ROTECH HEALTHCARE INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our consolidated financial statements for the year endedDecember 31, 2011 and the notes thereto included in our Annual Report on Form 10-K previously filed with theSecurities and Exchange Commission . As used herein, unless otherwise specified or the context otherwise requires, references to the "Company", "we", "our" and "us" refer to the business and operations ofRotech Healthcare Inc. and its subsidiaries.
Introduction
Background
We are one of the largest providers of home medical equipment and related products and services inthe United States , with a comprehensive offering of respiratory therapy and durable home medical equipment and related services. We provide home medical equipment and related products and services principally to older patients with breathing disorders, such as chronic obstructive pulmonary diseases (COPD), which include chronic bronchitis, emphysema, obstructive sleep apnea and other cardiopulmonary disorders. We provide equipment and services in 49 states through approximately 410 operating locations located primarily in non-urban markets. Our revenues are principally derived from respiratory equipment rental and related services, which accounted for 86.4% and 87.4% of net revenues for the three months endedSeptember 30, 2012 and 2011, respectively, and 86.6% and 87.4% of net revenues for the nine months endedSeptember 30, 2012 and 2011. Revenues from respiratory equipment rental and related services include rental of oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy systems, nebulizer equipment and sleep disorder breathing therapy systems, and the sale of nebulizer medications. We also generate revenues through the rental and sale of durable medical equipment, which accounted for 10.9% and 10.7% of net revenues for both the three and nine months endedSeptember 30, 2012 and 2011, respectively. Revenues from rental and sale of durable medical equipment include hospital beds, wheelchairs, walkers, patient aids and ancillary supplies. We derive our revenues principally from reimbursement by third-party payors, includingMedicare ,Medicaid , theVeterans Administration (VA) and private insurers. Executive Summary We face significant financial andMedicare reimbursement related challenges that continue to negatively affect our financial position. We anticipate that we will continue to face such challenges in the near and long-term future. Most of these difficulties result from our highly leveraged capital structure, while others are the result of significantMedicare reimbursement reductions applicable to our industry. In light of these challenges, our operational focus is on reducing our cost structure while maintaining internal growth and improving our overall collection rates. Specifically, we are focused on: • Simplifying the operational processes performed in our branch locations
following the successful implementation of our new order intake system
(implemented in late 2011).
• Expanding quality assurance functions to ensure that orders are entered
accurately and timely and all required billing paperwork is obtained in
an expeditious manner.
We also believe that our national geographic coverage, patient care reputation and strong managed care relationships position us well for accelerated patient growth as managed care plans continue to focus on network consolidation. Although we have slowed the pace of our asset and equipment purchase transactions during the first nine months of 2012, we do expect to continue seeking opportunities to gain market share through selective asset and equipment purchases from competitors exiting the home medical equipment market. In particular: • During the first nine months of 2012, we purchased$2.5 million of new
and used rental equipment, inventory and certain identifiable</p>
intangible assets from competitors exiting the home medical equipment
market. Some of the equipment purchased in these transactions is currently on rent and located in patients' homes. We believe that we will be successful in continuing to identify additional asset and equipment purchase opportunities and that we will be able to
successfully transition a high percentage of the associated patients
onto service with our Company. During the nine months ended
revenues associated with patients transitioned onto service with our Company through asset and equipment purchases.
• During the first nine months of 2011, we purchased
and used rental equipment and inventory from competitors exiting the home medical equipment market. Some of the equipment purchased in these 16
-------------------------------------------------------------------------------- transactions is currently on rent and located in patients' homes. During the nine months endedSeptember 30, 2011 , we recognized approximately$17.9 million of revenues associated with patients transitioned onto service with our Company through asset and equipment purchases. We expect that we will continue to evaluate and explore strategic alternatives and opportunities as they may arise, including potential acquisitions, business combination transactions, strategic partnerships or similar transactions. In addition, either in connection with or independent of such a transaction, we expect that we may engage in financing activities through public or private offerings of equity, debt or convertible securities, including common stock, preferred stock, warrants, convertible notes or other instruments. Based on our current liquidity position and the expected capital resources generated from our operations, we believe that in order to meet the cash needs to support our ongoing business, service our debt structure, and capital expenditures over the next twelve months, we will need to borrow the aforementioned$15.0 million in debt, realize the incremental capital resources from new initiatives, and realize the growth in patients. In the event that we lack the ability to generate adequate cash to support our ongoing operations, we may need to access the financial markets by seeking additional debt or equity financing. As disclosed in our Risk Factors, there may be uncertainty surrounding our ability to access capital in the marketplace. The Company may be unable to secure the$15.0 million in additional financing permitted to it under the Indentures for our Senior Secured Notes and our Senior Second Lien Notes or to refinance its indebtedness on commercially reasonable terms, in which case it would need to identify alternative options to address its current and prospective credit situation, such as a sale of the Company or other strategic transaction, or a transformative transaction, such as a possible restructuring or reorganization of the Company's operations which could include filing for bankruptcy protection. OnJune 28, 2011 , we submitted our application for relisting of our common stock on theNASDAQ Global Market . The application review by NASDAQ's Listing Qualifications department for compliance with allNASDAQ Stock Market standards is substantially complete. However, we do not currently meet the$4.00 per share minimum bid price required for initial listing on theNASDAQ Global Market . While we intend to satisfy all of NASDAQ's requirements for relisting, there can be no assurance that our application will be approved, or of when or if our common shares will be listed on theNASDAQ Stock Market or another stock exchange. Our common stock will continue to trade on the OTC Bulletin Board under our current symbol, ROHI, during the NASDAQ listing process. OnOctober 1, 2012 , the Company executed two Supplemental Indentures adding three new subsidiary entities, Best Care HHC Acquisition Company LLC,NeighborCare Home Medical Equipment, LLC andNeighborCare Home Medical Equipment of Maryland, LLC , as subsidiary guarantors under the Company's First Lien Indenture, datedOctober 6, 2010 , and the Second Lien Indenture, datedMarch 17, 2011 . Reimbursement by Third-Party Payors We derive substantially all of our revenues from reimbursement by third-party payors, includingMedicare ,Medicaid , the VA and private insurers. Revenue derived fromMedicare ,Medicaid and other federally funded programs represented 53.6% and 56.7% of our patient service revenue for the three months endedSeptember 30, 2012 and 2011, respectively, and 54.9% and 57.0% of our patient service revenue for the nine months endedSeptember 30, 2012 and 2011, respectively. Our business has been, and may continue to be, significantly impacted by changes mandated byMedicare legislation. Under existingMedicare laws and regulations, the sale and rental of our products generally are reimbursed by theMedicare program according to prescribed fee schedule amounts calculated using statutorily-prescribed formulas. Significant legislation affecting home medical equipment (HME) reimbursement has been signed into law, including the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act (collectively, the "PPACA"), Medicare Improvement for Patients and Providers Act of 2008 (MIPPA),Medicare ,Medicaid and State Children's Health Insurance Program Extension Act of 2007 ("SCHIP Extension Act"), the Deficit Reduction Act of 2005 (DRA) and the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA), contain provisions that negatively impact reimbursement for the primary HME products that we provide. The PPACA, MIPPA, the SCHIP Extension Act, DRA and MMA provisions (each of which is discussed in more detail below), when fully implemented, could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations. • The PPACA includes, among other things, annual, non-deductible fees on
any entity that manufacturers or imports certain prescription drugs and
biologics, which began in 2011; a deductible excise tax on any entity that manufactures or imports medical devices offered for sale inthe United States , with limited exceptions, beginning in 2013; new face-to-face physician encounter requirements for HME and home health services; and a requirement that by 2016, the competitive bidding process must be nationalized or prices in non-competitive bidding areas must be adjusted to match competitive bidding prices. 17
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• MIPPA retroactively delayed the implementation of competitive bidding
for eighteen months from previously established dates as noted below
and decreased the 2009 fee schedule payment amounts by 9.5% for product
categories included in competitive bidding.
