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Healthcare Markets, Part Deux

I heard yesterday that my Paper on healthcare markets tentatively titled Healthcare Market Structure And Its Implication For Valuation Of Privately Held Provider Entities: An Empirical Analysis will appear in the Summer Edition of Business Valuation Review - barring unforseen delays. In addition to speaking in part on this topic at the AICPA/ASA BV Conference, I will also present portions of it at the AICPA Healthcare Conference in September and the Tennessee Society of CPAs Healthcare Conference on December 2.

Now that the paper has been accepted for publication - after pre-submission peer review and critique -  I think it is reasonable to state that it has fairly dramatic implications for the use of out-of-market transaction data when using the Guideline Publicly Traded Company method or the Guideline Merged and Acquired Company method.

Healthcare Markets

As participants in the February BVR Teleseminar heard, my detailed research into for-profit and not for profit healthcare markets in the US yielded some striking differences and underlying structural reasons for those differences.  A brief synopsis follows.  I hope to see the related Paper published later this year and the findings will be one of the topics discussed at my Joint Presentation with Don Barbo at the AICPA/ASA Business Valuation Conference in November.

The degree of revenue and profit for healthcare provider entities varies significantly from state to state and even within different regions of individual states.  As a threshold matter, areas with high healthcare spending and particularly high Medicare[1] spending tend to offer the greatest opportunity for profit.  The elderly, of course, receive the bulk of medical care.  Given that high localized spending is the primary driver of profit, the other factors contributing to the pattern of location of larger for-profit providers include: 

• The presence and market strength of Blue Cross plans,
• The degree of market strength of local nonprofit hospitals versus for-profit hospitals,
• The degree of market strength of local nonprofit health insurers versus for-profit health insurers,
• Certificate of Need laws and
• Other local demographic and economic factors.

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[1] Medicare spending varies considerably from region to region with states such as Florida, Texas, California and Tennessee having high per capita and total dollar spending and many for-profit providers.

Gas Stations, Accounting Firms and Medical Practices

I continue to encounter resistance to the idea that a coding analysis is necessary to value a physician practice when you can get the data; codes indicate not only the source of revenue in the practice, e.g., office encounters versus tests, but also the character of services being provided and the underlying illness of the patient base.  A subspecialist who relies on referrals and therefore the consult codes for his or her income is in a very different position than a primary care physician who relies on codes 99212, 99213 and 99214 for his or her income.  Incorrect use of a higher level code can dramatically overstate the revenue in the practice while a lower level code can understate the revenue. Further, a Payor Analysis is necessary to see how much revenue comes from Medicare, Blue Cross, Medicaid and so on, and how much of each of those revenue sources is actually collected.

I recently analogized this to trying to value a gas station without knowing how much of the sales were for gas, how much for candy, soda, sandwiches and/or groceries, and how much for renting space to the Dunkin Donuts!  Similarly, I have never heard anyone suggest that you can value an accounting practice without knowing how much revenue came from accounting, bookkeeping, tax and consulting - and what the billing rates were for each staff member providing services in those areas and what portion of the billing was realized in cash collections!

Nuff said.

2008 National Conference Presentations

I will be speaking at the AICPA National Healthcare Industry Conference in September as well as at the AICPA/ASA National Business Valuation Conference in November.

http://www.cpa2biz.com/AST/Main/CPA2BIZ_Primary/Accounting/IndustryspecificGuidance/HealthCare/PRDOVR~PC-CARE/PC-CARE.jsp

The National Healthcare Industry Conference is in San Diego this year and features a number of sessions devoted to valuation.  I will be particpating in a 4 hour pre-Conference session on FASB valuation issues with, among others, Jim Rigby, ABV, ASA one of the original contributors to FASB on Intangible Asset Impairment.  I will be sharing a session with Carol Carden, CPA/ABV, ASA on current issues in healthcare valuation as well as doing a Current Issues Confronting Physician Practice session with my colleague Reed Tinsley, CPA, CVA and several other experts. This marks my fifth consecutive invitation.

