ended June 30, 2016 from $47.1 million in 2015. The growth in membership counts at WNI-DFW accounted for $5.0 million of the increase and a rise in the aggregate risk score assigned to our managed Medicare Advantage population accounted for $4.7 million of the increase. We anticipate expanding our capitated member counts through WNI-DFW and other entities focused on the Medicare Advantage market as we execute our strategy to move from an early-stage integrated health system to a fully integrated health system. During 2014, we invested in systems to train and monitor our physicians and staff with the intent to improve the accuracy of physician documentation and coding of patient conditions. We believe these efforts have resulted in a more accurate assessment by CMS of the risk score of our managed Medicare Advantage population.

Management and Other Services Revenue

Management services revenue includes revenue earned through the provision of management and support services to our nonconsolidated managed entities and is generated through our management of hospitals, cancer treatment centers and, prior to the sale of our Lithotripsy Services business, lithotripsy centers. Management and other services revenue increased 6.6% to $10.9 million for the six months ended June 30, 2016 from $10.2 million in 2015 for the reasons noted below.

Hospital management revenue earned from USMD Arlington and USMD Fort Worth increased $0.3 million or 4.3% in 2016 as compared to 2015. An increase in surgical case volume and in the contractual inflation adjustment to reimbursable support costs contributed $0.4 million to the increase in hospital management revenue and was offset by a $0.1 million decrease related to an unfavorable shift to a lower acuity surgical case mix at the hospitals and an unfavorable change in commercial versus government payer mix.

Cancer treatment center management revenue increased $0.3 million or 24.2% in 2016 as compared to 2015. We earn cancer treatment center management revenue by charging the cancer treatment center a contracted management fee that is based on a percentage of the managed entity’s account collections, net income, a combination of collections and net income, or a fixed monthly fee and reimbursement of variable support costs. We negotiate the management fee with each cancer treatment center and the fee differs between managed entities. Shifts in the level of activity between managed entities affect the price mix of cancer treatment center management revenue. The opening of new cancer treatment centers during the first quarter of 2016 and during the first quarter of 2015 resulted in a $0.3 million increase in consolidated cancer treatment center management revenue in 2016 as compared to 2015. Same facility cancer treatment center management revenue remained flat in 2016 as compared to 2015. Same facility year over year individual entity contractual rates did not change in 2016 as compared to 2015 rates.

Other services revenue primarily consists of healthcare information technology consulting services provided to third parties and income related to the early termination of management agreements. Other services revenue increased $0.8 million to $2.3 million for the six months ended June 30, 2016 from $1.4 million in 2015. In the second quarter of 2016, we entered into a settlement agreement and recognized $0.8 million as a result of the early termination of a management agreement.

Operating Expenses

Salaries, wages and employee benefits decreased $0.7 million to $83.2 million for the six months ended June 30, 2016 from $83.9 million in 2015. Physician and physician extenders salary expense decreased $4.0 million primarily due to the new physician compensation model offset by a $1.7 million increase related to an increase in RVUs and growth in salaried physician cost. Effective July 2015, we completed implementation of many of the key components of the model. As a result of the implementation, physician salaries decreased during the six months ended June 30, 2016 relative to the run rate experienced since the plan became effective. In addition, during the six months ended June 30, 2016, physician and extender salary expense incurred per RVU generated and as a percent of NPSR declined as compared to salary expense incurred prior to July 2015. We anticipate continued reduction in the relative run rate in 2016 and future years. Employee benefit costs increased $1.1 million primarily due to increases in health benefits expense, retirement benefits expense and payroll taxes. Contract labor costs increased $0.3 million and non-physician salary and wages expense increased $0.2 million.

Medical services and supplies expense includes external medical claims costs associated with population health management (WNI-DFW) as well as medical services and supplies associated with all patients, such as drugs, medications and general medical supplies. Medical services and supplies expense increased $5.6 million to $56.6 million for the six months ended June 30, 2016 from $51.0 million in 2015. Drug supplies expense increased $2.7 million for 2016 as compared to 2015, commensurate with the increase in drug supplies revenue. WNI-DFW medical services expense increased $2.9 million to $39.3 million for 2016 from $36.4 million in 2015. Medical services expense of WNI-DFW includes the direct medical cost of caring for the patient population including incurred but not reported (“IBNR”) medical claims.

