Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended September 30, 2013

or

 

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

For the transition period from                      to                     .

Commission file number 333-168159

 

 

APRIA HEALTHCARE GROUP INC.

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   33-0488566

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

26220 Enterprise Court

Lake Forest, CA

  92630
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (949) 639-2000

 

 

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

(Note: As a voluntary filer not subject to the filing requirements of Section 13 or 15(d) of the Exchange Act, the registrant has filed all reports pursuant to Section 13 or 15(d) of the Exchange Act during the preceding 12 months as if the registrant were subject to such filing requirements.)

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

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

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   x  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

As of November 6, 2013, there were 100 shares of the issuer’s common stock, par value $0.01 per share, issued and outstanding.

 

 

 


Table of Contents

APRIA HEALTHCARE GROUP INC.

FORM 10-Q

TABLE OF CONTENTS

 

         Page
No.
 
  PART I — Financial Information   

Item 1.

 

Financial Statements

     4   
 

Unaudited Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012

     4   
 

Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September  30, 2013 and September 30, 2012

     5   
 

Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and September 30, 2012

     6   
 

Notes to Unaudited Condensed Consolidated Financial Statements

     8   

Item 2.

 

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

     35   

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

     64   

Item 4.

 

Controls and Procedures

     64   
  PART II — Other Information   

Item 1.

 

Legal Proceedings

     65   

Item 1A.

 

Risk Factors

     65   

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

     79   

Item 3.

 

Defaults Upon Senior Securities

     79   

Item 4.

 

Mine Safety Disclosures

     79   

Item 5.

 

Other Information

     79   

Item 6.

 

Exhibits

     80   

SIGNATURES

  

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This quarterly report on Form 10-Q includes forward-looking statements regarding, among other things, our plans, strategies and prospects, both business and financial. These statements are based on the beliefs and assumptions of our management. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Generally, statements that are not historical facts, including statements concerning our possible or assumed future actions, business strategies, events or results of operations, are forward-looking statements. These statements may be preceded by, followed by or include the words “believes”, “expects”, “anticipates”, “intends”, “plans”, “estimates” or similar expressions.

Forward-looking statements are not guarantees of performance. You should not put undue reliance on these statements. You should understand that various important factors, in addition to those discussed elsewhere in this quarterly report on Form 10-Q, could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in our forward-looking statements. Examples of such factors include the following:

 

    trends and developments affecting the collectability of accounts receivable;

 

    government legislative and budget developments that could continue to affect reimbursement levels;

 

    potential reductions in reimbursement rates by government and third-party payors;

 

    the effectiveness of our operating systems and controls, systems implementation risks;

 

    healthcare reform and the effect of federal and state healthcare regulations;

 

    economic and political events, international conflicts and natural disasters;

 

    risks associated with our indebtedness;

 

    risks associated with our reorganization plans;

 

    acquisition-related risks; and

 

    the items discussed under “Risk Factors” in this quarterly report on Form 10-Q.

All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing cautionary statements. We undertake no obligations to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

As used in this report, unless otherwise noted or the context otherwise requires, references to “Company,” “we,” “us,” and “our” are to Apria Healthcare Group Inc., a Delaware corporation, and its subsidiaries; references to “Apria” and the “Issuer” are to Apria Healthcare Group Inc., exclusive of its subsidiaries; references to “Merger Sub” are to Sky Merger Sub Corporation, a Delaware corporation; references to “Holdings” are to Apria Holdings LLC, a Delaware limited liability company, exclusive of its subsidiaries; references to “Sky LLC” or “Buyer” are to Sky Acquisition LLC, a Delaware limited liability company, exclusive of its subsidiaries; references to “Blackstone” and the “Sponsor” are to Blackstone Capital Partners V L.P.; references to the “Investor Group” are, collectively, to Blackstone and certain funds affiliated with Blackstone, Dr. Norman C. Payson and certain members of our management; and references to “home medical equipment,” “durable medical equipment” and “DME” are used synonymously. On October 28, 2008, the Company was acquired by private investment funds affiliated with the Sponsor via a merger of the Merger Sub with and into Apria (the “Merger”), with Apria being the surviving corporation following the Merger. As a result of the Merger, the Investor Group beneficially owns all of Apria’s issued and outstanding common stock.

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     September 30,
2013
    December 31,
2012
 
     (in thousands, except share data)  

ASSETS

  

CURRENT ASSETS

    

Cash and cash equivalents

   $ 18,543      $ 27,080   

Accounts receivable, less allowance for doubtful accounts of $64,909 and $53,017 at September 30, 2013 and December 31, 2012, respectively

     333,495        344,421   

Inventories

     83,930        68,075   

Deferred expenses

     3,476        3,798   

Prepaid expenses and other current assets

     22,933        16,890   
  

 

 

   

 

 

 

TOTAL CURRENT ASSETS

     462,377        460,264   

PATIENT SERVICE EQUIPMENT, less accumulated depreciation of $198,502 and $185,774 at September 30, 2013 and December 31, 2012, respectively

     198,314        186,460   

PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET

     71,433        76,823   

GOODWILL

     258,725        258,725   

INTANGIBLE ASSETS, NET

     133,223        133,781   

DEFERRED DEBT ISSUANCE COSTS, NET

     13,918        30,207   

OTHER ASSETS

     36,032        26,448   
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 1,174,022      $ 1,172,708   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ DEFICIT

    

CURRENT LIABILITIES

    

Accounts payable

   $ 168,695      $ 157,530   

Accrued payroll and related taxes and benefits

     78,493        70,547   

Deferred income taxes

     304        986   

Other accrued liabilities

     75,310        74,464   

Deferred revenue

     24,626        27,785   

Current portion of long-term debt

     31,031        25,195   
  

 

 

   

 

 

 

TOTAL CURRENT LIABILITIES

     378,459        356,507   

LONG-TERM DEBT, net of current portion

     1,037,759        1,017,515   

DEFERRED INCOME TAXES

     71,558        68,907   

INCOME TAXES PAYABLE AND OTHER NON-CURRENT LIABILITIES

     67,243        61,203   
  

 

 

   

 

 

 

TOTAL LIABILITIES

     1,555,019        1,504,132   

COMMITMENTS AND CONTINGENCIES

    

STOCKHOLDERS’ DEFICIT

    

Common stock, $0.01 par value: 1,000 shares authorized; 100 shares issued at September 30, 2013 and December 31, 2012

     —         —    

Additional paid-in capital

     699,414        695,211   

Accumulated deficit

     (1,080,411     (1,026,635
  

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ DEFICIT

     (380,997     (331,424
  

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT

   $ 1,174,022      $ 1,172,708   
  

 

 

   

 

 

 

See notes to unaudited condensed consolidated financial statements.

 

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APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2013     2012     2013     2012  
     (in thousands)  

Net revenues:

        

Fee-for-service arrangements

   $ 561,831      $ 562,867      $ 1,706,650      $ 1,675,930   

Capitation

     45,366        45,606        135,925        135,928   
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL NET REVENUES

     607,197        608,473        1,842,575        1,811,858   
  

 

 

   

 

 

   

 

 

   

 

 

 

Costs and expenses:

        

Cost of net revenues:

        

Product and supply costs

     234,476        215,681        685,379        637,229   

Patient service equipment depreciation

     24,552        20,301        66,700        61,383   

Home respiratory therapy services

     5,636        6,650        17,024        20,957   

Nursing services

     10,856        10,422        31,115        32,354   

Other

     4,115        4,200        12,959        13,194   
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL COST OF NET REVENUES

     279,635        257,254        813,177        765,117   

Provision for doubtful accounts

     23,933        13,495        60,160        46,143   

Selling, distribution and administrative

     295,431        307,131        888,035        933,390   

Amortization of intangible assets

     186        344        558        1,488   

Non-cash impairment of intangible assets

     —         280,000        —         280,000   
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     599,185        858,224        1,761,930        2,026,138   
  

 

 

   

 

 

   

 

 

   

 

 

 

OPERATING INCOME (LOSS)

     8,012        (249,751     80,645        (214,280

Interest expense

     23,157        33,794        89,546        101,189   

Loss on early retirement of debt

     —         —         44,221        —    

Interest income and other

     (188     (311     (1,341     (1,082
  

 

 

   

 

 

   

 

 

   

 

 

 

LOSS BEFORE TAXES

     (14,957     (283,234     (51,781     (314,387

Income tax expense (benefit)

     828        (107,523     1,995        (106,333
  

 

 

   

 

 

   

 

 

   

 

 

 

NET LOSS

   $ (15,785   $ (175,711   $ (53,776   $ (208,054
  

 

 

   

 

 

   

 

 

   

 

 

 

See notes to unaudited condensed consolidated financial statements.

 

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APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Nine Months Ended
September 30,
 
     2013     2012  
          

(As Restated –

See Note 2)

 
     (in thousands)  

OPERATING ACTIVITIES

    

Net loss

   $ (53,776   $ (208,054

Items included in net loss not requiring cash:

    

Provision for doubtful accounts

     60,160        46,143   

Depreciation

     87,558        84,935   

Amortization of intangible assets

     558        1,488   

Non-cash impairment of intangible assets

     —         280,000   

Amortization of deferred debt issuance costs

     7,854        10,661   

Deferred income taxes

     1,969        (105,572

Profit interest compensation

     4,203        2,465   

Gain on sale of patient service equipment and other

     (12,938     (19,409

Loss on early retirement of debt

     44,221        —    

Changes in operating assets and liabilities, exclusive of effects of acquisitions

    

Accounts receivable

     (49,235     (71,642

Inventories

     (15,855     (8,471

Prepaid expenses and other assets

     (15,628     8,587   

Accounts payable

     6,893        16,325   

Accrued payroll and related taxes and benefits

     7,947        7,368   

Income taxes payable

     (181     (1,677

Deferred revenue, net of related expenses

     (2,837     10   

Accrued expenses

     7,066        34,218   
  

 

 

   

 

 

 

NET CASH PROVIDED BY OPERATING ACTIVITIES

     77,979        77,375   
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Purchases of patient service equipment and property, equipment and improvements, exclusive of effects of acquisitions

     (106,608     (121,008

Proceeds from sale of patient service equipment and other

     29,791        34,544   

Cash paid for acquisitions

     —         (121
  

 

 

   

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (76,817     (86,585
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Proceeds from ABL Facility

     502,000        317,000   

Payments on ABL Facility

     (505,000     (321,000

Payments on Series A-1 Notes

     (700,000     —    

Payments on Series A-2 Notes

     (160,000     —    

Proceeds from Senior Secured Term Loan

     900,000        —    

Payments on Term Loan

     (2,250     —    

Premium paid on early retirement of Series A-1 and A-2 Notes

     (24,641     —    

Debt issuance costs on Senior Secured Term Loan

     (10,628     —    

Payment of original issue discount associated with Senior Secured Term Loan

     (9,000     —    

Payments on other long-term debt

     (180     (256

Cash paid on profit interest units

     —         (102
  

 

 

   

 

 

 

NET CASH USED IN FINANCING ACTIVITIES

     (9,699     (4,358
  

 

 

   

 

 

 

NET DECREASE IN CASH AND CASH EQUIVALENTS

     (8,537     (13,568

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     27,080        29,096   
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 18,543      $ 15,528   
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURES—See Note 4 for a discussion of cash paid for interest and loss on early retirement of debt. See Note 7 for a discussion of cash paid on income taxes.

 

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Purchases of patient service equipment and property, equipment and improvements exclude purchases that remain unpaid at the end of the respective quarter. Such amounts are then included in the following period’s purchases when paid. Unpaid purchases were $18.1 million and $9.7 million at September 30, 2013 and September 30, 2012, respectively.

See notes to unaudited condensed consolidated financial statements.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation: The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These statements include the accounts of Apria Healthcare Group Inc. (“Apria” or “the Company”) and its subsidiaries. Intercompany transactions and accounts have been eliminated in consolidation.

In the opinion of management, all adjustments, consisting of normal recurring accruals necessary for a fair presentation of the results of operations for the interim periods presented, have been reflected herein. The unaudited results of operations for interim periods are not necessarily indicative of the results to be expected for the entire year. For further information, refer to the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2012.

On October 28, 2008, the Company completed the Merger with Merger Sub, a Delaware corporation and wholly-owned subsidiary of Sky LLC. Buyer is controlled by private investment funds affiliated with the Sponsor.

Company Background: The Company operates in the home healthcare segment of the healthcare industry, providing a variety of high-quality clinical patient care management programs, related products and supplies as prescribed by a physician and/or authorized by a case manager as part of a care plan. Essentially all products and services offered by the Company are provided through the Company’s network of approximately 510 locations, which are located throughout the United States. The Company provides services and products in two operating segments: home respiratory therapy/home medical equipment and home infusion therapy. Each operating segment constitutes a separate reporting unit and within these two operating segments there are four core service lines: home respiratory therapy, home medical equipment, home infusion therapy, including total parenteral nutrition (“TPN”), and enteral nutrition services. Both segments provide products and services in the home setting to patients and are primarily paid for by a third-party payor, such as Medicare, Medicaid, managed care or other third-party insurer. Sales for both segments are primarily derived from referral sources such as hospital discharge planners, medical groups or independent physicians.

Use of Accounting Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Among the significant estimates affecting the consolidated financial statements are those related to revenue recognition and the resulting accounts receivable, share-based compensation, income taxes, goodwill and long-lived assets.

Revenue Recognition and Concentration of Credit Risk: Revenues are recognized under fee-for-service/product arrangements for equipment the Company rents to patients, sales of equipment, supplies, pharmaceuticals and other items the Company sells to patients and under capitation arrangements with third party payors for services and equipment the Company provides to the patients of these payors. Revenue generated from equipment that the Company rents to patients is recognized over the rental period, typically one month, and commences on delivery of the equipment to the patients. Revenue related to sales of equipment, supplies and pharmaceuticals is recognized on the date of delivery to the patients. Revenues derived from capitation arrangements were approximately 7% of total net revenues for the three and nine months ended September 30, 2013 and approximately 7% and 8% of total net revenues for the three and nine months ended September 30, 2012. Capitation revenue is earned as a result of entering into a contract with a third party to provide its members certain services without regard to the actual services provided, therefore revenue is recognized in the period that the beneficiaries are entitled to healthcare services. All revenues are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors, including private insurers, prepaid health plans, Medicare and Medicaid. Revenues reimbursed under arrangements with Medicare and Medicaid were approximately 22% and 5% of total net revenues for the three months ended September 30, 2013 and 23% and 6% of total net revenues for the nine months ended September 30, 2013. Revenues reimbursed under arrangements with Medicare and Medicaid were approximately 22% and 6% of total net revenues for the three months ended September 30, 2012 and 23% and 6% of total net revenues for the nine months ended September 30, 2012. No other third-party payor group represented more than 9.1% of the Company’s revenues.

 

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Rental and sale revenues in the fee-for-service/product arrangement revenue line item were:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 

(dollars in millions)

   2013            2012            2013            2012         

Rental

   $ 157.2         28.0   $ 163.5         29.0   $ 491.3         28.8   $ 494.0         29.5

Sale

     404.6         72.0        399.4         71.0        1,215.4         71.2        1,181.9         70.5   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total fee for service

   $ 561.8         100.0   $ 562.9         100.0   $ 1,706.7         100.0   $ 1,675.9         100.0
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

The Company provides various services and products to patients. These arrangements involve the sale of equipment, pharmaceuticals and medical supplies. Revenues from the sale of equipment, pharmaceuticals and medical supplies are recognized upon confirmation of delivery of the products. Additionally, the Company provides clinical nursing services to patients. Nursing services are recognized as revenue when the service is rendered.

Cash and Cash Equivalents: Cash is maintained with various financial institutions. These financial institutions are located throughout the United States and the Company’s cash management practices limit exposure to any one institution. Management considers all highly liquid instruments purchased with a maturity of less than three months to be cash equivalents.

Accounts Receivable: Included in accounts receivable are earned but unbilled receivables of $72.6 million at September 30, 2013 and $56.8 million at December 31, 2012. Delays ranging from a day up 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 such as physicians and hospitals who must document medical necessity to third-party payors for the products and services we provide to patients. Unbilled receivables can also be impacted by the transition of patients during the integration of acquisitions and overall revenue growth. Earned but unbilled receivables are aged from date of service and are considered in the analysis of historical performance and collectability. Unbilled receivables increased in the third fiscal quarter primarily due to anticipated delays in billings associated with the internal separation and transfer of our enteral operations.

Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required to record total 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 periodic analyses to evaluate accounts receivable balances to ensure that recorded amounts reflect estimated net realizable value. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends, the extent of contracted business and business combinations. Also considered are relevant business conditions such as governmental and managed care payor claims processing procedures and system changes. Additionally, focused reviews of certain large and/or problematic payors are performed. Due to continuing changes in the healthcare industry and third-party reimbursement, it is possible that management’s estimates could change in the near term, which could have an impact on operations and cash flows.

Accounts receivable are reduced by an allowance for doubtful accounts which provides for those accounts from which payment is not expected to be received, although services were provided and revenue was earned. Upon determination that an account is uncollectible, it is written-off and charged to the allowance.

Deferred Revenue and Deferred Expense: A lessor is required to recognize rental income over the lease term. Rental of patient equipment is billed on a monthly basis beginning on the date the equipment is delivered. Since deliveries can occur on any day during a month, the amount of billings that apply to the next month are deferred. Only the direct costs associated with the initial rental period are deferred.

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market and consist primarily of pharmaceuticals and items used in conjunction with patient service equipment.

Patient Service Equipment: Patient service equipment is stated at cost less depreciation and consists of medical equipment rented to patients on a month-to-month basis. Depreciation is provided using the straight-line method over the estimated useful lives of the equipment, which range from one to ten years.

 

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Property, Equipment and Improvements: Property, equipment and improvements are stated at cost less depreciation. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, which range from one to fifteen years or for leasehold improvements the shorter of the useful life of the asset or the remaining life of the related lease.

Capitalized Software: Included in property, equipment and improvements are costs related to internally developed and purchased software that are capitalized and amortized over periods that the assets are expected to provide benefit. Capitalized costs include direct costs of materials and services incurred in developing or obtaining internal-use software and payroll and benefit costs for employees directly involved in the development of internal-use software. Additions to capitalized internally developed software totaled $1.9 million and $2.2 million for the three months ended September 30, 2013 and 2012, respectively, and $6.3 million and $6.4 million for the nine months ended September 30, 2013 and 2012, respectively.

Goodwill and Long-Lived Assets: Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization.

Goodwill and indefinite-lived intangible assets are not amortized but instead tested at least annually for impairment, or more frequently when events or changes in circumstances indicate that the assets might be impaired. Goodwill is tested for impairment by comparing the carrying value to the fair value of the reporting unit to which the goodwill is assigned. A two-step test is used to identify the potential impairment and to measure the amount of impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired; otherwise, goodwill is impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit with the carrying amount of goodwill. Management has determined that our two operating segments are reporting units. As such, the Company has two reporting units: home respiratory therapy/home medical equipment and home infusion therapy. The Company performs the annual test for impairment as of the first day of its fourth quarter and determines fair value based on a combination of the income approach and the market approach. The income approach is based on discounted cash flows. The market approach uses a selection of comparable companies in determining market value. The fair values of trade names are also tested for impairment on the first day of its fourth quarter by comparing the carrying value to the fair value. Fair value of a trade name is determined using a relief from royalty method under the income approach, which uses projected revenue allocable to the trade name and an assumed royalty rate.

Long-lived assets, including property and equipment and purchased definite-lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment tests. Recoverability of assets to be held and used is measured by the comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such an asset is considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Remaining intangible assets on the Company’s consolidated balance sheets consist primarily of trade names, accreditations with commissions, capitated relationships, payor relationships and customer lists resulting from the Merger. Purchased intangible assets that have definite lives are amortized over the estimated useful lives of the related assets, generally ranging from one to twenty years.

Deferred Debt Issuance Costs: Capitalized debt issuance costs include those associated with the Company’s Senior Secured Term Loan, Series A-1 Notes, Series A-2 Notes and Asset Based Revolving Credit Facility (“ABL Facility”). Such costs are classified as non-current assets. Costs relating to the ABL Facility are being amortized through the maturity date of August 2014. Costs relating to the Series A-1 Notes and Series A-2 Notes are amortized from the issuance date through October 2014. Costs related to the Senior Secured Term Loan are amortized from the issuance date through the maturity date of March 2020.

Fair Value of Financial Instruments: The carrying value of debt approximates fair value because the underlying instruments are variable notes that reprice frequently. The fair values of cash and cash equivalents, short-term investments, Senior Secured Term Loan and the Series A-2 Notes and are determined based upon “Level 1” inputs, consisting of quoted prices in active markets for identical items. The fair value of the Senior Secured Term Loan and Series A-2 Notes was $903.4 million and $159.0 million at September 30, 2013, respectively. The carrying amounts of cash and cash equivalents, accounts receivable, ABL Facility, trade payables and accrued expenses approximate fair value due to their short maturity.

 

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Product and Supply Costs: Product and supply costs presented within cost of total net revenues are comprised primarily of the cost of supplies and equipment provided to patients, infusion drug costs and enteral nutrition product costs.

Home Respiratory Therapy Expenses: Home respiratory therapy expenses presented within cost of total net revenues are comprised primarily of employee salary and benefit costs or contract fees paid to respiratory therapists and other related professionals who are deployed to service a patient. Home respiratory therapy personnel are also engaged in a number of administrative and marketing tasks, and accordingly, these costs are classified within selling, distribution and administrative expenses and amounted to $7.5 million and $9.4 million in the three months ended September 30, 2013 and September 30, 2012, respectively, and $23.3 million and $29.4 million in the nine months ended September 30, 2013 and September 30, 2012, respectively.

Distribution Expenses: Distribution expenses are included in selling, distribution and administrative expenses and totaled $44.5 million and $49.5 million in the three months ended September 30, 2013 and September 30, 2012, respectively, and $138.0 million and $148.7 million in the nine months ended September 30, 2013 and September 30, 2012, respectively. Such expense represents the cost incurred to coordinate and deliver products and services to the patients. Included in distribution expenses are leasing, maintenance, licensing and fuel costs for the vehicle fleet; salaries and other costs related to drivers and dispatch personnel; and amounts paid to courier and other outside shipping vendors. Such expenses fall within the definition of “shipping and handling” costs and are classified within selling and administrative expenses and may not be comparable to other companies.

Self-Insurance: Coverage for certain employee medical claims and benefits, as well as workers’ compensation, professional and general liability, and vehicle liability are self-insured. Amounts accrued for costs of workers’ compensation, medical, professional and general liability, and vehicle are classified as current or long-term liabilities based upon an estimate of when the liability will ultimately be paid.

Amounts accrued as current liabilities within other accrued liabilities are as follows:

 

(in thousands)

   September 30,
2013
     December 31,
2012
 

Workers’ compensation

   $ 11,839       $ 10,927   

Professional and general liability/vehicle

     4,653         3,773   

Medical insurance

     5,403         6,608   

Amounts accrued as long-term liabilities within income taxes payable and other non-current liabilities are as follows:

 

(in thousands)

   September 30,
2013
     December 31,
2012
 

Workers’ compensation

   $ 35,676       $ 33,130   

Professional and general liability/vehicle

     9,391         8,565   

Income Taxes: The Company’s provision for income taxes is based on expected income, permanent book/tax differences and statutory tax rates in the various jurisdictions in which the Company operates. Significant management estimates and judgments are required in determining the provision for income taxes.

Profit Interest Units: The Company measures and recognizes compensation expense for all profit interest unit awards made to employees based on estimated fair values on the date of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in the Company’s consolidated financial statements. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Profit interest unit expense is recognized on a straight-line basis over the requisite service period. The estimate of fair value of profit interest unit awards on the date of grant is determined through the allocation of all outstanding securities to a business enterprise valuation. The enterprise valuation is based upon a combination of the income approach and the market approach. The income approach is based on discounted cash flows. The market approach uses a selection of comparable companies in determining value. This determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. Changes in the subjective assumptions can materially affect the estimate of their fair value.

Recent Accounting Pronouncements: In July 2013, the the Financial Accounting Standards Board (“FASB”) issued a new accounting standard on the financial statement presentation of unrecognized tax benefits. The new standard requires a liability related to an unrecognized tax benefit to be presented as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax position is disallowed. The new standard becomes effective for the Company on January 1, 2014 and it should be applied prospectively to unrecognized tax benefits that exist at the effective date with retrospective application permitted. The Company currently presents the liability related to an unrecognized tax benefit as a reduction to the related deferred tax asset for net operating loss carryforwards and/or tax credit carryforwards.

 

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In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. The Company adopted the provisions of the guidance and the adoption did not have any impact on the condensed consolidated financial statements.

NOTE 2 — RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS

Historically, the Company accounted for cash receipts from the sale of patient service equipment in operating activities in its consolidated statements of cash flows. Subsequent to the issuance of the 2011 financial statements, the Company concluded that the cash receipts from the sale of patient service equipment should be recorded in investing activities on the Company’s consolidated statements of cash flows. Accordingly, the Company has restated its consolidated statements of cash flows for the nine months ended September 30, 2012. The impact of the restatement decreased net cash provided by operating activities in the Company’s consolidated statements of cash flows by $34.4 million or 30.8% for the nine months ended September 30, 2012. Additionally, net cash used in investing activities in the Company’s consolidated statements of cash flows decreased by $34.4 million or 28.4% in the nine months ended September 30, 2012. There is no change to the total cash flows in the nine months ended September 30, 2012.

The following tables show the impact of the restatement.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS ITEMS

 

     Nine Months Ended September 30, 2012  

(in thousands)

   (As Previously
Reported)
    (Adjustments)     (As
Restated)
 

Loss (Gain) on sale of patient service equipment and other

   $ 14,949      $ (34,358   $ (19,409

Net cash provided by (used in) operating activities

     111,733        (34,358     77,375   

Proceeds from sale of patient service equipment and other

     186        34,358        34,544   

Net cash used in investing activities

   $ (120,943   $ 34,358      $ (86,585

The restatement described above did not impact the Company’s consolidated statements of operations or total cash flows for nine months ended September 30, 2012.

NOTE 3 — GOODWILL AND INTANGIBLE ASSETS

Changes in goodwill by segment are as follows:

 

(in thousands)

   Home
Infusion
Therapy
     Home
Respiratory
Therapy
and Home
Medical
Equipment
     Total  

Balance, December 31, 2012

   $ 258,725       $ —         $ 258,725   

Acquisitions

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Balance, September 30, 2013

   $ 258,725       $ —         $ 258,725   
  

 

 

    

 

 

    

 

 

 

The Company recorded a non-cash impairment charge of $350.0 million related to intangible assets in the year ended December 31, 2012, of which $270.0 million related to the home respiratory therapy/home medical equipment reporting unit and $80.0 million related to the enteral nutrition business, which is part of the home infusion therapy reporting unit.

 

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Intangible assets consist of the following:

 

     September 30, 2013      December 31, 2012  

(dollars in thousands)

   Average
Life in
Years
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net Book
Value
     Gross
Carrying
Amount
     Accumulated
Amortization
    Impairment
Charge
    Net Book
Value
 

Intangible assets subject to amortization:

                    

Capitated relationships

     20.0       $ 4,400       $ (1,473   $ 2,927       $ 4,400       $ (1,327     —        $ 3,073   

Payor relationships

     20.0         11,000         (2,704     8,296         11,000         (2,292     —          8,708   

Customer list

     0.9         121         (121     —           121         (121     —          —     
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Subtotal

        15,521         (4,298     11,223         15,521         (3,740     —          11,781   

Intangible assets not subject to amortization:

                    

Trade names

        115,000         —          115,000         465,000         —          (350,000     115,000   

Accreditations with commissions

        7,000         —          7,000         7,000         —          —          7,000   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Subtotal

        122,000         —          122,000         472,000         —          (350,000     122,000   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total

      $ 137,521       $ (4,298   $ 133,223       $ 487,521       $ (3,740   $ (350,000   $ 133,781   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Amortization expense amounted to $0.6 million and $1.5 million for the nine months ended September 30, 2013 and 2012, respectively. Estimated amortization expense for each of the fiscal years ending December 31 is presented below:

 

Year Ending December 31,

   (in thousands)  

2013

   $ 744   

2014

     744   

2015

     744   

2016

     744   

2017

     744   

Thereafter

     8,060   

NOTE 4 — LONG-TERM DEBT

Long-term debt consists of the following:

 

(in thousands)    September 30,
2013
    December 31,
2012
 

Series A-1 Notes

   $ —        $ 700,000   

Series A-2 Notes

     157,500        317,500   

Senior Secured Term Loan

     897,750        —     

Unamortized original issue discount associated with Senior Secured Term Loan

     (8,491     —     

Amended ABL Facility

     22,000        25,000   

Capital lease obligations

     31        210   
  

 

 

   

 

 

 
     1,068,790        1,042,710   

Less: current maturities

     (31,031     (25,195
  

 

 

   

 

 

 
   $ 1,037,759      $ 1,017,515   
  

 

 

   

 

 

 

Senior Secured Term Loan. On April 5, 2013, the Company entered into a senior secured credit agreement (the “Senior Secured Term Loan”), among Apria, as borrower, Sky Acquisition LLC, as parent, the other guarantors party thereto from time to time, Bank of America, N.A., as administrative agent, U.S. Bank National Association as collateral agent, certain other agents party thereto and a syndicate of financial institutions and institutional lenders.