• The SCHIP Extension Act, which went into effect
Medicare reimbursement amounts for covered Medicare Part B drugs, including inhalation drugs that we provide. • The DRA capped theMedicare rental period for oxygen equipment at 36 months of continuous use, after which time title of the equipment would
transfer to the beneficiary. For purposes of this cap, the DRA provided
for a new 36-month rental period that began
oxygen equipment. With the passage of MIPPA, transfer of title of
oxygen equipment at the end of the 36-month rental cap was repealed,
although the rental cap remained in place. ? The MMA significantly reduced reimbursement for inhalation drug therapies beginning in 2005, reduced payment amounts for five categories of HME, including oxygen, beginning in 2005, froze payment amounts for other covered HME items through 2007, established a
competitive bidding program for HME and implemented quality standards
and accreditation requirements for HME suppliers.
We cannot predict the impact that any federal legislation enacted in the future will have on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations. Further, changes in the law or new interpretations of existing laws could have a dramatic effect on permissible activities, the relative costs associated with doing business and the amount of reimbursement by government and other third-party payors. Reimbursement we receive fromMedicare and other government programs is subject to federal and state statutory and regulatory requirements, administrative rulings, interpretations of policy, implementation of reimbursement procedures, renewal of VA contracts, retroactive payment adjustments and governmental funding restrictions. Our levels of revenue and profitability, like those of other health care companies, are affected by the continuing efforts of government payors to contain or reduce the costs of health care, including competitive bidding initiatives, measures that impose quality standards as a prerequisite to payment, policies reducing certain HME payment rates and restricting coverage and payment for inhalation drugs, and refinements to payments for oxygen and oxygen equipment. (1)Competitive Bidding Program for HME . OnApril 2, 2007 , theCenters for Medicare & Medicaid Services (CMS), the agency responsible for administering theMedicare program, issued its final rule implementing a competitive bidding program for certain HME products under Medicare Part B. This nationwide competitive bidding program is designed to replace the existing fee schedule payment methodology. Under the competitive bidding program, suppliers compete for the right to provide items to beneficiaries in a defined geographic region. CMS selects contract suppliers that agree to receive as payment the "single payment amount" calculated by CMS after bids are submitted. Round 1 of the competitive bidding program began onJuly 1, 2008 in ten high-population competitive bidding areas (CBAs). As a winning bidder in nine of the ten competitive bidding areas, we signed contracts with CMS to become a contracted supplier for the Round 1 contract period ofJuly 1, 2008 throughJune 30, 2011 . The competitive bidding program was scheduled to expand to 70 additional CBAs for a total of 80 CBAs in 2009 and additional areas thereafter. However, onJuly 15, 2008 , theUnited States Congress , following an override of a Presidential veto, enacted MIPPA. MIPPA retroactively delayed the implementation of competitive bidding for eighteen months, and terminated all existing contracts previously awarded. MIPPA included a 9.5% nationwide reduction in reimbursement effectiveJanuary 1, 2009 for the product categories included in competitive bidding, as a budget-neutrality offset for the eighteen month delay. OnJanuary 16, 2009 , CMS published an interim final rule with comment period (IFC) addressing the MIPPA provisions that affect Round 1 of the competitive bidding program. This IFC announced the delay of Round 1 of the program from 2007 to 2009. The round one competition, also known as the Round 1 rebid, occurred in the same CBAs as the 2007 Round 1 bidding, excludingPuerto Rico . The product categories for 2009 were the same as those selected for the 2007 round one bidding, with the exception of negative pressure wound therapy and Group 3 complex rehabilitative wheelchairs. The IFC also announced the delay of Round 2 of the program from 2009 to 2011, the national mail order program until after 2010 and competition in additional areas, other than mail order, until after 2011. Suppliers are required to meet all applicable eligibility, financial, quality and accreditation standards. The MIPPA changes that were addressed in this IFC did not alter the fundamental requirements of the final regulation for the competitive bidding program published onApril 10, 2007 . OnJuly 2, 2010 , CMS announced the single payment amount for each of the respective Round 1 rebid CBAs and product categories and began offering contracts to certain bidders in the CBAs. We were awarded and accepted 17 contracts. The contracts became effective onJanuary 1, 2011 and have a term of three years. In addition, onJuly 1 andSeptember 9, 2011 , we completed two acquisitions in two of the Round 1 rebid CBAs. As part of these acquisitions, we assumed six additional competitive bid contracts, for a total of 23, as follows: 18 --------------------------------------------------------------------------------
• 7 CBAs for oxygen supplies and equipment;
• 6 CBAs for enteral nutrients, equipment and supplies;
• 5 CBAs for continuous positive airway pressure, respiratory assist devices and related supplies and accessories;
•
•
• 2 CBAs for standard power wheelchairs, scooters and related accessories.