Rent expense increased $0.5 million to $8.7 million for the six months ended June 30, 2016 from $8.2 million in 2015 primarily due to an increase in leased square footage.

Other operating expenses consist primarily of management fees, consulting and professional fees, purchased services, repairs and maintenance, utilities and other expense. Other operating expenses increased $1.6 to $21.6 million for the six months ended June 30, 2016 from $20.1 million in 2015. Medical management and administrative fees incurred at WNI-DFW increased $1.4 million. As

WNI-DFW member counts and revenues grow, and as WNI-DFW gains efficiencies in its provision of care coordination and overall medical management services, we anticipate that medical management fees incurred at WNI-DFW will continue to increase. The remaining increase is primarily related to an increase of $1.1 million in purchased services and insurance offset by $0.7 million decrease in professional fees and a $0.6 million decrease in repairs and maintenance.

Depreciation and amortization increased $0.4 million for the six months ended June 30, 2016 as compared to the same period in 2015, primarily due to asset additions. The $0.4 million net increase in depreciation and amortization is comprised of increases in fixed asset depreciation and amortization offset by $0.1 million in intangible asset amortization.

Other Income, net

Other income, net decreased $0.4 million to $2.7 million for the six months ended June 30, 2016 from $3.1 million in 2015 due primarily to a $0.6 million increase in net interest expense and a $0.2 expense related to the sale of our Lithotripsy Services business, offset by $0.3 net increase in equity in income of nonconsolidated affiliates. Equity in income of USMD Arlington and USMD Fort Worth remained flat in 2016 as compared to 2015 while comparative equity in income of the remaining nonconsolidated affiliates increased $0.3 million.

Income Tax Benefit

Our effective tax rates were 26.5% and 58.9% for the six months ended June 30, 2016 and 2015, respectively. The 2016 variance from the statutory rate is primarily due to nondeductible interest expense related to our convertible debt. The 2015 variance from the statutory rate is primarily due to the impact that net income attributable to noncontrolling interests has on a tax rate when a pretax loss exists.

Net Income Attributable to Noncontrolling Interests

As of the date of sale of our Lithotripsy Services business, we no longer eliminate income or loss attributable to non-USMD ownership interests.

Liquidity and Capital Resources

Our principal uses of cash are for working capital requirements, financing obligations and capital expenditures. Our primary sources of liquidity include existing cash and cash flows from operations including distributions from USMD Arlington and USMD Fort Worth. In addition, we may apply various mechanisms to manage cash flows, including utilizing our common stock as a form of liquidity. We continue to explore potential sources of additional liquidity. Liquidity provided by distributions from USMD Arlington and USMD Fort Worth can vary materially depending on hospital profitability and the individual cash requirements of the hospital. Additionally, we anticipate distributions from USMD Arlington to be lower than historical distributions due to the mechanics of repayment of certain borrowings from USMD Arlington (see Financing Activities below). At June 30, 2016, we had $5.2 million of cash and cash equivalents available for general corporate purposes. This amount is net of $8.7 million of restricted cash and $14.0 million of cash held by WNI-DFW, which is only available for use by WNI-DFW. As further described in the Credit Agreement section below, we are required to maintain a compensating balance of $6.8 million as collateral for our borrowings under our credit agreement. We believe that these sources of cash and cash management techniques will be adequate to fund our working capital requirements, debt service obligations, ongoing capital expenditures and other ongoing cash needs until 2019, when certain convertible subordinated notes are due.

We may utilize our common stock as a form of liquidity, primarily in payment of certain compensation and when acquiring physician practices. Our physician compensation model allows for up to 25% of the base salary of certain physicians to be deferred under certain conditions, and later paid in cash, our common stock, or a combination of both. We do not anticipate deferring physician salaries in 2016.