On April 5, 2013, the Company borrowed $900.0 million in aggregate principal amount of term loans under the Senior Secured Term Loan. At the Company’s option, the Company may borrow additional term loans under the Senior Secured Term Loan, subject to certain customary conditions, including consent of the lenders providing such additional term loans, in an amount not to exceed $175.0 million, plus the aggregate principal amount of voluntary prepayments of term loans on or prior to such time, plus additional amounts subject to compliance on a pro forma basis with certain financial ratio tests.

 

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Borrowings under the Senior Secured Term Loan bear interest at a fluctuating rate per annum equal to, at the Company’s option (i) a base rate equal to the highest of (a) the federal funds rate plus 1/2 of 1%, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America, N.A. as its “prime rate” and (c) the one month LIBOR Rate plus 1.00% (provided that in no event shall such base rate with respect to the initial Term Loans be less than 2.25% per annum), in each case plus an applicable margin of 4.50% or (ii) a LIBOR Rate for the applicable interest period (provided that in no event shall such LIBOR rate with respect to the initial Term Loans be less than 1.25% per annum) plus an applicable margin of 5.50%.

The Senior Secured Term Loan will mature on April 5, 2020 and will amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of term loans, with the balance payable on the final maturity date; provided that the Senior Secured Term Loan provides the right for individual lenders to agree to extend the maturity date of their outstanding term loans upon the Company’s request and without the consent of any other lender, subject to customary terms and conditions.

All the Company’s obligations under the Senior Secured Term Loan (i) are unconditionally guaranteed by the Company’s parent and substantially all of its existing and future, direct and indirect, wholly-owned domestic restricted subsidiaries and (ii) are secured, subject to certain exceptions, by substantially all of the Company’s assets and the assets of the guarantors.

The Senior Secured Term Loan is entitled to a priority of payment over the Series A-2 Notes in certain circumstances, including upon any acceleration of the obligations in respect of the Senior Secured Term Loan, the Series A-2 Notes or any bankruptcy or insolvency event or default with respect to Apria or any guarantor of the Senior Secured Term Loan and the Series A-2 Notes.

The Senior Secured Term Loan includes a financial maintenance covenant that prohibits the Company’s consolidated first priority net leverage ratio as of the last day of any test period of four consecutive fiscal quarters (commencing with the test period ending September 30, 2013) to exceed 5.50 to 1.00.

The Senior Secured Term Loan also includes customary negative covenants that, subject to certain exceptions, limit the Company’s ability and the ability of the Company’s parent and subsidiaries to, among other things: incur liens; make investments or loans; incur, assume or permit to exist additional indebtedness or guarantees; and pay dividends, make payments or redeem or repurchase capital stock.

Under the terms of the Senior Secured Term Loan, outstanding loans under the Senior Secured Term Loan may be accelerated if more than $75.0 million of the Series A-2 Notes remain outstanding on or after September 2, 2014.

The Company used proceeds from the borrowings under the Senior Secured Term Loan to: (i) redeem all of the Company’s outstanding 11.25% Senior Secured Notes due 2014 (Series A-1) (the “Series A-1 Notes”); (ii) redeem an aggregate principal amount of $160.0 million of the Company’s outstanding 12.375% Senior Secured Notes due 2014 (Series A-2) (the “Series A-2 Notes” and, together with the Series A-1 Notes, the “Notes”) and (iii) pay fees and expenses associated with the entering into the Senior Secured Term Loan and the redemption of the Notes.

In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, the Company paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, the Company wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed. Such amounts are included in Loss on Early Retirement of Debt on the Company’s Condensed Consolidated Statement of Operations for the nine months ended September 30, 2013.

Borrowings under the Senior Secured Term Loan were incurred with an original issue discount of $9.0 million. The Company incurred $10.6 million of debt issuance costs in connection with the Senior Secured Term Loan.

Series A-1 Notes and Series A-2 Notes. Series A-1 Notes and Series A-2 Notes were issued by us in May 2009 and August 2009, respectively. On April 5, 2013, all Series A-1 Notes and $160.0 million of Series A-2 Notes were refinanced using the proceeds of the Senior Secured Term Loan as described above. The Series A-1 Notes and the Series A-2 Notes bear interest at a rate equal to 11.25% per annum and 12.375% per annum, respectively. The indenture governing the Series A-1 Notes and the Series A-2 Notes, among other restrictions, limits our ability and the ability of its restricted subsidiaries to:

 

    incur additional debt;

 

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    pay dividends and make other distributions;

 

    make certain investments;

 

    repurchase the Company stock;

 

    incur certain liens;

 

    enter into transactions with affiliates;

 

    merge or consolidate;

 

    enter into agreements that restrict the ability of the Company’s subsidiaries to make dividends or other payments to us; and

 

    transfer or sell assets.

Subject to certain exceptions, the indenture governing the Series A-2 Notes permits us and our restricted subsidiaries to incur additional indebtedness, including senior indebtedness and secured indebtedness.

The remaining balance of the Series A-2 Notes will mature on November 1, 2014. On and after November 1, 2011, we may redeem the Series A-2 Notes, in whole or in part, at the redemption prices described below:

 

Series A-2 Notes

   Percentage  

November 1, 2012

     103.094

November 1, 2013 and thereafter

     100.000

Substantially all of the Company’s 100% owned subsidiaries (the “Guarantors”) jointly and severally, unconditionally guarantee the $900.0 million Senior Secured Term Loan and the $157.5 million Series A-2 Notes on a senior secured basis. The Guarantors also guarantee Apria’s ABL Facility.

Amended and Restated ABL Facility. On August 8, 2011, we entered into a senior secured asset-based revolving credit facility, or ABL Facility, with Bank of America, N.A., as administrative agent and collateral agent and a syndicate of financial institutions and institutional lenders. The ABL Facility amended and restated our prior senior secured asset-based revolving credit facility dated October 28, 2008, which provided for a revolving credit financing of up to $150.0 million.

The ABL Facility provides for revolving credit financing of up to $250.0 million, subject to borrowing base availability, with a maturity of the earlier of (a) five years and (b) 90 days prior to the earliest maturity of our outstanding Senior Secured Term Loan and Series A-2 Notes, and includes both a letter of credit and swingline loan sub-facility. The borrowing base at any time is equal to the sum (subject to certain reserves and other adjustments) of (i) 85% of eligible receivables, (ii) the least of (a) 85% of eligible self-pay accounts, (b) 10% of the borrowing base, (c) $25,000,000 and (d) the aggregate amount of self-pay accounts collected within the previous 90 days, (iii) the lesser of (a) 85% of eligible accounts invoiced but unpaid for more than 180 days but less than 360 days and (b) 10% of eligible accounts invoiced but unpaid for 180 days or less and (iv) the lesser of (a) 85% of the net orderly liquidation value of eligible inventory and (b) $35.0 million.

Borrowings under our ABL Facility bear interest at a rate per annum equal to, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Bank of America, N.A. and (2) the federal funds effective rate plus 1/2 of 1% (“Base Rate”), plus an applicable margin (currently 1.25%) or (b) a LIBOR rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin (currently 2.25%). The applicable margin for borrowings under our ABL Facility is subject to (a) 25 basis points step ups and step downs based on average excess availability under the ABL Facility and (b) a step down of 25 basis points based on achieving a consolidated fixed charge coverage ratio greater than 1.75 to 1.00. In addition to paying interest on outstanding amounts under our ABL Facility, we are required to pay a commitment fee, in respect of the unutilized commitments thereunder, ranging from 0.375% to 0.50% per annum, which fee will be determined based on utilization of our ABL Facility (increasing when utilization is low and decreasing when utilization is high). We also pay customary letter of credit fees equal to the applicable margin on LIBOR loans and other customary letter of credit and agency fees.

From time to time, we issue letters of credit in connection with our business, including commercial contracts, leases, insurance and workers’ compensation arrangements. If the holders of our letters of credit draw funds under such letters of credit, it would increase our outstanding senior secured indebtedness.

As of September 30, 2013, there was $22.0 million outstanding under the ABL Facility, outstanding letters of credit totaled $25.0 million and additional availability under the ABL Facility, subject to the borrowing base, was $203.0 million. As of September 30, 2013, the available borrowing base did not constrain our ability to borrow the entire $203.0 million

 

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available borrowing capacity under our ABL Facility. At September 30, 2013, we were in compliance with all of the financial covenants required by the credit agreement governing the ABL Facility. As of November 8, 2013, there was approximately 62.9 million outstanding under the ABL Facility.

Interest Paid and Accrued Interest. Interest paid on debt totaled $16.1 million and $0.7 million for the three months ended September 30, 2013 and 2012, respectively, and $77.9 and $61.1 million for the nine months ended September 30, 2013 and 2012, respectively. In addition, the Company paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes in connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes for the nine months ended September 30, 2013. Accrued interest was $23.7 million at September 30, 2013 and $19.9 million at December 31, 2012.

Loss on Early Retirement of Debt. The Company paid $24.6 million of premiums to the holders of the Series A-1 Notes and Series A-2 Notes in connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes for the nine months ended September 30, 2013. In addition, the Company wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were repaid for the nine months ended September 30, 2013.

Maturities of long-term debt and the ABL Facility are as follows:

 

Year Ending December 31,

   (in thousands)  

2013

   $ 24,281   

2014

     166,500   

2015

     9,000   

2016

     9,000   

2017

     9,000   

Thereafter

     859,500   
  

 

 

 
   $ 1,077,281   
  

 

 

 

The Company and its major equity holders, including the Sponsor and its affiliates, may from time to time, depending upon market conditions, seek to refinance or repurchase our debt securities or loans in privately negotiated or open market transactions, by tender offer or otherwise.

NOTE 5 — STOCKHOLDERS’ DEFICIT

For the nine months ended September 30, 2013, changes to stockholders’ deficit were comprised of the following amounts (in thousands):

 

     Common
Stock
     Additional
Paid In
Capital
     Accumulated
Deficit
    Total
Stockholders’
Deficit
 

Balance as of December 31, 2012

   $ —         $ 695,211       $ (1,026,635   $ (331,424

Net loss

     —           —           (53,776     (53,776

Profit interest compensation

     —           4,203         —          4,203   
  

 

 

    

 

 

    

 

 

   

 

 

 

Balance as of September 30, 2013

   $ —         $ 699,414       $ (1,080,411   $ (380,997
  

 

 

    

 

 

    

 

 

   

 

 

 

NOTE 6 — PROFIT INTEREST UNITS

Profit Interest Units. In November and December of 2008, BP Healthcare Holdings LLC (“BP Holdings”) and Sky LLC, parent entities of the Company affiliated with the Sponsor, granted equity units to the Company’s former Chief Executive Officer and the Company’s former Chief Financial Officer for purposes of retaining them and enabling such individuals to participate in the long-term growth and financial success of the Company. In addition, in 2009, 2010 and 2011, Sky LLC (and following the Company’s reorganization in March 2010, Holdings granted equity units to certain management employees for purposes of retaining them and enabling such individuals to participate in the long-term growth and financial success of the Company. Profit interest units are measured at the grant date, based on the calculated fair value of the award, and are recognized as an expense over the employee’s requisite service period. These equity awards were issued in exchange for services to be performed.

 

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In November 2008, BP Holdings granted Norman C. Payson, M.D., who was then the Company’s Chief Executive Officer, 38,697,318 Class B units, all of which were subject to vesting terms based on either (i) continued service to BP Holdings or its subsidiaries and/or (ii) performance/market conditions.

 

    Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 80% of the total Class B units. These units vest over four years starting on October 28, 2008 based on continued service, but will become fully vested on an accelerated basis either (x) upon a change in control while the Company’s Chief Executive Officer continues to provide services to BP Holdings or its subsidiaries or (y) if affiliates of the Sponsor receive cash proceeds in respect to 50% of their units in BP Holdings equal to at least 200% of their aggregate capital contributions in respect of such units while the Company’s Chief Executive Officer continues to provide services to BP Holdings or its subsidiaries. In addition, if the Company’s Chief Executive Officer’s services are terminated (a) by the Company without “cause” or (b) by the Chief Executive Officer as a result of “constructive termination,” an additional number of these time-vesting Class B units will vest equal to the number that would have vested over the 24-month period following the applicable termination date. Any of these time-vesting Class B units that are unvested on termination of the executive’s services will be forfeited. These units were fully vested as of December 31, 2012.

 

    Performance-Vesting Units. The remaining portion of the Class B units that vest based on performance/market conditions represent 20% of the total Class B units. One-half of these units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of all of their units in BP Holdings, with the other half eligible to vest if they receive cash proceeds equal to at least 300% of their aggregate capital contributions in respect of all of their units in BP Holdings. Any of these performance-vesting units that are unvested upon a termination of Dr. Payson’s services (x) by the Company without “cause,” (y) by the executive as a result of “constructive termination” or (z) by the executive for any reason on or following October 28, 2012, will remain outstanding until the second anniversary of the applicable termination date (unless they vest prior to that date). If the units do not vest by such anniversary, then any unvested performance-vesting units shall be immediately forfeited.

Assumptions used were as follows:

 

Expected Asset Volatility(1)

     23.0

Risk Free Interest Rate(2)

     2.24

Expected Life(3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the constant maturity treasury rate (“CMT Rate”) as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

On November 29, 2012, Norman C. Payson, M.D. announced his retirement from his position as Chief Executive Officer and Chairman of the Board of Directors. Dr. Payson remains on the Company’s Board of Directors and serves as a senior advisor to the Company. In connection with Dr. Payson’s retirement, the Board of Directors determined that in order to retain Dr. Payson’s continued services it was appropriate to amend the terms of his existing performance-vesting Class B Units to, among other things, provide that (1) his performance-vesting Class B Units will become time-vesting units and will vest in equal monthly installments over a two-year period commencing on November 29, 2012 (or an earlier termination of his services) regardless of whether the existing performance-vesting conditions are met during such time and (2) his performance-vesting Class B units will become fully vested on an accelerated basis upon (x) a change in control while he continues to serve as an advisor or director or (y) if his advisory or board services are terminated without “cause” or if he resigns as a result of a “constructive termination” on or prior to November 29, 2014. In addition, Dr. Payson was granted an additional 3,830,365 time-vesting Class B Units which will generally vest in equal installments every three months over a period of four years from the grant date.

 

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The following table summarizes activity for Dr. Payson’s profit interest units for the period December 31, 2012 to September 30, 2013:

 

     Class B Units  

Balance at December 31, 2012

     42,527,683   

Granted

     —     

Exercised

     —     

Forfeited

     —     
  

 

 

 

Balance at September 30, 2013

     42,527,683   
  

 

 

 

Vested units at September 30, 2013

     34,900,824   

There is no stated contractual life for the B units.

In December 2008, Sky LLC granted to Chris A. Karkenny, who was then the Company’s Chief Financial Officer, 500,000 Class A-2 units, 6,675,287 Class B units and 2,225,096 Class C units, all of which were subject to vesting terms based on either (i) continued service to Sky LLC or its subsidiaries or (ii) performance/market conditions.

 

    Class A-2 Units. The Class A-2 units vest if an initial public offering (“IPO”) or change of control occurs and the valuation of Class A-1 units of Holdings implied by the transaction exceeds 110% of the aggregate capital contributions of affiliates of the Sponsor for the Class A-1 units. Mr. Karkenny does not need to be employed at the time of the IPO or change in control to vest. The Class A-2 Units will be forfeited if an IPO or change of control occurs at a valuation that does not result in vesting.

 

    Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 66 2/3% of the total Class B units. These units vest over 57 months starting on October 28, 2008 based on continued service, but will become fully vested on an accelerated basis upon a change in control of Holdings while Mr. Karkenny continues to provide services to Sky LLC or its subsidiaries. Any of these time-vesting Class B units that are unvested on termination of the executive’s services will be forfeited.

 

    Performance-Vesting Units. The remaining portion of the Class B units and all of the Class C units vest based on performance/market conditions. These units would have vested if affiliates of the Sponsor received cash proceeds equal to at least 200% of their aggregate capital contributions in respect of 25% of their units in Sky LLC while Mr. Karkenny continued to provide services to Sky LLC or its subsidiaries.

Assumptions used were as follows:

 

Expected Asset Volatility(1)

     23.0

Risk Free Interest Rate(2)

     1.35

Expected Life(3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimates.

On December 31, 2012, Mr. Karkenny left the Company to pursue other business opportunities. In connection with Mr. Karkenny’s termination of employment, the Board of Directors determined to amend his management unit subscription agreement to (1) provide that his performance-vesting Class B and Class C Units would not be forfeited as a result of his termination of employment and instead will remain eligible to vest if the performance conditions are satisfied prior to March 31, 2014 and (2) provide that his vested units can only be purchased by the Company during the period from March 31, 2014 to June 1, 2014. Mr. Karkenny forfeited 667,529 units, which were unvested time-vesting units on the date of his departure.

 

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The following table summarizes activity for Mr. Karkenny’s profit interest units for the period December 31, 2012 to September 30, 2013:

 

     Class A-2
Units
     Class B
Units
     Class C
Units
 

Balance at December 31, 2012

     500,000         6,007,758         2,225,096   

Exercised

     —           —           —     

Forfeited

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Balance at September 30, 2013

     500,000         6,007,758         2,225,096   
  

 

 

    

 

 

    

 

 

 

Vested units at September 30, 2013

        3,782,284      

There are no stated contractual lives for the A-2, B or C units.

Sky LLC (and following the Company’s reorganization in March 2010, Holdings granted certain management employees 72,563,564 Class B units and 20,786,303 Class C units, all of which are subject to vesting terms based on either (i) continued service to Sky LLC or its subsidiaries or (ii) performance/market conditions.

 

    Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 66 2/3% of the total Class B units. These units vest over five years starting on the later of (x) October 28, 2008 and (y) the date the employee commenced employment based on continued service, but will become fully vested on an accelerated basis upon a change in control of Holdings while the employee continues to provide services to Sky LLC or its subsidiaries. Any of these time-vesting Class B units that are unvested on termination of the employee’s services will be forfeited.

 

    Performance-Vesting Units. The remaining portion of the Class B units and all of the Class C units vest based on performance/market conditions. These units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of 25% of their units in Sky LLC while the employee continues to provide services to Sky LLC or its subsidiaries.

Notwithstanding the vesting terms described above, if the employee voluntarily resigns (in the absence of “constructive termination”) on or prior to the second anniversary of the applicable grant date, then Sky LLC may require the forfeiture of any vested Class B or C units.

Assumptions used were as follows:

 

     2010     2011     2012     2013  

Expected Asset Volatility(1)

     25.0     25.0     25.0     30.0

Risk Free Interest Rate(2)

     2.39     2.01     0.83     0.72

Expected Life(3)

     5.0 years        5.0 years        5.0 years        5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

The following table summarizes activity for profit interest units granted to management employees for the period December 31, 2012 to September 30, 2013:

 

     Class A-2
Units
     Class B
Units
    Class C
Units
 

Balance at December 31, 2012

     1,075,000         42,852,564        11,078,113   

Granted

     —           7,860,635        2,370,211   

Forfeited

     —           (3,918,104     (1,306,035
  

 

 

    

 

 

   

 

 

 

Balance at September 30, 2013

     1,075,000         46,795,095        12,142,289   
  

 

 

    

 

 

   

 

 

 

Vested units at September 30, 2013

        16,873,945     

There are no stated contractual lives for the A-2, B or C units.

 

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Pursuant to a reorganization the Company conducted in March 2010, units of Sky LLC were converted or exchanged into units of Holdings, its parent entity.

In October 2011, Holdings granted to Mike S. Zafirovski, a Board member, 5,030,651 Class B units, all of which are subject to vesting terms based on either (i) continued service or (ii) performance/market conditions.

 

    Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 33 1/3% of the total Class B units. These units vest over three years starting on the anniversary of the grant date, but will become fully vested on an accelerated basis upon a change in control while the director continues to provide services to Sky LLC or its subsidiaries. Any of these time-vesting Class B units that are unvested on termination of the director’s services will be forfeited; provided however, if Mr. Zafirovski’s service is terminated by the Company without “cause” or due to his death or disability, a pro-rata portion of the time-vesting Class B units that would have vested on the next anniversary of the grant date will vest.

 

    Performance-Vesting Units. The remaining portion of the Class B units vest based on performance/market conditions. These units are divided into two categories, with vesting in each category based on the Company’s achievement of EBITDA (as defined in the Company’s credit agreement) targets and return on the investment of the Sponsor (defined as Blackstone Capital Partners V L.P. and its affiliates). The first category of the target-based Class B Units will vest if either of the following conditions is satisfied while Mr. Zafirovski continues to serve as a director (or within 24 months after termination by the Company of his service on the Board of Directors without cause): (1) the Company achieves a specified EBITDA target for each of fiscal year 2012 and fiscal year 2013; or (2) the Sponsor achieves a specified return on investment on or prior to December 31, 2014. The second category of the target-based Class B Units will vest if both of the following conditions are satisfied while Mr. Zafirovski continues to serve as a director (or within 24 months after a termination by the Company of his service on the Board of Directors without cause): (1) the Company achieves a more challenging specified EBITDA target for either fiscal year 2012 or fiscal year 2013 (such year of achievement, the “Subject Year”); and (2) one of the following conditions is satisfied: (a) the Company achieves a more challenging specified EBITDA target for the fiscal year immediately succeeding the Subject Year; or (b) the Sponsor achieves a specified return on investment on or prior to December 31, 2014. The Company believes that the targets set for the target based Class B Units are reasonable, although neither automatically nor easily achieved.

The Class B units granted to Mr. Zafirovski are similar to the other Class B units, except that the Class B units contain a special term that would require the value of Holdings’ Class A-2 Units to exceed $1.63 for him to receive any value, such that no payment would be made in respect of a Class B Unit if the value of a Class A-2 Unit fails to exceed $1.63.

Assumptions used were as follows for the 2011 grants:

 

Expected Asset Volatility(1)

     25.0

Risk Free Interest Rate(2)

     2.01

Expected Life(3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

The following table summarizes activity for profit interest units granted to Mr. Zafirovski for the period December 31, 2012 to September 30, 2013:

 

     Class A-2
Units
     Class B
Units
     Class C
Units
 

Balance at December 31, 2012

     1,000,000         5,030,651         —     

Granted

     —           —           —     

Forfeited

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Balance at September 30, 2013

     1,000,000         5,030,651         —     
  

 

 

    

 

 

    

 

 

 

Vested units at September 30, 2013

        558,956      

 

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In December 2012, Holdings and our Chief Executive Officer and Chairman of the Board of Directors, John G. Figueroa, entered into a management unit subscription agreement pursuant to which Mr. Figueroa purchased 1,000,000 Class A-2 Units of Holdings at the price of $1.00 per unit. The Class A-2 Units purchased by Mr. Figueroa were fully vested when purchased and contain different economic terms than Holdings’ normal Class A-2 Units which will not entitle him to receive any value above $1.00 per Class A-2 Unit unless and until the cumulative value attributable to each of his Class A-2 Units exceeds $1.10, at which point the special Class A-2 Units will become entitled to receive $0.10 per unit and thereafter will become entitled to receive the same amount as other Class A-2 Units.

Holdings granted Mr. Figueroa 12,257,169 Class B Units, all of which are subject to vesting terms based on continued service to BP Holdings or its subsidiaries. The Class B Units granted to Mr. Figueroa contain a special term that requires the value of Holdings’ Class A Units to exceed $1.10 in order for him to receive any value from such units, such that no payment will be made in respect of his Class B Units if the value a Class A Unit fails to exceed $1.10.

 

    Time Vesting Units. All of Mr. Figueroa’s Class B Units are time-vesting, with 20% of the Class B Units vesting on December 5, 2013 and an additional 5% of the Class B Units vesting every three months for a period of four years thereafter. The Class B Units will become fully vested if a change in control of Holdings occurs while Mr. Figueroa is still employed with the Company. Any Class B Units that are unvested upon termination of Mr. Figueroa’s employment will be forfeited.

Assumptions used were as follows:

 

Expected Asset Volatility(1)

     25.0

Risk Free Interest Rate(2)

     0.83

Expected Life(3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

The following table summarizes activity for profit interest units granted to Mr. Figueroa for the period December 31, 2012 to September 30, 2013:

 

     Class A-2
Units
     Class B
Units
     Class C
Units
 

Balance at December 31, 2012

     1,000,000         12,257,169         —     

Granted

     —           —           —     

Forfeited

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Balance at September 30, 2013

     1,000,000         12,257,169         —     
  

 

 

    

 

 

    

 

 

 

Vested units at September 30, 2013

        —        

In May 2013, Holdings granted a subsidiary’s board member 1,160,920 Class B units, all of which are subject to time vesting terms based on continued service. The Class B units vest based on continued service, with 10% vesting immediately, an additional 23 1/3% of the Class B units vested on September 4, 2013, an additional 34 1/3% of the Class B units will vest on September 4, 2014 and an additional 32 1/3% of the Class B units will vest on September 4, 2015. These units will become fully vested on an accelerated basis upon a change in control of such subsidiary while the director continues to provide services to the subsidiary. Any of these Class B units that are unvested on termination of the director’s services will be forfeited.

Assumptions used were as follows for the 2013 grants:

 

Expected Asset Volatility(1)

     30.0

Risk Free Interest Rate(2)

     0.72

Expected Life(3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

 

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The following table summarizes activity for profit interest units granted to this subsidiary’s director for the period December 31, 2012 to September 30, 2013:

 

     Class A-2
Units
     Class B
Units
     Class C
Units
 

Balance at December 31, 2012

     —           —           —     

Granted

     —           1,160,920         —     

Forfeited

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Balance at September 30, 2013

     —           1,160,920         —     
  

 

 

    

 

 

    

 

 

 

Vested units at September 30, 2013

        386,586      

Expense recorded related to profit interest units was $1.5 million and $0.9 million in each of the three months ended September 30, 2013 and 2012, respectively, and $4.2 million and $2.5 million in each of the nine months ended September 30, 2013 and 2012, respectively. As of September 30, 2013, total unrecognized profit interest compensation cost related to unvested profit interest units was $10.9 million, which is expected to be expensed over a weighted average period of 3.3 years. The total fair market value of shares vested was $1.1 million and $1.4 million in the three months ended September 30, 2013 and 2012, respectively, and $3.2 million and $3.8 million in the nine months ended September 30, 2013 and 2012, respectively.

The following table summarizes activity for all profit interest units for the period December 31, 2012 to September 30, 2013:

 

     Class A-2
Shares
     Weighted-
Average Grant
Date Fair
Value
     Class B Units     Weighted-
Average
Grant Date
Fair Value
     Class C Units     Weighted-
Average
Grant Date
Fair Value
 

Balance at December 31, 2012

     3,575,000         0.81         108,675,825        0.37         13,303,209        0.21   

Granted

     —           —           9,021,555        0.38         2,370,211        0.21   

Forfeited

     —           —           (3,918,104     0.38         (1,306,035     0.23   
  

 

 

       

 

 

      

 

 

   

Balance at September 30, 2013

     3,575,000         0.81         113,779,276        0.37         14,367,385        0.21   
  

 

 

       

 

 

      

 

 

   

NOTE 7 — INCOME TAXES

The Company’s effective tax rate was (5.5)% for the three months ended September 30, 2013, compared to 38.0% for the three months ended September 30, 2012. The Company’s effective tax rate was (3.9)% for the nine months ended September 30, 2013, compared to 33.8% for the nine months ended September 30, 2012.

For the three and nine months ended September 30, 2013, the Company’s effective tax rate differed from federal and state statutory rates primarily due to the accrual of a valuation allowance against substantially all of the Company’s net deferred tax assets and the tax expense related to separate state filings. In computing its Estimated Annual Effective Tax Rate for the three and nine months ended September 30, 2012, the Company recognized a $104.0 million deferred tax benefit related to the impairment of the indefinite life trade name.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized.

Beginning with the year ended December 31, 2011, the Company accrued a valuation allowance against substantially all of its net deferred tax assets since the Company determined that it is more likely than not that substantially all of its net deferred tax assets will not be realized. The Company intends to maintain its valuation allowance until sufficient positive evidence exists to support the reversal of all or a portion of its valuation allowance.