The average reduction from currentMedicare payment rates in this round of competitive bidding across the CBAs is 32%. Suppliers that were not contracted by CMS may continue to provide certain capped rental and oxygen equipment for those beneficiaries that were patients at the time the program began and are known as "grandfathered suppliers". In the CBAs and product categories where we are not a contracted supplier, we continue to service ourMedicare patients as grandfathered suppliers under applicable guidelines. Based upon CMS release information, it appears that approximately 70% of existing providers across the Round 1 Rebid CBAs were not awarded competitive bidding contracts and are therefore not able to provide competitive bid products to newMedicare patients during the term of these contracts in the respective CBAs. We have experienced significant volume increases within the CBAs where we were awarded contracts, which we attribute in part to an increase in market share, and we believe that the revenue associated with these volume increases will more than offset the impact of the associated reductions in reimbursement rates over time. The application of the new competitive bid rates in the Round 1 rebid reduced our net revenue by approximately$1.3 million per quarter. To continue to participate in competitive bidding for the Round 1 Rebid CBAs, suppliers must submit new bids for the Round 1 Recompete. OnOctober 15, 2012 , CMS opened the 60-day bid window for the Round 1 Recompete. The contracting process and the announcement of the single payment rate is scheduled for Spring 2013. Implementation of the Round 1 Recompete contracts will beginJanuary 1, 2014 . For Round 2 and national mail order items and supplies in 91 additional markets, CMS expects to announce single payment amounts and began the contracting process in Fall 2012, with contracts expected to be effective inJuly 2013 . OurMedicare revenues from the product categories in the 91 additional markets to be included in Round 2 of competitive bidding were approximately$54.0 million in 2011. The PPACA legislation requires CMS to expand competitive bidding further to additional geographic markets (certain markets may be excluded at the discretion of CMS) or to use competitive bid pricing information to adjust the payment amounts otherwise in effect for areas that are not competitive bidding areas byJanuary 1 , 2016.Other changes impacting competitive bidding and current payment policies for certain items of durable medical equipment, prosthetics, orthotics and supplies were finalized by CMS onNovember 2, 2010 , including: • Implementation of certain statutory provisions under MIPPA and the PPACA, include: (1) the subdivision of metropolitan statistical areas (MSAs) with populations over 8,000,000 into smaller CBAs, as required under MIPPA; (2) the addition of 21 MSAs to the 70 MSAs already designated as included in Round 2, for a total of 91 MSAs, as required under the PPACA; and (3) the implementation of payment policies adopted under the PPACA for power wheelchairs, which eliminated the lump sum purchase option for standard power wheelchairs furnished on or afterJanuary 1, 2011 , and adjusted the amount of the capped rental payments for power wheelchairs. EffectiveJanuary 1, 2011 , rental payments under the adjusted fee schedule are 15% (instead of 10%) of the purchase price for the first three months and 6% (instead of 7.5%) for the remaining rental months not to exceed 13 months; and • The establishment of an appeals process for competitive bidding contract suppliers that are notified that they are in breach of contract. CMS in the 2010 rule also solicited comments on whether to reduce the maximum number of payments a contract supplier would receive beyond the 13-month (for capped rental) and 36-month (for oxygen and oxygen equipment) caps when a beneficiary who is receiving the equipment from a non-contract supplier elects to switch to the contract supplier. To date CMS has not made any changes. In addition, beginning onSeptember 1, 2012 , the agency implemented a new Prior Authorization for Power Mobility Devices (PMDs) Demonstration, which requires Medicare HME suppliers of certain PMDs, such as power wheelchairs, to receive prior approval from aDME MAC before submitting claims for payment. The demonstration impacts PMDs for beneficiaries residing inCalifornia ,Florida ,Illinois ,Michigan , NewYork, North Carolina , andTexas and is scheduled to last 3 years. The failure to receive prior approval will result in a 25% payment reduction in areas not covered by competitive bidding. We do not anticipate that the demonstration will have a material impact on our operations. (2) Certain Clinical Conditions, Accreditation Requirements and Quality Standards. The MMA required establishment and implementation of new clinical conditions of coverage for HME products and quality standards for HME suppliers. Some clinical conditions have been implemented, such as the requirement for a face-to-face visit by treating physicians for beneficiaries seeking power mobility devices. CMS published its quality standards and criteria for accrediting 19 -------------------------------------------------------------------------------- organizations for HME suppliers in 2006 and revised some of these standards inOctober 2008 . As an entity that billsMedicare and receives payment from the program, we are subject to these standards. We have revised our policies and procedures to ensure compliance in all material respects with the quality standards. These standards, which are applied by independent accreditation organizations, include business-related standards, such as financial and human resources management requirements, which would be applicable to all HME suppliers, and product-specific quality standards, which focus on product specialization and service standards. The product specific standards address several of our products, including oxygen and oxygen equipment, CPAP and power and manual wheelchairs and other mobility equipment. Currently, all of our operating locations are accredited by the Joint Commission (formerly referred to as theJoint Commission on Accreditation of Healthcare Organizations ).The Joint Commission is a CMS recognized accrediting organization. Round 1 re-bid competitive bid suppliers were required to be accredited bySeptember 30, 2009 . Additional clinical conditions for coverage were imposed under PPACA, authorizing CMS to require a physician or other licensed professional to conduct a face-to-face encounter with the beneficiary before writing a prescription for certain HME. EffectiveJanuary 1, 2013 , CMS finalized its proposal earlier this year to implement the face-to-face requirement for items that, among other things, cost more than$1,000 and items that in the view of CMS are particularly susceptible to fraud, waste and abuse. CMS identified oxygen and oxygen equipment, positive airway pressure devices, and respiratory assist devices as requiring such a face-to-face requirement, which implicate our products. Supplier standards for Medicare HME companies, effectiveMarch 3, 2009 require HME suppliers to meet certain surety bond requirements. For each National Provider Identifier (NPI) number subject toMedicare billing privileges, suppliers must obtain a surety bond in the amount of$50,000 . Each of our 410 operating locations is required to have its own NPI number. There may be an upward adjustment for suppliers that have had adverse legal actions imposed on them in the past. HME suppliers already enrolled inMedicare were required to obtain a surety bond byOctober 2, 2009 , and newly enrolled suppliers or those changing ownership were subject to the provisions of the new rule onMay 4, 2009 . We maintain surety bonds covering all of our NPI numbers at each of our operating locations. (3) Reduction in Payments for HME and Inhalation Drugs. The MMA changes also included a reduction in reimbursement rates beginning inJanuary 2005 for oxygen equipment and certain other HME items (including wheelchairs, nebulizers, hospital beds and air mattresses) based on the percentage difference between the amount of payment otherwise determined for 2002 and the 2002 median reimbursement amount under the Federal Employee Health Benefits Program (FEHBP) as determined by theOffice of the Inspector General of the Department of Health and Human Services (OIG). The FEHBP adjusted payments remained "frozen" through 2008. With limited exceptions, items that were not included in competitive bidding received a 5% update for 2009. As discussed above, for 2009, MIPPA included a 9.5% nationwide reduction in reimbursement for the product categories included in competitive bidding, as a budget neutrality offset for the eighteen month delay. The MMA also revised the payment methodology for certain drugs, including inhalation drugs dispensed through nebulizers. Historically, prescription drug coverage underMedicare has been limited to drugs furnished incident to a physician's services and certain self-administered drugs, including inhalation drug therapies. Prior to MMA,Medicare reimbursement for covered drugs, including the inhalation drugs that we provide, was limited to 95 percent of the published average wholesale price (AWP) for the drug. MMA established new payment limits and procedures for drugs reimbursed under Medicare Part B. Beginning in 2005, inhalation drugs furnished toMedicare beneficiaries are reimbursed at 106 percent of the volume-weighted average selling price (ASP) of the drug, as determined from data provided each quarter by drug manufacturers under a specific formula described in MMA. Implementation of the ASP-based reimbursement formula resulted in a significant reduction in payment rates for inhalation drugs. Given the overall reduction in payment for inhalation drugs dispensed through nebulizers, CMS established a dispensing fee for inhalation drugs shipped to a beneficiary beginning in 2005. The current dispensing fee is$57 for the first 30-day period in which aMedicare beneficiary uses inhalation drugs and$33 for each subsequent 30-day period. The dispensing fee for a 90-day supply of inhalation drugs is$66 . The dispensing fee has remained unchanged since 2006. Future changes from quarterly updates to ASP pricing, as well as any future dispensing fee reductions or eliminations, if they occur, could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations. Furthermore, because the ASP amounts vary from quarter to quarter, changes in market forces influence theMedicare payment rate. In late 2006, theUS Food and Drug Administration approved a first-time generic formulation for DuoNeb. The introduction of this generic product into the market has contributed to the reduction of the ASP for DuoNeb from$1.079 in the fourth quarter of 2007 to$0.210 in the fourth quarter 2012. The impact of this reduction to our profit margins, profitability, operating cash flows and results of operations was partially mitigated through the dispensing of generic DuoNeb and changes in nebulizer product mix. 20 -------------------------------------------------------------------------------- (4) Reduction in Payments for Oxygen and Oxygen Equipment. The DRA which was signed into law onFebruary 8, 2006 , made certain changes to the wayMedicare Part B pays for certain of our HME products, including oxygen and oxygen equipment. For oxygen equipment, prior to the DRA,Medicare made monthly rental payments indefinitely, provided medical need continued. The DRA capped theMedicare rental period for oxygen equipment at 36 months of continuous use, after which time ownership of the equipment would transfer to the beneficiary. For purposes of this cap, the DRA provided for a new 36-month rental period that beganJanuary 1, 2006 for all oxygen equipment. In addition to the changes in the duration of the rental period for capped rental items and oxygen equipment, the DRA permitted payments for servicing and maintenance of the products after ownership transfers to the beneficiary. OnNovember 1, 2006 , CMS released a final rule to implement the DRA changes, which went into effectJanuary 1, 2007 . Under the rule, CMS clarified the DRA's 36-month rental cap on oxygen equipment. CMS also revised categories and payment amounts for the oxygen equipment and contents during the rental period and for oxygen contents after equipment ownership by the beneficiary as described below. With the passage of MIPPA onJuly 15, 2008 , transfer of title to oxygen equipment at the end of the 36-month rental cap was repealed, although the rental cap remained in place. EffectiveJanuary 1, 2009</chron>, after the 36th continuous month during which payment is made for the oxygen equipment, the equipment is to continue to be furnished during any period of medical need for the remainder of the reasonable useful lifetime of the equipment. The reasonable useful lifetime for stationary or portable oxygen equipment begins when the oxygen equipment is first delivered to the beneficiary and continues until the point at which the stationary or portable oxygen equipment has been used by the beneficiary on a continuous basis for five years (60 months) provided there are no breaks in service due to medical necessity. Computation of the reasonable useful lifetime is not based on the age of the equipment. During the capped rental period from months 37 through 60 of continuous use, payment is made only for oxygen and for certain reasonable and necessary maintenance and servicing (for parts and labor not covered by the supplier's or manufacturer's warranty) (as discussed in more detail below). • Payment for Rental Period. The 2012 and 2011 rate for stationary oxygen
equipment is
monthly portable oxygen add-on amount is
respectively. The 2012 monthly payment amount for oxygen-generating
portable oxygen equipment remains unchanged at
• Payment for Contents after 36-Month Rental Cap. Payment is based on the
type of equipment owned and whether it is oxygen-generating. CMS pays
separate monthly payments
oxygen content. If the beneficiary uses both stationary and portable
equipment that is not oxygen-generating, the monthly payment amount for
oxygen contents is
that is oxygen-generating, there will be no monthly payment for contents.
