UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarter Ended
March 31, 2003
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 1-4034
DAVITA INC.
21250 Hawthorne Blvd., Suite 800
Torrance, California 90503-5517
Telephone number (310) 792-2600
Delaware
(State of incorporation)
51-0354549
(I.R.S. Employer Identification No.)
The Registrant 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 and has been subject to such filing requirements for the past 90 days.
The Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
As of May 1, 2003, there were approximately 61.1 million shares of the Registrant’s common stock (par value $0.001) outstanding.
INDEX
Page No.
PART I. FINANCIAL INFORMATION
Item 1.
Condensed Consolidated Financial Statements:
Consolidated Balance Sheets as of March 31, 2003 and December 31, 2002
1
Consolidated Statements of Income and Comprehensive Income for the three months ended March 31, 2003 and March 31, 2002
2
Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and March 31, 2002
3
Notes to Condensed Consolidated Financial Statements
4
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
13
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
17
Item 4.
Controls and Procedures
Risk Factors
18
PART II. OTHER INFORMATION
Legal Proceedings
23
Item 6.
Exhibits and Reports on Form 8-K
24
Signature
25
Certifications
26
i
CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands, except per share data)
December 31, 2002
ASSETS
Cash and cash equivalents
$
304,994
96,475
Accounts receivable, less allowance of $48,743 and $48,927
346,145
344,292
Inventories
25,465
34,929
Other current assets
24,049
28,667
Deferred income taxes
41,773
40,163
Total current assets
742,426
544,526
Property and equipment, net
305,742
298,475
Amortizable intangibles, net
60,080
63,159
Investments in third-party dialysis businesses
3,368
3,227
Other long-term assets
2,609
1,520
Goodwill
865,449
864,786
1,979,674
1,775,693
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable
71,295
77,890
Other liabilities
113,505
101,389
Accrued compensation and benefits
82,391
95,435
Current portion of long-term debt
43,908
7,978
Income taxes payable
26,550
9,909
Total current liabilities
337,649
292,601
Long-term debt
1,420,585
1,311,252
Other long-term liabilities
10,346
9,417
72,381
65,930
Minority interests
27,156
26,229
Shareholders’ equity:
Preferred stock ($0.001 par value, 5,000,000 shares authorized; none issued)
Common stock ($0.001 par value, 195,000,000 shares authorized; 89,162,390 and 88,874,896 shares issued)
89
Additional paid-in capital
523,572
519,369
Retained earnings
249,750
213,337
Treasury stock, at cost (28,187,326 and 28,216,177 shares)
(661,854
)
(662,531
Total shareholders’ equity
111,557
70,264
See notes to condensed consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
Three months ended
March 31,
2003
2002
Net operating revenues
459,807
427,665
Operating expenses and charges:
Dialysis centers and labs
316,710
291,634
General and administrative
36,787
36,053
Depreciation and amortization
17,445
15,805
Provision for uncollectible accounts
8,237
5,255
Minority interests and equity income, net
1,294
2,135
Total operating expenses and charges
380,473
350,882
Operating income
79,334
76,783
Debt expense
19,456
15,072
Other income, net
785
267
Income before income taxes
60,663
61,978
Income tax expense
24,250
26,000
Net income
36,413
35,978
Comprehensive income
Earnings per share:
Basic
0.60
0.43
Diluted
0.52
0.40
Weighted average shares for earnings per share:
60,905,056
82,967,141
78,772,410
102,246,452
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to cash provided by operating activities:
Loss (gain) on divestitures
119
(458
4,841
7,861
Non-cash debt expense
840
634
Stock options, principally tax benefits
1,378
8,931
Equity investment income
(519
(298
Minority interests in income of consolidated subsidiaries
1,813
2,433
Distributions to minority interests
(2,465
(1,501
Changes in operating assets and liabilities, excluding acquisitions and divestitures:
Accounts receivable
(676
(11,163
9,543
6,726
4,721
(2,840
(2,457
(6,674
8,969
(13,075
(2,617
Other current liabilities
11,952
15,050
Income taxes
16,641
261
809
(287
Net cash provided by operating activities
80,649
83,484
Cash flows from investing activities:
Additions of property and equipment, net
(21,708
(16,115
Acquisitions and divestitures, net
(718
(1,379
Investments in affiliates, net
1,931
499
Intangible assets
(300
Net cash used in investing activities
(20,795
(16,995
Cash flows from financing activities:
Borrowings
623,822
335,883
Payments on long-term debt
(478,659
(355,803
Deferred financing costs
(57
Purchase of treasury stock
(67,877
Proceeds from issuance of common stock
3,502
16,351
Net cash provided by (used in) financing activities
148,665
(71,503
Net increase (decrease) in cash
208,519
(5,014
Cash and cash equivalents at beginning of period
36,711
Cash and cash equivalents at end of period
31,697
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Unless otherwise indicated in this Form 10-Q “the Company”, “we”, “us”, “our” and similar terms refer to DaVita Inc. and its subsidiaries.