The Company increased its valuation allowance by $20.3 million to $258.8 million at September 30, 2013 from $238.5 million at December 31, 2012 to offset corresponding increases in its net deferred tax assets for the nine months ended September 30, 2013. The Company increased its valuation allowance by $6.9 million to $258.8 million at September 30, 2013 from $251.9 million at June 30, 2013 to offset corresponding increases in its net deferred tax assets for the three months ended September 30, 2013.

 

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The Company is required to disclose certain information, within its interim financial statements, when material changes occur regarding its tax uncertainties. For the nine months ended September 30, 2013, no material changes occurred with respect to the Company’s tax uncertainties which would require disclosure.

As of September 30, 2013, federal net operating loss (“NOLs”) carryforwards of approximately $478.4 million were available to offset future federal taxable income. Such NOLs will expire at various times and in varying amounts during the Company’s calendar 2015 through 2033 tax years. A significant portion of these NOLs are subject to an annual utilization limitation as required by Section 382 of the Internal Revenue Code of 1986, as amended.

The Company files federal and state income tax returns in jurisdictions with varying statutes of limitations expiration dates. The Company’s calendar 2009 through 2012 tax years generally remain subject to examination by tax authorities. The Internal Revenue Service (“IRS”) has recently completed its audit of the Company’s calendar 2009 Federal income tax return and made immaterial changes to the Company’s NOL carryforwards. Certain state tax agencies are currently examining the tax years 2006 and forward.

Net income tax payments made (and refunds received) for the nine-month period ended September 30, 2013 and 2012 amounted to $0.8 million and $1.2 million, respectively.

NOTE 8 — COMMITMENTS AND CONTINGENCIES

Litigation: The Company is engaged in the defense of certain claims and lawsuits arising out of the ordinary course and conduct of its business, the outcomes of which are not determinable at this time. Insurance policies covering such potential losses, where such coverage is cost effective, are maintained. In the opinion of management, any liability that might be incurred upon the resolution of these claims and lawsuits will not, in the aggregate, have a material adverse effect on the Company’s financial condition or results of operations, cash flows and liquidity.

Medicare and Medicaid Reimbursement: There are a number of provisions contained within recent, proposed or contemplated legislation that affect or may affect Medicare and Medicaid reimbursement policies for items and services provided. The Company cannot be certain of the ultimate impact of all legislated and contemplated changes, and therefore cannot provide assurance that these changes will not have a material adverse effect on the Company’s financial condition or results of operations.

Supplier Concentration: Currently, on a year to date basis, approximately 73.0% of purchases for patient service equipment and supplies are from five vendors. Although there are a limited number of suppliers, management believes that other vendors could provide similar products on comparable terms. However, a change in suppliers could cause delays in service delivery and possible losses in revenue, which could adversely affect the Company’s financial condition or operating results.

Guarantees and Indemnities: From time to time, certain types of contracts are entered into that contingently require indemnification of parties against third party claims. These contracts primarily relate to (i) certain asset purchase agreements, under which indemnification may be provided to the seller of the business being acquired; (ii) certain real estate leases, which may require indemnification to property owners for environmental or other liabilities and other claims arising from use of the applicable premises; and (iii) certain agreements with officers, directors and employees, which may require indemnification of such persons for liabilities arising out of their relationship with the Company.

The terms of such obligations vary by contract and in most instances a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, no liabilities have been recorded for these obligations on the balance sheets for any of the periods presented.

NOTE 9 — SEGMENTS

The Company has two reportable operating segments: (1) home respiratory therapy and home medical equipment and (2) home infusion therapy. Within these two operating segments there are four core service lines: home respiratory therapy, home medical equipment, home infusion therapy, including TPN services, and enteral nutrition services. The home respiratory therapy and home medical equipment segment provides services and equipment to assist patients who require oxygen systems, sleep apnea equipment / supplies, and ambulatory aids in the home, as well as respiratory medications and related services. The home infusion therapy segment primarily provides patients with pharmaceuticals, medical equipment and clinical services prescribed in conjunction with the administration of nutrients or medication intravenously or through a gastrointestinal tube (“tube feeding”).

 

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Table of Contents

Segment financial results are based on directly assignable net revenues, cost of goods sold, bad debt expenses and selling, distribution and administrative costs, where available. Costs that are not directly assignable, such as corporate costs and certain selling, distribution and administrative expenses, are allocated based on various metrics including billed census, headcount and branch locations by segment, among others.

During the fourth quarter of 2012, the Company revised its allocation to its reporting segments. This allocation is based on how the Company currently manages and discusses its operations.

 

    Net Revenue  
        Three Months Ended    
    September 30,    
        Nine Months Ended    
    September 30,    
 
(in thousands)   2013     2012     2013     2012  

Operating Segment

       

Home Respiratory Therapy and Home Medical Equipment

  $    278,097      $ 301,199      $ 867,287      $ 905,525   

Home Infusion Therapy

    329,100        307,274        975,288        906,333   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 607,197      $ 608,473      $ 1,842,575      $ 1,811,858   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

    EBIT  
        Three Months Ended    
    September 30,    
        Nine Months Ended    
    September 30,    
 
(in thousands)   2013     2012     2013     2012  

Operating Segment

       

Home Respiratory Therapy and Home Medical Equipment

  $ (7,794   $ (199,770   $ (7,166   $ (226,503

Home Infusion Therapy

    15,806        (49,981     87,811        12,223   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $     8,012      $ (249,751   $ 80,645      $ (214,280
 

 

 

   

 

 

   

 

 

   

 

 

 

 

    Depreciation and Amortization  
        Three Months Ended    
    September 30,    
        Nine Months Ended    
    September 30,    
 
(in thousands)   2013     2012     2013     2012  

Operating Segment

       

Home Respiratory Therapy and Home Medical Equipment

  $ 27,691      $ 24,041      $ 76,281      $ 73,623   

Home Infusion Therapy

    3,975        4,156        11,835        12,800   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 31,666      $ 28,197      $ 88,116      $ 86,423   
 

 

 

   

 

 

   

 

 

   

 

 

 

The Company’s Chief Operating Decision Maker (“CODM”) does not review assets assigned to segments. Therefore, such items are not reflected in the table above.

Earnings before interest and taxes (“EBIT”). EBIT is the measure used by the Company’s management to measure operating performance. EBIT is defined as net income (loss) plus interest expense, loss on early retirement of debt and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles (“GAAP”) and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.

The following table provides a reconciliation from net loss to EBIT:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
(in thousands)    2013     2012     2013     2012  

Net loss(a)

   $ (15,785   $ (175,711   $ (53,776   $ (208,054

Interest expense, net(b)

     22,969        33,483        88,205        100,107   

Loss on early retirement of debt(c)

     —          —          44,221        —     

Income tax expense

     828       (107,523     1,995        (106,333
  

 

 

   

 

 

   

 

 

   

 

 

 

EBIT

   $ 8,012      $ (249,751   $ 80,645      $ (214,280
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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(a) Net loss for the three and nine months periods ended September 30, 2012 reflects the following non-cash impairment charge based on the results of the Company’s impairment testing as of September 30, 2012 and the tax impact associated with the impairment charge:

 

  (i) Trade name impairment of $280.0 million, $200.0 million of which relates to the home respiratory therapy/home medical equipment reporting unit and $80.0 million of which relates to the home infusion therapy reporting unit; and

 

  (ii) Tax benefit of $104.0 million relating to the intangible assets impairment.

All of these items resulted in a $176.0 million increase in the net loss in the three and nine months ended September 30, 2012.

 

(b) Reflects $23.2 million of interest expense, net of $0.2 million of interest income for the three months ended September 30, 2013. Reflects $33.8 million of interest expense, net of $0.3 million of interest income for the three months ended September 30, 2012. Reflects $89.5 million of interest expense, net of $1.3 million of interest income for the nine months ended September 30, 2013. Reflects $101.2 million of interest expense, net of $1.1 million of interest income for the nine months ended September 30, 2012.
(c) Reflects $24.6 million of premiums paid to the holders of the redeemed Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed for the nine months ended September 30, 2013. Reflects $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed in the nine months ended September 30, 2013.

The Company allocates certain corporate expenses that are not directly attributable to a product line based upon Company metrics. The following table shows corporate costs allocated to each segment for the three and nine months ended September 30, 2013 and September 30, 2012.

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
(in millions)    2013      2012      2013      2012  

Operating Segment

           

Home Respiratory Therapy and Home Medical Equipment

   $ 31,470       $ 33,518       $ 95,252       $ 107,727   

Home Infusion Therapy

   $ 18,267       $ 16,336       $ 49,480       $ 41,733   

NOTE 10 — CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Management Fee Agreement: In connection with the Merger, Merger Sub entered into a management fee agreement with Blackstone Management Partners V L.L.C. (“BMP”). The Company succeeded to and assumed the rights and obligations of Merger Sub pursuant to the transaction and management fee agreement upon the closing of the Merger. Under the management fee agreement, BMP (including through its affiliates) agreed to provide services, including without limitation, (a) advice regarding the structure, distribution and timing of debt and equity offerings and advice regarding relationships with the Company’s lenders and bankers, (b) advice regarding the business and strategy of the Company, including compensation arrangements, (c) advice regarding dispositions and/or acquisitions and (d) such advice directly related or ancillary to the above financial advisory services as may be reasonably requested by the Company. In consideration for the services, the Company pays BMP at the beginning of each fiscal year a management fee equal to the greater of $7.0 million or 2.0% of the Company’s consolidated EBITDA, as defined in the agreement, for the immediately preceding fiscal year. BMP shall have no obligation to provide any other services to the Company absent express agreement. In addition, in the absence of an express agreement to provide investment banking or other financial advisory services to the Company, and without regard to whether such services were provided, BMP is entitled to receive a fee equal to 1.0% of the aggregate transaction value upon the consummation of any acquisition, divestiture, disposition, merger, consolidation, restructuring, refinancing, recapitalization, issuance of private or public debt of equity securities (including an initial public offering of equity securities), financing or similar transaction by the Company.

At any time in connection with or in anticipation of a change of control of the Company, a sale of all or substantially all of the Company’s assets or an initial public offering of common equity of the Company or its successor, BMP may elect to receive, in consideration of BMP’s role in facilitating such transaction and in settlement of the termination of the services, a single lump sum cash payment equal to the then-present value of all then-current and future annual management fees payable under the transaction and management fee agreement, assuming a hypothetical termination date of the agreement to be the twelfth anniversary of such election. The transaction and management fee agreement will continue until the earlier of the twelfth anniversary of the date of the agreement or such date as the Company and BMP may mutually determine. The Company has agreed to indemnify BMP and its affiliates, directors, officers, employees, agents and representatives from and

 

25


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against all liabilities relating to the services contemplated by the transaction and management fee agreement and the engagement of BMP pursuant to, and the performance of BMP and its affiliates of the services contemplated by, the transaction and management fee agreement. In accordance with the management agreement, the Company expensed $1.8 million for both the quarters ended September 30, 2013 and 2012.

Intelenet Agreement: In May 2009, the Company entered into a Master Services Agreement (“the Intelenet Agreement”) with Intelenet Global Services Private Limited (“Intelenet”), an Indian company then-affiliated with the Sponsor, regarding the outsourcing of certain functions relating to billing, collections and other administrative and clerical services. In July 2011 an affiliate of the Sponsor, along with other shareholders of Intelenet, sold Intelenet to Serco Group PLC, an international services company and as of that date they were no longer a related party. The Company continues to rely on Serco to perform certain administrative functions, but other administrative functions included in the original Intelenet Agreement are now incorporated into our internal Company-run customer care centers and branch operations staffed with our personnel.

Equity Healthcare Agreement: Effective as of January 1, 2010, the Company entered into an employer health program agreement with Equity Healthcare LLC (“Equity Healthcare”), an affiliate of the Sponsor, pursuant to which Equity Healthcare will provide to the Company certain negotiating, monitoring and other services in connection with our health benefit plans. Because of the combined purchasing power of its client participants, Equity Healthcare is able to negotiate pricing terms for providers that are believed to be more favorable than the companies could obtain for themselves on an individual basis. In consideration for Equity Healthcare’s services, the Company paid Equity Healthcare a fee of $2 per participating employee per month (the “PEPM” Fee”) until the parties entered into an amended agreement on December 22, 2011. Under the amendment, in consideration for Equity Healthcare’s services, the Company paid Equity Healthcare a PEPM fee of $2.25 or $2.50 in 2012, and will pay $2.35 or $2.60 in 2013, depending upon whether the Company’s employees are enrolled in a grandfathered or custom health benefit plan. As of September 30, 2013, the Company had approximately 6,900 employees enrolled in Equity Healthcare health benefit plans.

NOTE 11 — FINANCIAL GUARANTEES

The Company conducts substantially all of its business through its subsidiaries. Substantially all of the Company’s 100%-owned subsidiaries, jointly and severally, unconditionally guarantee the Senior Secured Term Loan and the Series A-2 Notes on a senior secured basis. The Guarantors also guarantee the Company’s ABL Facility. See also Note 4—Long-Term Debt.

The following condensed consolidating financial statements quantify the financial position as of September 30, 2013 and December 31, 2012, the operations for the three and nine months ended September 30, 2013 and 2012, and the cash flows for the three months ended September 30, 2013 and 2012. These condensed consolidating financial statements present financial information for the parent issuer, the guarantor subsidiaries, the non-guarantor subsidiaries and consolidating adjustments, consisting of the entries that eliminate the investment in subsidiaries and intercompany balances and transactions.

For periods beginning after July 1, 2013, income taxes have been allocated to certain guarantor subsidiaries which are organized as limited liabilities companies (“LLCs”). For federal and state income tax filing purposes, these LLCs are disregarded as separate taxable entities from the parent issuer; however, these LLCs are reflected as guarantor subsidiaries within the Company’s condensed consolidating financial statements.

The financial information as presented below is based on estimates to bifurcate shared resources, costs and revenues between entities and such information may not be indicative of results, if separate financial statements were prepared for these subsidiaries.

 

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Table of Contents

CONDENSED CONSOLIDATING BALANCE SHEETS

September 30, 2013

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  
ASSETS            

CURRENT ASSETS

           

Cash and cash equivalents

   $ 17,218      $ 927      $ 398       $ —        $ 18,543   

Accounts receivable less allowance for doubtful accounts

     —          331,747        1,748         —          333,495   

Inventories, net

     —          83,477        453         —          83,930   

Deferred expenses

     —          3,476        —           —          3,476   

Intercompany

     360,264        977,759        —           (1,338,023     —     

Prepaid expenses and other current assets

     1,444        21,477        12         —          22,933   

Deferred income taxes current

     —          5,298        —           (5,298     —     

Intercompany loan

     710,000        —          —           (710,000     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT ASSETS

     1,088,926        1,424,161        2,611         (2,053,321     462,377   

PATIENT SERVICE EQUIPMENT, less accumulated depreciation

     —          198,311        3         —          198,314   

PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET

     32,530        38,761        142         —          71,433   

GOODWILL

     —          258,725        —           —          258,725   

INTANGIBLE ASSETS, NET

     50,000        83,223        —           —          133,223   

DEFERRED DEBT ISSUANCE COSTS, NET

     13,918        —          —           —          13,918   

INVESTMENT IN SUBSIDIARIES

     —          1,012        —           (1,012     —     

OTHER ASSETS

     6,008        30,024        —           —          36,032   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL ASSETS

   $ 1,191,382      $ 2,034,217      $ 2,756       $ (2,054,333   $ 1,174,022   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY

           

CURRENT LIABILITIES

           

Accounts payable

   $ —        $ 168,425      $ 270       $ —        $ 168,695   

Accrued payroll and related taxes and benefits

     9,177        69,116        200         —          78,493   

Deferred income taxes current

     5,602        —          —           (5,298     304   

Other accrued liabilities

     23,690        51,339        281         —          75,310   

Deferred revenue

     —          24,626        —           —          24,626   

Intercompany

     136,742        1,201,280        —           (1,338,022     —     

Current portion of long-term debt

     31,000        710,031        —           (710,000     31,031   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT LIABILITIES

     206,211        2,224,817        751         (2,053,320     378,459   

LONG-TERM DEBT, net of current portion

     1,037,759        —          —           —          1,037,759   

DEFERRED INCOME TAXES

     14,049        57,509        —           —          71,558   

INVESTMENT IN SUBSIDIARIES

     306,926        —          —           (306,926     —     

INCOME TAXES PAYABLE & OTHER NON-CURRENT LIABILITIES

     7,433        58,817        993         —          67,243   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES

     1,572,378        2,341,143        1,744         (2,360,246     1,555,019   

COMMITMENTS AND CONTINGENCIES

           

STOCKHOLDERS’ (DEFICIT) EQUITY

           

Additional paid-in capital

     699,413        (184,453     —           184,454        699,414   

(Accumulated deficit) retained earnings

     (1,080,409     (122,473     1,012         121,459        (1,080,411
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ (DEFICIT) EQUITY

     (380,996     (306,926     1,012         305,913        (380,997
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

   $ 1,191,382      $ 2,034,217      $ 2,756       $ (2,054,333   $ 1,174,022   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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CONDENSED CONSOLIDATING BALANCE SHEETS

December 31, 2012

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  
ASSETS            

CURRENT ASSETS

           

Cash and cash equivalents

   $ 23,457      $ 3,354      $ 269       $ —        $ 27,080   

Accounts receivable less allowance for doubtful accounts

     —          343,100        1,321         —          344,421   

Inventories

     —          67,857        218         —          68,075   

Deferred expenses

     —          3,798        —           —          3,798   

Intercompany

     667,745        475,973        —           (1,143,718     —     

Prepaid expenses and other current assets

     835        16,043        12         —          16,890   

Intercompany loan

     710,000        —          —           (710,000     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT ASSETS

     1,402,037        910,125        1,820         (1,853,718     460,264   

PATIENT SERVICE EQUIPMENT, less accumulated depreciation

     —          186,457        3         —          186,460   

PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET

     37,210        39,430        183         —          76,823   

GOODWILL

     —          258,725        —           —          258,725   

INTANGIBLE ASSETS, NET

     50,000        83,781        —           —          133,781   

DEFERRED DEBT ISSUANCE COSTS, NET

     30,207        —          —           —          30,207   

INVESTMENT IN SUBSIDIARIES

     —          774        —           (774     —     

OTHER ASSETS

     5,390        21,058        —           —          26,448   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL ASSETS

   $ 1,524,844      $ 1,500,350      $ 2,006       $ (1,854,492   $ 1,172,708   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

           

CURRENT LIABILITIES

           

Accounts payable

   $ 4,751      $ 152,593      $ 186       $ —        $ 157,530   

Accrued payroll and related taxes and benefits

     8,774        61,562        211         —          70,547   

Deferred income taxes

     3,578        (2,592     —           —          986   

Other accrued liabilities

     19,883        54,536        45         —          74,464   

Deferred revenue

     —          27,785        —           —          27,785   

Intercompany

     402,475        741,243        —           (1,143,718     —     

Current portion of long-term debt

     25,000        710,195        —           (710,000     25,195   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT LIABILITIES

     464,461        1,745,322        442         (1,853,718     356,507   

LONG-TERM DEBT, net of current portion

     1,017,500        15        —           —          1,017,515   

DEFERRED INCOME TAXES

     15,222        53,685        —           —          68,907   

INVESTMENT IN SUBSIDIARIES

     351,927        —          —           (351,927     —     

INCOME TAXES PAYABLE & OTHER NON-CURRENT LIABILITIES

     7,158        53,255        790         —          61,203   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES

     1,856,268        1,852,277        1,232         (2,205,645     1,504,132   

COMMITMENTS AND CONTINGENCIES

           

STOCKHOLDERS’ EQUITY

           

Common stock

     —          —          —           —          —     

Additional paid-in capital

     695,211        (247,215     —           247,215        695,211   

(Accumulated deficit) retained earnings

     (1,026,635     (104,712     774         103,938        (1,026,635
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ (DEFICIT) EQUITY

     (331,424     (351,927     774         351,153        (331,424
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

   $ 1,524,844      $ 1,500,350      $ 2,006       $ (1,854,492   $ 1,172,708   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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Table of Contents

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2013

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 607,479      $ 2,992      $ (3,274   $ 607,197   

Income from subsidiaries

     53,034        —          —          (53,034     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL NET REVENUES

     53,034        607,479        2,992        (56,308     607,197   

TOTAL COST OF NET REVENUES

     —          280,901        2,008        (3,274     279,635   

Provision for doubtful accounts

     —          24,083        (150     —          23,933   

Selling, distribution and administrative

     37,826        309,795        844        (53,034     295,431   

Amortization of intangible assets

     —          186        —          —          186   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     37,826        614,965        2,702        (56,308     599,185   

OPERATING INCOME (LOSS)

     15,208        (7,486     290        —          8,012   

Interest expense

     23,150        7        —          —          23,157   

Loss on early retirement of debt

     —          —          —          —          —     

Interest income and other

     (11,669     11,339        142        —          (188
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

INCOME (LOSS) BEFORE TAXES

     3,727        (18,832     148        —          (14,957

Income tax expense (benefit)

     5,496        (4,668     —          —          828   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET (LOSS) INCOME

     (1,769     (14,164     148        —          (15,785

Equity in income of subsidiaries, net of tax

     (14,016     148        —          13,868        —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (15,785   $ (14,016   $ 148      $ 13,868      $ (15,785
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2013

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 1,838,843      $ 8,028      $ (4,296   $ 1,842,575   

Income from subsidiaries

     152,479        —          —          (152,479     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL NET REVENUES

     152,479        1,838,843        8,028        (156,775     1,842,575   

TOTAL COST OF NET REVENUES

     —          812,548        4,925        (4,296     813,177   

Provision for doubtful accounts

     —          60,280        (120     —          60,160   

Selling, distribution and administrative

     116,739        921,519        2,256        (152,479     888,035   

Amortization of intangible assets

     —          558        —          —          558   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     116,739        1,794,905        7,061        (156,775     1,761,930   

OPERATING INCOME

     35,740        43,938        967        —          80,645   

Interest expense

     89,520        26        —          —          89,546   

Loss on early retirement of debt

     44,221        —          —          —          44,221   

Interest income and other

     (39,036     37,221        474        —          (1,341
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (58,965     6,691        493        —          (51,781

Income tax expense (benefit)

     2,689        (694     —          —          1,995   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET (LOSS) INCOME

     (61,654     7,385        493        —          (53,776

Equity in income of subsidiaries, net of tax

     7,878        493        —          (8,371     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (53,776   $ 7,878      $ 493      $ (8,371   $ (53,776
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2012

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 606,729      $ 2,262       $ (518   $ 608,473   

Income from subsidiaries

     46,342        —          —           (46,342     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL NET REVENUES

     46,342        606,729        2,262         (46,860     608,473   

TOTAL COST OF NET REVENUES

     —          256,563        1,209         (518     257,254   

Provision for doubtful accounts

     —          13,440        55         —          13,495   

Selling, distribution and administrative

     40,048        312,726        699         (46,342     307,131   

Amortization of intangible assets

     —          344        —           —          344   

Non-cash impairment of intangible assets

     280,000        —          —           —          280,000   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     320,048        583,073        1,963         (46,860     858,224   

OPERATING (LOSS) INCOME

     (273,706     23,656        299         —          (249,751

Interest expense

     33,562        232        —           —          33,794   

Interest income and other

     (15,290     14,832        147         —          (311
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (291,978     8,592        152         —          (283,234

Income tax benefit

     (106,370     (1,153     —           —          (107,523
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

     (185,608     9,745        152         —          (175,711

Equity in income of subsidiaries, net of tax

     9,897        152        —           (10,049     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (175,711   $ 9,897      $ 152       $ (10,049   $ (175,711
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2012

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 1,805,692      $ 7,389       $ (1,223   $ 1,811,858   

Income from subsidiaries

     148,694        —          —           (148,694     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL NET REVENUES

     148,694        1,805,692        7,389         (149,917     1,811,858   

TOTAL COST OF NET REVENUES

     —          762,506        3,834         (1,223     765,117   

Provision for doubtful accounts

     —          45,978        165         —          46,143   

Selling, distribution and administrative

     127,996        951,876        2,212         (148,694     933,390   

Amortization of intangible assets

     306        1,182        —           —          1,488   

Non-cash impairment of intangible assets

     280,000        —          —           —          280,000   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     408,302        1,761,542        6,211         (149,917     2,026,138   

OPERATING (LOSS) INCOME

     (259,608     44,150        1,178         —          (214,280

Interest expense

     100,616        573        —           —          101,189   

Interest income and other

     (46,747     45,088        577         —          (1,082
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (313,477     (1,511     601         —          (314,387

Income tax benefit

     (105,803     (530     —           —          (106,333
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

     (207,674     (981     601         —          (208,054

Equity in income of subsidiaries, net of tax

     (380     601        —           (221     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (208,054   $ (380   $ 601       $ (221   $ (208,054
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2013

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Consolidating
Adjustments
     Consolidated  
     (in thousands)  

OPERATING ACTIVITIES

           

NET CASH PROVIDED BY OPERATING ACTIVITIES

   $ 15,759      $ 62,081      $ 139      $ —         $ 77,979   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

INVESTING ACTIVITIES

           

Purchases of patient service equipment and property, equipment and improvements

     (12,543     (94,055     (10     —           (106,608

Proceeds from sale of patient service equipment and other

     64        29,727        —          —           29,791   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (12,479     (64,328     (10     —           (76,817
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

FINANCING ACTIVITIES

           

Proceeds from ABL Facility

     502,000        —          —          —           502,000   

Payments on ABL Facility

     (505,000     —          —          —           (505,000

Payments on Series A-1 Notes

     (700,000     —          —          —           (700,000

Payments on Series A-2 Notes

     (160,000     —          —          —           (160,000

Proceeds from Senior Secured Term Loan

     900,000        —          —          —           900,000   

Payments on Senior Secured Loan

     (2,250     —          —          —           (2,250

Debt issuance costs on Senior Secured Term Loan

     (10,628     —          —          —           (10,628

Payment of original issue discount associated with Senior Secured Term Loan

     (9,000     —          —          —           (9,000

Payments on other long-term debt

     —          (180     —          —           (180

Premium paid on early retirement of Series A-1 and A-2 Notes

     (24,641     —          —          —           (24,641
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

NET CASH USED IN FINANCING ACTIVITIES

     (9,519     (180     —          —           (9,699
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

     (6,239     (2,427     129        —           (8,537

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     23,457        3,354        269        —           27,080   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 17,218      $ 927      $ 398      $ —         $ 18,543   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

 

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2012

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Consolidating
Adjustments
    Consolidated  
     (in thousands)  

OPERATING ACTIVITIES

          

NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES

   $ (13,717   $ 79,970      $ 307      $ 10,815      $ 77,375   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

INVESTING ACTIVITIES

          

Purchases of patient service equipment and property, equipment and improvements

     (6,881     (114,123     (4     —          (121,008

Proceeds from disposition of assets

     15        34,529        —          —          34,544   

Cash paid for acquisitions

     —          (121     —          —          (121
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (6,866     (79,715     (4     —          (86,585
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

FINANCING ACTIVITIES

          

Proceeds from ABL Facility

     317,000        —          —          —          317,000   

Payments on ABL Facility

     (321,000     —          —          —          (321,000

Payments on other long-term debt

     —          (256     —          —          (256

Cash paid on profit interest

     (102     —          —          —          (102
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET CASH USED IN FINANCING ACTIVITIES

     (4,102     (256     —          —          (4,358
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

     (24,685     (1     303        10,815        (13,568

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     43,552        1        475        (14,932     29,096   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 18,867      $ —        $ 778      $ (4,117   $ 15,528   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not be indicative of future performance. Our forward-looking statements reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties such as the current global economic uncertainty, including government legislative and budget developments that could continue to affect reimbursement levels, that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in the “Risk Factors” and “Forward-Looking Statements” sections of this quarterly report on Form 10-Q. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and the related notes and other information included in this quarterly report on Form 10-Q. References in this report to the “Company,” “we,” “us” and “our” refer to Apria Healthcare Group Inc. and its subsidiaries, unless otherwise noted or the context requires otherwise.

Overview. We have four core service lines: home respiratory therapy, home medical equipment, home infusion therapy, including total parenteral nutrition (“TPN”) services, and enteral nutrition services. In these core service lines, we offer a variety of patient care management programs, including clinical and administrative support services, products and supplies, most of which are prescribed by a physician as part of a care plan. We provide these services to patients through approximately 510 locations throughout the United States. We have two reportable operating segments:

 

    home respiratory therapy and home medical equipment; and

 

    home infusion therapy.

Recent Events

Internal Restructuring. On July 1, 2013, we separated and transferred the assets and operations of our enteral nutrition business to certain wholly-owned subsidiaries of the home infusion therapy reporting unit to enable it to function more autonomously and achieve certain operating efficiencies. This separation and transfer was part of an ongoing effort to streamline our organizational structure and operations. In connection with the separation and transfer, certain of our subsidiaries entered into transition services agreements in order to facilitate the transition process.