• Payment for maintenance and service after 36-Month Rental Cap. CMS pays
for one in-home, maintenance and service visit for oxygen concentrators
and transfilling equipment every six months, beginning six months after the end of the 36-month rental cap. This payment will be made if the supplier visits the beneficiary's home, performs any necessary maintenance and service, and inspects the equipment to ensure that it will function safely for the next six months. CMS pays for such in-home
maintenance and service visits every six months until medical necessity
ends or the beneficiary elects to obtain new equipment. BeginningJuly 1, 2010 , the six-month maintenance and service payment rate is capped at 10% of the cost of acquiring a stationary oxygen concentrator, which resulted in a payment of$66 for calendar year 2010. For calendar year 2011 and subsequent years, the maintenance and servicing fee is adjusted by the covered item update for DME, which resulted in a payment of$65.93 for calendar year 2011, and$67.51 for calendar year 2012. Finally, CMS clarified that though it retains title to the equipment, a supplier is required to continue to furnish needed oxygen equipment and contents for liquid or gaseous equipment after the 36-month rental cap until the end of the equipment's reasonable useful lifetime. CMS determined the reasonable useful lifetime for oxygen equipment to be five years provided there are no breaks in service due to medical necessity, computed based on the date the equipment is delivered to the beneficiary. OnJanuary 27, 2009 , CMS posted further instructions on the implementation of the 36-month rental cap, including guidance on payment for oxygen contents after month 36 and the replacement of oxygen equipment that has been in continuous use by the patient for the equipment's reasonable useful lifetime (as defined above). In accordance with the instructions, and consistent with the final rule published onOctober 30, 2008 , suppliers may bill for oxygen contents on a monthly basis after the 36-month rental cap, and the supplier can deliver up to a maximum of three months of oxygen contents at one time. Additionally, in accordance with these instruction, and consistent with the final rule published onOctober 30, 2008 , we provide replacement equipment to our patients that exceed five years of continuous use. The ongoing financial impact of the 36-month rental cap will depend upon a number of variables, including, (i) the number ofMedicare oxygen customers reaching 36 months of continuous service, (ii) the number of patients receiving oxygen contents beyond the 36-month rental period and the coverage and billing requirements established by CMS for suppliers to receive payment for such oxygen contents, (iii) the mortality rates of patients on service beyond 36 months, (iv) the incidence 21 -------------------------------------------------------------------------------- of patients with equipment deemed to be beyond its reasonable useful life that may be eligible for new equipment and therefore a new rental episode and the coverage and billing requirements established by CMS for suppliers to receive payment for a new rental period, (v) any breaks in continuous use due to medical necessity, and (vi) payment amounts established by CMS to reimburse suppliers for maintenance of oxygen equipment. We cannot predict the impact that any future rulemaking by CMS will have on our business. If payment amounts for oxygen equipment and contents are further reduced in the future, this could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations. CMS also has authority to make other adjustments to reimbursement for HME. With the passage of the Balanced Budget Act of 1997, CMS may determine to increase or reduce the reimbursement for HME, including oxygen, by up to 15% each year under an inherent reasonableness procedure. The regulation implementing the inherent reasonableness authority establishes a process for adjusting payments for certain items and services covered by Medicare Part B when the existing payment amount is determined to be grossly excessive or deficient. The regulation lists factors that may be used by CMS and itsMedicare contractors to determine whether an existing reimbursement rate is grossly excessive or deficient and to determine what a realistic and equitable payment amount is. Also, under the regulation, CMS and its contractors will not consider a payment amount to be grossly excessive or deficient and make an adjustment if they determine that an overall payment adjustment of less than 15% is necessary to produce a realistic and equitable payment amount. The implementation of the inherent reasonableness procedure itself does not trigger payment adjustments for any items or services and to date, no payment adjustments have occurred or been proposed under this inherent reasonableness procedure. Though the inherent reasonableness authority has not been exercised, in past years, CMS historically has reduced the publishedMedicare reimbursement rates for HME to an amount based on the payment amount for the least costly alternative (LCA) treatment that meets theMedicare beneficiary's medical needs. LCA determinations have been applied to particular products and services by CMS and its contractors through the notice and comment process used in establishing local coverage policies for HME. With respect to its LCA policies, onOctober 16, 2008 , aU.S. District Court in theDistrict of Columbia held that CMS did not have the authority to implement LCA determinations in setting payment amounts for an inhalation drug. This decision was upheld by theU.S. Court of Appeals and, as a result, CMS and its contractors withdrew their LCA policy for the inhalation drug. In addition, CMS instructed its contractors that they may no longer apply LCA policies to any HME. EffectiveFebruary 4, 2011 , all coverage policies have been revised to eliminate their LCA provisions. During the quarter endedMarch 31, 2012 , management identified an error made in certain programming logic within its billing system. As a result of this error, we determined that we had been overpaid on certain specificMedicare claim types sinceJanuary 1, 2009 . The amount of the overpayment totaled approximately$6.5 million . The programming logic that caused this error has been corrected in our billing system and we are not aware of any otherMedicare overpayment issues as a result of this or any other programming error. We engaged an outside technical firm to conduct an independent review of our new programming logic to confirm that the programming logic is consistent with all associatedMedicare regulations and such review was completed prior to implementation in our billing system. OnMay 7, 2012 , we voluntarily refunded the above described overpayment to the appropriate Durable Medical Equipment Medicare Administrative Contractors (DME MACs) (see "Notes to Unaudited Condensed Consolidated Financial Statements-(1) Basis of Presentation" included herein in Item 1, "Financial Statements"). 22 --------------------------------------------------------------------------------
Results of Operations The following table shows our results of operations for the three and nine months ended
(unaudited) Three months ended Nine months ended September 30, September 30, 2012 2011 2012 2011 Net revenues $ 113,782 $ 122,406 $ 347,283 $ 365,350 Costs and expenses: Cost of net revenues 39,063 37,825 114,996 112,854 Selling, general and administrative 65,088 63,217 201,791 188,842 Provision for doubtful accounts 5,340 6,428 22,255 18,776 Depreciation and amortization 2,249 2,370 7,047 7,005 Total costs and expenses 111,740 109,840 346,089 327,477 Operating income 2,042 12,566 1,194 37,873 Other expense (income): Interest expense, net 15,012 14,692 44,898 45,366 Other (income) expense, net (21 ) 97 68 (783 ) Loss on debt extinguishment - - - 1,216 Total other expense 14,991 14,789 44,966 45,799 Loss before income taxes (12,949 ) (2,223 ) (43,772 ) (7,926 ) Income tax benefit (88 ) (168 ) (41 ) (208 ) Net loss (12,861 ) (2,055 ) (43,731 ) (7,718 ) Accrued dividends on convertible redeemable preferred stock - 18 124 232 Net loss attributable to common stockholders $ (12,861 ) $ (2,073 ) $ (43,855 ) $ (7,950 )