1. Condensed consolidated interim financial statements
The condensed consolidated interim financial statements included in this report are prepared by the Company without audit. In the opinion of management, all adjustments consisting only of normal recurring items necessary for a fair presentation of the results of operations are reflected in these consolidated interim financial statements. All significant intercompany accounts and transactions have been eliminated. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. The most significant estimates and assumptions underlying these financial statements and accompanying notes generally involve revenue recognition and provisions for uncollectible accounts, impairments and valuation adjustments, accounting for income taxes and variable compensation accruals. The results of operations for the three month period ended March 31, 2003 are not necessarily indicative of the operating results for the full year. The consolidated interim financial statements should be read in conjunction with the Management’s Discussion and Analysis and consolidated financial statements and notes thereto included in the Company’s 2002 Form 10-K. Financial statement presentations and classifications have been conformed for all periods presented.
Stock-based compensation
If the Company had adopted the fair value-based compensation expense provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123 upon the issuance of that standard, net income and net income per share would have been adjusted to the pro forma amounts indicated below:
Pro forma - As if all stock options were expensed
Net income:
As reported
Add: Stock-based employee compensation expense included in reported net income, net of tax
161
88
Deduct: Total stock-based employee compensation expense under the fair value-based method, net of tax
(1,911
(3,561
Pro forma net income
34,663
32,505
Pro forma basic earnings per share:
Pro forma net income for basic earnings per share calculation
Weighted average shares outstanding during the quarter
60,847
82,925
Vested deferred stock units
58
42
Weighted average shares for basic earnings per share calculation
60,905
82,967
Basic net income per share—pro forma
0.57
0.39
Basic net income per share—as reported
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
Pro forma diluted earnings per share:
Debt expense savings, net of tax, from assumed conversion of convertible debt
4,915
1,067
Pro forma net income for diluted earnings per share calculation
39,578
33,572
Assumed incremental shares from stock plans
3,268
5,386
Assumed incremental shares from convertible debt
15,394
4,879
Weighted average shares for diluted earnings per share calculation
79,567
93,232
Diluted net income per share—pro forma
0.50
0.36
Diluted net income per share—as reported
2. Significant new accounting standards
In January 2003 the FASB issued Interpretation (FIN) No. 46 Consolidation of Variable Interest Entities, which addresses the consolidation of certain entities (“variable interest entities”) in which an enterprise has a controlling financial interest through other than voting interests. FIN No. 46 requires that a variable interest entity be consolidated by the holder of the majority of the expected risks and rewards associated with the activities of the variable interest entity. FIN No. 46 is not expected to have a material effect on the Company’s consolidated financial statements.
5
3. Earnings per share
The reconciliation of the numerators and denominators used to calculate basic and diluted earnings per share is as follows:
Basic:
Weighted average shares outstanding during the period
Weighted average shares for basic earnings per share calculations
Basic net income per share
Diluted:
Net income for diluted earnings per share calculations
41,328
40,893
2,473
3,885
Weighted average shares for diluted earnings per share calculations
78,772
102,246
Diluted net income per share
Options to purchase 2,854,224 shares at $22.40 to $33.00 per share and 643,573 shares at $23.61 to $33.00 per share were excluded from the diluted earnings per share calculations for the three months ended March 31, 2003 and 2002, respectively, because they were anti-dilutive. The calculation of diluted earnings per share assumes conversion of both the 55/8% convertible subordinated notes and the 7% convertible subordinated notes for all periods presented.
6
4. Long-term debt
In January 2003 the Company borrowed $150,000 that was available under the Term Loan A senior credit facility that was entered into in 2002. At March 31, 2003, $143,662 of the Term Loan A remained outstanding. The Term Loan A bears interest equal to LIBOR plus a margin ranging from 1.5% to 2.75% based on the Company’s leverage ratio. The current margin is 2.25% for an overall effective rate of 3.61%. The aggregate annual principal payments for the Term Loan A are approximately $34,000 in years one through three and the balance of approximately $42,000 in year four, due no later than March 2007.
Long-term debt was comprised of the following:
December 31,
Term Loans under senior secured credit facilities
985,162
841,825
Convertible subordinated notes, 7%, due 2009
345,000
Convertible subordinated notes, 5 5/8%, due 2006
125,000
Capital lease obligations
8,713
6,820
Acquisition obligations and other notes payable
618
585
1,464,493
1,319,230
Less current portion
(43,908
(7,978
Scheduled maturities of long-term debt at March 31, 2003 were as follows:
2004
2005
43,082
2006
43,025
2007
176,569
2008
406,178
Thereafter
751,731
5. Contingencies
The Company’s revenues may be subject to adjustment as a result of (1) examination by government agencies or contractors, for which the resolution of any matters raised may take extended periods of time to finalize; (2) differing interpretations of government regulations by different fiscal intermediaries or regulatory authorities; (3) differing opinions regarding a patient’s medical diagnosis or the medical necessity of services provided; (4) retroactive applications or interpretations of governmental requirements; and (5) claims for refunds from private payors.
Laboratory payment dispute
The Company’s Florida laboratory is subject to a third-party carrier review of its Medicare reimbursement claims. The carrier has reviewed claims for services provided in six separate review periods, extending from January 1995 to May 2001. The carrier had made determinations that many of the claims submitted were not supported by the prescribing physicians’ medical justification. The carrier had also suspended all payments of
7
Medicare claims to this laboratory from May 1998 to June 2002, and referred the matter to the Centers for Medicare and Medicaid Services, or CMS, and the Department of Justice, or DOJ. The Company has disputed each of the carrier’s determinations and has provided supporting documentation of its claims.