http://www.cpa2biz.com/AST/Main/CPA2BIZ_Primary/BusinessValuationandLitigationServices/Engagements/PRDOVR~PC-BVAL08/PC-BVAL08.jsp

Don Barbo, CPA/ABV and I will again share a microphone at the joint AICPA/ASA National Business Valuation Conference in Las Vegas in November.  Testifying to the heightened importance of healthcare valuation, Don and I have been granted two back to back sessions to cover a broad spectrum of industry issues, including subsectors, revenue trends and market-specific factors.

This will be the seventh time since 1999 that I have been privileged to speak at this Conference on healthcare valuation.

MedPAC's 2008 Report

I have been reviewing the Physician chapter of MedPAC's newly released Report to Congress http://www.medpac.gov/documents/Mar08_EntireReport.pdf.  There are a number of significant findings and recommendations, notably - again - aimed at the excessive growth in imaging. The growth rate in High Tech Imaging (MR, CT) has slowed considerably in the 2005 to 2006 year compared to prior years, particularly Brain MR. Importantly, MedPAC attributes this slowing to the actions taken by Congress aimed at same, such as the DRA.

An analysis of the Report and its recommendations for imaging give considerable insight into what future legislation might look like and MedPAC has an excellent batting average when it comes to getting its recommendations adopted.  Page 96 reminds one of the fact that the practice expense component of imaging will decline (by a total of 9%) thru 2010.  More significantly, MedPAC is now suggesting that the 50% utilization assumption for physician-based equipment be increased - a provision that was in one version of last year's SCHIP legislation - which would have a dramatic downward effect on technical component revenue. A short example helps illustrate the dramatic effect this provision could have.

For MR, the technical component represents about 80% of the global fee. That technical component assumes that the equipment is being used 50% of the time.  Last year's failed SCHIP legislation would have raised that 50% to 75%. Assume the fixed costs of an MR are $300,000 per year and expected volume at 50% is 1000 cases; this nets a reimbursement of $300 per case. If the volume assumption is raised to 75%, the expected cases are 1500 which nets a reimbursement of $200 per case, a drop of 33%!

Next, the Table at the top of page 100 and the recommendation immediately below it are what drive reimbursement decisions and therefore potential future cashflow growth rates. Bottom line is that the indicated 2.6% estimated increase in costs leads to a 1.1% increase in fees because of increased utilization; thus, increased utilization is offset by decreased fees because technical component costs are recovered over a higher volume - that is what also underlies the recommended change in the utilization assumption for physician-based equipment.

Finally, what might be considered an obscure observation if one was not familiar with MedPAC's successful track record also appears on page 97. Here, there is a suggestion that those portions (equipment and supplies!) of the practice expense component which do not vary geographically be dropped from the geographic adjustment! This could lead to considerable cuts in high cost areas such as Florida, New York, Boston, San Francisco and the like.

Understanding Healthcare Revenue

One of the things that continues to surprise if not astound me is the number of individuals who believe you can value a healthcare enterprise without looking at the underlying coding that generates the revenue.  I rarely hear anyone suggest that you can value a generic business without understanding what it is the company sells, who the customers are, etc.  Given the common use of revenue multiples in valuation - notwithstanding my distrust of them - it is even more astounding.

The healthcare world is replete with examples of where coding is significant, but here is a recent example.  Medicare - followed by many other insurers - limited the payment for the technical component of same day contiguous CT and MR.  If you did not analyze the imaging center's coding to see what was CT or MR and how much was the technical component and the impact of the new rule for same day contiguous body parts, how could you forecast revenue? Last time I checked, revenue was based on units and rate per unit.  Absent a coding analysis, there would be no way to get the rate.