Strategy

Our strategy is to position ourselves in the marketplace as a high-quality, cost-efficient provider of a broad range of healthcare services and patient care management programs to our customers. The specific elements of our strategy are to:

 

    Grow profitable revenue and market share. We are focused on growing profitable revenues and increasing market share in our core home infusion therapy, enteral nutrition and home respiratory therapy service lines. We have undertaken a series of steps towards this end. Since our acquisition of Coram in December 2007, we have grown our revenue and patient census in the home infusion therapy segment (including enteral nutrition) and expanded our platform for further cross-selling opportunities. Our acquisition of Praxair’s homecare business in the United States in March 2011 expanded our geographic footprint and market share in several key markets of the country. Since early 2010, we have expanded our home respiratory therapy and home medical equipment sales force by 19%, of which 8% relates to the acquisition of Praxair assets. During the same time period, the home infusion therapy sales force has grown by 45% and become further stratified with dedicated sales resources allocated to fast-growing therapeutic service lines. This expansion in both reporting units has allowed us to more efficiently cover each market served by promoting our products and services to physicians, clinical specialists, hospital discharge planners and managed care organizations. On an ongoing basis, we continually evaluate the size of our sales force and the products / services we offer to the market within the context of changing market conditions, the competitive landscape, pricing, opportunities and threats. Additionally, this may include exiting certain products, markets, payors, and hospital agreements or reorganizing of certain of our operations.

 

    Continue to participate in the managed care market and pursue opportunities created by healthcare reform. We participate in the managed care market as a long-term strategic customer group because we believe that our scale, expertise, nationwide presence and array of home healthcare products and services enable us to sign preferred provider agreements and participating Health Maintenance Organization (“HMO”) agreements with managed care organizations. Managed care represented approximately 72% of our total net revenues for the nine months ended September 30, 2013. Healthcare reform may create new models of care, such as Accountable Care Organizations and state insurance exchanges. Our size and scope of services may give us a competitive advantage in serving these new markets.

 

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    Leverage our national distribution infrastructure. With approximately 510 locations and a robust platform supporting shared national services, we believe that we can efficiently add products, services and patients to our systems to grow our revenues and leverage our cost structure. For example, we have successfully leveraged this distribution platform across a number of product and service offerings, including a continuous positive airway pressure (“CPAP”) / bi-level supply replenishment program, enteral nutrition and negative pressure wound therapy (“NPWT”) services, and we are using our nursing capacity to provide infusion services through our growing network of ambulatory infusion suites. We seek to achieve margin improvements through operational initiatives focused on the continual reduction of costs and delivery of incremental efficiencies. At the same time, we believe that it is essential to consistently deliver superior customer service in order to increase referrals and retain existing patients. Performance improvement initiatives are underway in all aspects of our operations including customer service, patient and referral satisfaction, logistics, supply chain, clinical services and billing/collections. We believe that by being responsive to the needs of our patients and payors we can provide ourselves with opportunities to take market share from our competitors.

 

    Continue to lead the industry in accreditation. The Medicare Improvements for Patients and Providers Act of 2008 (“MIPPA”) made accreditation mandatory for Medicare providers of durable medical equipment, prosthetics, orthotics and supplies (“DMEPOS”), effective October 1, 2009, per Centers for Medicare and Medicaid Services (“CMS”) regulation. We were the first durable medical equipment provider to seek and obtain voluntary accreditation from The Joint Commission (the “Commission”). In June 2013, we completed a nationwide independent triennial accreditation renewal process conducted by The Joint Commission and the Commission renewed our accreditation for another three years. The Commission accreditation encompasses our full complement of services including home health, home medical equipment, clinical respiratory, ambulatory infusion services, pharmacy dispensing, and clinical consultant pharmacist services. In June 2013, we celebrated our 25th anniversary of our initial accreditation by the Commission—more years than any other homecare provider.

We review our business on an ongoing basis in the light of current and anticipated market conditions and other factors and, from time to time, may undertake restructuring efforts and/or engage in dispositions of our existing assets or businesses in order to optimize our overall business, performance or competitive position. From time to time, we may also engage in acquisitions of new assets and/or businesses, some of which may be significant. In addition, significant dispositions or restructuring transactions could result in material reductions of our assets, revenues or profitability or otherwise have a material adverse effect on our results of operations, cash flow and capital resources. To the extent any such decisions are made, we would likely incur costs, expenses, impairment and/or restructuring charges associated with such transactions, which could be material.

Critical Accounting Policies. We consider the accounting policies that govern revenue recognition and the determination of the net realizable value of accounts receivable to be the most critical in relation to our consolidated financial statements. These policies require the most complex and subjective judgments of management. Additionally, the accounting policies related to goodwill, long-lived assets, share-based compensation and income taxes require significant judgment. These policies are presented in detail in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section in our Annual Report on Form 10-K for the year ended December 31, 2012.

Government Regulation

We are subject to extensive government regulation, including numerous laws directed at regulating reimbursement of our products and services under various government programs and preventing fraud and abuse, as more fully described below. We maintain certain safeguards intended to reduce the likelihood that we will engage in conduct or enter into arrangements in violation of these restrictions. Corporate contract services and legal department personnel review and approve written contracts with vendors, manufacturers, subcontractors, service providers and other entities, as applicable. We also maintain various educational and internal audit programs designed to keep our managers updated and informed regarding developments of new rules, regulations, policies and/or procedures and to reinforce to employees our policy of strict compliance in this area. Federal and state laws require that we obtain facility and other regulatory licenses and that we enroll as a supplier with federal and state health programs. Under various federal and state laws, we are required to make filings or submit notices in connection with transactions that might be defined as a change of control of us or of organizations we acquire. We are aware of these requirements and routinely make such filings with, and seek such approvals from, the applicable regulatory agencies. Notwithstanding these measures, due to changes in and new interpretations of such laws and regulations, and changes in our business, among other factors, violations of these laws and regulations may still occur, which could subject us to civil and criminal enforcement actions; licensure revocation, suspension or non-renewal; severe fines and penalties; the repayment of amounts previously paid to us and even the termination of our ability to provide services, including those provided under certain government programs such as Medicare and Medicaid. See “Risk Factors—Risks

 

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Relating to Our Business—Continued Reductions in Medicare and Medicaid Reimbursement Rates and the Comprehensive Healthcare Reform Law Could Have a Material Adverse Effect on Our Results of Operations and Financial Condition” and “Risk Factors—Risks Relating to Our Business—Our Failure To Maintain Required Licenses Could Impact Our Operations.

Medicare and Medicaid Revenues. In the three months ended September 30, 2013, approximately 22% and 5% of our total net revenues were reimbursed by the Medicare and state Medicaid programs. In the nine months ended September 30, 2013, approximately 23% and 6% of our total net revenues were reimbursed by the Medicare and state Medicaid programs. No other third-party payor represented more than 9.1% of our total net revenues for the three and nine months ended September 30, 2013. The majority of our revenues are derived from rental income on equipment rented and related services provided to patients, sales of equipment, supplies and pharmaceuticals and other items we sell to patients for patient care under fee-for-service arrangements. Revenues derived from capitation arrangements represented 7% of total net revenues for the three and nine months ended September 30, 2013, respectively.

Medicare Reimbursement. There are a number of legislative and regulatory initiatives in Congress and at CMS that affect or may affect Medicare reimbursement policies for products and services we provide. Specifically, a number of important legislative changes that affect our business were included in the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“MMA”); the Deficit Reduction Act of 2005 (“DRA”); MIPPA, which became law in 2008, the comprehensive healthcare reform law signed in March 2010 (“the Reform Package”), the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012. These Acts and their implementing regulations and guidelines contain numerous provisions that are significant to us and continue to have an impact on our operations today.

Budget Control Act of 2011. In August 2011, the Budget Control Act of 2011 was signed into law. The Budget Control Act of 2011 authorized increases in the United States’ debt limit of at least $2.1 trillion, established caps on funding appropriations estimated to reduce federal spending by $917 billion over the next ten years, and created the Joint Select Committee on Deficit Reduction (“Joint Committee”), a bipartisan Congressional committee instructed to develop legislation to reduce the federal deficit by at least another $1.5 trillion over the ten-year period of fiscal years 2012 – 2021. Because Congress and the President failed to enact legislation reducing the deficit by at least $1.2 trillion over the ten-year period of fiscal years 2012 – 2021 by the January 15, 2012 deadline, automatic spending reductions in fiscal years 2013 – 2021 through sequestration (the required cancellation of budgetary resources) were triggered. Under sequestration, certain federal programs are protected, including Medicaid. However, effective April 1, 2013, sequestration caused payments to Medicare providers and suppliers to be reduced by 2%. This reduction applies to both competitively bid and non-competitively bid markets and products. Unless Congress takes action to change the law, federal spending will be subject to sequestration until fiscal year 2022. These reductions, along with any further reductions in provider and supplier reimbursement rates under federal healthcare programs, could have a material adverse effect on our financial condition and results of operations.

DMEPOS Competitive Bidding. The MMA required implementation of a competitive bidding program for certain DMEPOS items. By statute, CMS was originally required to implement the DMEPOS competitive bidding program over time, with Round 1 of competition occurring in portions of 10 of the largest Metropolitan Statistical Areas (“MSAs”) in 2007, launch of the program in 2008 and in 70 additional markets in 2009, and then in additional markets after 2009.

Although CMS administered a bid process in 2007 and launched the original Round 1 program in mid-2008, shortly thereafter, MIPPA was enacted. This delayed the DMEPOS competitive bidding program by requiring that Round 1 competition commence in 2009 and required a number of program reforms prior to CMS re-launching the program. Changes mandated by MIPPA included requirements for the government to administer the program more transparently, exemption of certain DMEPOS products from the program and a new implementation schedule.

Under MIPPA, the initial Competitive Bidding Areas (“CBAs”) and product categories subject to rebidding in the Round 1 Rebid were very similar to those of Round 1. However, MIPPA excluded Negative Pressure Wound Therapy Pumps and Related Supplies and Accessories as a competitive bidding product category in Round 1 and permanently excluded Group 3 Complex Rehabilitative Power Wheelchairs and Related Accessories as a competitive bidding product category.

We received contract offers for a substantial majority of the Round 1 Rebid bids we submitted. The rates took effect on January 1, 2011 for the Round 1 Rebid markets and will remain in place through December 31, 2013. CMS reported that the average price reduction for all products in all Round 1 Rebid CBAs was 32%. After the price reduction and volume growth / reduction experienced in the Round 1 Rebid markets is accounted for, an estimated $16.6 million of net revenue was subject to competitive bidding in the calendar year ended December 31, 2012.

In April 2012, CMS announced the product categories to be included in the “recompete” of the Round 1 Rebid contracts and an associated schedule. The Round 1 Recompete included additional products and CMS elected to group products in an all-new way, such as a “Respiratory Equipment” category which included oxygen therapy, sleep therapy and

 

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nebulizers, and a “General Home Equipment” category which includes a variety of home medical equipment, accessories and supplies. CMS concluded the bid submission process in the fourth quarter of 2012. New rates for the Round 1 Recompete were announced in early October 2013 and are scheduled to take effect on January 1, 2014. CMS reported that the average price reduction for all products in all Round 1 Recompete CBAs was 37%, but several individual product categories will be impacted by greater price reductions that are more analogous to Round 2 rates. We estimate that once the additional products which are included in the Round 1 Recompete program are accounted for, the estimated annual total net revenues associated with items subject to competitive bidding in the Round 1 markets was approximately $17.0 million for the 2012 calendar year, or 0.7% of our annual total net revenues. After applying the actual Single Payment Amounts (“SPAs”) for each impacted CBA to our actual 2012 revenue for the product categories included in the bidding program, we estimate that the incremental Round 1 revenue reduction as compared to the Round 1 Rebid rates will be $2.9 million before any changes in volume are accounted for as a result of the contract offers received and accepted.

Notwithstanding the changes implemented by MIPPA, competitive bidding imposes a significant risk to DMEPOS suppliers under the rules governing both the competitive bidding program and other existing Medicare rules concerning medical necessity documentation. If a DMEPOS supplier operating in a CBA is not awarded a contract for that CBA, the supplier generally will not be able to bill and be reimbursed by Medicare for DMEPOS items supplied in that CBA for the time period covered by the competitive bidding program unless the supplier meets certain exceptions or acquires a winning bidder. Because the applicable statutes mandate financial savings from the competitive bidding program, a winning contract supplier will receive lower Medicare payment rates under competitive bidding than the otherwise applicable DMEPOS fee schedule rates. As competitive bidding has been phased in across the country, we have experienced a reduction in reimbursement and an increase in administrative burdens associated with retrieving medical necessity documentation from referral sources and/or transitioning patients’ from previous suppliers. These factors impact all DMEPOS contract suppliers participating in the bidding program in impacted areas. In addition, there is an increasing risk that the competitive bidding prices will become a benchmark for reimbursement from other payors, as evidenced by the Administration’s 2013 and 2014 fiscal budget proposals which would limit state Medicaid reimbursement levels for certain durable medical equipment services and products to Medicare reimbursement rates for the same products and services in the same state. Neither MIPPA nor the Reform Package prevents CMS from adjusting prices for DMEPOS items in non-bid areas. Additionally, the Reform Package requires that all areas of the country are subject either to DMEPOS competitive bidding or payment rate adjustments using competitive bid pricing in a yet-to-be-determined method by 2016. Before using its authority to adjust prices in non-bid areas, MIPPA requires that CMS issue a regulation that specifies the methodology to be used and consider how prices through competitive bidding compare to costs for those items and services in the non-bid areas.

The Reform Package included additional changes to the Medicare DMEPOS competitive bidding program. Significantly, Round 2 of the competitive bidding program was expanded from 70 to 91 of the largest MSAs. Round 2 includes the majority of the same product categories as Round 1, but CMS expanded the program by (i) combining standard power wheelchairs and manual wheelchairs into a single new product category, (ii) including Negative Pressure Wound Therapy as a category in all Round 2 markets and (iii) including the Support Surfaces (Group 2 mattresses and overlays) category in all Round 2 markets. The bid process for Round 2 ended on March 30, 2012. CMS announced the Single Payment Amounts (“SPAs”) on January 30, 2013. The new Round 2 rates and guidelines took effect on July 1, 2013. We estimate that approximately $122 million, or approximately 5% of our net revenues for the fiscal year ending December 31, 2012 is subject to Round 2 of the competitive bidding program. CMS reported that the average payment reduction for Round 2 is 45%. After applying the actual SPAs for each impacted CBA to our actual 2012 revenue for the product categories included in the bidding program, we estimate that the annual Round 2 revenue reduction will be $57 million before any changes in volume are accounted for as a result of the contract offers received and accepted.

In addition, efforts to repeal the competitive bidding program altogether or mandate significant program changes continue. In March 2011, the Fairness in Medicare Bidding Act of 2011 (“FIMBA”) was introduced into the U.S. House of Representatives and referred to the House Subcommittee on Health. FIMBA would have repealed the program without specifying a reduction in the industry’s current reimbursement levels. Other efforts are underway by independent economists who seek to alter certain critical aspects of the program. Specifically, those efforts are designed to change the way in which CMS conducts the auction process itself, establishes the single payment rates, determines supplier capacity needed and related aspects which, if adopted by CMS in their entirety or in part, would change how the program would be administered. In September 2012, a bill titled “Medicare DMEPOS Market Pricing Program Act of 2012 was introduced in the U.S. House of Representatives and referred to the House Committees on Energy and Commerce and Ways and Means. This bill was introduced again in April 2013 as the “Medicare DMEPOS Market Pricing Program Act of 2013” and was referred to the same committees as well as to the House Appropriations Committee. The bill would repeal the current DMEPOS competitive bidding program as designed and replace it with a modified auction program. In January 2013, a bill titled “Small Supplier Fairness in Bidding Competition Act of 2013” was introduced in the U.S. House of Representatives to repeal the competitive bidding program and was referred to the House Committees on Energy and Commerce, Ways and Means, Judiciary and

 

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Small Business. Finally, a bill titled “Transparency and Accountability in Medicare Bidding Act of 2013” was introduced in the U.S. House of Representatives in June 2013 and referred to the House Committees on Energy and Commerce and Ways and Means. This legislation would alter certain aspects of the already-implemented rounds of the competitive bidding program, give Congress an opportunity to reform the program and also obtain an evaluation of the program by auction experts.

We believe that our geographic coverage, clinical marketing programs and purchasing strength provide competitive advantages to maintain and enhance market share under Medicare competitive bidding. We were offered competitive bidding contracts for a substantial majority of the CBAs and products for which we submitted bids in the three most recent rounds of bidding. However, there is no guarantee that we will garner additional market share as a result of these contracts. Both the Round 1 Recompete and Round 2 of the DMEPOS competitive bidding program include products which may require us to subcontract certain services or products to be performed on our behalf, and there is no guarantee that CMS will either approve such subcontracting arrangements or that the subcontractor will perform its contractual obligations to us. Certain aspects of the program’s oversight and administration remain unclear in CMS’ written regulations that have been promulgated and therefore individual negotiations may be required between us, CMS and/or its contractors. The outcome of such negotiations cannot be predicted or assured. Under the current competitive bidding regulations, in the CBAs, and for the products, for which we do not have competitive bidding contracts, we will generally not be allowed to supply Medicare beneficiaries in the CBA with products subject to competitive bidding for the contract term of the program, unless we elect to continue to service existing patients under the “grandfathering provision” of the program’s final rule for certain products. In addition, stringent medical necessity documentation criteria required by Medicare and its contractors for initial patient setups are also applicable to those patients who seek to transition their care to us in the CBAs. Therefore, it may be necessary for patients to requalify for the products and services they received from their previous suppliers solely due to missing or incomplete documentation in their physician’s, hospital’s or previous supplier’s records. Because of our combination of both managed care and traditional business, we believe we can nevertheless maintain a favorable overall market position in a particular CBA even if we are not a contract supplier for certain products.

Medicare Fee Schedule for DMEPOS and Consumer Price Index-Urban (“CPI-U”) Adjustments. In addition to the adoption of the DMEPOS competitive bidding program, the MMA implemented a five-year freeze on annual Consumer Price Index (“CPI”) payment increases for most durable medical equipment from 2004 to 2008. In MIPPA, in order to offset the cost of delaying the implementation of the DMEPOS competitive bidding program, Congress approved a nationwide average payment reduction of 9.5% in the DMEPOS fee schedule payments for those product categories included in Round 1, effective January 1, 2009. Product categories subject to competitive bidding but furnished in non-competitive bid areas were eligible to receive mandatory annual CPI-U updates beginning in 2010. Competitively bid items and services in metropolitan areas with contracts in place are not eligible to receive a CPI-U payment update during a contract period, which, except for the mail order diabetes contract, is currently a three-year period. The CPI-U for 2012 was +3.6%, but the “multi-factor productivity adjustment” remained -1.2%, so the net result was a 2.4% increase in DMEPOS fee schedule payments in 2012 for items and services not included in an area subject to competitive bidding. For 2013, the CPI-U is +1.7%, but the adjustment is -0.9%, so the net result is a 0.8% increase in DMEPOS fee schedule payments in 2013 for the same items and services as described above.

The Administration’s 2014 fiscal budget proposal would change the way the government calculates measures of inflation for government programs, among other things. As compared to the current CPI method, the switch in the inflation formula would cut spending on government programs by $130 billion over 10 years. At this time, it is unclear how this change, if implemented, would impact annual DMEPOS payment updates. It is possible that such a change, if implemented, could have an adverse impact on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

Capped Rentals, Oxygen Equipment and PAP Patient Compliance. Under the DRA, ownership of certain durable medical equipment categorized by CMS in the “capped rental” category (e.g., hospital beds, wheelchairs, nebulizers, patient lifts and PAP devices) automatically transfers to the Medicare beneficiary at the end of a maximum rental period. As of January 1, 2006, the maximum rental period for this category became 13 months. Additional DRA regulations published subsequently established new payment classes for oxygen equipment, including transfilling and portable equipment, new monthly rental reimbursement rates, and new reimbursement rates for the delivery of oxygen contents.

With respect to oxygen equipment, Medicare reimbursement is limited to a maximum of 36 months, after which time the equipment continues to be owned by the home oxygen provider for as long as the patient’s medical need exists. The provider that billed Medicare for the 36th month continues to be responsible for the patient’s care, even in a CBA or in the event of a patient’s relocation. Limited reimbursement is available to providers from months 37 through 60, depending on the oxygen modality and patient’s needs. CMS does not reimburse suppliers for oxygen tubing, cannulas and supplies patients may need between the 37th and 60th months of oxygen therapy and requires that the initial supplier of oxygen therapy make

 

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arrangements with another supplier if a patient relocates temporarily or permanently outside of the initial supplier’s service area. In addition, CMS did not establish any reimbursement rates for non-routine services patients may require after the 36-month rental period. In fact, implementing regulations impose other repair and replacement obligations on suppliers with respect to equipment that does not last the useful lifetime of the equipment, which CMS has generally defined as being five years. The existing implementing regulations to the DRA and MIPPA provisions limit supplier replacement of oxygen equipment during the rental period, and require suppliers to replace equipment that does not last the useful lifetime of the equipment. After the five year useful life is reached, the patient may request replacement equipment and, if he/she can be requalified for the Medicare benefit, a new maximum 36-month rental period would begin. The supplier may not arbitrarily issue new equipment. More recently, however, in response to reports of suppliers exiting the Medicare oxygen business both inside and outside of CBAs, CMS announced in late August 2013 that, effective immediately, a new supplier can replace oxygen equipment when accepting a transfer patient and can restart that patient’s 36-month rental period and reasonable useful lifetime of the equipment when the patient transitions to the new supplier (subject to qualifying or requalifying for Medicare coverage) and certain other administrative steps occur. CMS will consider the patient’s original oxygen equipment as lost. CMS has not yet released guidance on how suppliers can prove abandonment in these situations. However, CMS has stated that suppliers exiting the Medicare oxygen business must facilitate the transfers of their Medicare patients or risk being in violation of statutory and regulatory requirements.

Regarding repairs and maintenance of oxygen equipment, CMS revised its regulations so that for services provided on or after January 1, 2009, the implementing regulations permitted payment in calendar year 2009 only to suppliers for general maintenance and servicing of certain oxygen equipment every six months, beginning after the first six-month period elapsed after the initial 36-month rental period. CMS issued guidance in November 2009 continuing the general maintenance and servicing payments for certain oxygen equipment.

In a proposed rule issued in June 2010, CMS proposed to change the threshold rental month from which the original oxygen supplier would continue to be responsible for serving a patient, regardless of his/her move outside of the supplier’s service area, from the 36th to the 18th month. The agency sought public comments, and in a final rule published in November 2010, the agency indicated that it would not change its current policy but would continue to study the issue. We cannot speculate on any future changes CMS may make to its repair, maintenance and service, supply or other fee schedules related to oxygen. We may or may not continue to provide repair and maintenance service on oxygen equipment that has met the cap. We routinely evaluate the impact of the changes caused by all applicable legislation and regulations and adjust our operating policies accordingly.

In recent years, there have been legislative and executive branch efforts to further reduce the maximum rental period for oxygen therapy, equipment and related services. However, President Obama’s 2012, 2013 and 2014 budget proposals did not include a reduction in the oxygen rental period; neither did the Reform Package. Nonetheless, President Obama’s 2013 and 2014 fiscal budget proposals would limit the state Medicaid reimbursement levels for certain durable medical equipment services and products, including oxygen therapy, to Medicare reimbursement rates for the same products and services in the same state, including those impacted by the Medicare DMEPOS competitive bidding program. It is premature to know whether these or future budgets or proposals will contain such a provision or any other provisions based on these or future studies released by one or more government agencies.

CMS and the durable medical equipment Medicare administrative contractors (“DME MACs”) also have issued coverage determinations for positive airway pressure (“PAP”) devices, including CPAP and bi-level devices. Among other changes, the Medicare DME MAC local coverage determinations (“LCDs”) require additional documentation of clinical benefit of the PAP devices for continued coverage of the device beyond the first three months of therapy. Specifically, for PAP, documentation of clinical benefit must be demonstrated by: (1) a face-to-face clinical re-evaluation by the treating physician (between the 31st and 90th day) with documentation that symptoms of obstructive sleep apnea are improved; and (2) objective evidence of adherence to use of the PAP device, reviewed by the treating physician. The LCDs define adherence to therapy as the use of the PAP device greater than or equal to four (4) hours per night on 70% of nights during a consecutive 30-day period anytime during the first three months of initial usage. If the clinical benefit requirements are not met, then continued coverage of the PAP device and related accessories are denied by Medicare as not medically necessary. These policies also apply to any patients who seek to transition to our service from a non-contract supplier in a CBA; if the documentation is incomplete or insufficient to meet current Medicare audit standards, patients must undergo a protracted requalification process. We adjusted our operational model, patient care, device provision and payment policies to comply with the new compliance and documentation requirements when they were implemented. These requirements apply to Medicare Part B fee-for-service (FFS) patients, not to those patients enrolled in Medicare Advantage or commercial health plans, and Medicare Part B FFS patients represent a smaller portion of the overall PAP patient market. However, some commercial and Medicare Advantage payors have implemented the same, similar or, at times, more arduous rules as those adopted by Medicare. Despite our continuous and intensive efforts to educate patients about the importance of complying

 

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with their physician-prescribed therapy, some of our patients, or those who seek to transition to our care, do not meet the threshold for compliance. We continue to educate patients and referral sources concerning the importance of compliance with the patient’s prescribed therapy and the government’s need for documentation pertaining to initial and ongoing medical necessity. However, these and similar LCDs and trends are likely to continue to significantly impact the PAP industry.

Reimbursement for Inhalation and Infusion Therapy Drugs. As a result of the MMA, Medicare Part B reimbursement for most drugs, including inhalation drugs, is based upon the manufacturer-reported average sales price (“ASP”) (subject to adjustment each quarter), plus 6%. For inhalation drugs specifically, an additional dispensing fee applies. In November 2011, CMS published regulations adopting a price substitution policy also set forth in the MMA whereby reimbursement would be limited to 103% of the Average Manufacturer Price (“AMP”) when ASP exceeds AMP by 5% for either the two previous consecutive quarters or three of the previous four quarters. However, CMS did not apply that price substitution policy during 2012. Instead, CMS amended the regulations in November 2012 to exempt drugs that the FDA reports are in short supply. According to the CMS website, the quarterly ASP price file now includes a column in which CMS will identify those drugs for which an AMP-based payment amount has been substituted, and the amount of that payment. CMS publishes the ASP plus 6% payment levels in the month that precedes the first day of each quarter, and we have no way of knowing whether they will increase or decrease, because manufacturers report applicable ASP information directly to CMS. Since 2006, dispensing fees have remained at $57.00 for a 30-day supply for a new patient, $33.00 for each 30-day supply thereafter, and $66.00 for each 90-day supply.

Late in the last decade, there were other changes to the reimbursement methodology for certain inhalation drugs. When CMS changed its reimbursement methodology for calculating the ASP, CMS reduced its reimbursement to providers of Xopenex and albuterol. We implemented strategies intended to partially mitigate these negative impacts in our operations, including the discontinuation of the inhalation drug Xopenex from our inhalation pharmacies’ drug formulary and other formulary changes.

The Medicare reimbursement methodology for non-compounded, infused drugs administered through durable medical equipment, such as infusion pumps, was not affected by this MMA change. Nor are such infused drugs included in the Medicare DMEPOS competitive bidding program in any phase of bidding that is currently underway. Reimbursement for such drugs remains based upon either 95% of the October 1, 2003 Average Wholesale Price (“AWP”) or, for those drugs whose AWPs were not published in the applicable 2003 compendia, at 95% of the first published AWP. However, in a first quarter 2013 written response to an OIG report concerning Part B infusion drug reimbursement, CMS expressed an interest in including these drugs/therapies in future phases of the DMEPOS competitive bidding program. Such inclusion could occur no earlier than the Recompete of Round 2, which does not take effect until July 2016. Since CMS has not announced any definitive plans, at this time we cannot predict whether the Medicare reimbursement methodology for these drugs will in fact change, nor can we predict when these changes would occur or their potential impact on us.

A limited number of infusion therapies, supplies and equipment are covered by Medicare Part B. The MMA, through the Medicare Part D program, provided expanded coverage for certain home infusion therapy drugs, but excluded coverage for the corresponding supplies and clinical services needed to safely and effectively administer these drugs. We have contracted with a limited number of Medicare Part D payors with prescription drug plans.