In June 2002 an administrative law judge ruled that the sampling procedures and extrapolations that the carrier used as the basis of its overpayment determinations for the first two review periods were invalid. This decision invalidated the carrier’s overpayment determinations, totaling $20,600, for the first two review periods. The administrative law judge’s decision on the first two review periods does not apply to the remaining four review periods. The hearings before a carrier hearing officer for the third and fourth review periods are scheduled to take place in the second quarter of 2003. A total of $27,700 in claims are in dispute. The Company has also filed a notice of appeal to the carrier for the fifth and sixth review periods, for which a total of $3,800 in claims are in dispute.
During 2000 the Company stopped accruing Medicare revenue from this laboratory because of the uncertainties regarding both the timing of resolution and the ultimate revenue valuations. Following the favorable ruling by the administrative law judge in 2002, the carrier lifted the payment suspension and began making payments in July 2002 for lab services provided subsequent to May 2001. After making its determinations with respect to the fifth and sixth review periods in December 2002, the carrier paid the laboratory all amounts that it is not disputing for the third through sixth review periods. In the second half of 2002, the Company received a total of $68,778, which represented approximately 70% of the total outstanding Medicare lab billings for the period from January 1995 through June 2002. These cash collections were recognized as revenue in the quarter received. We do not expect to receive any significant additional payments relative to prior periods unless and until the dispute over the remaining disallowed claims are resolved in our favor. The Company will continue to recognize Medicare lab revenue associated with prior periods as cash collections actually occur, to the extent that cumulative recoveries do not exceed the aggregate amount that management believes the Company will ultimately recover upon final review and settlement of disputed billings.
In addition to processing prior period claims, the carrier also began processing billings for current period services on a timely basis. Based on these developments, the Company began recognizing estimated current period Medicare lab revenue in the third quarter of 2002.
The carrier is also currently conducting a study of the utilization of dialysis-related laboratory services to determine what ongoing program safeguards are appropriate. During the study, the carrier has suspended dialysis laboratory prepayment screens. In its initial findings from the study, the carrier had determined that some of its prior prepayment screens were invalidating appropriate claims. The Company cannot determine what prepayment screens, post-payment review procedures, documentation requirements or other program safeguards the carrier may yet implement as a result of its study. The carrier has also informed the Company that any claims that it reimburses during the study period may also be subject to post-payment review and retraction if determined inappropriate.
In November 2001, the Company closed a smaller laboratory that it operated in Minnesota and combined its operations with those of the Florida laboratory. The Medicare carrier for the Minnesota laboratory is conducting a post-payment review of Medicare reimbursement claims for the period January 1996 through December 1999. The scope of the review is similar to the review of our Florida laboratory. The Company responded to the most recent request from the carrier for claims documentation in May 2001. At this time, the Company is unable to determine how long it will take the carrier to complete this review. There is currently no overpayment determination with respect to the Minnesota laboratory. Medicare revenues at the Minnesota laboratory, which was much smaller than the Florida laboratory, were approximately $15,000 for the period under review.
8
In addition to the formal appeal processes with the carrier and a federal administrative law judge, the Company also has pursued resolution of this matter through meetings with representatives of CMS and the DOJ. Discussions with CMS are ongoing. The DOJ has requested, and the Company has provided, information with respect to both the Florida and the Minnesota laboratories, most recently in September 2001. If a court determines that there has been wrongdoing by the Company or its laboratories, the fines and penalties under applicable statutes could be substantial.
United States Attorney inquiry
In February 2001 the Civil Division of the United States Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted the Company and requested its cooperation in a review of some of the Company’s historical practices, including billing and other operating procedures and its financial relationships with physicians. The Company cooperated in this review and provided the requested records to the United States Attorney’s Office. In May 2002, the Company received a subpoena from the Philadelphia office of the Office of Inspector General of the Department of Health and Human Services, or OIG. The subpoena required an update to the information the Company provided in its response to the February 2001 request, and also sought a wide range of documents relating to pharmaceutical and other ancillary services provided to patients, including laboratory and other diagnostic testing services, as well as documents relating to the Company’s financial relationships with physicians and pharmaceutical companies. The subpoena covers the period from May 1996 to May 2002. The Company has provided the documents requested and continues to cooperate with the United States Attorney’s Office and the OIG in its investigation. This inquiry remains at an early stage. As it proceeds, the government could expand its areas of concern. If a court determines that there has been wrongdoing, the penalties under applicable statutes could be substantial.
Other
In addition to the foregoing, DaVita is subject to claims and suits in the ordinary course of business. Management believes that the ultimate resolution of these additional pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
6. Other commitments
The Company has obligations to purchase the third-party interests in several of its joint ventures. These obligations are in the form of put options, exercisable at the third-party owners’ discretion, and require the Company to purchase the minority owners’ interests at either the appraised fair market value or a predetermined multiple of cash flow or earnings. As of March 31, 2003, the Company’s potential obligations under these put options totaled approximately $60,000 of which approximately $34,000 was exercisable within one year. Additionally, the Company has certain other potential working capital commitments relating to managed and minority-owned centers of approximately $5,000 that could be called in the event of non-performance of the centers over the next five years.
