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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.

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.

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.

Post-Transaction Compensation

I received a question the other day inquiring as to the basis for  my statement in the November 2005 Journal of Accountancy that "the IRS says physician compensation in a valuation model should agree with any post-transaction employment contract."  I thought my response to that question would assist a lot of other appraisers.

This concept originally appeared in a letter attached to the valuation submitted in connection with the exemption ruling for the Friendly Hills Transaction as described below:

Quote from my book:

“The Friendly Hills HealthCare Foundation was the first ruling by the IRS in favor of tax exemption for an Integrated Delivery System (IDS) involving physician compensation in tax-exempt settings.  Certain aspects of the Ruling, including the use of the Discounted Cashflow Method, were later elaborated upon in the 1995 Exempt Organization Continuing Professional Education Technical Instruction Program Textbook.  Notably, the value determined in Friendly Hills was based, in part, on an agreed-upon reduction in physician compensation.”

“In fact, the valuation submitted in connection with the Friendly Hills transaction  contains a letter signed by the managing partner stating that the partners recognized they were selling a portion of their earnings and that their future incomes would be less by virtue of that sale.  In relevant part he states “... It has been clearly stated to the partners that, in the past, their compensation reflected not only the value of their medical services, but also the profits attributable to their ownership of the Network; that the latter element will be replaced by a cash payment, which they can invest ... that the Medical Group’s income will thereafter be derived from arms-length contract for medical services; and that these rates will necessarily be significantly lower than the total historical income they have been receiving ...” (emphasis added).  (Friendly Hills Valuation Report)”

See the 1994 Exempt Organization CPE text INTEGRATED DELIVERY SYSTEMS (eotopicn94.pdf) and 1995 Exempt Organization CPE text INTEGRATED DELIVERY SYSTEMS AND JOINT VENTURE DISSOLUTIONS UPDATE (eotopicl95.pdf).  Note in particular bottom of page 8 forward in 1994 text and the general discussion of compensation in 1995.  You can obtain these at http://www.irs.gov/pub/irs-tege/. These are still cited as recently as 2004.

Fundamentally, why would a hospital buy a practice for a value based upon the physicians receiving X compensation for their future services, when the Employment contract provided they would be paid X+?  You would not buy my practice, or I yours, for a $1 million and continue to pay me/you everything it generates, I suspect.  For a hospital to do so raises serious inurement and excess benefit issues, and more importantly, Stark and AKS issues.

CCFs, MVIC and BEV

A number of recent reviews of other's reports have prompted me to make this post.  There seems to be a segment of the valuation world that does not understand the definition of operating assets or operating cashflows. There are three principal components on the left side of the accounting equation or balance sheet that equal the right hand side of the accounting equation or Market Value of Invested Capital (MVIC): Working Capital, Fixed Assets and Intangible Assets or BEV. This is easily seen in the discussion of cashflow in the annual Ibbotson Yearbook or in classic valuation texts such as Pratt's (4th Edition, page 70) or Hitchner's (2d Edition, page 118). Discount rates developed from Ibbotson data therefore apply to ALL operating cashflows, not just to, for example, fixed assets and intangible assets.

Near as I can tell the "confusion" or mistakes result from looking at market data where the transaction price excludes working capital, as it often does for many small businesses. For some reason, the individuals making the mistake assume that because a small business transaction does not include working capital, the cashflows from that business do not require working capital! In fact, the purchaser of a small business who does not acquire the working capital MUST infuse that working capital.  Thus, for market data, one would have to add working capital to the values to get the MVIC. This must NOT be done however for the CCF or DCF methods, which ALREADY INCLUDE the working capital value.

When one derives valuation multiples from transaction databases that include operating cashflow and transaction data with only fixed assets and intangibles, the numerator (the transaction price) is lower than the MVIC of the business, while the denominator (cashflow) is the same.

For example, assume the business has cashflow of 3 and transaction value of 12; required working capital is 3 so MVIC is equal to 15.  Thus, fixed assets and intangibles  have an apparent valuation multiple of 4 times operating cashflow, while MVIC would have a multiple of 5 times the same operating cashflows. Inexperienced or poorly trained valuators confuse the different numerators when trying to compare transaction data to income methods.  All things being equal, the example indicates that the cap rate for cashflows to MVIC would be 20% (1 divided by 5) and result in the value of 15. Adding the 3 to the 15 is CLEARLY a double count,  Not surprisingly, I often find valuators who make this mistake getting higher value numbers under the income approach than the market approach due to the double count.

As I stated in my peer-reveiwed Journal of Accountancy article in 2005 and numerous other places, the excess earnings method is no more than a two-stage CCF, with separate rates of return assigned to the left hand or asset side of the accounting equation, which, again MUST be equal to the right hand or equity and long-term debt side.  For an in-depth, classic explanation of this topic, see Pratt's 4th Edition, Chapter 13 explaining the excess earnings method.

Working capital deficiency

We do not often hear the expression nonoperating liabilities in valuation. When we hear about the concept, it is either nonoperating assets, or excess working capital. A deficiency in working capital, then, is the other side of the equation. Several recent engagements have reminded me of the import of normalizing working capital before using an income approach to valuation, be it a DCF, CCF or excess earnings method.

When the premise of value is that of a going concern, the working capital assumption must be consistent with the industry norm, i.e., what a hypothetical buyer/seller would expect. A particular medical practice being valued may not necessarily have a normal level of working capital. Typical sources of working capital deficiencies include patient prepays or credit balances, accruals in excess of available cash for retirement plan contributions, and accrued vacation time, sick time or "personal time" where the practice permits unlimited or significant carryovers.

Accruals for personal time were long ago identified as an issue for GAAP financial reporting. Given that the typical medical practice sale is structured as an asset sale, the proceeds of that sale must be used to pay off all outstanding liabilities before anything is distributed to equity holders. If the subject practice permits unlimited carryovers of personal time, the magnitude of the liability may be shocking. Sufficient effort must be expended to determine what a normal level of personal time accrual is in order to have an appropriate measure of working capital in the valuation model.

Even in simple buy-in transactions, the valuation analyst or consultant must be certain to inquire as to this liability.  Excluding it could result in the younger owners being left "holding the bag" at some point in the future for a large unfunded liability - analogous to those defined benefit obligations of airlines and "old economy" manufacturers.