The following table shows our results of operations as a percentage of our net revenues for the three and nine months ended
23 --------------------------------------------------------------------------------
(unaudited) Three months ended Nine months ended September 30, September 30, 2012 2011 2012 2011 Net revenues 100.0 % 100.0 % 100.0 % 100.0 % Costs and expenses: Cost of net revenues 34.3 % 30.9 % 33.1 % 30.9 % Selling, general and administrative 57.2 % 51.6 % 58.1 % 51.7 % Provision for doubtful accounts 4.7 % 5.3 % 6.4 % 5.1 % Depreciation and amortization 2.0 % 1.9 % 2.0 % 1.9 % Total costs and expenses 98.2 % 89.7 % 99.6 % 89.6 % Operating income 1.8 % 10.3 % 0.4 % 10.4 % Other expense (income): Interest expense, net 13.2 % 12.0 % 12.9 % 12.4 % Other (income) expense, net - % 0.1 % - % (0.2 )% Loss on debt extinguishment - % - % - % 0.3 % Total other expenses 13.2 % 12.1 % 12.9 % 12.5 % Loss before income taxes (11.4 )% (1.8 )% (12.5 )% (2.1 )% Income tax benefit (0.1 )% (0.1 )% - % (0.1 )% Net loss (11.3 )% (1.7 )% (12.5 )% (2.0 )% Accrued dividends on convertible redeemable preferred stock - % - % - % 0.1 % Net loss attributable to common stockholders (11.3 )% (1.7 )%
(12.5 )% (2.1 )%
Three months endedSeptember 30, 2012 as compared to the three months endedSeptember 30, 2011 Total net revenues for the three months endedSeptember 30, 2012 were$113.8 million as compared to$122.4 million for the comparable period in 2011. This net decrease of$8.6 million from the comparable period in 2011 is primarily attributable to: • Decreased nebulizer medication volume and reimbursement totaling approximately$1.8 million ;
• Decreased net revenue from higher rates of contractual/revenue adjustments
compared to prior year totaling approximately
• Patients moved to non-billable status primarily as a result of
claim denials from pre-payment and post-payment audits totaling approximately$3.3 million ; • Decreased net revenue fromMedicare oxygen patients reaching their 36 month rental cap totaling approximately$3.5 million ; and
• Decreased net revenue from non-core product lines totaling approximately
These decreases were partially offset by: • Organic growth of 6% in oxygen patients, 12% in CPAP rental patients and
7% in CPAP sales compared to prior year, totaling approximately$2.7 million in incremental revenue; and
• Growth in the net number of active patients on service with us through
equipment and asset purchase transactions totaling
Cost of net revenues totaled$39.1 million for the three months endedSeptember 30, 2012 , an increase of$1.2 million , or 3.3%, from the comparable period in 2011. Cost of net revenues for the three months endedSeptember 30, 2012 and 2011 was comprised of the following: 24 --------------------------------------------------------------------------------
Three months ended September 30, 2012 2011 Cost of net revenues: Product and supply costs $ 21,543 $ 23,162 Patient service equipment depreciation 14,502 12,569 Operating costs 3,018 2,094 $ 39,063 $ 37,825 The decrease in product and supply costs is primarily attributable to volume-related decreases in product and supply costs for nebulizer medications net of increased volume in CPAP supply sales . The increase of$1.9 million in patient service equipment depreciation is primarily attributable to the shortening of our average composite useful life for CPAP equipment as a result of a higher percentage of CPAP equipment renting to purchase. Operating costs primarily consist of salary and benefit costs associated with our respiratory services and pharmacy operations. These costs are reclassified from selling, general and administrative expenses to cost of net revenues. The increase in operating costs is primarily attributable to a higher reclassification of respiratory therapy expenses from selling, general and administrative to cost of net revenues as a result of a change in classification of respiratory therapists from independent contractors to employees beginning late in the second quarter 2012. Cost of net revenues as a percentage of net revenues was 34.3% for the three months endedSeptember 30, 2012 as compared to 30.9% for the comparable period in 2011. Selling, general and administrative expenses for the three months endedSeptember 30, 2012 totaled$65.1 million , an increase of$1.9 million , or 3.0%, from the comparable period in 2011. The increase in selling, general and administrative expenses was primarily attributable to: • Incremental salary and benefit costs associated with asset purchases completed during and since third quarter 2011 totaling approximately$0.7 million ;
• Annual merit increase as compared to the same period in 2011 totaling
approximately
• Increased legal expenses of
activities;
• Additional commissions expense associated with accelerated patient growth
in the nine months ended
in 2011 totaling approximately
These increases were offset by one less payroll day in third quarter 2012 as compared to the same period in 2011 totaling approximately$0.5 million . The provision for doubtful accounts for the three months endedSeptember 30, 2012 totaled$5.3 million , a$1.1 million decrease from the comparable period in 2011. As a percentage of net revenues, the provision for doubtful accounts was 4.7% and 5.3% for the three months endedSeptember 30, 2012 and 2011, respectively. This decrease is attributable to the factors described below under the heading "Liquidity and Capital Resources." Depreciation and amortization for the three months endedSeptember 30, 2012 totaled$2.2 million , a decrease of$0.1 million from the comparable period in 2011. Depreciation and amortization as a percentage of net revenues increased to 2.0% as compared to 1.9% for the comparable period in 2011. Net interest expense for the three months endedSeptember 30, 2012 totaled$15.0 million , an increase of$0.3 million from the comparable period in 2011. Net loss for the three months endedSeptember 30, 2012 was$12.9 million compared to net loss of$2.1 million for the comparable period in 2011. This difference is attributable to the changes in revenue, and costs and expenses described above. Nine months endedSeptember 30, 2012 as compared to the nine months ended endedSeptember 30, 2011 Total net revenues for the nine months endedSeptember 30, 2012 were$347.3 million as compared to$365.4 million for the comparable period in 2011. This net decrease of$18.1 million from the comparable period in 2011 is primarily attributable to: • Decreased nebulizer medication volume and reimbursement totaling approximately$7.8 million ; • Decreased net revenue from increased rates of contractual/revenue
adjustments compared to prior year totaling approximately
• Patients moved to non-billable status primarily as a result of
claim denials from pre-payment and post-payment audits totaling approximately$10.0 million ; 25
--------------------------------------------------------------------------------
• Decreased net revenue fromMedicare oxygen patients reaching their 36 month rental cap totaling approximately$9.3 million ; and
• Decreased net revenue from non-core product lines totaling approximately
These decreases were partially offset by: • Organic growth of 6% in oxygen, 12% in CPAP rental and 7% in CPAP sales
compared to prior year, totaling approximately$15.3 million in incremental revenue; and
• Growth in the net number of active patients on service with us through