Due to ongoing Part D and Part B coverage and payment issues associated with home infusion therapy, the industry is continuing to work with CMS, the Center for Medicare and Medicaid Innovation (“CMMI”) and Congress to rectify the Medicare coverage and payment limitations that restrict Medicare beneficiary and referral source access to quality home infusion therapy services. Bills were introduced in the 110th, 111th and 112th Congresses to consolidate home infusion therapy coverage under Part B. The Medicare Home Infusion Therapy Coverage Act would provide for Medicare infusion benefit coverage in a more comprehensive manner that is analogous to how the therapy is covered by the managed care sector, including Medicare Advantage plans. Industry representatives continue to present the cost-saving and patient care advantages of home infusion therapy to CMS, members of Congress and the Administration in an effort to, at a minimum, include a formal demonstration project in either CMS’s or the CMMI’s work plan or future legislation. In addition to a June 2010 report issued by the GAO, entitled “Home Infusion Therapy: Differences Between Medicare and Private Insurers’ Coverage,” testimony before the Senate Finance Committee in fall 2009 acknowledged the current gap in coverage and potential benefits of home infusion therapy to the Medicare program and beneficiaries. In June 2012, the Medicare Payment Advisory Commission (“MedPAC”), in its annual report to Congress, also acknowledged certain coverage gaps associated with home infusion therapy and concluded that additional research is warranted. During the same month, the House Ways and Means Subcommittee on Health held a hearing that focused on MedPAC’s report. Groups such as the National Home Infusion Association, in comments to the Subcommittee, criticized MedPAC’s report and recommended that there be a demonstration project to examine the benefit for home infusion therapy. In early 2013, President Obama signed into law legislation requiring a demonstration project providing Medicare coverage for items and services related to the in-home

 

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administration of intravenous immune globulin (“IVIG”). The broader industry continues to collect cost-benefit data that will provide an objective basis for Congress, CMS and/or the CMMI to make a decision to fund other such demonstration projects. At this time, we cannot predict whether additional legislation will be passed or whether CMS and/or the CMMI will include other demonstration projects in a future work plan.

In February 2013, the OIG released a report entitled, “Part B Payments for Drugs Infused Through Durable Medical Equipment”. The report compared the ASP of each DME infused drug to its AWP-based Medicare payment amount for every year between 2005 and 2011. The report found that, overall, Medicare payment amounts for DME infusion drugs exceeded ASPs by 54 to 122 percent annually. The report also found that Medicare spending on DME infusion drugs would have been reduced by 44% ($344 million) between 2005 and 2011, had payment been based on ASPs. However, the report found that for as many as one third of DME infusion drugs in each year, the payment amounts were below their ASPs, meaning that Medicare may be underpaying suppliers for those drugs. In the report, the OIG offered the following recommendations to CMS: (1) seek a legislative change requiring DME infusion drugs to be paid using the ASP methodology or (2) include DME infusion drugs in the next round of the DMEPOS competitive bidding program. CMS stated in its response to the OIG report that it is interested in including DME infusion drugs in a future round of the competitive bidding program but has not publicly commented on when this might occur. In addition, in order to preserve beneficiary access, and in the absence of wholesale reform of the Medicare home infusion therapy benefit, the government’s adoption of the ASP methodology for infusion drugs would require an offset by establishing a reasonable dispensing fee to cover the extensive non-drug cost of serving beneficiaries, not unlike what CMS implemented for Part B inhalation therapies in 2003. Due to the complexities of the issue and the current competitive bidding timelines, at this time we cannot predict whether the Medicare reimbursement methodology for DME infusion drugs will change or, if so, when it will change.

Enrollment and Accreditation of Durable Medical Equipment Suppliers; Surety Bond Requirements. While we support the elimination of fraudulent suppliers and are working with CMS to support these initiatives, some of the CMS initiatives and developments with respect to the enrollment and accreditation of providers could impact our operations in the future. For example, all durable medical equipment providers who bill the Medicare program for DMEPOS services and products are required by MIPPA to be accredited. Although we and all of our branches currently are accredited, if we or any of our branches lose accreditation, or if any of our new branches are unable to become accredited, that could have a material adverse effect on our results of operations, cash flow and capital resources.

CMS also requires that all durable medical equipment providers who bill the Medicare program maintain a surety bond of $50,000 per National Provider Identifier (“NPI”) number which Medicare has approved for billing privileges. We obtained the required surety bonds for all of our applicable locations before the October 2009 deadline and continue to do so for any new locations. In addition, the National Supplier Clearinghouse prescribes an elevated bond amount of $50,000 per occurrence of an adverse legal action within the 10 years preceding enrollment, reenrollment or revalidation. The rule is designed to ensure that Medicare can recover any erroneous payment amounts or civil money penalties up to $50,000 that result from fraudulent or abusive supplier billing practices.

In March 2013, the OIG released a report entitled, “Surety Bonds Remain an Underutilized Tool to Protect Medicare from Supplier Overpayments”. In the report, the OIG found that CMS did not have accurate surety bond information for all suppliers. Additionally, the OIG found that CMS has yet to recover millions of dollars in supplier debt resulting from overpayments. In its response to the OIG report, CMS stated that it will make appropriate updates and improvements in conjunction with the OIG’s recommendations. We believe our surety bonds are complete and accurate, but despite our best efforts, we cannot predict what follow-up activities CMS may undertake or new requirements it may implement in the future, or their impact on us.

In recent years, CMS has announced enhancements to its program integrity initiatives designed to identify and prevent waste, fraud and abuse. The initiatives include: (i) conducting more stringent reviews of DMEPOS suppliers’ applications, including background checks of new DMEPOS suppliers’ principals and owners to ensure they have not been suspended by Medicare; (ii) making unannounced site visits to suppliers and home health agencies to ensure they are active, legitimate businesses; (iii) implementing extensive pre- and post-payment claims review; (iv) verifying the relationship between physicians who order a large volume of DMEPOS equipment and the beneficiaries for whom they ordered these services; and (v) identifying and visiting beneficiaries to ensure appropriate receipt of Medicare-reimbursable items and services. We work cooperatively with CMS and its contractors in response to these initiatives but cannot predict whether CMS’s various program integrity efforts will or will not negatively impact our operations.

In February 2011, CMS released a final rule implementing certain provisions of the Reform Package intended to prevent fraud, waste and abuse. This final rule includes new requirements regarding enrollment screening, enrollment application fees, payment suspension, temporary moratoria on enrollment and supplier termination. Significantly, as part of the final rule, CMS classified providers and suppliers as limited, moderate and high risk according to their risk of fraud,

 

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waste and abuse. Currently enrolled DMEPOS suppliers are classified in the moderate risk category while newly enrolled DMEPOS suppliers are classified in the high risk category. As such, DMEPOS suppliers will be under greater scrutiny relative to many other healthcare providers and suppliers. In October 2011 and again in March 2013, Senate representatives of key committees with jurisdiction over Medicare / Medicaid sent letters to U.S. Secretary of Health and Human Services Kathleen Sebelius, asking for an explanation as to why CMS has not yet imposed temporary moratoria on the enrollment of new providers and suppliers where there is a high risk for fraud. More recently, in July 2013, CMS announced the first temporary moratoria on new provider enrollment. Although this moratoria only affects home health and ambulance providers in selected geographic areas, CMS is continuing to monitor fraud trends and risk factors across various types of providers and suppliers and may exercise this authority again so that it impacts DMEPOS suppliers. Additionally, CMS is implementing a provider and supplier enrollment screening system that automates its pre-enrollment risk assessment and screening processes. In March 2013, CMS announced that if Medicare claims are submitted with dates of service on or after May 1, 2013, if a referring physician / supplier were not registered in this system, submitted claims would be denied. According to CMS about 1% of physicians nationwide are not registered. However, in April 2013, CMS announced a temporary delay in implementing ordering and referring denial edits. We have undertaken extensive efforts to ensure that our referral sources are registered with the system, but a small percentage remains unregistered. We work cooperatively with CMS and its contractors in response to these initiatives to prevent fraud, waste and abuse but cannot predict whether CMS’s various program integrity efforts will negatively impact our operations.

In 2010, CMS implemented more stringent standards for DMEPOS suppliers, pertaining to enrollment standards and participation requirements, all of which DMEPOS suppliers must meet to establish and maintain billing privileges in the Medicare program. In 2012, CMS revised four of the 30 Medicare supplier standards that apply to our business. These concern direct solicitation of Medicare beneficiaries, the use of licensed subcontractors to perform certain services on a supplier’s behalf and certain state licensure exceptions. Our policies and procedures comply with the revised standards.

Congress now requires HHS to implement the Recovery Audit Contractor (“RAC”) initiative as a permanent, nationwide program. Prior to initiating any audits, RACs are required to obtain CMS’s pre-approval of the issue that will be subject to audit, and then post the approved audit issue on their websites. All RACs now post CMS-approved audit issues on their websites. The currently posted approved audit issues include those which apply to durable medical equipment suppliers. States have also implemented similar state Medicaid audit programs, often known as Medicaid Integrity Contractors (“MICs”). In addition, the Reform Package requires states to establish contracts with RACs to identify underpayments and overpayments and to recoup overpayments made for services provided under state Medicaid programs. Absent an exception, states were required to implement their RAC programs by January 1, 2012. We cannot at this time quantify any negative impact that the expansion of the RAC program or other similar programs may have on us.

Another group of auditors is the Zone Program Integrity Contractors (“ZPICs”), who are responsible for ensuring the integrity of all Medicare-related claims. The ZPICs assumed the responsibilities previously held by Medicare’s Program Safeguard Contractors (“PSCs”). Industry-wide, ZPIC audit activity has increased significantly since 2010 and is expected to continue to increase for the foreseeable future due to increased federal funding. The industry trade associations and certain Congressional committees of jurisdiction continue to advocate for more standardized and rational audit procedures, contractor transparency and consistency surrounding all government audit activity directed toward the DMEPOS industry and other healthcare segments.

CMS also has implemented the Comprehensive Error Rate Testing (“CERT”) program to measure the rate of improper payments in the Medicare FFS program. During each annual reporting period, CERT contractors randomly select a sample of claims, stratified by claim type, submitted to Carriers, MACs, DME MACs and Fiscal Intermediaries. CERT contractors then request documentation from the provider or supplier that submitted each of the claims. Based on the claims review conducted by the CERT contractors and on an annual basis, the CERT contractors calculate an improper payment rate that is considered to be reflective of all paid claims in the Medicare FFS program during the year. The 2011 Medicare FFS improper payment rate was 8.6%, representing nearly $29 billion in allegedly improper payments. The projected improper payment amount for DMEPOS during the 2011 period was approximately 68%, with approximately 91% representing not fraud but technical errors due to insufficient documentation to meet the new and changing auditing standards. In September 2013, the CERT contractor issued its 2012 report. In it, the contractor reported a 8.5% Medicare FFS improper payment rate, representing nearly $29.6 billion in allegedly improper payments. The DMEPOS improper payment rate during the 2012 period was reported to be 66%, with approximately 94% representing the same kind of technical errors described above, not fraud or abuse.

The American Taxpayer Relief Act of 2012 extended the recoupment period for overpayments from three years to five years. This further expands the scope of audit activity, which is already paper-intensive, administratively burdensome and redundant. Appeals are protracted over many months. We cannot predict the impact of all governmental auditing activities and ever-changing rules issued by the same on our business, but it may be material.

 

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Other Issues

 

    Medical Necessity & Other Documentation Requirements. In order to ensure that Medicare beneficiaries only receive medically necessary and appropriate items and services, the Medicare program has adopted a number of documentation requirements. For example, the DME MAC Supplier Manuals provide that clinical information from the “patient’s medical record” is required to justify the initial and ongoing medical necessity for the provision of DME. DME MAC medical directors, CMS staff and government subcontractors have taken the position, among other things, that the “patient’s medical record” refers not to documentation maintained by the DME supplier but instead to documentation maintained by the patient’s physician, healthcare facility or other clinician, and that clinical information created by the DME supplier’s personnel and confirmed by the patient’s physician is not sufficient to establish medical necessity. It may be difficult, and sometimes impossible, for us to obtain documentation from other healthcare providers. Moreover, auditors’ interpretations of these policies are inconsistent and subject to individual interpretation. This is then translated to individual supplier significant error rates and aggregated into a DMEPOS industry error rate, which is significantly higher than other Medicare provider / supplier types. High error rates lead to further audit activity and regulatory burdens. In 2012 and throughout 2013, DME MACs have continued to conduct extensive pre-payment reviews across the DME industry and have determined a wide range of error rates with only marginal improvement over time. For example, error rates for CPAP claims have ranged from 30% to 80%. DME MACs have repeatedly cited medical necessity documentation insufficiencies or technical deficiencies as the primary reason for claim denials. If these or other burdensome positions are generally adopted by auditors, DME MACs, other contractors or CMS in administering the Medicare program, or if non-government payors were to adopt similar positions, we would have the right to challenge these positions as being contrary to law. If these interpretations of the documentation requirements are ultimately upheld, however, it could result in our making significant refunds and other payments to Medicare and our future revenues from Medicare may be significantly reduced. We have adjusted certain operational policies to address the current expectations of Medicare, its contractors and certain other payors.

 

    Face-to-Face Requirements. In November 2012, CMS issued a Final Rule pertaining to additional face-to-face documentation requirements and certain DMEPOS that would be subject to an incremental requirement for suppliers to obtain a Written Order Prior to Delivery. The rule was promulgated as part of the Reform Package. In the Final Rule, CMS outlined the general requirements to be included in patients’ medical records as maintained by their physicians or healthcare practitioners in order to justify the medical necessity for DMEPOS. However, in the absence of additional supplier and referral source education issued by CMS, and due to an ongoing lack of clarity surrounding the new requirements, in June 2013, CMS announced that the new requirements will not be enforced until October 1, 2013. Subsequently, in September 2013, CMS announced that it will start actively enforcing and will expect full compliance with the face-to-face documentation requirements beginning by a date that will be announced sometime in calendar year 2014. CMS has delayed the enforcement date in order to allow providers and suppliers additional time to establish operational protocols necessary to comply with the face-to-face documentation requirements. It is unclear when CMS expects to launch additional supplier and referral source education, but we will adjust both our policies / procedures and IT systems accordingly to comply with the new regulations. We cannot predict the adverse impact, if any, of the documentation requirements or our revised policies might have on our operations, referral source relationships, cash flow and capital resources, but such impact could be material.

 

    Inherent Reasonableness. The Balanced Budget Act of 1997 granted authority to HHS to increase or reduce Medicare Part B reimbursement for home medical equipment, including oxygen, by up to 15% each year under an “inherent reasonableness” authority. Pursuant to that authority, CMS published a final rule that established a process by which such adjustments may be made. The rule applies to all Medicare Part B services except those paid under a physician fee schedule, a prospective payment system, or a competitive bidding program. Aside from a 2012 announcement by CMS to use the authority to reduce retail payment rates for diabetic supplies, a plan made moot by recent legislation, neither HHS nor CMS has issued any subsequent communication or information for several years and therefore, we cannot predict whether or when HHS would exercise its authority in this area or predict any negative impact of any such change.

The impact of increased government audits and changes in Medicare reimbursement that have been enacted to date are reflected in our results of operations for the applicable periods through September 30, 2013. We cannot estimate the combined possible impact of all retroactive audit activities, legislative, regulatory and contemplated reimbursement changes that could have a material adverse effect on our results of operations, cash flow, and capital resources. Moreover, our estimates of the impact of certain of these changes appearing in this “Government Regulation” section are based on a number of assumptions and are subject to uncertainties and there can be no assurance that the actual impact was not or will not be

 

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different from our estimates. However, given the ongoing, significant increases in industry audit volume and the increasing regulatory burdens associated with responding to those audits, it is likely that the negative pressures from legislative and regulatory changes will continue and accelerate.

Medicaid Reimbursement. State Medicaid programs implement reimbursement policies for the items and services we provide that may or may not be similar to those of the Medicare program. Budget pressures on these state programs often result in pricing and coverage changes and delayed payment practices that may have a detrimental impact on our operations and/or financial performance. States sometimes have interposed intermediaries to administer their Medicaid programs, or have adopted alternative pricing methodologies for certain drugs, biologicals, and home medical equipment under their Medicaid programs that reduce the level of reimbursement received by us without a corresponding offset or increase to compensate for the service costs incurred. We periodically evaluate the possibility of stopping or reducing our Medicaid business in a number of states with reimbursement or administrative policies that make it difficult for us to safely care for patients or conduct operations profitably.

Moreover, the Reform Package increases Medicaid enrollment over a number of years and imposes additional requirements on states which, combined with the current economic environment and state deficits, could further strain state budgets and therefore result in additional policy changes or rate reductions. In June 2012, the United States Supreme Court upheld the Reform Package provision expanding Medicaid eligibility to new populations as constitutional, but only so long as the expansion of the Medicaid program is optional for the states. States that choose not to expand their Medicaid programs to newly eligible populations can only lose the new federal Medicaid funding included in the Reform Package but cannot lose their eligibility for existing federal Medicaid matching payments. In view of the Supreme Court decision, some states have announced plans to reduce their Medicaid enrollments, which may have a negative impact on our revenues. We cannot currently predict the adverse impact, if any, that any such change to or reduction in our Medicaid business might have on our operations, cash flow and capital resources, but such impact could be material. In addition, we cannot predict whether states will consider similar or other reimbursement reductions, whether or how healthcare reform provisions pertaining to Medicaid will ultimately be implemented or whether any such changes would have a material adverse effect on our results of operations, cash flow and capital resources.

HIPAA. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) is comprised of a number of components pertaining to the privacy and security of certain protected health information (“PHI”), as well as the standard formatting of certain electronic health transactions. Many states have similar, but not identical, restrictions. Existing and any new laws or regulations have a significant effect on the manner in which we handle healthcare related data and communicate with payors. Among other provisions, the Health Information Technology for Economic and Clinical Health (“HITECH”) Act of the American Recovery and Reinvestment Act of 2009 (“ARRA”) includes additional requirements related to the privacy and security of PHI, clarifies and increases penalties of HIPAA and provides State Attorneys General with HIPAA enforcement authority. In January 2013, the U.S. Department of Health and Human Services released the HIPAA regulations (the “Omnibus Rule”) implementing the statutory amendments under the HITECH Act. The effective date of the Omnibus Rule was March 26, 2013, with a compliance date of September 23, 2013 for most provisions. We have modified our policies and procedures to reflect the new requirements. Among the numerous changes the Omnibus Rule makes to the HIPAA privacy and security regulations, several specific provisions in the Omnibus Rule are likely to have significant impact. By way of example, the Omnibus Rule:

 

    replaces the current “significant risk of harm” standard with a “low probability of compromise” standard for determining whether a security incident or other loss of information is reportable, which may result in more breach notifications being made.

 

    expands the definition of “marketing” and, in turn, extends the range of marketing activities requiring prior written authorization.

 

    removes an exception in the HIPAA Privacy Rule that has protected Covered Entities from liabilities associated with acts of Business Associates, even where the Covered Entity has complied with its contractual obligations and had no knowledge of the wrongdoing.

 

    makes clear the direct liability that flows to Business Associates as a result of the modifications to the HITECH Act.

We have adopted a number of policies and procedures to conform to HIPAA requirements, as modified by the HITECH Act of ARRA and the Omnibus Rule, throughout our operations, and we continually educate our workforce about these requirements. With such a large workforce that increasingly relies on mobile technology for daily operations, HIPAA privacy or data security is always a concern. We face potential administrative, civil and criminal sanctions if we do not comply with the existing or new laws and regulations dealing with the privacy and security of PHI. Imposition of any such

 

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sanctions could have a material adverse effect on our operations. In 2012, one of our Company-owned laptops containing PHI was stolen from a locked vehicle. We thoroughly investigated the incident and, as applicable and required by law, notified individuals, the media and government authorities. We also provided the option of complimentary credit monitoring to affected individuals. In May 2013, subsequent to providing the required notice, we received a letter from the U.S. Department of Health and Human Services Office for Civil Rights (“OCR”) initiating a compliance review. We have cooperated with OCR and provided information and materials requested in the letter to evidence compliance. OCR has the authority to enter into resolution agreements and to impose civil monetary penalties for failure to comply. Civil monetary penalties can range from $100 to $50,000 for each violation with a maximum penalty of $1,500,000 for identical violations in a calendar year. At this point in time, it is too early to predict when OCR will complete its compliance review or what actions OCR may take. At this time there have been no other claims against us related to this incident, although we cannot predict whether such claims will occur in the future. We are taking additional steps to minimize the chances of a reoccurrence of this type of incident.

Enforcement of Healthcare Fraud and Abuse Laws. In recent years, the federal government has made a policy decision to significantly increase and accelerate the financial resources allocated to enforcing the healthcare fraud and abuse laws. Moreover, Congress adopted a number of additional provisions in the Reform Package that are designed to reduce healthcare fraud and abuse. In addition, private insurers and various state enforcement agencies have increased their level of scrutiny of healthcare claims through pre- and post-payment audit activities in an effort to identify and prosecute fraudulent and abusive practices in the healthcare area. From time to time, we may be the subject of investigations or a party to additional litigation which alleges violations of law. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial position, results of operations or prospects.

Anti-Kickback Statutes. As a provider of services under the Medicare and Medicaid programs, we must comply with a provision of the federal Social Security Act, commonly known as the “federal anti-kickback statute.” The federal anti-kickback statute prohibits the offer or receipt of any bribe, kickback or rebate in return for the referral or arranging for the referral of patients, products or services covered by federal healthcare programs. Federal healthcare programs have been defined to include plans and programs that provide health benefits funded by the United States Government, including Medicare, Medicaid and TRICARE (formerly known as the Civilian Health and Medical Program of the Uniformed Services or CHAMPUS), among others. Some courts and the OIG interpret the statute to cover any arrangement where even one purpose of the remuneration is to influence referrals. Violations of the federal anti-kickback statute may result in civil and criminal penalties and exclusion from participation in federal healthcare programs.

Due to the breadth of the federal anti-kickback statute’s broad prohibition, there are a few statutory exceptions that protect various common business transactions and arrangements from prosecution. In addition, the OIG has published safe harbor regulations that outline other arrangements that also are deemed protected from prosecution under the federal anti-kickback statute, provided all applicable criteria are met. The failure of an activity to meet all of the applicable safe harbor criteria does not necessarily mean that the particular arrangement violates the federal anti-kickback law, but these arrangements will be subject to greater scrutiny by enforcement agencies.

Some states have enacted statutes and regulations similar to the federal anti-kickback statute, but which apply not only to the federal healthcare programs, but also to any payor source of the patient. These state laws may contain exceptions and safe harbors that are different from those of the federal law and that may vary from state to state. A number of states in which we operate have laws that prohibit fee-splitting arrangements between healthcare providers, if such arrangements are designed to induce or encourage the referral of patients to a particular provider. Additionally, several states have passed laws further regulating interactions between healthcare providers and physician referral sources. For example, the state of New York requires certain healthcare providers to file a formal annual statement in which they attest that they have adopted a formal corporate compliance program which meets the state’s specific requirements; we comply with that annual requirement. Possible sanctions for violations of these restrictions include exclusion from state-funded healthcare programs, loss of licensure, and civil and criminal penalties. Such statutes vary from state to state, are often vague and often have been subject to only limited court or regulatory agency interpretation.

Marketing Laws. Because of our drug compounding and oxygen services, we may be subject to new and increasingly common state laws and regulations regarding our marketing activities and the nature of our interactions with physicians and other healthcare entity customers. These laws may require us to comply with certain codes of conduct, limit or report certain marketing expenses, disclose certain physician and customer arrangements, and ensure the appropriate licensure of certain sales personnel. There have also been similar federal legislative and regulatory initiatives. Violations of these laws and regulations, to the extent applicable, could subject us to civil and criminal fines and penalties, as well as possible exclusion from participation in federal healthcare programs, such as Medicare and Medicaid. From time to time, we may be the subject of investigations or audits or be a party to litigation which alleges violations of these laws. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial position, results of operations or prospects.

 

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Physician Self-Referral. Certain provisions of the Omnibus Budget Reconciliation Act of 1993 (the “Stark Law”) prohibit healthcare providers such as us, subject to certain exceptions, from submitting claims to the Medicare and Medicaid programs for designated health services if we have a financial relationship with the physician making the referral for such services or with a member of such physician’s immediate family. The term “designated health services” includes several services commonly performed or supplied by us, including durable medical equipment and home health services. In addition, “financial relationship” is broadly defined to include any ownership or investment interest or compensation arrangement pursuant to which a physician receives remuneration from the provider at issue. The Stark Law prohibition applies regardless of the reasons for the financial relationship and the referral; and therefore, unlike the federal anti-kickback statute, an intent to violate the law is not required. Like the federal anti-kickback statute, the Stark Law contains a number of statutory and regulatory exceptions intended to protect certain types of transactions and business arrangements from penalty.

In order to qualify an arrangement under a Stark Law exception, compliance with all of the exception’s requirements is necessary. Violations of the Stark Law may result in loss of Medicare and Medicaid reimbursement, civil penalties and exclusion from participation in the Medicare and Medicaid programs.

In addition, a number of the states in which we operate have similar prohibitions against physician self-referrals, which may not necessarily be limited to Medicare or Medicaid services and may not include the same statutory and regulatory exceptions found in the Stark Law.

False Claims. The federal False Claims Acts impose civil and criminal liability on individuals or entities that submit false or fraudulent claims for payment to the government. Violations of the federal civil False Claims Act may result in treble damages, civil monetary penalties and exclusion from the Medicare, Medicaid and other federally funded healthcare programs. If certain criteria are satisfied, the federal civil False Claims Act allows a private individual to bring a qui tam suit on behalf of the government and, if the case is successful, to share in any recovery. Federal False Claims Act suits brought directly by the government or private individuals against healthcare providers, like us, are increasingly common and are expected to continue to increase.

The federal government has used the federal False Claims Act to prosecute a wide variety of alleged false claims and fraud allegedly perpetrated against Medicare and state healthcare programs. The government and a number of courts also have taken the position that claims presented in violation of certain other statutes, including the federal anti-kickback statute or the Stark Law, can be considered a violation of the federal False Claims Act, based on the theory that a provider impliedly certifies compliance with all applicable laws, regulations and other rules when submitting claims for reimbursement.

In May 2009, President Obama signed into law the Fraud Enforcement and Recovery Act of 2009 (“FERA”). Among other things, FERA modifies the federal False Claims Act by expanding liability to contractors and subcontractors who do not directly present claims to the federal government. FERA also expanded the False Claims Act liability for what is referred to as a “reverse false claim” by explicitly making it unlawful to knowingly conceal or knowingly and improperly avoid or decrease an obligation owed to the federal government.

A number of states have enacted false claims acts that are similar to the federal False Claims Act. Even more states are expected to do so in the future because Section 6031 of the DRA amended the federal law to encourage these types of changes in law at the state level. In addition, there is a corresponding increase in state-initiated false claims enforcement efforts.

Other Fraud and Abuse Laws. HIPAA created, in part, two new federal crimes: “Healthcare Fraud” and “False Statements Relating to Healthcare Matters.” The Healthcare Fraud statute prohibits executing a knowing and willful scheme or artifice to defraud any healthcare benefit program. A violation of this statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.

The increased public focus on waste, fraud and abuse and their related cost to society will likely result in additional Congressional hearings, CMS regulatory changes and/or new laws. The Reform Package also provides for new regulatory authority, additional fines and penalties. At this time, we cannot predict whether these or other reforms will ultimately become law, or the impact of such reforms on our business operations and financial performance.

Facility and Clinician Licensure. Various federal and state authorities and clinical practice boards regulate the licensure of our facilities and clinical specialists working for us, either directly as employees or on a per diem or contractual

 

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basis. Regulations and requirements vary from state to state, and in some states, we are required to make filings in connection with transactions that may be defined as a change of control. Moreover, several states are currently contemplating the establishment or expansion of facility licensure related to the home healthcare industry, and such changes may require us to modify our operations, particularly in multi-state service areas. We are committed to complying with all applicable licensing requirements and maintain centralized functions to manage over 4,500 facility licenses and/or permits that are required to operate our business.

Healthcare Reform. Economic, political and regulatory influences are causing fundamental changes in the healthcare industry in the United States. Various healthcare reform proposals are formulated and proposed by the legislative and administrative branches of the federal government on a regular basis. In addition, some of the states in which we operate periodically consider various healthcare reform proposals. Even with the passage of the Reform Package, we anticipate that federal and state governments will continue to review and assess alternative healthcare delivery systems and payment methodologies and public debate of these issues will continue in the future.

In June 2012, the United States Supreme Court upheld the constitutionality of the requirement in the Reform Package that individuals maintain health insurance or pay a penalty under Congress’s taxing power. The Supreme Court also upheld the Reform Package provision expanding Medicaid eligibility to new populations as constitutional, but only so long as the expansion of the Medicaid program is optional for the states. Changes in the law or new interpretations of existing laws can have a substantial effect on permissible activities, the relative costs associated with doing business in the healthcare industry and the amount of reimbursement by governmental and other third-party payors. Also, the government is in the process of promulgating the implementing rules and regulations of the Reform Package, including additional requirements related to our business, our role as an employer and our customers’ business. Recently, for example, the Internal Revenue Service (“IRS”) announced a one-year delay in the employer mandate and the reporting requirements associated with it. Until the rules are more clearly understood, and due to uncertainties regarding the ultimate features of additional reform initiatives and their enactment and implementation over the next few years, we cannot predict whether any such reforms will have a material adverse effect on our results of operations, cash flow, capital resources and liquidity.