Similarly, Ambulatory Surgery Centers are under a whole new billing regime in 2008.  There were dramatic increases and decreases in per unit revenue based upon the type of procedure.  The only way to determine what future revenue would be is - you guessed it - look at the code!

Physician practices are no different and a coding analysis is critical not only to understanding the revenue stream, but also to understanding the practice!  Many times, valuation analysts look at the number of encounters a practice does and compare it to norms from the MGMA.  If the MGMA median is, say, 4500 for a given specialty, and the practice does 4000, the conclusion is that its under-producing.  Then, if it is under-producing, it must have excess capacity, which leads to a forecast of more encounters!  WRONG!  What if there is a disproportionate number of Level 4 encounters which take more time than a Level 3 for example? The encounter volume cannot be evaluated for reasonableness without the coding analysis.

BVR's Guide to Personal v. Enterprise Goodwill

I am privileged to have several articles included in the newly released Guide to Personal v. Enterprise Goodwill from Business Valuation Resources.  These include my methodology for valuing personal goodwill and noncompete agreements based upon the probability adjusted loss of cashflows attributable to the individual as well as an entirely new piece on the interplay of reasonable compensation and goodwill.

BVR's descrption of the Guide says it best: "BVR"s Guide to Personal v. Enterprise Goodwill is a compilation of thought leadership, including new and original contributions from David Wood, Jay Fishman, Mark Dietrich, Jim Alerding, Shannon Pratt, Kevin Yeanoplos, and many others."

Upcoming Teleseminar

On February 20, I will be moderating a Teleseminar for Business Valuation Resources.  The panel will include last year’s highly-rated participants Carol Carden, CPA/ABV, Don Barbo, CPA/ABV along with J. D. Epstein, a Houston-based healthcare attorney and highly rated speaker.  We’ll be looking at current valuation trends and issues in different subsectors of the industry as well last year’s regulatory changes and likely changes in 2008. Finally, I will be introducing for the first time a brief overview of the results of my research into the historical structure of healthcare markets across the country and how that effects valuation under the market approach.  I hope this research will be published later this year.

http://www.bvresources.com/defaulttextonly.asp?f=february20AudioConference08

Imaging and the Anti-Markup Rule

CMS adopted the changes it proposed this past summer in the 2008 MPFS Proposed Rule with respect to the so-called anti-markup provision.  The effect of these new administrative rules which occur outside the Stark regulations is to effectively make the “in office ancillary services exception” (IOASE) practically moot.  The IOASE, issued in Phase 2 of the Stark regs after complaints from various physician groups, allowed physicians to get around the general prohibition against referral to a DHS entity through sharing equipment located in a building in which they provided some non-DHS services.  Structures such as block leases were commonly used.  It appears that the interpretation of the requirement that DHS equipment be located in the “same space” means the same office suite.  Office suite likely means commonly connected contiguous space.  Thus, even a DHS facility on the same floor as the physicians’ non-DHS space would not qualify if there are third parties located in intervening space or even if a common space hallway is used to access the DHS facility.

As a slide in my 2005 presentation at the AICPA’s National Valuation Conference stated: “MedPAC also suggested Stark be expanded to cover physician ownership of equipment, or entities that provide equipment and services, used in imaging centers.”  Thus, we have yet another circumstance where MedPAC recommendations to reign in spending in high utilization areas are adopted several years later with catastrophic results for those affected.  To reiterate what I been saying in print and lecture since the turn of the millennium, these changes are foreseeable.  The same thing has already occurred, for example, with the addition of PET services to the Stark regulations effective this past January and we are going to see a need for the wholesale sell-off or closure of facilities violating the anti-markup provision before the effective date of January 2009 just as we did for PET.

When market participants do not appear to respond to the foreseeable changes, a consequential valuation issue arises.  There may be several possible explanations for this.  One is regulatory ignorance, which at least in my view is inconsistent with the requirement under the fair market value standard for “reasonable knowledge of the relevant facts.”  My career-long experience suggests that this does, in fact, account for a large amount of the failure to respond in the physician community, although certainly not in the broader business community of imaging operators.