equipment and asset purchase transactions totaling
Cost of net revenues totaled$115.0 million for the nine months endedSeptember 30, 2012 , an increase of$2.1 million , or 1.9%, from the comparable period in 2011. Cost of net revenues for the nine months endedSeptember 30, 2012 and 2011 was comprised of the following: Nine months ended September 30, 2012 2011 Cost of net revenues: Product and supply costs $ 65,734 $ 68,732 Patient service equipment depreciation 41,859 37,710 Operating costs 7,403 6,412 $ 114,996 $ 112,854 The decrease in product and supply costs is primarily attributable to volume-related decreases in product and supply costs for nebulizer medications net of increased volume in CPAP supply sales. The increase of$4.1 million in patient service equipment depreciation is primarily attributable to the shortening of our average composite useful life for CPAP equipment as a result of a higher percentage of CPAP equipment renting to purchase. Operating costs primarily consist of salary and benefit costs associated with our respiratory services and pharmacy operations. The costs are reclassified from selling, general and administrative expenses to cost of net revenues. The increase in operating costs are primarily attributable to a higher reclassification of respiratory therapy expenses from selling, general and administrative to cost of net revenues as a result of a change in classification of respiratory therapists from independent contractors to employees beginning late in the second quarter 2012. Cost of net revenues as a percentage of net revenues was 33.1% for the nine months endedSeptember 30, 2012 as compared to 30.9% for the comparable period in 2011. Selling, general and administrative expenses for the nine months endedSeptember 30, 2012 totaled$201.8 million , an increase of$12.9 million , or 6.9%, from the comparable period in 2011. The increase in selling, general and administrative expenses was primarily attributable to: •$2.0 million retirement award due to Mr.Philip Carter , Chief Executive
Officer of the Company, under terms of his employment agreement;
• Incremental salary and benefit costs associated with asset purchases
completed during and since third quarter 2011 totaling approximately$3.0 million ; • Annual merit increase as compared to the same period in 2011 net of reductions in benefit costs totaling approximately$1.1 million ;
• Increased telephone expense of approximately
the excise tax refund (credit) recorded during the three months endedMarch 31, 2011 ;
• Increased temporary labor costs and overtime totaling approximately $2.1
million primarily associated with addressing the operational backlogs
experienced during the implementation of our new order intake system that led to the increase in earned but unbilled accounts receivable as ofDecember 31, 2011 ;
• Additional commissions expense associated with accelerated patient growth
in the nine months ended
in 2011 totaling approximately
• Increased legal expenses of
and quantification of the aforementioned
legal costs associated with various strategic activities; and
• Increased vehicle fleet maintenance and fuel costs primarily as a result
of higher gas prices totaling approximately$1.0 million . 26
-------------------------------------------------------------------------------- These increases were partially offset by decreased occupancy costs totaling approximately$0.6 million compared to the same period in 2011. The provision for doubtful accounts for the nine months endedSeptember 30, 2012 totaled$22.3 million , a$3.5 million increase from the comparable period in 2011. As a percentage of net revenues, the provision for doubtful accounts was 6.4% and 5.1% for the nine months ended endedSeptember 30, 2012 and 2011, respectively. This increase is attributable to the factors described below under the heading "Liquidity and Capital Resources." Depreciation and amortization for the nine months endedSeptember 30, 2012 totaled$7.0 million , the same as the comparable period in 2011. Depreciation and amortization as a percentage of net revenues increased to 2.0% as compared to 1.9% for the comparable period in 2011. Net interest expense for the nine months endedSeptember 30, 2012 totaled$44.9 million , a decrease of$0.5 million from the comparable period in 2011. This decrease is primarily the result of the additional interest incurred during the nine months endedSeptember 30, 2011 as a result of the 30 day notice period to bondholders required for redemption of the Senior Subordinated Notes paidApril 18, 2011 . Net loss for the nine months endedSeptember 30, 2012 was$43.7 million compared to net loss of$7.7 million for the comparable period in 2011. This difference is attributable to the changes in revenue, and costs and expenses described above. Non-GAAP Financial Measure We present Adjusted EBITDA as a supplemental measure of our performance that is not required by, or presented in accordance with, generally accepted accounting principles (GAAP) inthe United States of America . We define Adjusted EBITDA as net earnings (loss) adjusted for (i) income tax (benefit) expense, (ii) interest expense and (iii) depreciation and amortization, as further adjusted to eliminate the impact of certain items, consistent with definitions provided under our former Senior Facility, that we do not consider indicative of our ongoing operating performance. These further adjustments are itemized below. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. We believe Adjusted EBITDA assists investors and securities analysts in comparing our performance across reporting periods on a consistent basis by excluding items, consistent with definitions provided under our former Senior Facility, that we do not believe are indicative of our core operating performance. However, there may be additional items which are non-recurring as set forth above in Management's Discussion and Analysis of Financial Condition and Results of Operations. We use Adjusted EBITDA to evaluate the effectiveness of our business strategies. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. Our presentation of Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. 27 -------------------------------------------------------------------------------- The following table is a reconciliation of Adjusted EBITDA to net loss (in thousands): Three months ended Nine months ended September 30, September 30, 2012 2011 2012 2011 Net loss $ (12,861 ) $ (2,055 ) $ (43,731 ) $ (7,718 ) Income tax expense (benefit) (88 ) (168 ) (41 ) (208 ) Interest expense 15,052 14,703 44,945 45,540 Depreciation and amortization, including patient service equipment depreciation 16,751 14,940 48,907 44,715 Non-cash equity-based compensation expense 180 161 793 355 Operational restructuring and transition related costs(1) 950 26 3,557 49 Settlement costs(2) 12 101 103 120 Loss on extinguishment of debt(3) - - - 1,216 Intake system implementation(4) - - 8,421 - Oxygen content overbilling (5) 91 - 1,089 - Legal fees(6) 307 - 674 - Other adjustments(7) 1,000 - 1,000 - $ 21,394 $ 27,708 $ 65,717 $ 84,069 (1) Includes$2.0 million retirement award due to Mr.Philip Carter , Chief Executive Officer of the Company, under the terms of his employment
agreement, as well as other operational restructuring and transition related
costs generally consisting of severance and location closure costs, and
temporary, transitional employee costs associated with patient transition
following asset or equipment purchase transactions.
(2) Settlement costs incurred outside our ordinary course of business which we
do not believe reflect the current and ongoing cash charges related to our operating cost structure. (3) We redeemed our 9.5% Senior Subordinated Notes dueApril 2012 on March 17,
2011, and recorded a
unamortized debt issue costs.