We may also utilize our common stock to pay certain compensation deferred under our Salary Deferral Plan (the “Deferral Plan”). Participation in the Deferral Plan is limited to certain of our executives and permits us to defer the payment of a predetermined portion of a participant’s base salary each calendar quarter. The plan administrator decides after the end of each quarter whether deferred amounts will be paid in the form of cash, shares of common stock or a combination of both. No executives have elected to participate in the Deferral Plan in 2016.

Shares of common stock issued pursuant to the Deferral Plan or in payment of deferred physician compensation are issued from the shares of common stock authorized for issuance under the USMD Holdings, Inc. 2010 Equity Compensation Plan, as amended.

As we execute our physician-led integrated health system strategy, we anticipate making capital investments, primarily as related to the opening of another IDTF, the continued consolidation and expansion of our physician clinics and investments in certain information technology infrastructure. Significant capital investments, including expansion related capital investments, may be financed through long-term debt or lease arrangements, funded with borrowings under the revolving credit facility, if available, or paid for with existing cash. As we execute our strategy to expand our physician-led integrated health system, we will continue to invest in our infrastructure and incur acquisition and integration costs. Significant expansion may be financed with our equity and/or additional indebtedness or through lease arrangements. As our business model matures, we believe cash flows from operations will provide the cash flow necessary to support integration costs and infrastructure investment. However, certain growth plans and infrastructure investment may be curtailed depending upon the availability of cash and additional sources of financing. In addition, our WNI-DFW joint venture may require cash advances from us.

Our credit agreement provides for a revolving credit facility (“Revolver”) commitment of up to $10.0 million through December 21, 2016, subject to certain financial covenants. The Revolver is available for working capital needs and capital expenditures (up to $1.5 million per year), both subject to certain criteria. At June 30, 2016, we had no borrowings under the Revolver and no amounts were available to borrow under the Revolver, as calculated per the financial covenants in our credit agreement. Our ability to borrow amounts under the Revolver is limited and our credit agreement limits our ability to incur additional indebtedness. We continue to seek additional liquidity and believe that such liquidity may be available to us through alternative debt/equity financings. We believe that additional financing will enable us to continue execution of our expansion strategy. However, there is no guarantee we will be able to find such additional liquidity. In addition, adequate funds may not be available when needed or may be available only on terms not acceptable to us. If we are unable to secure additional financing on terms acceptable to us, our growth could be materially adversely impacted. Even if we secure additional financing, such financing could have a negative impact on our long-term cash flows and results of operations and may be dilutive to existing stockholders.

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


	Six Months Ended June 30,
	2016			2015
Cash flows from operating activities:
Net loss	$	(6,671	)	$	(2,244	)
Net loss to net cash reconciliation adjustments		9,762			7,184
Change in operating assets and liabilities, net of effects of business combinations		(13,698	)		(2,534	)

Net cash provided by (used in) operating activities		(10,607	)		2,406

Cash flows from investing activities:
Capital expenditures		(549	)		(2,070	)
Payments received for the sale of ownership interests in nonconsolidated affiliates		141			210
Payments received for the sale of lithotropsy services business		721			—
Proceeds from sale of property and equipment		13			18

Net cash provided by (used in) investing activities		326			(1,842	)

Cash flows from financing activities:
Proceeds from issuance of long-term debt		—			4,350
Payments on long-term debt and capital lease obligations		(1,106	)		(1,279	)
Proceeds from issuance of related party long-term debt		—			700
Principal payments on related party long-term debt		—			(347	)
Payment of debt issuance costs		—			(18	)
Release of restricted cash		997			—
Distributions to noncontrolling interests, net of contributions		—			(4,441	)

Net cash used in financing activities		(109	)		(1,035	)

Net decrease in cash and cash equivalents		(10,390	)		(471	)
Cash and cash equivalents at beginning of year		29,593			15,940

Cash and cash equivalents at end of period	$	19,203		$	15,469

Operating Activities

For the six months ended June 30, 2016, we had cash used for current assets and current liabilities of $13.7 million.