Results of Operations

Three Months Ended September 30, 2013 and 2012

Net Revenues. Net revenues in the three months ended September 30, 2013 were $607.2 million compared to $608.5 million in the three months ended September 30, 2012. Net revenues for the three months ended September 30, 2013 decreased primarily due to a reduction in Medicare revenue as a result of reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration, and decreased volume in the respiratory therapy and home medical equipment segment. The decreases were partially offset by increased volume in the home infusion therapy segment.

We expect to continue to face pricing pressures from Medicare and Medicaid, such as Medicare competitive bidding or government sequestrations, as well as from our managed care customers as these payers seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See “Business—Government Regulation.”

Gross Profit. Gross profit margin is defined as total net revenues less total costs of total net revenues divided by total net revenues. The gross profit margin for the three months ended September 30, 2013 was 53.9%, compared to 57.7% for the three months ended September 30, 2012. The decline in gross profit margin percentage is primarily due to a decrease in the home infusion therapy segment margin percentage due to an increase in specialty revenue as a percent of infusion therapy segment net revenue and an increase in the revenue of the home infusion therapy segment as a percent of total net revenue. Our specialty revenue has a lower gross profit margin as a percentage of net revenue than our other infusion therapy revenue. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenue than the home respiratory and home medical equipment segment. Additionally, the gross profit margin declined due to reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on management’s estimate of the net realizable value of accounts receivable. Accounts receivable estimated to be uncollectible are provided for by computing a required reserve using estimated future cash receipts based on historical cash receipts collections as a percentage of revenue. In addition, management adjusts for changes in billing practices, cash collection protocols or practices, or changes in general economic conditions, contractual issues with specific payors, new markets or products. The provision for doubtful accounts, expressed as a percentage of total net revenues, was 3.9% and 2.2% in the three months ended September 30, 2013 and

 

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September 30, 2012, respectively. Overall cash collections on gross revenue have improved during the three months ended September 30, 2013 compared to the three months ended September 30, 2012. However, the distribution of our actual write-offs has shifted to be more heavily weighted towards bad debts. This shift has resulted in an increase in our allowance for doubtful accounts and our provision for doubtful accounts expense.

Selling, Distribution and Administrative Expenses. Selling, distribution and administrative expenses are comprised of expenses incurred in direct support of operations and those associated with administrative functions. Expenses incurred by the operating locations include salaries and other expenses in the following functional areas: selling, distribution, clinical services, warehousing and repair. Many of these operating costs are directly variable with revenue growth patterns. Some are also very sensitive to market-driven price fluctuations such as facility lease and fuel costs. The administrative expenses include overhead costs incurred by the operating locations and regional and corporate support functions. These expenses are generally less sensitive to fluctuations in revenue growth than operating costs.

Selling, distribution and administrative expenses were $295.4 million, or 48.7%, of total net revenues for the three months ended September 30, 2013 compared to $307.1 million, or 50.5%, of total net revenues for the three months ended September 30, 2012.

Selling, distribution and administrative expenses decreased by $11.7 million for the three months ended September 30, 2013 compared to the three months ended September 30, 2012. The decrease was comprised of an increase in labor costs of $0.7 million and a $12.4 million decrease in other operating expenses. For the three months ended September 30, 2013 and 2012, the corporate costs included in selling, distribution and administrative expense were $49.7 million and $49.9 million, respectively.

The increase in labor costs of $0.7 million was primarily due to higher salaries in our home infusion therapy segment due to growth, as well as to certain employee fringe benefit items and estimated bonus and commission. These increases were partially offset by lower salaries and related fringe benefits due to headcount decreases associated with strategic reductions in workforce in our home respiratory therapy/home medical equipment business segment.

The decrease in other operating expenses of $12.4 million was primarily due to lower delivery costs, employee travel, outside answering services, and other operating expenses. In addition there were lower professional and legal fees due to certain 2012 corporate initiatives not recurring in 2013 and other corporate matters.

Amortization of Intangible Assets. Amortization of intangible assets was $0.2 million and $0.3 million in the three months ended September 30, 2013 and September 30, 2012, respectively.

Interest Expense. Interest expense decreased $10.6 million, or 31.5%, to $23.2 million in the three months ended September 30, 2013 from $33.8 million in the three months ended September 30, 2012. The decrease in interest expense is the result of our Senior Secured Term Loan, which has a lower interest rate than the Series A-1 Notes and the remaining portion of our Series A-2 Notes which were reduced in the second quarter of 2013.

Interest Income and Other. Interest income and other decreased to $0.2 million for the three months ended September 30, 2013 from $0.3 million in the three months ended September 30, 2012.

Income Tax Expense/(Benefit). Our overall effective tax rate is the ratio of our tax expense (benefit) over our pre-tax income (loss) for the reporting period. Our tax expense/(benefit) is comprised of two items: (1) the tax computed using an Estimated Annual Effective Tax Rate (“EAETR”) and (2) certain tax charges and benefits which are recognized on a discrete basis in the interim period in which they occur.

Our EAETR is determined by taking into account estimated pre-tax income (loss) and permanent book/tax differences. Our EAETR is applied to year-to-date pre-tax income (loss) at the end of each interim period to compute a year-to-date tax expense (or benefit). Significant differences in our EAETR compared with statutory rates can arise from permanent book/tax differences as a percentage of our estimated pre-tax income (loss).

Our effective tax rate was an expense of 5.5% for the three months ended September 30, 2013, compared to a benefit of 38.0% for the three months ended September 30, 2012. For the three months ended September 30, 2013 and 2012 our effective tax rate differed from federal and state statutory rates primarily due to the accrual of a valuation allowance against substantially all of our net deferred tax assets and the tax expense related to separate state filings.

In computing our EAETR for the three months ended September 30, 2012, we recognized a $104.0 million deferred tax benefit related to the impairment of the indefinite life trade name.

 

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Our provision for income taxes is based on expected income, permanent book/tax differences and statutory tax rates in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining the provision for income taxes. We are routinely under audit by federal, state or local authorities regarding the timing and amount of deductions, allocation of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately reflect our potential obligations.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized.

Beginning with the year ended December 31, 2011, we accrued a valuation allowance against substantially all of our net deferred tax assets since we determined that it is more likely than not that substantially all of the our net deferred tax assets will not be realized. We intend to maintain our valuation allowance until sufficient positive evidence exists to support the reversal of all or a portion of its valuation allowance.

We increased our valuation allowance by $6.9 million to $258.8 million at September 30, 2013 from $251.9 million at June 30, 2013 to offset corresponding increases in our net deferred tax assets for the three months ended September 30, 2013.

Segment Net Revenues and EBIT

Segment financial results are based on directly assignable net revenues, cost of goods sold, bad debt expenses and selling, distribution and administrative costs, where available. Costs that are not directly assignable, such as corporate costs and certain selling, distribution and administrative expenses, are allocated based on various metrics including billed census, headcount and branch locations by segment, among others.

During the fourth quarter of 2012, we revised our allocation to reporting segments. This allocation is based on how we currently manage and discuss our operations.

The following table sets forth a summary of results of operations by segment:

 

     Net Revenues  
(in thousands)    Three Months Ended
September 30, 2013
     Percentage of 
Net Revenues
    Three Months Ended
September 30, 2012
     Percentage of 
Net Revenues
 

Operating Segment

          

Home respiratory therapy and home medical equipment

   $ 278,097         45.8   $ 301,199         49.5

Home infusion therapy

     329,100         54.2        307,274         50.5  
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 607,197         100.0   $ 608,473         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

     EBIT  
(in thousands)    Three Months Ended
September 30, 2013
    Percentage of 
Net Revenues
    Three Months Ended
September 30, 2012
    Percentage of 
Net Revenues
 

Operating Segment

        

Home respiratory therapy and home medical equipment(a)

   $ (7,794     (2.8 )%    $ (199,770     (66.3 )% 

Home infusion therapy(b)

     15,806        4.8     (49,981     (16.3 )% 
  

 

 

     

 

 

   

Total

   $ 8,012        $ (249,751  
  

 

 

     

 

 

   

 

(a) EBIT for the three month period ended September 30, 2012 for the home respiratory therapy/home medical equipment reporting unit includes a non-cash impairment charge of $200.0 million.
(b) EBIT for the three month period ended September 30, 2012 for the home infusion therapy reporting unit includes a non-cash impairment charge of $80.0 million.

See definition and reconciliation of EBIT to net loss included at the end of this section.

 

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Home Respiratory Therapy and Home Medical Equipment Segment. For the home respiratory therapy and home medical equipment segment total net revenues decreased $23.1 million, or 7.7%, to $278.1 million in the three months ended September 30, 2013 from $301.2 million in the three months ended September 30, 2012. Revenues for the home respiratory therapy and home medical equipment segment decreased to 45.8% of total revenue in the three months ended September 30, 2013 from 49.5% in the three months ended September 30, 2012.

Home respiratory therapy revenues are derived primarily from the provision of oxygen systems, obstructive sleep apnea equipment, home ventilators, nebulizers, respiratory medications and related services. Revenues from the home respiratory therapy service line decreased by 6.8% in the three months ended September 30, 2013 compared to the three months ended September 30, 2012. The decrease in revenue resulted primarily from a decrease in Medicare revenue due to reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration, a decrease in other respiratory therapy (primarily nebulizers and ventilators) revenue due to a planned decrease in volume and a decrease in sleep apnea revenue due to a decrease in sales volume.

Home medical equipment revenues are derived from the rental and sale of equipment to assist patients with ambulation, safety and general care in and around the home. Home medical equipment revenues decreased by 12.2% in the three months ended September 30, 2013 compared to the three months ended September 30, 2012. The decrease in home medical equipment revenue was primarily due to a planned decrease in the volume of home medical equipment products and a decrease in Medicare revenue due to reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration. The decrease was partially offset by an increase in the volume of negative pressure wound therapy products.

EBIT for the home respiratory therapy and home medical equipment segment in the three months ended September 30, 2013 was negative $7.8 million compared to a negative $199.8 million (including a non-cash impairment charge of $200.0 million related to our trade name) in the three months ended September 30, 2012. EBIT was negative 2.8% of segment net revenues in the three months ended September 30, 2013 compared to a negative 66.3% of segment net revenues in the three months ended September 30, 2012. Excluding the non-cash impairment charge, EBIT for the three months ended September 30, 2012 would have been 0.1% of segment net revenues. The decrease in the EBIT as a percentage of segment net revenues from 0.1% in the three months ended September 30, 2012, excluding the non-cash impairment charge, to a negative 2.8% in the three months ended September 30, 2013 is primarily due to a decrease in the gross margin as a percentage of net segment revenues, as a result of the reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration. There was also an increase in the provision for doubtful accounts as a percentage of net segment revenue. These were partially offset by a decrease in sales, distribution and administrative costs as a percentage of net segment revenues.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $21.8 million, or 7.1% to $329.1 million for the three months ended September 30, 2013 from $307.3 million in the three months ended September 30, 2012. Revenues for this segment increased to 54.2% of total revenue in the three months ended September 30, 2013 from 50.5% in the three months ended September 30, 2012.

The home infusion therapy segment involves the administration of drugs or nutrients directly into the body intravenously through a needle or catheter. Infusion therapy services also include administering enteral nutrients directly into the gastrointestinal tract through a feeding tube. The growth in home infusion therapy revenue resulted primarily from an increase in the overall volume of specialty drugs. When classifying a pharmaceutical product or service as “specialty,” we consider the following factors: the product or service’s cost; its ability to treat complex and chronic diseases; its special handling, storage and delivery requirements; its categorization as one of our biological drugs; and, in some cases, a product’s limited distribution channels. Our use of the term “specialty” to define a portion of our business may not be comparable to that used by other industry participants, including our competitors.

EBIT for the home infusion therapy segment in the three months ended September 30, 2013 was $15.8 million compared to negative $50.0 million (including a non-cash impairment charge of $80.0 million related to our trade name) in the three months ended September 30, 2012. EBIT was 4.8% of segment net revenues in the three months ended September 30, 2013 compared to negative 16.3% of segment net revenues in the three months ended September 30, 2012. Excluding the non-cash impairment charge, EBIT for the three months ended September 30, 2012 would have been 9.8% of segment net revenues. The decrease in EBIT as a percentage of net segment revenues from 9.8% in the three months ended September 30, 2012, excluding the non-cash impairment charge, to 4.8% in the three months ended September 30, 2013, is primarily due to a decrease in gross profit margin as a percentage of net segment revenues, an increase in selling, distribution and administrative costs as a percentage of segment net revenues and an increase in the provision for doubtful accounts as a percentage of segment net revenues in the three months ended September 30, 2013 compared to the three months ended September 30, 2012.

 

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EBIT is a measure used by our management to measure operating performance. EBIT is defined as net income (loss) plus interest expense, loss on early retirement of debt and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles (“GAAP”) and does not purport to be an alternative net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.

The following table provides a reconciliation from net loss to EBIT:

 

(in thousands)    Three Months Ended
September 30, 2013
    Three Months Ended
September 30, 2012
 

Net loss(a)

   $ (15,785   $ (175,711

Interest expense, net

     22,969        33,483   

Income tax expense

     828        (107,523
  

 

 

   

 

 

 

EBIT(b)

   $ 8,012      $ (249,751
  

 

 

   

 

 

 

 

(a) Net loss for the three month period ended September 30, 2012 reflects the following non-cash impairment charge based on the results of impairment testing as of September 30, 2012 and the tax impact associated with the impairment charge:

 

  (i) Trade name impairment of $280.0 million, $200.0 million of which relates to the home respiratory therapy/home medical equipment reporting unit and $80.0 million of which relates to the home infusion therapy reporting unit; and

 

  (ii) Tax benefit of $104.0 million relating to the intangible assets impairment.

All of these items resulted in a $176.0 million increase in the net loss in the three and nine months ended September 30, 2012.

 

(b) EBIT for the three months ended September 30, 2012 includes a $280.0 million non-cash impairment charge described above.

Nine Months Ended September 30, 2013 and 2012

Net Revenues. Net revenues in the nine months ended September 30, 2013 were $1,842.6 million compared to $1,811.9 million in the nine months ended September 30, 2012. Net revenues for the nine months ended September 30, 2013 increased primarily due to increased volume in the home infusion therapy segment, partially offset by decreased volume in the respiratory therapy and home medical equipment segment, a decrease in Medicare revenue due to reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013, and the budget sequestration.

We expect to continue to face pricing pressures from Medicare and Medicaid, such as Medicare competitive bidding or government sequestrations, as well as from our managed care customers as these payers seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See “Business—Government Regulation.”

Gross Profit. Gross profit margin is defined as total net revenues less total costs of total net revenues divided by total net revenues. The gross profit margin for the nine months ended September 30, 2013 was 55.9%, compared to 57.8% for the nine months ended September 30, 2012. The decline in gross profit margin percentage is primarily due to a decrease in the home infusion therapy segment margin percentage due to an increase in specialty revenue as a percent of infusion therapy segment net revenue, and an increase in the revenue of the home infusion therapy segment as a percent of total net revenue. Our specialty revenue has a lower gross profit margin as a percentage of net revenue than our other infusion therapy revenue. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenue than the home respiratory and home medical equipment segment. Additionally, the gross profit margin declined due to reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on management’s estimate of the net realizable value of accounts receivable. Accounts receivable estimated to be uncollectible are provided for by computing a required reserve using estimated future cash receipts based on historical cash receipts collections as a percentage of revenue. In addition, management adjusts for changes in billing practices, cash collection protocols or practices, or changes in general

 

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economic conditions, contractual issues with specific payors, new markets or products. The provision for doubtful accounts, expressed as a percentage of total net revenues, was 3.3% and 2.5% in the nine months ended September 30, 2013 and September 30, 2012, respectively. Overall cash collections on gross revenue have improved during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012. However, the distribution of our actual write-offs has shifted to be more weighted towards bad debts. This shift has resulted in an increase in our allowance for doubtful accounts and our provision for doubtful accounts expense.

Selling, Distribution and Administrative Expenses. Selling, distribution and administrative expenses are comprised of expenses incurred in direct support of operations and those associated with administrative functions. Expenses incurred by the operating locations include salaries and other expenses in the following functional areas: selling, distribution, clinical services, warehousing and repair. Many of these operating costs are directly variable with revenue growth patterns. Some are also very sensitive to market-driven price fluctuations such as facility lease and fuel costs. The administrative expenses include overhead costs incurred by the operating locations and regional and corporate support functions. These expenses are generally less sensitive to fluctuations in revenue growth than operating costs.

Selling, distribution and administrative expenses were $888.0 million, or 48.2%, of total net revenues for the nine months ended September 30, 2013 compared to $933.4 million, or 51.5%, of total net revenues for the nine months ended September 30, 2012.

Selling, distribution and administrative expenses decreased by $45.4 million for the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012. The decrease was comprised of a decrease in labor costs of $22.0 million and a $23.4 million decrease in other operating expenses. For the nine months ended September 30, 2013 and 2012, the corporate costs included in selling, distribution and administrative expenses were $144.7 million and $149.5 million, respectively.

The decrease in labor costs of $22.0 million was primarily due to a net decrease in salaries and related benefits resulting from headcount decreases associated with strategic reductions in workforce in our home respiratory therapy/home medical equipment business segment, offset partially by increases in our home infusion therapy segment due to growth.

The decrease in other operating expenses of $23.4 million was primarily due to lower employee travel, delivery costs, depreciation on plant, property, and equipment, outside answering services, and advertising. In addition there were lower professional and legal fees due to certain 2012 corporate initiatives not recurring in 2013 and other corporate matters.

Amortization of Intangible Assets. Amortization of intangible assets was $0.6 million and $1.5 million in the nine months ended September 30, 2013 and September 30, 2012, respectively.

Interest Expense. Interest expense decreased $11.6 million, or 11.5%, to $89.5 million in the nine months ended September 30, 2013 from $101.2 million in the nine months ended September 30, 2012. The decrease in interest expense is the result of our Senior Secured Term Loan, which has a lower interest rate than the Series A-1 Notes and the portion of our Series A-2 Notes which were reduced in the second quarter of 2013.

Loss on Early Retirement of Debt. In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, we paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, we wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the remaining portion of the Series A-2 Notes that were redeemed in the nine months ended September 30, 2013.

Interest Income and Other. Interest income and other increased to $1.3 million for the nine months ended September 30, 2013 from $1.1 million in the nine months ended September 30, 2012.

Income Tax Expense/(Benefit). Our overall effective tax rate is the ratio of our tax expense (benefit) over our pre-tax income (loss) for the reporting period. Our tax expense/(benefit) is comprised of two items: (1) the tax computed using an EAETR and (2) certain tax charges and benefits which are recognized on a discrete basis in the interim period in which they occur.

Our EAETR is determined by taking into account estimated pre-tax income (loss) and permanent book/tax differences. Our EAETR is applied to year-to-date pre-tax income (loss) at the end of each interim period to compute a year-to-date tax expense (or benefit). Significant differences in our EAETR compared with statutory rates can arise from permanent book/tax differences as a percentage of our estimated pre-tax income (loss).

Our effective tax rate was an expense of 3.9% for the nine months ended September 30, 2013, compared to a benefit of 33.8% for the nine months ended September 30, 2012. For the nine months ended September 30, 2013 and 2012, our effective tax rate differed from federal and state statutory rates primarily due to the accrual of a valuation allowance against substantially all of our net deferred tax assets and the tax expense related to separate state filings.

 

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In computing our EAETR for the three months ended September 30, 2012, we recognized a $104.0 million deferred tax benefit related to the impairment of the indefinite life trade name.

Our provision for income taxes is based on expected income, permanent book/tax differences and statutory tax rates in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining the provision for income taxes. We are routinely under audit by federal, state or local authorities regarding the timing and amount of deductions, allocation of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately reflect our potential obligations.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized.

Beginning with the year ended December 31, 2011, we accrued a valuation allowance against substantially all of our net deferred tax assets since we determined that it is more likely than not that substantially all of the our net deferred tax assets will not be realized. We intend to maintain our valuation allowance until sufficient positive evidence exists to support the reversal of all or a portion of its valuation allowance.

We increased our valuation allowance by $20.3 million to $258.8 million at September 30, 2013 from $238.5 million at December 31, 2012 to offset corresponding increases in our net deferred tax assets for the nine months ended September 30, 2013.

Segment Net Revenues and EBIT

Segment financial results are based on directly assignable net revenues, cost of goods sold, bad debt expenses and selling, distribution and administrative costs, where available. Costs that are not directly assignable, such as corporate costs and certain selling, distribution and administrative expenses, are allocated based on various metrics including billed census, headcount and branch locations by segment, among others.

During the fourth quarter of 2012, we revised our allocation to reporting segments. This allocation is based on how we currently manage and discuss our operations.

The following table sets forth a summary of results of operations by segment:

 

     Net Revenues  
(in thousands)    Nine Months Ended
September 30, 2013
     Percentage of 
Net Revenues
    Nine Months Ended
September 30, 2012
     Percentage of 
Net Revenues
 

Operating Segment

          

Home respiratory therapy and home medical equipment

   $ 867,287         47.1   $ 905,525         50.0

Home infusion therapy

     975,288         52.9        906,333         50.0  
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,842,575         100.0   $ 1,811,858         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

     EBIT  
(in thousands)    Nine Months Ended
September 30, 2013
    Percentage of 
Net Revenues
    Nine Months Ended
September 30, 2012
    Percentage of 
Net Revenues
 

Operating Segment

        

Home respiratory therapy and home medical equipment(a)

   $ (7,166     (0.8 )%    $ (226,503     (25.0 )% 

Home infusion therapy(b)

     87,811        9.0     12,223        1.3
  

 

 

     

 

 

   

Total

   $      80,645        $ (214,280  
  

 

 

     

 

 

   

 

(a) EBIT for the nine month period ended September 30, 2012 for the home respiratory therapy/home medical equipment reporting unit includes a non-cash impairment charge of $200.0 million.
(b) EBIT for the nine month period ended September 30, 2012 for the home infusion therapy reporting unit includes a non-cash impairment charge of $80.0 million.

 

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See definition and reconciliation of EBIT to net loss included at the end of this section.

Home Respiratory Therapy and Home Medical Equipment Segment. For the home respiratory therapy and home medical equipment segment total net revenues decreased $38.2 million, or 4.2%, to $867.3 million in the nine months ended September 30, 2013 from $905.5 million in the nine months ended September 30, 2012. Revenues for the home respiratory therapy and home medical equipment segment decreased to 47.1% of total revenue in the nine months ended September 30, 2013 from 50.0% in the nine months ended September 30, 2012.

Home respiratory therapy revenues are derived primarily from the provision of oxygen systems, obstructive sleep apnea equipment, home ventilators, nebulizers, respiratory medications and related services. Revenues from the home respiratory therapy service line decreased by 3.8% in the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012. The decrease in revenue resulted primarily from a decrease in Medicare revenue due to reduced reimbursement rates as part of the Medicare competitive bidding program starting July 1, 2013 and the budget sequestration, a decrease in other respiratory therapy (primarily nebulizers and ventilators) revenue due to a planned decrease in volume and a decrease in sleep apnea revenue due to a decrease in volume.

Home medical equipment revenues are derived from the rental and sale of equipment to assist patients with ambulation, safety and general care in and around the home. Home medical equipment revenues decreased by 6.7% in the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012. The decrease in home medical equipment revenue was primarily due to a planned decrease in the volume of home medical equipment products and a decrease in Medicare revenue due to reduced reimbursement rates as part of the Medicare competitive bidding program and the budget sequestration starting July 1, 2013. The decrease was partially offset by an increase in the volume of negative pressure wound therapy products.

EBIT for the home respiratory therapy and home medical equipment segment in the nine months ended September 30, 2013 was negative $7.2 million compared to a negative $226.5 million (including a non-cash impairment charge of $200.0 million related to our trade name) in the nine months ended September 30, 2012. EBIT was negative 0.8% of segment net revenues in the nine months ended September 30, 2013 compared to negative 25.0% of segment net revenues in the nine months ended September 30, 2012. Excluding the non-cash impairment charge, EBIT for the nine months ended September 30, 2012 would have been a negative 2.9% of segment net revenues. The improvement in the EBIT as a percentage of segment net revenues from a negative 2.9% in the nine months ended September 30, 2012, excluding the non-cash impairment charge to a negative 0.8% in the nine months ended September 30, 2013, is primarily due to a decrease in the sales, distribution and administrative costs as a percentage of net segment revenues. This was partially offset by a decrease in gross margin as a percentage of net segment revenues, as a result of the reduced reimbursement rates as part of the Medicare competitive bidding program effective July 1, 2013 and the budget sequestration and an increase in the provision for doubtful accounts as a percentage of net segment revenues.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $69.0 million, or 7.6% to $975.3 million for the nine months ended September 30, 2013 from $906.3 million in the nine months ended September 30, 2012. Revenues for this segment increased to 52.9% of total revenue in the nine months ended September 30, 2013 from 50.0% in the nine months ended September 30, 2012.

The home infusion therapy segment involves the administration of drugs or nutrients directly into the body intravenously through a needle or catheter. Infusion therapy services also include administering enteral nutrients directly into the gastrointestinal tract through a feeding tube. The growth in home infusion therapy revenue resulted primarily from an increase in the overall volume of specialty drugs.

EBIT for the home infusion therapy segment in the nine months ended September 30, 2013 was $87.8 million compared to $12.2 million (including a non-cash impairment charge of $80.0 million related to our trade name) in the nine months ended September 30, 2012. EBIT was 9.0% of segment net revenues in the nine months ended September 30, 2013 compared to 1.3% of segment net revenues in the nine months ended September 30, 2012. Excluding the non-cash impairment charge, EBIT for the nine months ended September 30, 2012 would have been 10.2% of segment net revenues. The decrease in EBIT as a percentage of net segment revenues from 10.2% in the nine months ended September 30, 2012, excluding the non-cash impairment charge to 9.0% in the nine months ended September 30, 2013, is primarily due to a decrease in the gross margin as a percentage of net segment revenues.

 

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EBIT is a measure used by our management to measure operating performance. EBIT is defined as net income (loss) plus interest expense, loss on early retirement of debt and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles (“GAAP”) and does not purport to be an alternative net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.

The following table provides a reconciliation from net loss to EBIT:

 

(in thousands)    Nine Months Ended
September 30, 2013
    Nine Months Ended
September 30, 2012
 

Net loss(a)

   $ (53,776   $ (208,054

Interest expense, net

     88,205        100,107   

Loss on early retirement of debt

     44,221        —    

Income tax expense(b)

     1,995        (106,333
  

 

 

   

 

 

 

EBIT

   $ 80,645      $ (214,280
  

 

 

   

 

 

 

 

(a) Net loss for the nine month period ended September 30, 2012 reflects the following non-cash impairment charge based on the results of impairment testing as of September 30, 2012 and the tax impact associated with the impairment charge:

 

  (i) Trade name impairment of $280.0 million, $200.0 million of which relates to the home respiratory therapy/home medical equipment reporting unit and $80.0 million of which relates to the home infusion therapy reporting unit; and

 

  (ii) Tax benefit of $104.0 million relating to the intangible assets impairment.

All of these items resulted in a $176.0 million increase in the net loss in the three and nine months ended September 30, 2012.

 

(b) EBIT for the nine months ended September 30, 2012 includes a $280.0 million non-cash impairment charge described above.

Liquidity and Capital Resources

Our principal source of liquidity is our operating cash flow, which is supplemented by our Amended ABL Facility (as defined below), which provides for revolving credit of up to $250.0 million, subject to borrowing base availability. In recent years, we have generated operating cash flows in excess of our operating needs, which has afforded us the ability to pursue acquisitions and fund patient service equipment purchases to support revenue growth. We believe that our operating cash flow, together with our existing cash and cash equivalents, and Amended ABL Facility, will continue to be sufficient to fund our operations and growth strategies for at least the next 12 months.