(4) During the second half of 2011, we completed implementation of our new order
intake system. In conjunction with our electronic medical record system
implemented in 2009, we have redesigned our front-end order intake
processes. As a result, we have been able to automate and consolidate many
of our historically paper-based processes. However, during the six month
implementation process, we experienced extended delays in obtaining certain
required payor-specific documentation required to release claims. Such
delays were caused by unanticipated operational backlogs associated with our
conversion to the new order intake system. These operational backlogs caused
our earned but unbilled accounts receivable to increase to approximately
operational initiatives designed to eliminate this backlog and as of April
30, 2012, we have reduced the total earned but unbilled receivables to $22.0
million. In the process of reducing our earned but unbilled receivables
during the first quarter of 2012, we incurred incremental labor expense
including overtime and temporary labor costs of approximately
as well as write-offs of accounts receivable associated with insurance and
patient balances of approximately
months ended
issues are substantially resolved and the associated increases in labor
costs, contractual/revenue adjustments impacting net revenue, and the
provision for doubtful accounts recorded during the three months ended March
31, 2012 are not indicative of our current operating performance and are not
expected to recur.
(5) Legal and consulting expenses related to review and quantification of the
Financial Statements-(1) Basis of Presentation" included herein in Item 1,
"Financial Statements".
(6) Legal fees associated with various non-recurring events and strategic
activities.
(7) Other adjustments not considered indicative of our ongoing operating
performance.
Adjusted EBITDA should not be considered as a measure of financial performance under GAAP, and the items excluded from EBITDA are significant components in understanding and assessing financial performance. Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are: 28 --------------------------------------------------------------------------------
• Adjusted EBITDA does not reflect our cash expenditures, future requirements for capital expenditures or contractual commitments;
• Adjusted EBITDA does not reflect changes in, or cash requirements for,
our working capital needs; • Adjusted EBITDA does not reflect significant interest expense, or the cash requirements necessary to service interest or principal payments on our debts;
• although depreciation and amortization are non-cash charges, the assets
being depreciated and amortized will often have to be replaced in the
future, and Adjusted EBITDA does not reflect any cash requirements for
such replacements; • non-cash compensation is and will remain a key element of our overall long-term incentive compensation package, although we exclude it as an expense when evaluating our ongoing operating performance for a particular period; • Adjusted EBITDA does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; and • other companies in our industry may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for performance measures calculated in accordance with GAAP. We compensate for these limitations by relying primarily on our GAAP results and using Adjusted EBITDA only supplementally. Liquidity and Capital Resources Net cash provided by operating activities was$20.4 million for the nine months endedSeptember 30, 2012 , as compared to$24.7 million for the same period in 2011. The decrease in net cash provided by operating activities for the nine months endedSeptember 30, 2012 primarily relates to a$36.7 million decrease in operating income partially offset by (i) a decrease in accounts receivable due to increased collections of approximately$8.9 million ; (ii) a decrease in inventory of approximately$7.6 million (iii) an increase in accounts payable of approximately$9.4 million ; (iv) an increase in interest payable of approximately$1.0 million related to the Indenture for our Senior Second Lien Notes (v) an increase in patient service equipment depreciation of approximately$4.1 million included in operating income. Our working capital requirements relate primarily to the working capital needed for general corporate purposes. Cash flows and cash on hand were sufficient to fund operations, capital expenditures and required repayments of debt during the nine months endedSeptember 30, 2012 . As mentioned in Note 9 of the Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q, onNovember 1, 2012 , we entered into a second amendment to our Original Credit Agreement which, among other things reset the maximum leverage ratio levels. The second amendment increased the maximum leverage ratios for specified periods of time. In addition, as part of the second amendment we received a waiver of any default or event of default that may have occurred as a result of the failure to comply with the maximum leverage ratio levels. As such, we are currently in compliance with our covenants under our Credit Agreement. From time to time, we will experience interruption in our cash flow and volatility in our cash position during inter-period quarters resulting from inconsistent timing of payments fromCenters for Medicare and Medicaid Services , its contractors and other third-party payors. Interruptions in our cash flow and the volatility of our cash position may cause our cash inflows to not coincide with our cash outflows including our debt service requirements and material vendor payments. Under our Indentures for Senior Secured Notes and Senior Second Lien Notes, we are permitted to borrow an additional$15.0 million in debt from existing or new lenders. In order to assist us with our varying cash inflows and to meet the cash needs to support our ongoing business, service our debt structure, and capital expenditure obligations, we are seeking to secure this additional$15.0 million in debt. However, there are no guarantees that we will be able to secure this additional financing on terms that are acceptable to us. 29 -------------------------------------------------------------------------------- Based on our current liquidity position and the expected capital resources generated from our operations, we believe that in order to meet the cash needs to support our ongoing business, service our debt structure, and capital expenditures over the next twelve months, we will need to borrow the aforementioned$15.0 million in debt, realize the incremental capital resources from new initiatives, and realize the growth in patients. There can be no assurance, however, that we will be able to refinance any of our debt, including our Senior Secured Notes and Senior Second Lien Notes, on commercially reasonable terms or at all and the Company may be unable to secure the additional financing available to it under the Indentures for our Senior Secured Notes and our Senior Second Lien Notes, in which case we may be required to consider all of our alternatives such as a sale of the Company or other strategic transaction or a restructuring of our business and our capital structure, including filing for bankruptcy protection. Additional discussion of our liquidity and capital resources is incorporated by reference to the disclosure under the heading "Liquidity" in Note 2 of the Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q. Accounts receivable before allowance for doubtful accounts decreased to$89.6 million atSeptember 30, 2012 from$90.5 million atDecember 31, 2011 . Allowances for contractual adjustments and doubtful accounts as a percentage of accounts receivable totaled 35.9% and 31.3% as ofSeptember 30, 2012 andDecember 31, 2011 , respectively. Days sales outstanding (DSO) in accounts receivable (calculated as of each period end by dividing net accounts receivable by the 90-day rolling average of net revenue) were 55.7 days atSeptember 30, 2012 , compared to 58.7 days atDecember 31, 2011 and 55.1 days atSeptember 30, 2011 . There are several factors that continue to impact our DSO: • Significant increases in the number of claims subject to prepayment review, primarily by the Durable Medical Equipment Medicare Administrative Contractors (DME MACs) and Zone Program Integrity Contractors (ZPICs); • Increased authorization, reauthorization, qualification,
requalification and ongoing compliance requirements that can result in
billing delays when patients fail to follow through with required physician follow-up visits or fail to follow prescribed therapy protocols;
• Increased patient co-payments and deductibles due from customers who
are finding it difficult to pay their out-of-pocket charges due to loss of insurance coverage, increases in deductibles and co-payment amounts or reductions in their investment or employment income; and
• More stringent patient collection standards. We have implemented more
stringent collection standards with respect to balances due from
patients including enhanced internal collection efforts and utilization
of a third-party collection resource. While these changes may result in
higher DSO, we believe that our efforts ultimately result in greater collection of amounts due from patients. As a result of the impact of the above factors, we increased our overall reserve level for doubtful accounts during the quarter endedMarch 31, 2012 and have continued to maintain such increased reserve levels. We continue to work with our third-party vendor to reduce our overall levels of bad debt, as well as internal initiatives to secure co-payment and deductibles amounts from patients. The following tables set forth the percentage breakdown of our accounts receivable by payor and aging category as ofSeptember 30, 2012 andDecember 31, 2011 :September 30, 2012 Accounts receivable by payor and Managed Care Patient aging category: Government and Other Responsibility Total Aged 0-90 days 36 % 21 % 10 % 67 % Aged 91-180 days 7 % 4 % 8 % 19 % Aged 181-360 days 3 % 2 % 9 % 14 % Aged over 360 days - % - % - % - % Total 46 % 27 % 27 % 100 % December 31, 2011 30