At June 30, 2016, accounts receivable, net increased $5.3 million as compared to December 31, 2015. NPSR accounts receivable, net increased $4.0 million due to an increase in NPSR over the comparative period and a slowdown in collections resulting in an increase in average days sales outstanding in accounts receivable (“DSO”). Average NPSR DSO increased to 47 days at June 30, 2016 from 41 days at December 31, 2015. Non-NPSR accounts receivable increased $3.3 million, primarily due to an increase in non-NPSR accounts receivable at WNI-DFW of $4.4 million offset by a $0.9 million decrease in accounts receivable from a related party. Prepaid assets increased $2.0 million primarily due to an increase in prepaid tax benefit.

For the six months ended June 30, 2016, we had cash flows of $3.9 million from accounts payable offset by $6.0 million used for accrued payroll and other accrued liabilities. Cash flows from accounts payable include a $2.1 million increase due to a related party. The decrease in other accrued liabilities is primarily due to a $1.5 million decline in IBNR payable balances at WNI-DFW offset by a $0.6 million growth-related increase in medical claims payable balances at WNI-DFW. In addition, we had decreases of $0.3 million in federal taxes payable and $2.7 million in accrued payables. Cash flows of $3.0 million used by accrued payroll are primarily due to a $1.0 million decrease in compensation amounts due to physicians and a net decrease of $2.2 million in payroll and payroll tax balances due to payroll timing differences between June 30, 2016 and December 2015.

Investing Activities

Net cash provided by investing activities of $0.3 million in 2016 was primarily attributable to $0.9 million in proceeds received from the 2015 sale of our lithotropsy services business and from the 2015 sale of ownership interests in an unconsolidated entity, offset by capital expenditures of $0.5 million. We anticipate minimum capital expenditures of $2.0 million in 2016.

Financing Activities

In 2015 we issued $20.0 million of debt with deferred principal payments and in 2013 we issued $24.3 million of debt with deferred principal payments. In December 2014, we restructured our credit agreement (see Credit Agreement below) resulting in principal payments on and proceeds from long-term debt of $6.8 million. Additionally, in 2014, we used a restricted cash compensating balance to repay a $5.0 million term loan and repaid the $3.0 million balance outstanding under the Revolver.

As a result of the sale of Lithotripsy Services, we paid off certain related party indebtedness and we made no distributions to noncontrolling interests, net of contributions during 2016. Additionally, we received $1.0 million from the release of restricted cash related to the sale of Lithotripsy Services. We anticipate payments on long-term debt and capital leases to increase substantially in 2016 as amounts outstanding under the credit agreement (see “Credit Agreement” below) become due in December 2016 and as we begin making payments under capital lease and financing arrangements that commenced in 2015.

On September 18, 2015, we executed an amendment to our partnership agreement with USMD Arlington to allow for a one-time special distribution to us from USMD Arlington. We received proceeds from the special distribution of $14.8 million, net of lender fees of $0.2 million. We have determined that the special distribution is, in substance, a debt arrangement (the “Advance”). The Advance accrues interest that is payable to USMD Arlington at the 30-Day London Interbank Offered Rate (“LIBOR”) plus a margin of 2.85% (3.27% at December 31, 2015). In addition, we are required to pay the limited partners of USMD Arlington a pre-determined quarterly financing fee equal to 3.22% per annum of the scheduled outstanding balance at the end of each month. To the extent available, principal and interest payments due on the Advance will be withheld monthly from USMD Arlington distributions otherwise due to us. If distributions to us withheld by USMD Arlington for any three month period ending in February, May, August or November during the debt term are less than principal and interest payments due for that three month period, we will make payments in amounts equal to the difference between amounts withheld from distributions and amounts due for that three month period. Subject to the preceding terms, principal payments of $312,500 are due monthly beginning December 31, 2016 and the debt matures November 28, 2020. If we fail to make payments due under the terms of the Advance, our ownership interest in USMD Arlington may be reduced and the ownership interest of the limited partners of USMD Arlington may be proportionally increased.