7. Condensed consolidating financial statements
The following information is presented as required under the Securities and Exchange Commission Financial Reporting Release No. 55 in connection with the Company’s publicly traded debt. The operating and investing activities of the separate legal entities included in the consolidated financial statements are fully interdependent and integrated. Revenues and operating expenses of the separate legal entities include intercompany charges for management and other services.
The $125,000 5 5/8% Convertible Subordinated Notes due 2006, issued by the wholly-owned subsidiary Renal Treatment Centers, Inc., or RTC, are guaranteed by DaVita Inc.
9
Condensed Consolidating Balance Sheets
DaVita Inc.
RTC
Non-
guarantor
subsidiaries
Consolidating
adjustments
Consolidated
total
As of March 31, 2003
304,986
Accounts receivable, net
194,600
114,108
37,437
73,018
15,745
2,524
91,287
572,604
129,861
39,961
174,908
92,180
38,654
Investments in subsidiaries
423,834
(423,834
Receivables from subsidiaries
119,790
(119,790
Amortizable intangible assets, net
40,282
16,015
3,783
Other assets
5,578
354
45
5,977
432,613
320,945
111,891
Total assets
1,769,609
559,355
194,334
(543,624
Current liabilities
309,512
15,598
12,539
Payables to subsidiaries/parent
97,969
21,821
Long-term liabilities
1,348,540
148,795
1,503,312
Shareholders’ equity
296,993
153,997
(450,990
Total liabilities and shareholders’ equity
As of December 31, 2002
96,468
213,410
98,825
32,057
86,777
14,368
2,614
103,759
396,655
113,200
34,671
185,676
80,532
32,267
399,190
(399,190
81,833
(81,833
44,090
15,062
4,007
3,973
729
4,747
461,153
291,602
112,031
1,572,570
501,125
183,021
(481,023
270,060
12,386
10,155
Payables to parent
60,489
21,344
1,232,246
148,877
5,476
1,386,599
279,373
146,046
(425,419
10
Condensed Consolidating Statements of Income
Non-guarantor subsidiaries
Consolidating adjustments
Consolidated total
For the three months ended March 31, 2003
291,365
153,522
51,631
(36,711
Operating expenses
239,358
133,157
42,856
(34,898
52,007
20,365
8,775
(1,813
16,661
1,710
1,085
Other income
16,434
7,816
Equity earnings in consolidated subsidiaries
16,716
(16,716
10,839
7,690
(18,529
For the three months ended March 31, 2002
272,862
137,960
46,690
(29,847
227,371
115,500
35,425
(27,414
45,491
22,460
11,265
(2,433
12,170
1,767
1,135
17,300
8,694
19,690
(19,690
11,999
10,124
(22,123
11
Condensed Consolidating Statements of Cash Flows
Changes in operating and intercompany assets and liabilities and non cash items included in net income
28,968
(2,176
(1,085
18,529
44,236
Net cash provided by (used in) operating activities
65,381
8,663
6,605
—
Purchases of property and equipment, net
(5,767
(8,643
(7,298
Other items
170
1,461
1,631
(5,597
(6,555
145,232
(19
(50
145,163
Net cash provided (used in) financing activities
148,734
Net decrease in cash
208,518
Cash at the beginning of the period
Cash at the end of the period
39,013
(4,746
(8,884
22,123
47,506
74,991
7,253
1,240
(6,870
(7,955
(1,290
(6,371
(9,334
(20,294
324
50
(19,920
(51,583
(71,877
(3,257
(1,757
34,949
1,762
31,692
12
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Forward-looking statements
This Form 10-Q contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These statements involve known and unknown risks and uncertainties, including risks resulting from the regulatory environment in which we operate, economic and market conditions, competitive activities, other business conditions, accounting estimates, and the risk factors set forth in this Form 10-Q. These risks, among others, include those relating to possible reductions in private mix and private and government reimbursement rates, the concentration of profits generated from PPO and private and indemnity patients and from ancillary services including the administration of pharmaceuticals, changes in pharmaceutical practice patterns or reimbursement policies, the ongoing review of the Company’s Florida laboratory subsidiary by its Medicare carrier and the DOJ, the ongoing review by the US Attorney’s Office and the OIG in Philadelphia and the Company’s ability to maintain contracts with physician medical directors. Our actual results may differ materially from results anticipated in our forward-looking statements. We base our forward-looking statements on information currently available to us, and we have no current intention to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments
Results of operations
Quarter ended
(dollars in millions)
Net operating revenues:
Current period services
460
100
%
461
428
Prior period services—laboratory
Total net operating revenues
503
317
69
292
68
37
41
36
16
Provision for uncollectible accounts, net of recoveries
Minority interest and equity income, net
381
83
385
351
82
79
118
77
Operating income excluding prior period service revenue
76
Dialysis treatments (000’s)
1,503
1,538
1,434
Average dialysis treatments per treatment day
19,673
19,319
18,767
Average dialysis revenue per dialysis treatment
296
291
290
The quarter ended March 31, 2002 includes $4 million of revenues and $4 million of operating expenses related to non-continental U.S. operations in Puerto Rico that were divested in the second quarter of 2002.