A second possibility involves the belief that the exit price for the to-be-banned business will compensate for the loss of future operating cashflows.  This is arguably rational under the fair market value standard, but let’s look at it more closely.  With respect to facilities operating under the soon to be defunct IOASE, it is difficult to see that this explanation passes the rational muster because a fire sale scenario invariably results.  The owner-seller has two choices: sell and get something or close and get less than nothing, given the abandonment of the tangible asset investment.  This does not set up a good negotiating scenario nor a strong basis for a going concern premise of value.

Physicians and their advisors structuring future joint ventures in high utilization areas where there is subsequent regulatory change risk should pay careful attention to exit clauses with the nonphysician joint venturer.  Buy-out or buyback language should call for the valuation to be done using a going concern premise of value.  The nonphysician buyer will be concerned about possible subsequent volume drops and the impact on both the valuation and the transaction price.  Careful attention needs to be paid to the language of the agreement as well as the assumptions in the valuation model because the government is known to be concerned about the implications of “future referrals” being the basis for a purchase price when the DHS is located within the selling physician’s office. 

Although very bad news for referring physicians engaged in such structures, it is very good news for hospitals, non-referring physicians, e.g. radiologists and entrepreneurs located within the referring physicians’ service area. 

Consolidation Trends

In the June 2002 Business Valuation Review, I had an article addressing the crossover of fair market value and strategic value in consolidating industries.  In that article, I looked at the history of the Physician Practice Management Companies and how the buying frenzy of the 1990s had driven up the price and lowered the perceived risk of physician practices.  My article with Ken Patton of Mercer Capital in the current (Fall 2007) edition of CPA Expert addresses a similar issue with respect to the purchase of Home Health Agencies in the Deep South during the mid-1990s in anticipation of the replacement of Medicare’s cost-cased reimbursement system by a PPS.

A variety of market conditions can lead to consolidation. One such circumstance appears to be developing now with respect to Imaging Centers.  The dramatic cutbacks in MR, CT and PET from the Deficit Reduction Act have significantly reduced the revenue and therefore the profits of physician-based imaging.  Not widely recognized is that the practice expense component for imaging under Medicare's RBRVS assumes that imaging equipment is utilized only at 50% capacity; the House version of the vetoed SCHIP legislation would have raised the volume assumption to 75%.  Thus, the high fixed overhead of expensive imaging technology is recovered over a low volume of procedures, resulting in a high revenue per unit!  This type of structure makes high volume providers very profitable, while low volume providers – and particularly those below breakeven - may be big losers.  The impact of the DRA has been to raise the breakeven volume requirement for imaging and to make sale to a higher volume, or combination with another low volume, facility a more likely course of action.

Thus, I think we are seeing a developing trend of consolidation of low volume providers by financially stronger entities who can take advantage of the low marginal cost of imaging beyond breakeven volume.  A principal issue for the selling entity is the capital invested in the equipment and whether the selling price is sufficient to pay off outstanding debts, such as long-term equipment leases common to the industry.  Those potential sellers facing the choice of investing in new (or refurbished) equipment may find selling more desirable, particularly if the buyer has already invested in the newer technology.  The buyers will find the added volume very attractive of course, particularly given some of the indications that future cuts may be forthcoming, resulting in lower margins per unit beyond breakeven volume.

The valuation analyst has to consider what normalization adjustments are appropriate in such a circumstance.  As I noted in the Caracci article “it might be appropriate to value a subject in a sector that is being consolidated on the basis of consolidator transactions if the consolidators are active in the subject’s service area. In that case, otherwise strategic adjustments such as a lower cost of capital, higher growth rates, and lower operating costs might be appropriate normalization adjustments in an income approach.”  This is consistent with long-established if not well-understood valuation theory about the meeting of strategic and fair market value.