On April 29, 2015, we issued convertible subordinated notes due 2020 in the principal amount of $1.6 million (the “2020-11 Convertible Notes”) to certain investors in a private unregistered offering. The 2020-11 Convertible Notes mature on November 1, 2020 and bear interest at a fixed rate of 7.25% per annum. Interest will be paid monthly, in cash or in shares of our common stock as we elect, on the last day of each month commencing on May 31, 2015. Principal is due in full at maturity. We may prepay the 2020-11 Convertible Notes, in whole or in part, at any time after April 29, 2016 without penalty. Each noteholder will have the right at any time after April 29, 2016, prior to the payment in full of the 2020-11 Convertible Note, to convert all or any part of the unpaid principal balance of the 2020-11 Convertible Note into shares of our common stock at the rate of one share of common stock for each $10.61 of principal. The conversion rate will be appropriately adjusted for stock splits, mergers or other fundamental corporate transactions. The indebtedness represented by the 2020-11 Convertible Notes is expressly subordinate to and junior and subject in right of payment to the prior payment in full in cash of all our senior indebtedness, which includes indebtedness in connection with our credit agreement.

Effective March 13, 2015, we issued convertible subordinated notes payable in the aggregate principal amount of $3.5 million (the “2020-09 Convertible Notes”) to certain investors in a private unregistered offering. The 2020-09 Convertible Notes mature on September 1, 2020 and bear interest at a fixed rate of 7.75% per annum. Interest payments are due and payable on the last day of each month and may be paid in cash or in shares of our common stock, as we elect. Principal is due in full upon maturity. We may prepay the 2020-09 Convertible Notes, in whole or in part, at any time after March 13, 2016 without penalty. Each noteholder has the right at any time after March 13, 2016, prior to the payment in full of the 2020-09 Convertible Note, to convert all or any part of the unpaid principal balance of its 2020-09 Convertible Note into shares of our common stock at the rate of one share of common stock for each $11.10 of principal. The conversion price will be appropriately adjusted for stock splits, mergers or other fundamental corporate transactions. The indebtedness represented by the 2020-09 Convertible Notes is expressly subordinate to and junior and subject in right of payment to the prior payment in full in cash of all our senior indebtedness, which includes indebtedness in connection with our credit agreement.

Credit Agreement

For the principal terms and more detailed summary of activity of our Credit Agreement (the “Credit Agreement”), see Note 11, Long-Term Debt and Capital Lease Obligations, to our December 31, 2015 Consolidated Financial Statements, included in Part II, Item 8, Financial Statements and Supplementary Data, of our Annual Report on Form 10-K filed with the SEC on April 14, 2016 (our “Annual Report”).

On December 22, 2014, we entered into an amendment to our credit agreement (as amended, the “Credit Agreement”) with Southwest Bank as sole lender and administrative agent (“Administrative Agent”), which governs certain loans from the Administrative Agent. The loans provided under the Credit Agreement consist of a $6.75 million term loan (“Term Loan”) and the Revolver. The obligations under the Credit Agreement are secured by substantially all of the assets of USMD and its wholly owned subsidiaries, subject to certain exceptions.

The maturity date of the Term Loan is December 21, 2016 and it bears interest at a fixed rate of 1.80%. The Credit Agreement requires us to maintain a compensating balance of $6.75 million, which is presented as restricted cash on our consolidated balance sheet. The collateralized compensating balance is held in a segregated account with the Administrative Agent and is governed by a deposit account control agreement executed in connection with a previous amendment to the Credit Agreement. The account bears interest at a rate of 0.55% per annum. We do not have the right to withdraw funds from such deposit account without the prior written consent of the Administrative Agent. We may, however, prepay the Term Loan at any time, in whole or in part, with the cash held in the segregated account. Once the Term Loan was fully cash collateralized, we were no longer required to make scheduled principal payments on the Term Loan and the outstanding principal balance of the Term Loan is due and payable at maturity. Proceeds from borrowings under the Term Loan were used to repay in full other lenders previously party to the Term Loan.

The maturity date of the Revolver is December 21, 2016. Interest on amounts outstanding under the Revolver is due monthly and accrues, at our option, at the 30-Day LIBOR plus 3.50%, or the U.S. prime rate plus 0.50%, with a floor of 4.00% in either case. An unused commitment fee is payable quarterly on the undrawn portion of the Revolver at a rate of 0.50% per annum. Proceeds from borrowings under the Revolver are available to finance our working capital needs and to finance up to $1.5 million of capital expenditures each year.