Net operating revenue
The net operating revenues of $460 million for the first quarter of 2003 represents an increase of $32 million, or an increase of $36 million excluding non-continental U.S. operations that were fully divested during 2002. This represented an 8.5% increase in continental U.S. revenue compared with the first quarter of 2002. Of this 8.5% increase, approximately 4.5% was due to an increase in the number of dialysis treatments, and approximately 2.0% was attributable to increases in the average reimbursement rate per dialysis treatment. The increase in 2003 also included approximately $6 million of Medicare laboratory revenue. No Medicare lab revenue had been recognized during the first quarter of 2002 due to the payment withholds by the third-party carrier, as discussed below. The increase in the number of treatments was principally attributable to a non-acquired annual growth rate of approximately 3.3%. The balance of the increase in treatment volumes was due to acquisitions. We continue to expect the non-acquired growth rate to remain in the range of 3.0% to 5.0% throughout 2003. The average dialysis revenue per treatment (excluding lab and clinical research revenues and management fee income) was $296 for the first quarter of 2003 as compared to $290 for the first quarter of 2002. The increase in average revenue per treatment was primarily due to rate increases and continued improvements in revenue capture.
First quarter 2003 current period operating revenues were approximately the same as the fourth quarter of 2002. The number of treatments decreased by approximately 2% in the first quarter of 2003 as compared to the fourth quarter of 2002 because of fewer treatments days in the first quarter. An increase in the average number of treatments per day of 1.8% and an increase in the net dialysis revenue per treatment of approximately $5 in the first quarter of 2003 offset substantially all of the decrease in revenue due to fewer treatment days. The increase in the revenue per treatment was primarily due to rate increases and continued improvements in revenue capture.
Lab and other services
As discussed in Note 6 to the condensed consolidated interim financial statements (Contingencies), our Florida-based laboratory subsidiary has been under an ongoing third-party carrier review for Medicare reimbursement claims since 1998. Prior to the third quarter 2002, no Medicare payments had been received since May 1998. Following a favorable ruling by an administrative law judge in June 2002 the carrier began releasing funds for lab services provided subsequent to May 2001. The carrier also paid us amounts it is not disputing for prior periods. During 2002, the carrier paid us a total of approximately $69 million, representing approximately 70% of the total outstanding Medicare lab billings for the period from January 1995 through June 2002. These cash collections were recognized as revenue in the quarter received. Approximately $42 million of these total collections were received in the fourth quarter of 2002. We do not expect to receive significant additional Medicare lab payments relating to prior periods unless and until the dispute over the remaining disallowed claims are resolved in our favor.
Dialysis centers and lab expenses
Center operating expenses were approximately 69% of net operating revenues in the first quarter of 2003 and the fourth quarter of 2002 (excluding prior period lab revenue) compared to 68% in the first quarter of 2002. On a per-treatment basis, center operating expenses for the first quarter of 2003 increased approximately $5 from the fourth quarter of 2002 and approximately $10 from the first quarter of 2002. The increase in both periods was primarily attributable to higher pharmaceutical, insurance and labor costs.
General and administrative expenses
General and administrative expenses were approximately 8% of current period net operating revenues for both the first quarters of 2003 and 2002. General and administrative expenses in the fourth quarter of 2002 included impairments and valuation adjustments of $2 million. Excluding these impairment charges, the fourth quarter general and administrative expenses were also approximately 8% of net operating revenue.
14
Provision for uncollectible accounts receivable
The provisions for uncollectible accounts receivable before considering cash recoveries were approximately 1.8% of current period net operating revenues for all periods presented. During the fourth quarter of 2002 and the first quarter of 2002, we realized recoveries of approximately $1 million and $2 million, respectively.
Debt expense of approximately $19.5 million for the first quarter of 2003 was approximately $4.5 million higher than the first quarter of 2002 as a result of higher debt balances, primarily associated with our recapitalization during the second quarter of 2002. Average interest rates for the first quarter of 2003 were 4.9% compared to 7.0% for first quarter of 2002.
Projections for 2003
Based on the current conditions and trends, our current projections for 2003 remain unchanged. Operating income for 2003 is currently projected to be in the range of $300 million to $320 million. These projections and the underlying assumptions involve significant risks and uncertainties, and actual results may vary significantly from these current projections. These risks, among others, include those relating to possible reductions in private and government reimbursement rates, the concentration of profits generated from non-governmental payors and physician-prescribed pharmaceuticals, changes in pharmaceutical practice patterns or reimbursement policies, and the ongoing review by the United States Attorney’s Office and the OIG. Additionally, the termination or restructuring of managed care contracts, medical director agreements or other arrangements may result in future impairments or otherwise negatively affect our operating results. We undertake no duty to update these projections, whether due to changes in current or expected trends, underlying market conditions, decisions of the United States Attorney’s Office, the DOJ or the OIG in any pending or future review of our business, or otherwise.
Significant new accounting standards
In January 2003 the FASB issued Interpretation (FIN) No. 46 Consolidation of Variable Interest Entities, which addresses the consolidation of certain entities (“variable interest entities”) in which an enterprise has a controlling financial interest through other than voting interests. FIN No. 46 requires that a variable interest entity be consolidated by the holder of the majority of the expected risks and rewards associated with the activities of the variable interest entity. FIN No. 46 is not expected to have a material effect on our consolidated financial statements.
Liquidity and capital resources
Cash flow from operations during the first quarter of 2003 amounted to $81 million. Investing cash outflows consisted principally of capital asset additions of $22 million, which includes approximately $12 million for center development and $10 million for equipment and information technology projects.