Cash Flow. The following table presents selected data from our consolidated statement of cash flows:

 

(in thousands)

   Nine Months Ended
September 30, 2013
    Nine Months Ended
September 30, 2012
 

Net cash provided by operating activities

   $ 77,979      $ 77,375   

Net cash used in investing activities

     (76,817     (86,585

Net cash used in financing activities

     (9,699     (4,358
  

 

 

   

 

 

 

Net decrease in cash and equivalents

     (8,537     (13,568

Cash and equivalents at beginning of period

     27,080        29,096   
  

 

 

   

 

 

 

Cash and equivalents at end of period

   $ 18,543      $ 15,528   
  

 

 

   

 

 

 

In the nine months ended September 30, 2013, our free cash flow was $1.2 million. For the nine months ended September 30, 2012 our free cash flow was $(9.1) million. See discussion below on changes in the components of free cash flow; net cash provided by operations and purchases of patient service equipment and property, equipment and improvements. Free cash flow is a financial measure which is not calculated in accordance with GAAP. Free cash flow is defined as cash provided by operating activities less purchases of patient service equipment and property, equipment and improvements, net of proceeds from the sale of patient service equipment and other exclusive of effects of acquisitions. It is presented as a supplemental performance measure and is not intended as an alternative to any other cash flow measure calculated in accordance with GAAP. Further, free cash flow may not be comparable to similarly titled measures used by other companies.

 

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A table reconciling free cash flow to net cash provided by operating activities is presented below:

 

(in thousands)

   Nine Months Ended
September 30, 2013
    Nine Months Ended
September 30, 2012
 
           (as restated)  

Reconciliation — Free Cash Flow:

    

Net loss(a)

   $ (53,776   $ (208,054

Non-cash items(b)

     193,585        300,711   

Change in operating assets and liabilities

     (61,830     (15,282
  

 

 

   

 

 

 

Net cash provided by operating activities

     77,979        77,375   

Less: Purchases of patient service equipment, property, equipment and improvements net of proceeds from sale of patient service equipment and other

     (76,817     (86,464
  

 

 

   

 

 

 

Free cash flow

   $ 1,162      $ (9,089
  

 

 

   

 

 

 

 

(a) Net loss for the nine months period ended September 30, 2012 reflects the following non-cash impairment charge based on the results of our impairment testing as of September 30, 2012 and the tax impact associated with the impairment charge:

(i) Trade name impairment of $280.0 million, $200.0 million of which relates to the home respiratory therapy/home medical equipment reporting unit and $80.0 million of which relates to the home infusion therapy reporting unit; and

(ii) Tax benefit of $104.0 million relating to the intangible assets impairment.

All of these items resulted in a $176.0 million increase in our net loss in the nine months ended September 30, 2012.

 

(b) The nine months ended September 30, 2012 includes a $280.0 million non-cash impairment charge described above.

The Nine Months Ended September 30, 2013 Results Compared to the Nine Months Ended September 30, 2012

Net cash provided by operating activities in the nine months ended September 30, 2013 was $78.0 million compared to $77.4 million provided in the nine months ended September 30, 2012, an increase of $0.6 million. The increase in net cash provided by operating activities resulted from a $47.2 million increase in the provision of cash from net income and non-cash items to a $139.8 million provision in 2013 from a $92.7 million provision in 2012, partially offset by a $46.5 million increase in cash used related to the change in operating assets and liabilities to a $61.8 million use of cash in 2013 from a $15.3 million use of cash in 2012.

The $46.5 million increase in cash used by the change in operating assets and liabilities consisted primarily of the following:

 

    $27.2 million decrease in cash provided by accrued expenses to a $7.1 million provision of cash in the nine months ended September 30, 2013 from a $34.2 million provision of cash in the nine months ended September 30, 2012. The decrease was primarily due to accrued interest related to the refinancing of our long term debt including a reduction in our aggregate interest rate payments and a change in payment timing related to the refinancing.

 

    $24.2 million increase in cash used by prepaid expenses and other assets to a $15.6 million use of cash in the nine months ended September 30, 2013 from an $8.6 million provision of cash in the nine months ended September 30, 2012. The increase was primarily due to the increase of certain other assets in the current year and reduction of certain prepaid balances in the prior year.

 

    $9.4 million decrease in cash provided by accounts payable to a $6.9 million provision of cash in the nine months ended September 30, 2013 from an $16.3 million provision of cash in the nine months ended September 30, 2012. The increase was primarily due to the timing of payments on invoices.

 

    $7.4 million increase in cash used by inventories to a $15.9 million use of cash in the nine months ended September 30, 2013 from an $8.5 million use of cash in the nine months ended September 30, 2012. The increase was primarily due to the increase in IV inventory.

 

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Offset by:

 

    $22.4 million decrease in cash used by accounts receivable to a $49.2 million use of cash in the nine months ended September 30, 2013 from a $71.6 million use of cash in the nine months ended September 30, 2012. The decrease was primarily due to our continuing focus on improvement of our billing and collections function.

Net cash used in investing activities in the nine months ended September 30, 2013 was $76.8 million, compared to $86.6 million in the nine months ended September 30, 2012. The primary use of funds in 2013 was $106.6 million to purchase patient service equipment and property equipment and improvements; $85.8 million related to patient service equipment to support revenue growth; and $20.8 million related to property equipment and improvements, primarily due to additions to our information systems software and hardware. This was partially offset by proceeds from the sale of patient service equipment and other of $29.8 million. The primary use of funds in 2012 was $121.0 million to purchase patient service equipment and property equipment and improvements; $98.8 million related to patient service equipment to support revenue growth; and $22.2 million related to property equipment and improvements, primarily due to additions to our information systems software and hardware. This was partially offset by proceeds from the sale of patient service equipment and other of $34.5 million.

In 2013, net cash used by financing activities in the nine months ended September 30, 2013 was $9.7 million compared to a $4.4 million use of cash in the nine months ended September 30, 2012. Cash used in financing activities in 2013 was primarily related to proceeds from the Senior Secured Term Loan and net borrowings on our ABL facility, partially offset by payments on the Series A-1 and A-2 Notes, debt issuance costs related to the Senior Secured Term Loan premium on early retirement of the Series A-1 and A-2 Notes, and original issue discount associated with the Senior Secured Term Loan. Cash provided in 2012 was primarily related to the net borrowings on our ABL facility.

Accounts Receivable. Accounts receivable before allowance for doubtful accounts increased to $398.4 million as of September 30, 2013 from $397.4 million at December 31, 2012. Days sales outstanding (calculated as of each period-end by dividing accounts receivable, less allowance for doubtful accounts, by the rolling average of total net revenues) were 51 days at September 30, 2013 and 51 days at December 31, 2012. Overall accounts receivable increased due to anticipated delays in billings associated with the internal separation and transfer of our enteral operations offset by a decrease in accounts receivables due to a settlement of aged accounts receivable with a payor.

Accounts aged in excess of 180 days expressed as percentages of total receivables for certain major payor categories, and in total, are as follows:

 

     September 30, 2013     December 31, 2012  

Total

     18.8     21.8

Medicare

     11.8     17.2

Medicaid

     4.3     15.7

Patient self pay

     39.9     31.5

Managed care/other

     17.7     22.5

Included in accounts receivable are earned but unbilled receivables of $72.6 million at September 30, 2013 and $56.8 million at December 31, 2012. Delays, ranging from a day up 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 such as physicians and hospitals. Earned but unbilled receivables are aged from date of service and are considered in our analysis of historical performance and collectability. Unbilled receivables increased in the third fiscal quarter primarily due to anticipated delays in billings associated with the internal separation and transfer of our enteral operations.

Inventories and Patient Service Equipment. Inventories consist primarily of pharmaceuticals and disposable products used in conjunction with patient service equipment. Patient service equipment consists of respiratory and home medical equipment that is provided to in-home patients for the course of their care plan, normally on a rental basis, and subsequently returned to us for redistribution after cleaning and maintenance is performed. We maintain inventory and patient service equipment at levels we believe will provide for the needs of our patients.

Long-term Debt.

Senior Secured Term Loan. On April 5, 2013, we entered into a senior secured credit agreement (the “Senior Secured Term Loan”), among Apria, as borrower, Sky Acquisition LLC, as parent, the other guarantors party thereto from time to time, Bank of America, N.A., as administrative agent, U.S. Bank National Association as collateral agent, certain other agents party thereto and a syndicate of financial institutions and institutional lenders.

 

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On April 5, 2013, we borrowed $900.0 million in aggregate principal amount of term loans under the Senior Secured Term Loan. At our option we may borrow additional term loans under the Senior Secured Term Loan, subject to certain customary conditions, including consent of the lenders providing such additional term loans, in an amount not to exceed $175.0 million, plus the aggregate principal amount of voluntary prepayments of term loans on or prior to such time, plus additional amounts subject to compliance on a pro forma basis with certain financial ratio tests.

Borrowings under the Senior Secured Term Loan bear interest at a fluctuating rate per annum equal to, at our option (i) a base rate equal to the highest of (a) the federal funds rate plus 1/2 of 1%, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America, N.A. as its “prime rate” and (c) the one month LIBOR Rate plus 1.00% (provided that in no event shall such base rate with respect to the initial Term Loans be less than 2.25% per annum), in each case plus an applicable margin of 4.50% or (ii) a LIBOR Rate for the applicable interest period (provided that in no event shall such LIBOR rate with respect to the initial Term Loans be less than 1.25% per annum) plus an applicable margin of 5.50%.

The Senior Secured Term Loan will mature on April 5, 2020 and will amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of term loans, with the balance payable on the final maturity date; provided that the Senior Secured Term Loan provides the right for individual lenders to agree to extend the maturity date of their outstanding term loans upon our request and without the consent of any other lender, subject to customary terms and conditions.

All of our obligations under the Senior Secured Term Loan (i) are unconditionally guaranteed by our parent and substantially all of its existing and future, direct and indirect, wholly-owned domestic restricted subsidiaries and (ii) are secured, subject to certain exceptions, by substantially all of our assets and the assets of the guarantors.

The Senior Secured Term Loan is entitled to a priority of payment over the Series A-2 Notes in certain circumstances, including upon any acceleration of the obligations in respect of the Senior Secured Term Loan, the Series A-2 Notes or any bankruptcy or insolvency event or default with respect to Apria or any guarantor of the Senior Secured Term Loan and the Series A-2 Notes.

The Senior Secured Term Loan includes a financial maintenance covenant that prohibits our consolidated first priority net leverage ratio as of the last day of any test period of four consecutive fiscal quarters (commencing with the test period ending September 30, 2013) to exceed 5.50 to 1.00.

The Senior Secured Term Loan also include customary negative covenants that, subject to significant exceptions, limit our ability and the ability of our parent and subsidiaries to, among other things: incur liens; make investments or loans; incur, assume or permit to exist additional indebtedness or guarantees; and pay dividends, make payments or redeem or repurchase capital stock.

Under the terms of the Senior Secured Term Loan, outstanding loans under the Senior Secured Term Loan may be accelerated if more than $75.0 million of the Series A-2 Notes remain outstanding on or after September 2, 2014.

We used proceeds from the borrowings under the Senior Secured Term Loan to: (i) redeem all of our outstanding 11.25% Senior Secured Notes due 2014 (Series A-1) (the “Series A-1 Notes”); (ii) redeem an aggregate principal amount of $160.0 million of our outstanding 12.375% Senior Secured Notes due 2014 (Series A-2) (the “Series A-2 Notes” and, together with the Series A-1 Notes, the “Notes”); and (iii) pay fees and expenses associated with the entering into the Senior Secured Term Loan and the redemption of the Notes.

In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, we paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, we wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed. Such amounts are included in Interest Expense on our Condensed Consolidated Statement of Operations for the nine months ended September 30, 2013.

Borrowings under the Senior Secured Term Loan were incurred with an original issue discount of $9.0 million. We incurred $10.6 million of debt issuance costs in connection with the Senior Secured Term Loan.

Series A-1 Notes and Series A-2 Notes. We issued Series A-1 Notes and Series A-2 Notes in May 2009 and August 2009, respectively. On April 5, 2013, all Series A-1 Notes and $160.0 million of Series A-2 Notes were refinanced using the

 

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proceeds of the Senior Secured Term Loan as described above. As of September 30, 2013, we had $157.5 million of aggregate principal amount of the Series A-2 Notes outstanding. The Series A-1 Notes and the Series A-2 Notes bear interest at a rate equal to 11.25% per annum and 12.375% per annum, respectively. The indenture governing the Series A-1 Notes and the Series A-2 Notes, among other restrictions, limits our ability and the ability of its restricted subsidiaries to:

 

    incur additional debt;

 

    pay dividends and make other distributions;

 

    make certain investments;

 

    repurchase our stock;

 

    incur certain liens;

 

    enter into transactions with affiliates;

 

    merge or consolidate;

 

    enter into agreements that restrict the ability of our subsidiaries to make dividends or other payments to us; and

 

    transfer or sell assets.

Subject to certain exceptions, the indenture governing the Series A-2 Notes permits us and our restricted subsidiaries to incur additional indebtedness, including senior indebtedness and secured indebtedness.

Substantially all of our 100%-owned subsidiaries (the “Guarantors”) jointly and severally, unconditionally guarantee the Series A-2 Notes on a senior secured basis. The Guarantors also guarantee our ABL Facility.

Amended and Restated ABL Facility. On August 8, 2011, we entered into a senior secured asset-based revolving credit facility, or ABL Facility, with Bank of America, N.A., as administrative agent and collateral agent and a syndicate of financial institutions and institutional lenders. The ABL Facility amended and restated our prior senior secured asset-based revolving credit facility dated October 28, 2008, which provided for a revolving credit financing of up to $150.0 million.

The ABL Facility provides for revolving credit financing of up to $250.0 million, subject to borrowing base availability, with a maturity of the earlier of (a) five years and (b) 90 days prior to the earliest maturity of our outstanding Senior Secured Term Loan and Series A-2 Notes, and includes both a letter of credit and swingline loan sub-facility. The borrowing base at any time is equal to the sum (subject to certain reserves and other adjustments) of (i) 85% of eligible receivables, (ii) the least of (a) 85% of eligible self-pay accounts, (b) 10% of the borrowing base, (c) $25,000,000 and (d) the aggregate amount of self-pay accounts collected within the previous 90 days, (iii) the lesser of (a) 85% of eligible accounts invoiced but unpaid for more than 180 days but less than 360 days and (b) 10% of eligible accounts invoiced but unpaid for 180 days or less and (iv) the lesser of (a) 85% of the net orderly liquidation value of eligible inventory and (b) $35.0 million.

Borrowings under our ABL Facility bear interest at a rate per annum equal to, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Bank of America, N.A. and (2) the federal funds effective rate plus 1/2 of 1% (“Base Rate”), plus an applicable margin (currently 1.25%) or (b) a LIBOR rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin (currently 2.25%). The applicable margin for borrowings under our ABL Facility is subject to (a) 25 basis points step ups and step downs based on average excess availability under the ABL Facility and (b) a step down of 25 basis points based on achieving a consolidated fixed charge coverage ratio greater than 1.75 to 1.00. In addition to paying interest on outstanding amounts under our ABL Facility, we are required to pay a commitment fee, in respect of the unutilized commitments thereunder, ranging from 0.375% to 0.50% per annum, which fee will be determined based on utilization of our ABL Facility (increasing when utilization is low and decreasing when utilization is high). We also pay customary letter of credit fees equal to the applicable margin on LIBOR loans and other customary letter of credit and agency fees.

From time to time, we issue letters of credit in connection with our business, including commercial contracts, leases, insurance and workers’ compensation arrangements. If the holders of our letters of credit draw funds under such letters of credit, it would increase our outstanding senior secured indebtedness.

As of September 30, 2013, there was $22.0 million outstanding under the ABL Facility, outstanding letters of credit totaled $25.0 million and additional availability under the ABL Facility, subject to the borrowing base, was $203.0 million. As of September 30, 2013, the available borrowing base did not constrain our ability to borrow the entire $203.0 million of available borrowing capacity under our ABL Facility. At September 30, 2013, we were in compliance with all of the financial covenants required by the credit agreement governing the ABL Facility. Under the terms of our ABL Facility, loans outstanding under the ABL Facility may be accelerated if any Series A-2 Notes remain outstanding on or after August 1, 2014.

 

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As market conditions warrant, we and our major equity holders, including the Sponsor and its affiliates, may from time to time, depending upon market conditions, seek to refinance or repurchase our debt securities or loans in privately negotiated or open market transactions, by tender offer or otherwise.

Covenant Compliance. Under the indenture governing our Series A-2 Notes and under the credit agreements governing our ABL Facility and the Senior Secured Term Loan, our ability to engage in activities such as incurring additional indebtedness, making investments, refinancing certain indebtedness, paying dividends and entering into certain merger transactions is governed, in part, by our ability to satisfy tests based on Adjusted EBITDA.

“Adjusted EBITDA” is defined as net income (loss), plus interest expense, net, loss on early retirement of debt, provision (benefit) for income taxes and depreciation and amortization, further adjusted for certain other non-cash items, costs incurred related to initiatives, cost reduction and other adjustment items that are permitted by the covenants included in the indenture governing the Series A-2 Notes and the credit agreements governing our ABL Facility and the Senior Secured Term Loan.

We believe that the presentation of Adjusted EBITDA is appropriate to provide additional information to investors about the calculation of, and compliance with, certain financial covenants in the indenture governing our Series A-2 Notes and in the credit agreements governing our ABL Facility and the Senior Secured Term Loan. Adjusted EBITDA is a material component of these covenants. We caution investors that amounts presented in accordance with our definition of Adjusted EBITDA may not be comparable to similar measures disclosed by other issuers, because not all issuers and analysts calculate Adjusted EBITDA in the same manner.

Adjusted EBITDA is not a measurement of our financial performance under GAAP and should not be considered as an alternative to net income or any other performance measures derived in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity.

The following table provides a reconciliation from our net loss to Adjusted EBITDA:

 

(in thousands)

   Three Months Ended
September 30, 2013
    Twelve Months Ended
September 30, 2013
 

Net loss(a)

   $ (15,785   $ (106,138

Interest expense, net(b)

     22,969        121,616   

Loss on early retirement of debt(c)

     —          44,221   

Income tax expense (benefit)

     828        (22,577

Depreciation and amortization

     31,666        115,647   

Non-cash impairment charges(d)

     —          70,000   

Non-cash items(e)

     9,568        28,939   

Costs incurred related to initiatives and non-recurring items(f)

     9,442        36,558   

Other adjustments(g)

     1,751        6,998   

Projected cost savings and synergies(h)

     2,634        3,057   
  

 

 

   

 

 

 

Adjusted EBITDA

   $ 63,073      $ 298,321   
  

 

 

   

 

 

 

 

(a) Net loss for the twelve months ended September 30, 2013 reflects the following non-cash impairment charge based on the results of our impairment testing as of December 31, 2012 and the tax impact associated with the impairment charge:

 

  (i) Trade name impairment of $70.0 million, all of which relates to the home respiratory therapy/home medical equipment reporting unit; and

 

  (ii) Tax benefit of $27.6 million relating to the intangible assets impairment.

 

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All of these items resulted in a $42.4 million increase in our net loss in the twelve months ended September 30, 2013.

 

Three Months Ending

   (in thousands)  

December 31, 2012

   $ (52,362

March 31, 2013

     (1,893

June 30, 2013

     (36,098

September 30, 2013

     (15,785
  

 

 

 

Net Loss

   $ (106,138
  

 

 

 

 

(b) Reflects $23.2 million of interest expense, net of $0.2 million of interest income for the three months ended September 30, 2013. Reflects $167.5 million of interest expense, net of $(1.7) million of interest income for the twelve months ended September 30, 2013.
(c) Reflects $24.6 million of premiums paid to the holder of the redeemed Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed for the twelve months ended September 30, 2013. Reflects $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed in the twelve months ended September 30, 2013.
(d) Reflects the $70.0 million non-cash impairment described in (a) above.
(e) Non-cash items are comprised of the following:

 

(in thousands)

   Three Months Ended
September 30, 2013
     Twelve Months Ended
September 30, 2013
 

Profit interest units compensation expense

   $ 1,458       $ 5,257   

Loss on patient service equipment, disposition of assets and other(i)

     5,710         21,282   

Other non-cash items

     2,400         2,400   
  

 

 

    

 

 

 

Total non-cash items

   $ 9,568       $ 28,939   
  

 

 

    

 

 

 

 

(i) Primarily represents the net book value of our patient service equipment upon sale, disposal or write-off, which is a non-cash expense included within cost of net revenues in our consolidated statements of operations.

 

(f) Costs incurred related to initiatives and non-recurring items are comprised of the following:

 

(in thousands)

   Three Months Ended
September 30, 2013
     Twelve Months Ended
September 30, 2013
 

Costs and expenses related to initiatives(i)

   $ 9,442       $ 30,924   

Executive severance and retention(ii)

     —           5,634   
  

 

 

    

 

 

 

Total costs incurred related to initiatives and non-recurring items

   $ 9,442       $ 36,558   
  

 

 

    

 

 

 

 

(i) Primarily represents salaries and wages, severance, relocation consulting fees and other expenses for the three and twelve months ended September 30, 2013, related to five key projects: (1) transition of our enteral business to the infusion reporting unit’s operating platform; (2) strategic reductions in workforce in our home respiratory therapy and home medical equipment business; (3) professional fees related to certain corporate matters; (4) a new billing and collections system for our home infusion therapy business; and (5) centralization of the admissions process for our home infusion therapy business.
(ii) Represents executive severance and retention expense for the three and twelve months ended September 30, 2013.

 

(g) Other adjustment items primarily related to the sponsor management fee of $1.8 million and $7.0 million for the three and twelve months ended September 30, 2013.
(h) Represents projected net cost savings and synergies to be realized in connection with acquisitions and cost saving, restructuring and other similar initiatives, primarily related to procurement savings.

Business Combinations and Asset Purchases. We periodically acquire complementary businesses. These transactions are accounted for as purchases and the results of operations of the acquired companies are included in the accompanying statements of operations from the dates of acquisition. Covenants not to compete are being amortized over the life of the

 

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respective agreements. Customer lists, favorable lease arrangements and patient referral sources are being amortized over the period of their expected benefit. During the nine months ended September 30, 2013 there were no asset acquisitions and during the nine months ended September 30, 2012, we purchased certain assets of a business for $0.1 million.

Inflation. We experience pricing pressures in the form of continued reductions in reimbursement rates, particularly from managed care organizations and from governmental payors such as Medicare and Medicaid. We are also impacted by rising costs for certain inflation-sensitive operating expenses such as labor and employee benefits, facility and equipment leases, and vehicle fuel. However, we generally do not believe these impacts are material to our revenues or net income.

Contractual Cash Obligations. The following table summarizes the long-term cash payment obligations to which we are contractually bound. The years presented below represent a 3-month period ending December 31, 2013 and 12-month periods in subsequent periods.

 

(in millions)    Less
than
1 Year
     1-3 Years      3-5 Years      More
than
5 Years
     Totals  

Senior Secured Term Loan(1)

   $ 2       $ 18       $ 18       $ 860       $ 898   

Interest Payments on Senior Secured Term Loan(1)

     15         120         117         143         395   

Operating Leases

     14         101         56         22         193   

Purchase Obligations(2)

     12         76         52         29         169   

Series A-2 Notes(3)

     —           158         —           —           158   

Interest Payments on Series A-2 Notes(3)

     10         19         —           —           29   

Amended ABL Facility(4)(5)

     22         —           —           —           22   

Fees on ABL Facility(4)(5)

     1         1         —           —           2   

Capitalized Leases(6)

     —           —           —           —           —     

Unrecognized Tax Benefits(7)

     —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Contractual Cash Obligations

   $ 76       $ 493       $ 243       $ 1,054       $ 1,866   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) On April 5, 2013, we entered into a senior secured credit agreement and borrowed $900.0 million in aggregate principal amount of term loans (“Senior Secured Term Loan”) from the lenders under this credit agreement. Interest payments on the Senior Secured Term Loan will total approximately $61 million annually until the term note matures on April 1, 2020. The effective interest rate at April 5, 2013 was 6.75%. Additionally, there is a 1% paydown feature on the original principal of the loan due quarterly.
(2) The purchase obligations primarily relate to approximately $136 million we expect to pay under an agreement with Dell Services (formerly Perot Systems) and approximately $30 million we expect to pay under an agreement with Serco (formerly Intelenet). However, if we terminated the agreements, the required obligation to vendors could be reduced to approximately $14.6 million for Dell Systems and $6.7 million for Serco.
(3) Represents aggregate interest payments on $157.5 million of the Series A-2 Notes issued in August 2009 that is paid semi-annually in May and November. Interest payments on the Series A-2 Notes will total approximately $19 million annually until the Series A-2 Notes mature on November 1, 2014. The interest rate on the Series A-2 Note is 12.375%. During the three months ended June 30, 2013, we redeemed all of our outstanding Series A-1 Notes and an aggregate principal amount of $160.0 million of the outstanding Series A-2 Notes.
(4) Borrowings under the Amended ABL Facility bear interest at a rate per annum equal to, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Bank of America, N.A. and (2) the federal funds effective rate plus 1/2 of 1%, plus an applicable margin of 1.00% to 1.50% based on the average excess availability (currently 1.00%) or (b) a LIBOR rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin of 2.00% to 2.50% based on average excess availability (currently 2.00%). The applicable margin for borrowings under our ABL Facility is subject to step ups and step downs based on average excess availability under the ABL Facility. The fees payable on the Amended ABL Facility are based on an assumed fee for undrawn amounts of 0.50%, which represents the fees payable under the Amended ABL Facility assuming no borrowings or drawn letters of credit. We are required to pay a commitment fee on the Amended ABL Facility, in respect of the unutilized commitments there under, ranging from 0.375% to 0.50% per annum, which fee is determined based on the utilization of our Amended ABL Facility (increasing when utilization is low and decreasing when utilization is high). The fees also include an administrative fee which is paid quarterly.
(5) The actual amounts of interest and fee payments under the ABL Facility will ultimately depend on the amount of debt and letters of credit outstanding and the interest rates in effect during each period. We are also required to pay customary letter of credit fees equal to the applicable margin on LIBOR loans and certain agency fees.
(6) Less than $1 million.
(7) Gross unrecognized tax benefits of $6.8 million are included within “Income Taxes Payable and Other Non-current Liabilities” in the total liabilities section of our September 30, 2013 consolidated balance sheet. The entire $6.8 million amount is not reflected in the contractual cash obligations table above since we cannot make a reliable estimate of the period in which cash payments will occur.

 

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Off-Balance Sheet Arrangements

We are not a party to off-balance sheet arrangements as defined by the Securities and Exchange Commission. However, from time to time we enter into certain types of contracts that contingently require us to indemnify parties against third-party claims. The contracts primarily relate to: (i) certain asset purchase agreements, under which we may provide customary indemnification to the seller of the business being acquired; (ii) certain real estate leases, under which we may be required to indemnify property owners for environmental and other liabilities, and other claims arising from our use of the applicable premises; and (iii) certain agreements with our officers, directors and employees, under which we may be required to indemnify such persons for liabilities arising out of their relationship with us. In addition, we issued certain letters of credit under our ABL Facility as described under “Liquidity and Capital Resources—Long-Term Debt.”

The terms of such obligations vary by contract and in most instances a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, no liabilities have been recorded for these obligations on our balance sheets for any of the periods presented.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At September 30, 2013, there was $22.0 million outstanding under our ABL Facility. As of November 8, 2013, there was approximately $62.9 million outstanding under the ABL Facility. The credit agreement governing the ABL Facility provides interest rate options based on the following indices: Federal Funds Rate, the Bank of America prime rate or LIBOR. All such interest rate options are subject to the application of an interest margin as specified in the credit agreement governing the ABL Facility. At September 30, 2013, any outstanding borrowings under the ABL Facility would have been tied to the Bank of America prime rate. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Long-term Debt.” In addition, on April 5, 2013, we borrowed $900.0 million in aggregate principal amount of term loans under the Senior Secured Term Loan. Borrowings under the Senior Secured Term Loan bear interest at a fluctuating rate per annum equal to, at the Company’s option (i) a base rate equal to the highest of (a) the federal funds rate plus 1/2 of 1%, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America, N.A. as its “prime rate” and (c) the one month LIBOR Rate plus 1.00% (provided that in no event shall such base rate with respect to the initial Term Loans be less than 2.25% per annum), in each case plus an applicable margin of 4.50% or (ii) a LIBOR Rate for the applicable interest period (provided that in no event shall such LIBOR rate with respect to the initial Term Loans be less than 1.25% per annum) plus an applicable margin of 5.50%.

 

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended (“Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. The Company’s management, with the participation of the Company’s Chief Executive Officer and Principal Financial Officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this Form 10-Q. Based upon that evaluation, the Company’s Chief Executive Officer and Principal Financial Officer concluded that, as of September 30, 2013, the Company’s disclosure controls and procedures were effective to accomplish their objectives at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There was no change in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the three month period ended September 30, 2013 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Part II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

We are engaged in the defense of certain claims and lawsuits arising out of the ordinary course and conduct of our business, the outcomes of which are not determinable at this time. Insurance policies covering such potential losses, where such coverage is cost effective, are maintained. In the opinion of management, any liability that might be incurred upon the resolution of these claims and lawsuits will not, in the aggregate, have a material adverse effect on our financial condition or results of operations, cash flows and liquidity.