The Credit Agreement requires us to meet a senior leverage ratio of no greater than 1.00:1.00 in order to borrow funds under the Revolver and to pay down the borrowings under the Revolver in the event its senior leverage ratio exceeds 1.00:1.00. Beginning on September 30, 2016, the Credit Agreement requires us to maintain a fixed charge coverage ratio of at least 1.25:1.00. Both covenants are calculated on a rolling four quarter basis. However, not more than once during any period of four consecutive fiscal quarters, we are permitted to maintain compliance with its financial covenants if the fixed charge coverage ratio is at least 1.00:1.00 and the senior leverage ratio is no greater than 1.25:1.00. Under the Credit Agreement, if the Term Loan is fully cash collateralized and there are no borrowings under the Revolver, the fixed charge coverage ratio will not be tested in any fiscal quarter ending on or after September 30, 2016, and the senior leverage ratio will not be tested in any fiscal quarter ending on or after September 30, 2015. The Credit Agreement contains a number of covenants that, among other things, limit or restrict our ability to dispose of assets, incur additional indebtedness, make dividend and other restricted payments, create liens securing other indebtedness and enter into restrictive agreements. As of June 30, 2016, we were in compliance with the financial covenant requirements of our Credit Agreement. The Credit Agreement allows for a maximum amount of capital expenditures of $6.0 million in 2016.

Convertible Subordinated Notes Due 2019

Effective September 1, 2013, we issued convertible subordinated notes due 2019 in the aggregate principal amount of $24.3 million (the “2019-03 Convertible Notes”) to certain limited partners of USMD Arlington to acquire their limited partnership interests in USMD Arlington. The 2019-03 Convertible Notes bear interest at a fixed rate of 5.00% per annum and mature on March 1, 2019. Interest payments are due and payable on the last day of each month and the principal is due upon maturity. We have the option to prepay the 2019-03 Convertible Notes, in whole or in part, at any time after September 1, 2014 without penalty. Each noteholder has the right at any time after September 1, 2014 to convert all or any part of the unpaid principal balance of its 2019-03 Convertible Note into shares of common stock of USMD at the rate of one share of common stock for each $23.37 of principal. The conversion price will be appropriately adjusted for stock splits, mergers or other fundamental corporate transactions. The conversion option has no cash settlement provisions. The 2019-03 Convertible Notes are convertible into 1,041,577 of our common shares at a conversion price of $23.37 per share. The indebtedness represented by the 2019-03 Convertible Notes is expressly subordinate to all senior indebtedness of USMD currently outstanding or incurred in the future, which includes its indebtedness under the Credit Agreement. We intend to fund the required interest payments under the 2019-03 Convertible Notes with available cash balances, cash provided by operating activities and distributions from USMD Arlington and USMD Fort Worth.

At the date of execution of the 2019-03 Convertible Notes, the commitment date, the conversion price was less than the fair value of shares our common stock. We recognized the intrinsic value of the conversion option’s in-the-money portion as a $3.7 million beneficial conversion discount to the debt with an offsetting entry to additional paid-in capital. The beneficial conversion discount is being accreted to the 2019-03 Convertible Notes using the effective interest method over 66 months until they mature on March 1, 2019. The 2019-03 Convertible Notes have an effective interest rate of 8.50%. Recognition of the beneficial conversion discount results in a temporary book-tax basis difference in the debt instrument. Accordingly, on September 1, 2013, we recorded a $1.3 million deferred tax liability with an offsetting entry to additional paid-in capital.