In January 2003 the Company borrowed $150,000 that was available under the Term Loan A senior credit facility that was secured during 2002. The Term Loan A bears interest equal to LIBOR plus a margin ranging from 1.5% to 2.75% based on the Company’s leverage ratio. The current margin is 2.25% for an overall effective rate of 3.61%. The aggregate annual principal payments for the Term Loan A are approximately $34,000 in years one through three and approximately $42,000 in year four.
Accounts receivable at March 31, 2003 amounted to $346 million, an increase of approximately $2 million during the quarter. The first quarter accounts receivable balance represented 69 days of revenue, compared to 70 days as of December 31, 2002.
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Our current plans continue to call for capital expenditures to be in the same range as 2002, including investment expenditures for information technology projects and for new dialysis centers, relocations and expansions. During the first quarter of 2003, we acquired a controlling ownership interest in two centers of which we were previously minority owners and opened seven new centers.
We believe that we will have sufficient liquidity and operating cash flows to fund our scheduled debt service and other obligations over the next twelve months.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Interest rate sensitivity
The table below provides information about our financial instruments that are sensitive to changes in interest rates.
Expected maturity date
Total
Fair
Value
Average Interest
Rate
Long-term debt:
Fixed rate
125
345
470
478
6.63
Variable rate
33
43
49
318
404
104
994
4.44
Item 4. Controls and Procedures.
Management maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the reports filed by the Company pursuant to the Securities Exchange Act of 1934, as amended, or Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and regulations, and that such information is accumulated and communicated to the Company’s management including its Chief Executive Officer and Chief Financial Officer as appropriate to allow for timely decisions regarding required disclosures. Management recognizes that these controls and procedures can provide only reasonable assurance of desired outcomes, and that estimates and judgements are still inherent in the process of maintaining effective controls and procedures.
Within 90 days of the date of this report, we carried out an evaluation, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures in accordance with the Exchange Act requirements. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective for timely identification and review of material information required to be included in the Company’s Exchange Act reports, including this report on Form 10-Q.
We have established and maintain a system of internal controls designed to provide reasonable assurance that transactions are executed with proper authorization and are properly recorded in the Company’s records, and that errors or irregularities that could be material to the financial statements are prevented or would be detected within a timely period. Internal controls are periodically reviewed and revised if necessary, and are augmented by appropriate oversight and audit functions.
Subsequent to the date that these controls were last evaluated by the Chief Executive Officer and Chief Financial Officer, we have not made any significant changes in the design and operation of our internal controls, nor have there been changes in other factors that could significantly affect the overall effectiveness of the control environment to process, record and disclose transactions.
RISK FACTORS
This Form 10-Q contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These forward-looking statements include statements regarding our expectations for treatment growth rates, revenue per treatment, expense growth, levels of the provision for uncollectible accounts receivable, operating income, and capital expenditures. We base our forward-looking statements on information currently available to us, and we do not intend to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.
These statements involve known and unknown risks and uncertainties, including risks resulting from economic and market conditions, the regulatory environment in which we operate, competitive activities and other business conditions. Our actual results may differ materially from results anticipated in these forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements include those set forth below. The risks discussed below are not the only ones facing our business.
If the percentage of our collections at or near our billed prices declines, then our revenues, cash flows and earnings would be substantially reduced.
Approximately 45% of our dialysis revenues are generated from patients who have private payors as the primary payor. A minority of these patients have insurance policies that reimburse us at or near our billed prices, which are significantly higher than Medicare rates. The majority of these patients have insurance policies that reimburse us at lower rates but, in most cases, higher than Medicare rates. We believe that pressure from private payors to decrease the rates they pay us may increase. If the percentage of collections at or near our billed prices decreases significantly, it would have a material adverse effect on our revenues, cash flows and earnings.
If the percentage of patients with insurance paying at or near our billed prices declines, then our revenues, cash flows and earnings would be substantially reduced.
Our revenue levels are sensitive to the mix of reimbursements from higher paying commercial plans to total reimbursements from all payor plans and program types. If there is a significant change in the number of patients under higher paying commercial plans relative to plans that pay at lower rates, for example a reduction in the average number of patients under indemnity and PPO plans compared with the average number of patients under HMO plans and government programs, it would negatively impact our revenues, cash flows and earnings.
If we are unable to renegotiate material contracts with managed care plans on acceptable terms, we may experience a decline in same center growth.
We have contracts with some large managed care plans that include unfavorable terms. Although we are attempting to renegotiate the terms of these contracts, we cannot predict whether we will reach agreement on new terms or whether we will renew these contracts. As a result, we may lose numerous patients of these managed care plans and experience a decline in our same center growth, which would negatively impact our revenues.
Changes in clinical practices and reimbursement rates or rules for EPO and other drugs could substantially reduce our revenue and earnings.
The administration of EPO and other drugs accounts for approximately one third of our net operating revenues. Changes in physician practice patterns and accepted clinical practices, changes in private and governmental reimbursement rates and rules, the introduction of new drugs and the conversion to alternate types of administration, for example from intravenous administration to subcutaneous or oral administration, that may
also result in lower or less frequent dosages, could reduce our revenues and earnings from the administration of EPO and other drugs. For example, some Medicare fiscal intermediaries are seeking to implement local medical review policies for EPO and vitamin D analogs that would effectively limit utilization of and reimbursement for these drugs.