-------------------------------------------------------------------------------- Accounts receivable by payor and Managed Care Patient aging category: Government and Other Responsibility Total Aged 0-90 days 37 % 20 % 8 % 65 % Aged 91-180 days 7 % 5 % 7 % 19 % Aged 181-360 days 5 % 3 % 7 % 15 % Aged over 360 days - % - % 1 % 1 % Total 49 % 28 % 23 % 100 % Included in accounts receivable are earned but unbilled receivables of$20.4 million atSeptember 30, 2012 and$28.1 million atDecember 31, 2011 . These amounts include$3.1 million and$3.6 million atSeptember 30, 2012 andDecember 31, 2011 , respectively, of receivables for which a prior authorization is required but has not yet been received. Delays, ranging from a day to several weeks, between the date of service and billing can occur due to delays in obtaining certain required payor-specific documentation from internal and external sources. In addition to the aforementioned delays, we are required to obtain revised documentation for patients transitioned onto service with us through equipment purchases which results in increased initial billing cycles for these patients. Earned but unbilled receivables are aged from the date of service and are considered in our analysis of historical performance and collectability. Due to the nature of the industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review. Management performs analyses to evaluate the net realizable value of accounts receivable. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends and relevant business conditions. Because of continuing changes in the health care industry and third-party reimbursement, it is possible that management's estimates could change, which could have an impact on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations. We derive a significant portion of our revenues from theMedicare andMedicaid programs and from managed care health plans. Payments for services rendered to patients covered by these programs may be less than billed charges. Revenue is recognized at net realizable amounts estimated to be paid by customers and third-party payors. Our billing system contains payor-specific price tables that reflect the fee schedule amounts in effect or contractually agreed upon by various government and commercial payors for each item of equipment or supply provided to a customer. ForMedicare andMedicaid revenues, as well as most other managed care and private payors, final payment is subject to administrative review and audit. Management makes estimated provisions for adjustments, which may result from administrative review and audit, based upon historical experience. Management closely monitors its historical collection rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate information management believes to be available. However, due to the complexities involved in these estimations, actual payments we receive could be different from the amounts we estimate and record. Collection of receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We manage billing and collection of accounts receivable through our own billing and collection centers. In addition, we utilize third-party collection resources to manage collection of amounts due from patients. Our primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. We record bad debt expense based on a percentage of revenue using historical Company-specific data. The percentage and amounts used to record bad debt expense and the allowance for doubtful accounts are supported by various methods including current and historical cash collections, bad debt write-offs, and aging of accounts receivable. Accounts are written off against the allowance when all collection efforts (including payor appeals processes) have been exhausted. We routinely review accounts receivable balances in conjunction with our historical contractual adjustment and bad debt rates and other economic conditions which might ultimately affect the collectability of patient accounts when we consider the adequacy of the amounts we record as provision for doubtful accounts. Significant changes in payor mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and results of operations. Further, even if our billing procedures comply with all third-party payor requirements, some of our payors may experience financial difficulties, may delay payments or may otherwise not pay accounts receivable when due, which would result in increased write-offs or provisions for doubtful accounts. If we are unable to collect our accounts receivable on a timely basis, our revenues, profitability and cash flow likely will significantly decline. 31
--------------------------------------------------------------------------------
Because of continuing changes in the health care industry and third-party reimbursement, it is possible that management's estimates could change, which could have an impact on revenues, profit margins, profitability, operating cash flows and results of operations. Our future liquidity may be materially adversely impacted by health care reform. Net cash used in investing activities was$34.6 million for the nine months endedSeptember 30, 2012 , as compared to$40.4 million for the same period in 2011. We currently have no contractual commitments for capital expenditures over the next twelve months other than to acquire equipment as needed to supply our patients. Our business requires us to make significant capital expenditures relating to the purchase and maintenance of the medical equipment used in our business. Cash paid for capital expenditures totaled approximately$34.4 million for the nine months endedSeptember 30, 2012 as compared to$37.5 million for the same period in 2011, including$0.4 million and$6.1 million paid for equipment purchases from competitors exiting the home health care market, respectively. Some of the equipment purchased in these transactions is currently on rent and located in a patient's home. As such, we have the opportunity to transition such patients onto service with our Company. We also paid$1.1 million and$6.8 million for the nine months endedSeptember 30, 2012 and 2011, respectively, for asset purchases from competitors. During the nine months endedSeptember 30, 2011 cash used in investing activities included a$4.2 million reduction in our surety bond and letter of credit collateral included in restricted cash. Refer to the "Notes to Unaudited Condensed Consolidated Financial Statements-(9) Debt" included herein in Item 1, "Financial Statements," for a complete description of our outstanding indebtedness. We have outstanding letters of credit totaling$7.5 million as ofSeptember 30, 2012 andDecember 31, 2011 . Our letters of credit were cash collateralized at 100% of their face amount as ofSeptember 30, 2012 andDecember 31, 2011 . The cash collateral for these outstanding letters of credit is included in restricted cash in our consolidated balance sheet as ofSeptember 30, 2012 andDecember 31, 2011 . Net cash provided by financing activities was$2.9 million for the nine months endedSeptember 30, 2012 , as compared to net cash used in financing activities of$14.3 million for the same period in 2011. This source of cash was primarily from the borrowing of$10.0 million against our revolving credit facility at an interest rate of 7.25%. Cash paid for the redemption of our Series A convertible redeemable preferred stock and accrued dividends totaled$3.6 million during the nine months endedSeptember 30, 2012 . Cash used in financing activities for the nine months endedSeptember 30, 2011 primarily related to the$11.4 million net use of cash associated with the issuance of the Senior Second Lien Notes and repayment of our outstanding Senior Subordinated Notes. Additionally, during the nine months endedSeptember 30, 2011 , we repurchased a portion of our Series A convertible redeemable preferred stock totaling$2.2 million . Off-balance Sheet Arrangements and Contractual Obligations We do not have off-balance sheet arrangements (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K) that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies Refer to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," as presented in our Annual Report on Form 10-K for the year endedDecember 31, 2011 regarding our critical accounting policies. Forward-Looking Statements This report contains certain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and the provisions of section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act) and section 27A of the Securities Act of 1933, as amended. These forward-looking statements include all statements regarding the intent, belief or current expectations regarding the matters discussed in this report and all statements which are not statements of historical fact. Words such as "expects," "anticipates," "intends," "plans," "believes," "estimates," "projects," "may," "will," "could," "should," "would," variations of such words and similar expressions are intended to identify such forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties, contingencies and other factors that could cause results, performance or achievements to differ materially from those stated in this report. For more information about the nature of forward-looking statements and risks that could affect our future results and the disclosure provided in this Quarterly Report, please see "Certain Significant Risks and Uncertainties and Significant Events" in Note 8 of the Condensed Consolidated Financial Statements in Part I, Item 1 and Exhibit 99.1, Forward-Looking Statements, which is incorporated herein by reference.
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CORNERSTONE CORE PROPERTIES REIT, INC. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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