Off-Balance Sheet Arrangements

Except for guarantees discussed below, we do not have any arrangements that qualify as off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

As of June 30, 2016, we had issued guarantees to third parties of the indebtedness and other obligations of certain of our current and one former nonconsolidated investees. Should the investees fail to pay the obligations due, we could be required to make payments totaling an aggregate of $24.0 million. The guarantees provide for recourse against the investee; however, if we are required to perform under one or more guarantees, recovery of any amount would be unlikely. Included in the guarantee amount above is our guarantee of 46.4% of the obligations of USMD Arlington that were incurred to finance the Advance to us. If we were required to perform under that guarantee or record a liability for that guarantee, our obligations under the Advance would likely decrease by an equal amount. The remaining terms of these guarantees range from 23 to 143 months. We record a liability for performance under financial guarantees when, upon review of available financial information of the nonconsolidated affiliate, and in consideration of pertinent factors, management determines it is probable that we will have to perform under the guarantee and the liability is reasonably estimable. We have not recorded a liability for these guarantees, as we believe the likelihood that we will have to perform under these agreements is remote.

Critical Accounting Policies and Estimates

Our significant accounting policies are discussed in Note 2, Summary of Significant Accounting Policies and Pronouncements, to the December 31, 2015 consolidated financial statements included in Part II, Item 8, Financial Statements and Supplementary Data in our Annual Report. Those significant accounting policies that we consider to be the most critical to aid in fully understanding and evaluating reported financial results, as they require management’s most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain, are disclosed in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Critical Accounting Policies and Estimates,” in our Annual Report.

Subsequent to the filing of our Annual Report, there have been no material changes to our critical accounting policies.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, see Note 1 – Description of Business, Basis of Presentation and Recently Issued Accounting Pronouncements to our June 30, 2016 Condensed Consolidated Financial Statements, included in Part I, Item 1, Financial Statements (Unaudited), of this Quarterly Report.

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

Not applicable.

Item 4.

Controls and Procedures.

Disclosure Controls and Procedures

We maintain “disclosure controls and procedures,” as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Our disclosure controls and procedures are designed to ensure that information required to be disclosed in our Exchange Act reports is i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and ii) accumulated and communicated to our management, including our Chief Executive

Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on the identification of material weaknesses in internal control over financial reporting as disclosed in our Annual Report, management concluded that, as of June 30, 2016, the Company’s disclosure controls and procedures remained not effective.

Changes in Internal Control over Financial Reporting

During our evaluation of the effectiveness of internal controls over financial reporting as of December 31, 2015, our management identified a material weakness related to its estimation of the collectability of its accounts receivables. In response to the material weakness, management has instituted a number of actions and commenced implementation of changes in internal control. Those actions are described below.

•

Management has enhanced its controls by incorporating the review of detailed collection reports on a per encounter basis into its accounts receivable estimation process.

•

Management has established a continuing process for the routine evaluation and revision of the methods and assumptions supporting its collectability estimates.

The implementation of our remediation plan is ongoing as of June 30, 2016. All controls designed and implemented as part of our remediation plan will be tested during the year as part of our Section 404 compliance program.

Except as noted above, there have been no significant changes in our internal controls over financial reporting (as defined by applicable SEC rules) during the period covered by this report that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings.

See Note 12 - Commitments and Contingencies in our June 30, 2016 Condensed Consolidated Financial Statements, included in Part I, Item 1, Financial Statements (Unaudited), of this Quarterly Report.

Item 2.

Unregistered Sale of Equity Securities and Use of Proceeds.

None.

Item 3.

Defaults Upon Senior Securities.

None.

Item 4.

Mine Safety Disclosures.

Not applicable.

Item 5.

Other Information.

None.

Item 6.

Exhibits


Exhibit No.		Description

31.1*		Certification of John House, M.D., Chairman and Chief Executive Officer, pursuant to Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*		Certification of Jim Berend, Chief Financial Officer, pursuant to Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1*		Certification of John House, M.D., Chief Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*		Certification of Jim Berend, Chief Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS*		XBRL Instance Document

101.SCH*		XBRL Schema Document

101.CAL*		XBRL Calculation Linkbase Document

101.DEF*		XBRL Definition Linkbase Document

101.LAB*		XBRL Label Linkbase Document

101.PRE*		XBRL Presentation Linkbase Document

*	Filed Herewith

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.

USMD HOLDINGS, INC.

/s/ Jim Berend

Jim Berend

Executive Vice President, Chief Financial Officer and Interim Chief Accounting Officer

(On behalf of registrant and as Principal Financial Officer)

Date: August 11, 2016

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