Future declines, or the lack of further increases, in Medicare reimbursement rates would reduce our net income and cash flows.
Approximately 49% of our dialysis revenues are generated from patients who have Medicare as their primary payor. The Medicare ESRD program reimburses us for dialysis and ancillary services at fixed rates. Unlike many other Medicare programs, the Medicare ESRD program does not provide for periodic inflation increases in reimbursement rates. Increases of 1.2% in 2000 and 2.4% in 2001 were the first increases in the composite rate since 1991, and were significantly less than the cumulative rate of inflation since 1991. Since then there has been no increase in the composite rate. Increases in operating costs that are subject to inflation, such as labor and supply costs, have occurred and are expected to continue to occur with or without a compensating increase in reimbursement rates. We cannot predict the nature or extent of future rate changes, if any. To the extent these rates are not adjusted to keep pace with inflation, our net income and cash flows would be adversely affected.
Future changes in the structure of, and reimbursement rates under, the Medicare ESRD program could substantially reduce our operating earnings and cash flows.
In legislation enacted in December 2000, Congress mandated government studies on whether:
If Medicare began to include in its composite reimbursement rate any ancillary services that it currently reimburses separately, our revenue would decrease to the extent there was not a corresponding increase in that composite rate. In particular, Medicare revenue from EPO is approximately 27% of our total Medicare revenue. In January 2003, CMS implemented a new payment structure utilizing a single drug pricer for all drugs that Medicare reimburses, including many we administer. Based on the initial prices CMS has set, we do not expect our reimbursement under this single drug pricer in 2003 to differ materially from what it would have been under the AWP-based reimbursement structure. We expect, however, that CMS will change the prices set under this single drug pricer in the future or make other changes to the payment structure for these drugs. If EPO were included in the composite rate, and if the composite rate were not increased sufficiently, our operating earnings and cash flows could decrease substantially. Reductions in current reimbursement rates for EPO or other outpatient prescription drugs would also reduce our net earnings and cash flows.
Future declines in Medicaid reimbursement rates would reduce our net income and cash flows.
Approximately 5% of our dialysis revenues are generated from patients who have Medicaid as their primary coverage. In addition approximately 3% of our dialysis revenues are from Medicaid secondary coverage. Approximately 45% of our Medicaid revenue is derived from patients in California. If state governments change Medicaid programs or the rates paid by those programs for our services, then our revenue and earnings may decline. Some of the states’ Medicaid programs have proposed eligibility changes or have announced that they are considering reductions in the rates for certain services. Any action to reduce the Medicaid coverage rules or reimbursement rates for dialysis and related services would adversely affect our revenue and earnings.
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If a significant number of physicians were to cease referring patients to our dialysis centers, whether due to regulatory or other reasons, our revenue and earnings would decline.
If a significant number of physicians stop referring patients to our centers, it could have a material adverse effect on our revenue and earnings. Many physicians prefer to have their patients treated at centers where they or other members of their practice supervise the overall care provided as medical directors of the centers. As a result, the primary referral source for most of our centers is often the physician or physician group providing medical director services to the center. If a medical director agreement terminates, whether before or at the end of its term, and a new medical director is appointed, it may negatively impact the former medical director’s decision to treat his or her patients at our center. Additionally, the medical directors have no obligation to refer their patients to our centers.
Our medical director contracts are for fixed periods, generally five to ten years. Medical directors have no obligation to extend their agreements with us. As of April 1, 2003, there were 24 centers at which the medical director agreements required renewal on or before March 31, 2004.
We also may take actions to restructure existing relationships or take positions in negotiating extensions of relationships in order to assure compliance with anti-kickback and similar laws. These actions could negatively impact physicians’ decisions to extend their medical director agreements with us or to refer their patients to us. In addition, if the terms of an existing agreement were found to violate applicable laws, we may not be successful in restructuring the relationship, which could lead to the early termination of the agreement, or force the physician to stop referring patients to the centers.
If the current shortage of skilled clinical personnel continues, we may experience disruptions in our business operations and increases in operating expenses.
We are experiencing increased labor costs and difficulties in hiring nurses due to a nationwide shortage of skilled clinical personnel. We compete for nurses with hospitals and other health care providers. This nursing shortage may limit our ability to expand our operations. If we are unable to hire skilled clinical personnel when needed, our operations and our same center growth will be negatively impacted.
Adverse developments with respect to EPO could materially reduce our net income and cash flows and affect our ability to care for our patients.
Amgen is the sole supplier of EPO and may unilaterally decide to increase its price for EPO at any time. For example, Amgen unilaterally increased its base price for EPO by 3.9% in each of 2002, 2001 and 2000. Also, we cannot predict whether we will continue to receive the same discount structure for EPO that we currently receive, or whether we will continue to achieve the same levels of discounts within that structure as we have historically achieved. In addition, Amgen has developed a new product, Aranesp®, that may replace EPO or reduce its use with dialysis patients. We cannot predict if or when Aranesp® will be introduced to the U.S. dialysis market, what its cost and reimbursement structure will be, or how it may impact our revenues from EPO. Increases in the cost of EPO and the introduction of Aranesp® could have a material adverse effect on our net income and cash flows.
The pending federal review of some of our historical practices and third-party carrier review of our laboratory subsidiary could result in substantial penalties against us.
We are voluntarily cooperating with the Civil Division of the United States Attorney’s Office and OIG in Philadelphia in a review of some of our practices, including billing and other operating procedures, financial relationships with physicians and pharmaceutical companies, and the provision of pharmaceutical and other ancillary services. In addition, our Florida laboratory and our now closed Minnesota laboratory are each the subject of a third-party carrier review of claims it has submitted for Medicare reimbursement. The DOJ has also requested and received information regarding these laboratories. We are unable to determine when these matters
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will be resolved, whether any additional areas of inquiry will be opened or any outcome of these matters, financial or otherwise. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs.
If we fail to adhere to all of the complex government regulations that apply to our business, we could suffer severe consequences that would substantially reduce our revenue and earnings.
Our dialysis operations are subject to extensive federal, state and local government regulations, including Medicare and Medicaid reimbursement rules and regulations, federal and state anti-kickback laws, and federal and state laws regarding the collection, use and disclosure of patient health information. The regulatory scrutiny of healthcare providers, including dialysis providers, has increased significantly in recent years. In addition, the frequency and intensity of Medicare certification surveys and inspections of dialysis centers has increased markedly since 2000.
We endeavor to comply with all of the requirements for receiving Medicare and Medicaid reimbursement and to structure all of our relationships with referring physicians to comply with the anti-kickback laws; however, the laws and regulations in this area are complex and subject to varying interpretations. In addition, our historic dependence on manual processes that vary widely across our network of dialysis centers exposes us to greater risk of errors in billing and other business processes.
Due to regulatory considerations unique to each of these states, all of our dialysis operations in New York and part of our dialysis operations in New Jersey are conducted through privately-owned companies to which we provide a broad range of administrative services. These operations account for approximately 7% of our dialysis revenues. We believe that we have structured these operations to comply with the laws and regulations of these states, but we can give no assurances that they will not be challenged.
If any of our operations are found to violate these or other government regulations, we could suffer severe consequences, including:
Our rollout of new information technology systems will significantly disrupt our billing and collection activity, may not work as planned and could have a negative impact on our results of operations and financial condition.
We will be continuing the rollout of new information technology systems and new processes in our billing offices over the next year. It is likely that this rollout will disrupt our billing and collection activity and may cause other disruptions to our business operations, which may negatively impact our cash flows. Also, the new information systems may not work as planned or improve our billing and collection processes as expected. If they do not, we may have to spend substantial amounts to enhance or replace these systems.
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Provisions in our charter documents and compensation programs we have adopted may deter a change of control that our stockholders would otherwise determine to be in their best interests.
Our charter documents include provisions which may deter hostile takeovers, delay or prevent changes of control or changes in our management, or limit the ability of our stockholders to approve transactions that they may otherwise determine to be in their best interests. These include provisions prohibiting our stockholders from acting by written consent, requiring 60 days advance notice of stockholder proposals or nominations to our Board of Directors and granting our Board of Directors the authority to issue up to five million shares of preferred stock and to determine the rights and preferences of the preferred stock without the need for further stockholder approval, and a poison pill that would substantially dilute the interest sought by an acquirer that our board of directors does not approve.
In addition, most of our outstanding employee stock options include a provision accelerating the vesting of the options in the event of a change of control. We have also adopted a change of control protection program for our employees who do not have a significant number of stock options, which provides for cash bonuses to the employees in the event of a change of control. Based on the shares of our common stock outstanding and the market price of our stock on March 31, 2003, these cash bonuses would total approximately $44 million if a control transaction occurred at that price and our Board of Directors did not modify the program. These compensation programs may affect the price an acquirer would be willing to pay.
These provisions could also discourage bids for our common stock at a premium and cause the market price of our common stock to decline.
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PART II
OTHER INFORMATION
Item 1. Legal Proceedings
The information in Note 5 of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this report is incorporated by this reference in response to this item.
Items 2, 3, 4 and 5 are not applicable.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit Number
Description
12.1
Ratio of earnings to fixed charges.ü
99.1
Certification of the Chief Executive Officer, dated May 7, 2003, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
99.2
Certification of the Chief Financial Officer, dated May 7, 2003, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
(b) Reports on Form 8-K
Current report on Form 8-K dated May 5, 2003, furnished under Item 9, “Regulation FD Disclosure” but furnished pursuant to Item 12, “Disclosure of Results of Operations and Financial Condition”, pursuant to interim guidance issued by the SEC in Release Nos. 33-8216 and 34-47583. A copy of the press release announcing the Company’s financial results for the quarter ended March 31, 2003 was attached to the Form 8-K as Exhibit 99.1.
SIGNATURE
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.
By:
/s/ GARY W. BEIL
Gary W. Beil
Vice President and Controller*
Date: May 8, 2003
CERTIFICATIONS
I, Kent J. Thiry, certify that:
/s/ KENT J. THIRY
Kent J. Thiry
Chief Executive Officer
I, Richard K. Whitney, certify that:
/s/ RICHARD K. WHITNEY
Richard K. Whitney
Chief Financial Officer
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INDEX TO EXHIBITS
28