 

ITEM 1A. RISK FACTORS

We operate in a rapidly changing environment that involves a number of risks. The following discussion highlights some of these risks and others are discussed elsewhere in this report. These and other risks could materially and adversely affect our business, financial condition, prospects, operating results or cash flows. The following risk factors are not an exhaustive list of the risks associated with our business. New factors may emerge or changes to these risks could occur that could materially affect our business.

Risks Relating to Our Business

Continued Reductions in Medicare and Medicaid Reimbursement Rates Could Have a Material Adverse Effect on Our Business Results of Operations and Financial Condition.

There are ongoing legislative and regulatory efforts to reduce or otherwise adversely affect Medicare and Medicaid reimbursement rates for products and services we provide. For example, the regulations implementing the mandates under the MMA, the DRA, MIPPA, the Reform Package and the Budget Control Act reduced the reimbursement for a number of products and services we provide and established or expanded a competitive bidding program for certain durable medical equipment under Medicare Part B. The Medicare DMEPOS competitive bidding program is intended to further reduce reimbursement for certain products and to decrease the number of companies permitted to serve Medicare beneficiaries. As an example, in July 2008, MIPPA was passed and included a delay to the competitive bidding program. In order to ensure that the delay would achieve the same level of savings projected for the DMEPOS competitive bidding program, Congress adopted a nationwide average payment reduction of 9.5% in the DMEPOS fee schedule for those product categories included in Round 1, effective January 1, 2009.

CMS was required to conduct the Round 1 Rebid and mandated certain changes for both the Round 1 Rebid and subsequent rounds of the program. Approximately $16.6 million of our net revenues for the year ended December 31, 2012 was generated by the products and CBAs included in the Round 1 Rebid, net of both the average price reduction of 32% as reported by CMS and volume fluctuations in the markets over the first two years of the three-year contract. When the additional products to be included in the more recent Round 1 Recompete process are accounted for, the same markets generated approximately $20.1 million in the year ended December 31, 2012. The Round 1 Recompete phase of the program takes effect in January 2014.

Round 2 of the DMEPOS competitive bidding program includes the majority of the same product categories as the Round 1 Rebid, but also includes: (i) a new product category including standard power wheelchairs and manual wheelchairs, (ii) Negative Pressure Wound Therapy, (iii) Support Surfaces (Group 2 mattresses and overlays) in all Round 2 markets and (iv) a national mail order competition for diabetic supplies. CMS announced the Single Payment Amounts (“SPAs”) for Round 2 on January 30, 2013. The new Round 2 rates and guidelines took effect on July 1, 2013. We were offered a significant number of contracts in Round 2 and estimate that approximately $122 million of our net revenues for the fiscal year ending December 31, 2012 are subject to Round 2 competitive bidding. CMS reported that the average payment reduction for Round 2 is 45%. After applying the actual SPAs for each impacted CBA to our actual 2012 revenue for the product categories included in the bidding program, the Company estimates that the annual Round 2 revenue reduction will be $57 million before any changes in volume are accounted for. The extent of the industry-wide competitive bidding reductions will likely have a profound effect on our competitors as well as on us.

In April 2012, CMS announced the timeline and product categories for the “recompete” of the Round 1 Rebid contracts and an associated schedule. New rates for the Round 1 Recompete were announced in early October 2013 and represent, on average, a 37% reduction from the prevailing Medicare fee schedule. However, certain product categories and products will absorb greater reductions that are more analogous to Round 2 rates. The Recompete and its new rates are scheduled to take effect on January 1, 2014. We estimate the impact of the Round 1 Recompete’s new rates translate to an incremental $2.9 million reduction in revenues as compared to the Round 1 Rebid. The Reform Package also made changes to the competitive bidding program and requires that all areas of the country are subject either to DMEPOS competitive bidding or payment rate adjustments using competitive bid pricing by 2016. However, the Secretary of Health and Human Services is also required to publish a proposed rule outlining the methodology to be used for such a program expansion. At this time, we cannot quantify what negative impact, if any, future program revisions will have upon our revenue or operations, but such impact would likely be material.

 

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Further, the DRA resulted in reduced reimbursement rates for certain durable medical equipment, including the home oxygen equipment and services we provide, a reduced period for rental revenue, and potential increased costs to us associated with replacement of certain patient-owned equipment. There have been various administrative and legislative proposals to further reduce the maximum capped rental period for oxygen equipment below the 36-month level mandated by the DRA to 13 and 18 months, respectively, and/or to reduce the monthly payment rates for oxygen equipment.

There are also ongoing state and federal legislative and regulatory efforts to reduce or otherwise adversely affect Medicaid reimbursement rates for products and services we provide. For a number of years, some states have adopted alternative pricing methodologies for certain drugs, biologicals and home medical equipment reimbursed under the Medicaid program. In a number of states, the changes reduced the level of reimbursement we received for these items without a corresponding offset or increase to compensate for the service costs we incurred. We periodically evaluate the possibility of stopping or reducing our Medicaid business in a number of states with reimbursement policies that make it difficult for us to conduct operations profitably.

Moreover, the Reform Package increases Medicaid enrollment over a number of years and imposes additional requirements on states, which could further strain state budgets and therefore result in additional policy changes or rate reductions. In June 2012, the United States Supreme Court upheld the Reform Package provision expanding Medicaid eligibility to new populations as constitutional, but only so long as the expansion of the Medicaid program is optional for the states. States that choose not to expand their Medicaid programs to newly eligible populations can only lose the new federal Medicaid funding included in the Reform Package but cannot lose their eligibility for existing federal Medicaid matching payments. In addition, changes to the federal regulations pertaining to prescription drug pricing may also impact the Medicare and Medicaid reimbursement available to us. The President’s 2013 and 2014 fiscal budget proposals would limit the state Medicaid reimbursement levels for certain durable medical equipment services and products to Medicare reimbursement rates for the same products and services in the same state, including those impacted by the Medicare DMEPOS competitive bidding program. In view of the Supreme Court decision, some states have announced plans to reduce their Medicaid enrollments, which may have a negative impact on our revenues. We cannot currently predict the adverse impact, if any, that any such changes to or reduction in our Medicaid business might have on our operations, cash flow and capital resources, but such impact could be material. In addition, we cannot predict whether other states will consider similar or other reimbursement reductions or whether any such changes could have a material adverse effect on our results of operations, cash flow and capital resources.

We cannot estimate the ultimate impact of all legislated and contemplated Medicare and Medicaid reimbursement changes or provide assurance to investors that additional reimbursement reductions will not be made or will not have a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity. However, given the recent significant increases in industry audit volume, auditors’ interpretation and enforcement of documentation requirements and the increasing regulatory burdens associated with responding to those audits, it is likely that the negative pressures from legislative and regulatory changes will continue and accelerate.

For further information, see “Business—Government Regulation.”

The Comprehensive Healthcare Reform Law and Other Federal and State Legislative Efforts Could Have a Material Adverse Effect on Our Business, Results of Operations and Financial Condition.

Federal and state legislative and regulatory activities may materially affect reimbursement policies and rates for other items and services we provide and may otherwise affect our business results of operations and financial condition. For example, in March 2010, Congress enacted the Reform Package which includes comprehensive healthcare reform. Among many other provisions, the Reform Package expands the Medicaid program, mandates extensive insurance market reforms, creates new health insurance access points (e.g., insurance exchanges), provides certain insurance subsidies (e.g., premiums and cost sharing), imposes individual and employer health insurance requirements and makes a number of changes to the Code.

There are various provisions in the Reform Package that impact our business. For example, the Reform Package requires certain pharmaceutical and medical device manufacturers to pay an excise tax to the government, which may, in turn, increase our costs for these products. However, new legislation aimed at repealing the medical device excise tax, the “Protect Medical Innovation Act of 2013”, was introduced in the House in February 2013. The Reform Package also provides for cuts in some Medicare payments made to certain providers and substantial cuts to Medicare Advantage plans, through which we contract to provide services to Medicare beneficiaries. Also included in the Reform Package are (i) an expansion of the Recovery Audit Contractor Program, (ii) certain fraud and abuse prevention measures and (iii) expanded regulatory authority concerning the types of conduct that can result in additional fines and penalties for those healthcare providers who

 

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do not comply with applicable laws and regulations. Furthermore, the Reform Package grants the Secretary of Health and Human Services authority to set a date by which certain providers and suppliers will be required to establish a compliance program.

The Reform Package makes a number of changes to how certain of our products will be reimbursed by Medicare. As discussed above, the Reform Package made changes to the Medicare durable medical equipment CPI adjustment for 2011 and each subsequent year based upon the CPI-U reduced by a new multi-factor productivity adjustment which may result in negative updates. The Administration’s 2014 fiscal budget proposal would change the way the government calculates measures of inflation for government programs, among other things. As compared to the current CPI method, the switch in the inflation formula would cut spending on government programs by $130 billion over 10 years. At this time, it is unclear how this change, if implemented, would impact annual DMEPOS payment updates. It is possible that such a change, if implemented, could have an adverse impact on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

In an effort to further strengthen the integrity of the Medicare program, the Reform Package includes additional requirements concerning physician enrollment and certain mandatory face-to-face patient/physician visits in conjunction with the ordering of durable medical equipment not currently subject to such requirements. These provisions have been and will continue to be the subject of rulemaking and are a high priority for the American Association for Homecare and other industry representative organizations. We expect the Administration to continue to enhance its oversight efforts and we strive to incorporate any necessary changes into its overall policies, procedures, corporate compliance and internal audit programs on a regular basis.

The effective dates of the various provisions within the Reform Package are staggered over several years. Much of the interpretation of what the Reform Package requires will be subject to administrative rulemaking, the development of agency guidance and court interpretations. We cannot currently predict the full impact of the Reform Package on our operations, cash flow and capital resources, but such impact could be material. In addition, other legislative and regulatory changes could have a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

Also, the number of the uninsured in the United States and the advent of additional high deductible health plans offered by employers has had an impact on certain healthcare services and products that may be more discretionary in nature. This has resulted in a slowing down of certain growth rates due to the patients’ more limited ability to pay the associated out-of-pocket fees. This could continue as the number of uninsured persons remains high even after the Reform Package becomes more fully implemented.

We Believe That Continued Pressure to Reduce Healthcare Costs Could Have a Material Adverse Effect on Us.

As a result of continuing reductions in payor reimbursement, we, like many other healthcare companies, are making substantial efforts to reduce our costs in providing healthcare services and products. Many managed care organizations and insurers also regularly attempt to seek reductions in the prices at which we provide services to them and their patients. Some managed care organizations and insurers also propose to limit coverage for our products and services and implement onerous payment rules, policies, administrative burdens, audits and other requirements that adversely impact our reimbursement and increase our costs of providing services and products. In addition to this increasing pressure to reduce costs, the use by managed care payors of benefit managers and other intermediaries is also increasing and may adversely impact us, including for example by imposing of burdensome reimbursement or utilization management policies we must comply with and adverse changes in our participation status with managed care organizations and insurers. We have a large number of contractual arrangements with managed care organizations and other parties, which represented approximately 72% of our total net revenues for the nine months ended September 30, 2013 and 2012, and we expect that we will continue to enter into more of these contractual arrangements. Many of these contracts allow, usually after due notice, for payors to alter their payment policies (or newly enforced policies that were previously enacted). We could be materially adversely affected by adverse payment policy practices. Also, the Reform Package significantly reduces the government’s payment rates to Medicare Advantage plans. Other provisions impose minimum medical-loss ratios, state and federal premium review procedures and benefit requirements on insurers. Mandatory sequestration and its associated price reductions will accelerate the risk of further pricing pressure on managed care payors and on us. These public policy changes have unpredictable effects on the insurance industry on which we rely. There can be no assurance that we will retain or obtain Medicare Advantage or other such managed care contracts or that such plans will not attempt to further reduce the rates they pay to providers. In addition, if we are unable to successfully reduce our costs, we may be unable to continue to provide services directly to patients of certain payors or through these contractual arrangements. This would have a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

The segment of the healthcare market in which we operate is highly competitive. In each of our service lines, there are a number of national providers and numerous regional and local providers. Other types of healthcare providers, including

 

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individual hospitals and hospital systems, home health agencies, health maintenance organizations and certain retailers, have entered and may continue to enter the market to compete with our various service lines. With access to significantly greater financial and market resources than what is available to us, some of these competitors may be better positioned to compete in the market. This may increase pricing pressure and limit our ability to maintain or increase our market share and may have a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

Non-Compliance With Laws and Regulations Applicable to Our Business and Future Changes in or Interpretations of Those Laws and Regulations Could Have a Material Adverse Effect on Us.

We are subject to many stringent and frequently changing laws and regulations, and interpretations thereof, at both the federal and state levels, requiring compliance with burdensome and complex billing and payment, substantiation and record-keeping requirements. Examples of such documentation requirements are contained in the DME MAC supplier manuals which provide that clinical information from the “patient’s medical record” is required to justify the medical necessity for the provision of DME. DME MAC medical directors, CMS staff and government auditors have taken the position, among other things, that the “patient’s medical record” refers not to documentation maintained by the DME supplier but instead to documentation maintained by the patient’s physician, healthcare facility, or other clinician, and that clinical information created by the DME supplier’s personnel and confirmed by the patient’s physician is not sufficient to establish medical necessity. It may be difficult, and sometimes impossible, for us to obtain such documentation from other healthcare providers. These stringent medical necessity documentation requirements not only apply to new setups but also to those patients who seek to transition their care to us in the Medicare DMEPOS competitive bidding program CBAs. It may be necessary in these instances for patients to requalify for the products and services they received from their previous suppliers solely due to missing or incomplete documentation in their physician’s, hospital’s or previous supplier’s records. Also, auditors’ interpretations of these policies are inconsistent and subject to individual interpretations leading to high supplier and industry error rates. In 2012 and throughout 2013, DME MACs have continued to conduct significant pre-payment reviews across the DME industry and have determined a wide range of error rates. For example, error rates for CPAP claims have ranged from 30% to 80%. DME MACs have repeatedly cited medical necessity documentation insufficiencies as the primary reason for claim denials. In addition, certain states have established unique documentation requirements concerning direct patient care activities provided by DME suppliers’ staff. In the absence of such documentation, the state may request a refund or impose sanctions such as fines. If these or other challenging positions continue to be adopted by auditors, DME MACs, states, CMS or its contractors in administering the Medicare program, we have the right to contest these positions as being contrary to law. Such appeal processes may be protracted and costly, even when the initial determinations are overturned. If these interpretations of the documentation requirements are ultimately upheld, it could result in our making significant refunds and other payments to Medicare and/or Medicaid and our future revenues from Medicare and/or Medicaid would likely be reduced. We cannot currently predict the adverse impact, if any, that these new, more onerous interpretations of the Medicare and/or Medicaid documentation requirements, or revised internal operational policies to address them, might have on our relationships with referral sources, operations, cash flow and capital resources, but such impact could be material.

The federal False Claims Act imposes civil and criminal liability on individuals or entities that submit false or fraudulent claims for payment to the government. The federal government and a number of courts also have taken the position that claims presented in violation of certain other statutes, including the federal anti-kickback statute or the Omnibus Budget Reconciliation Act of 1993 (the “Stark Law”), can be considered a violation of the federal False Claims Act. Violations of the federal civil False Claims Act may result in treble damages, civil monetary penalties and exclusion from the Medicare, Medicaid and other federally funded healthcare programs. If certain criteria are satisfied, the federal civil False Claims Act allows a private individual to bring a qui tam suit on behalf of the government and, if the case is successful, to share in any recovery. Federal False Claims Act suits brought directly by the government or private individuals against healthcare providers, like us, are increasingly common and are expected to continue to increase.

The Reform Package also includes certain fraud and abuse prevention measures and expands regulatory authorities concerning the types of conduct that can result in additional fines and penalties for those healthcare providers who do not comply with applicable laws and regulations. In July 2012, CMS opened its Program Integrity Command Center which is designed to build and improve sophisticated predictive analytics that identify and combat fraud. Although we cannot quantify at this time what, if any, impact such processes might have on our relationships with referral sources, operations, cash flow and capital resources, such impact could be material.

Financial relationships between us and physicians and other referral sources are also subject to strict limitations under laws such as the Stark Law and anti-kickback laws. In addition, strict licensure, accreditation, safety and marketing requirements apply to the provision of services, pharmaceuticals and medical equipment.

 

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Violations of these laws and regulations could subject us to civil and criminal enforcement actions; licensure revocation, suspension or non-renewal; severe fines; facility shutdowns; repayment of amounts received from third party payors and possible exclusion from participation in federal healthcare programs such as Medicare and Medicaid. We cannot assure you that we are in compliance with all applicable existing laws and regulations or that we will be able to comply with any new laws or regulations that may be enacted in the future. In addition, from time to time, we may be the subject of investigations or audits or be a party to qui tam or other False Claims Act litigation which alleges violations of law. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources, liquidity or prospects.

Changes in public policy, healthcare law, new interpretations of existing laws, or changes in payment methodology may have a material effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

Expanded Government Auditing and Oversight of Medicare and Medicaid Suppliers and More Stringent Interpretations by Those Auditors of Regulations and Rules Concerning Billing for Our Services and Products Could Have a Material Adverse Effect on Us.

Current law, including the recent Reform Package and an executive order signed by the President, provides for a significant expansion of the government’s auditing and oversight of suppliers who care for patients covered by various government healthcare programs. Examples of this expansion include audit programs being implemented by the DME MACs, the Zone Program Integrity Contractors (“ZPICs”), the Recovery Audit Contractors (“RACs”) and the Comprehensive Error Rate Testing contractors (“CERTs”) operating under the direction of CMSWe work cooperatively with these auditors and have long maintained a process for centrally tracking and managing our responses to their audit requests. However, unlike other government programs that are subject to a formal rulemaking process, there are only limited publicly-available guidelines and methodologies for determining errors or for providing clear and timely communications to DMEPOS suppliers in connection with these types of audits. As a result, there is significant lack of clarity regarding the authority of the auditors, their expectations for document production requested during audits and the methodology for determining errors and calculating error rates.

Along with other healthcare providers and suppliers, we have been subject to a significant increase in the number of audits conducted under these new programs. Many of these audits have ascribed error rates to our audited locations that are significantly higher than we, and others in the industry, have experienced in the past. In some cases, these high error rates appear to be based on the auditors’ incomplete or erroneous review of our submitted documentation, our inability to retrieve physician or hospital documentation from their records, the auditors’ enforcement of requirements for documentation for patients begun on service during a time period when lesser levels of documentation were accepted practice, or unclear scoring methodologies used by the auditors, among other factors. In other instances, high error rates have resulted from the auditors’ use of more stringent or brand-new interpretations of the types of medical necessity documentation required for CMS to pay for the services we provide. We have appealed the results of certain of these audits and made changes to our operating policies and procedures, but cannot predict the ultimate impact that the government’s expanded and more stringent auditing, or our policies, may have on our business, financial conditions or results of operations.

We have been informed by these auditors that other healthcare providers and all suppliers of certain DMEPOS product categories are expected to experience further increased scrutiny from these audit programs. When a government auditor ascribes a high error rate to one or more of our locations, it generally results in a protracted pre-payment claims review, payment delays, refunds and other payments to the government and/or our need to request more documentation from referral sources than has historically been required. It may also result in additional audit activity in other locations of ours in that state or DME MAC jurisdiction. Our error rate, aggregated with other DMEPOS suppliers in the industry, is then reported to Medicare contractors and Congress. According to the CERT contractors utilizing the more stringent interpretations of the medical necessity documentation requirements, the DMEPOS industry error rate increased in recent years, from 51.9% in 2009 to 66% in 2012. Further, DME MACs have continued to conduct extensive pre-payment reviews across the DME industry and, for example, have found that error rates for CPAP claims have ranged from 30% to 80%. We cannot currently predict the adverse impact, if any, these new audits, methodologies and interpretations might have on our operations, cash flow and capital resources, but such adverse impact could be material.

See “Risks Relating to Our Business—Non-Compliance with Laws and Regulations Applicable to Our Business and Future Changes in or Interpretations of These Laws and Regulations Could Have a Material Adverse Effect on Us” for additional information.

 

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Our Business and Financial Performance May Be Adversely Affected By Our Inability to Effectively Execute and Implement Cost Savings and Reorganization Initiatives.

We launched a substantial multi-year cost reduction plan in late 2007 across a number of identified initiatives realizing approximately $188.1 million in annualized pre-tax savings through September 30, 2013. As of September 30, 2013 we have approximately $3.1 million of projected costs savings and synergies remaining. Because of the ongoing reimbursement pressures on our industry, we plan to implement additional changes in our operating model to further reduce our costs. Projected cost savings associated with our future initiatives are subject to a variety of risks, including:

 

    the contemplated costs to effect these initiatives may exceed estimates;

 

    the initiatives we are contemplating may require consultation with various customers, employees or regulators, and such consultations may influence the timing, costs and extent of expected savings;

 

    the loss of skilled employees in connection with the initiatives; and

 

    the projected savings contemplated under these programs may fall short of targets.

While we expect to continue to implement and develop cost savings initiatives, there can be no assurance that we will be able to do so successfully or that we will realize all of the projected benefits. If we are unable to realize the anticipated cost savings from our initiatives, our business may be adversely affected. Moreover, our implementation of cost savings initiatives may have a material adverse effect on our business, results of operations and financial condition, including but not limited to the loss of revenue, increases in accounts receivable and reserves and/or write off of accounts receivable. Also, in response to changing business conditions from time to time we may discontinue or significantly adjust our cost savings initiatives which could affect our ability to achieve future cost savings.

We continue to seek opportunities to streamline our organizational structure and operations. We have taken certain steps designed to further separate our two reporting units to enable them to function more autonomously and achieve certain operating efficiencies. For example, July 1, 2013, we separated and transferred the assets and operations of our enteral nutrition business to certain of our wholly-owned subsidiaries in the home infusion therapy reporting unit. We expect these efforts to continue throughout 2013. If we fail to implement our reorganization plans, at the cost or within the time periods expected, we may not be able to achieve the expected results. In addition, we expect to incur substantial costs in connection with our reorganization plans.

Our Failure to Successfully Design, Modify and Implement Computer and Other Process Changes to Maximize Productivity and Ensure Compliance Could Ultimately Have a Significant Negative Impact on Our Results of Operations and Financial Condition.

We have identified a number of areas throughout our operations where we intend to modify the current processes or systems in order to attain a higher level of productivity or ensure compliance. The ultimate cost savings expected from the successful design and implementation of such initiatives will be necessary to help offset the impact of Medicare and Medicaid reimbursement reductions and continued downward pressure on pricing. Additionally, Medicare and Medicaid often change their documentation requirements. The standards and rules for healthcare transactions, code sets and unique identifiers also continue to evolve, such as ICD 10 and HIPAA 5010 and other data security requirements. Moreover, government programs and/or commercial payors may have difficulties administering new standards and rules for healthcare transactions and this may adversely affect timelines of payment or payment error rates. The DMEPOS competitive bidding program also imposes new reporting requirements on contracted providers. From time to time, our outsourced contractor for certain information systems functions, Dell Services, makes operational, leadership or other changes that could impact our plans and cost-savings goals. Our failure to successfully design and implement system or process modifications could have a significant impact on our operations and financial condition. The implementation of many of the new standards and rules will require us to make substantial investments. Further, the implementation of these system or process changes could have a disruptive effect on related transaction processing and operations. If our implementation efforts related to systems development are unsuccessful, we may need to write off amounts that we have capitalized related to systems development projects. Additionally, if systems development implementations do not occur, we may need to incur additional costs to support our existing systems.

Our Failure to Maintain Controls and Processes Over Billing and Collections or the Deterioration of the Financial Condition of Our Payors or Disputes With Third Parties Could Have a Significant Negative Impact on Our Results of Operations and Financial Condition.

The collection of accounts receivable is one of our most significant challenges and requires constant focus and involvement by management and ongoing enhancements to information systems and billing center operating procedures.

 

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There can be no assurance that we will be able to improve upon or maintain our current levels of collectability and days sales outstanding in future periods. Further, some of our payors and/or patients may experience financial difficulties, or may otherwise not pay accounts receivable when due, resulting in increased write-offs. If we are unable to properly bill and collect our accounts receivable, our results will be adversely affected. In addition, from time to time we are involved in disputes with various parties, including our payors and their intermediaries regarding their performance of various contractual or regulatory obligations. These disputes sometimes lead to legal and other proceedings and cause us to incur costs or experience delays in collections, increases in our accounts receivable or loss of revenue. In addition, in the event such disputes are not resolved in our favor or cause us to terminate our relationships such parties, there may be an adverse impact on our results of operations or financial condition.

Our Outsourcing, Offshoring and Onshoring Activities Subject Us to Risks That Could Have a Significant Negative Impact on Our Results of Operations and Financial Condition.

Beginning in 2009, we outsourced certain billing, collections and other administrative and clerical services to Intelenet (now Serco) and certain information systems functions to Perot Systems Corporation (now Dell Services), both of which perform many of these services outside of the United States. Operations in other parts of the world involve certain regional geopolitical risks that are different than operating in the United States, including the possibility of civil unrest, terrorism and substantial regulation by the individual governments. In addition, federal and state regulators have expressed concerns regarding the impact of offshoring on American business in general, including, for example, job loss, security and privacy concerns. During 2010, we experienced negative reactions from federal and state regulators, payors, patients and referral sources as a result of the actual or perceived concerns caused by the outsourcing of portions of our business operations related to certain billing, collections and other administrative and clerical services and we experienced increases in accounts receivable, reserves, write-offs of accounts receivable and loss of revenues. Accordingly, we determined to return certain of these outsourced functions to our personnel in the United States. This transition resulted in various one-time costs and operational inefficiencies that impacted our results in 2011 and 2012.

Our Failure to Maintain Required Licenses Could Impact Our Operations.

We are required to maintain a significant number of state and/or federal licenses for our operations and facilities. Certain employees—primarily those with clinical expertise in pharmacy, nursing, respiratory therapy and nutrition—are required to maintain licenses in the states in which they practice. We manage the facility licensing function centrally. In addition, individual clinical employees are responsible for obtaining, maintaining and renewing their professional licenses and we also have processes in place designed to notify branch or pharmacy managers of renewal dates for the clinical employees under their supervision. State and federal licensing requirements are complex and often open to subjective interpretation by various regulatory agencies. Accurate licensure is also a critical threshold issue for the Medicare competitive bidding program. In fact, in June 2013, CMS voided almost a third of the contracts issued to unlicensed competitive bidding contract suppliers in the state of Tennessee; we were not among them as our licenses were in order. From time to time, we may also become subject to new or different licensing requirements due to legislative or regulatory requirements developments or changes in our business, and such developments may cause us to make further changes in our business, the results of which may be material. Although we believe we have appropriate systems in place to monitor licensure, violations of licensing requirements may occur and our failure to acquire or maintain appropriate licensure for our operations, facilities and clinicians could result in interruptions in our operations, refunds to state and/or federal payors, sanctions or fines or the inability to serve Medicare beneficiaries in competitive bidding markets which could have an adverse material impact on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

Our Failure to Maintain Accreditation Could Impact Our Operations.

Accreditation is required by most of our managed care payors and became a mandatory requirement for all Medicare DMEPOS providers effective October 1, 2009. In June 2013, we completed a nationwide independent triennial accreditation renewal process conducted by The Joint Commission, and the Commission renewed our accreditation for another three years. The Joint Commission accreditation encompasses our full complement of services including home health, home medical equipment, clinical respiratory, ambulatory infusion services, pharmacy dispensing, and clinical consultant pharmacist services. In June 2013, we celebrated our 25th anniversary of continuous accreditation by The Joint Commission—more years than any other homecare provider. If we or any of our branches lose accreditation, or if any of our new branches are unable to become accredited, our failure to maintain accreditation or become accredited could have a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

 

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Political and Economic Conditions As Well As Significant Global or Regional Developments Such As Economic and Political Events, International Conflicts, Natural Disasters That are Out of Our Control and the Ongoing Number of the Uninsured Could Adversely Affect Our Revenue and Results of Operations and Overall Financial Growth and Could Have a Material Adverse Effect on Us.

Our business can be affected by a number of factors that are beyond our control such as general geopolitical, economic and business conditions, conditions in the financial services markets, and general political and economic developments. For example, federal deficit spending levels, the costs of military and security activities, government expenditures to support financial institutions or the U.S. credit markets in light of historical significant declines and volatility in the financial markets, or prolonged relief efforts in response to a natural disaster could increase pressure to reduce government expenditures for other purposes, including government-funded programs such as Medicare and Medicaid. Reductions in reimbursement from Medicare and Medicaid programs could result if there is a significant change in government spending priorities as a result. Any such reimbursement reductions could have a material adverse effect on our business, financial condition, results of operations, cash flow, capital resources and liquidity.

The Budget Control Act of 2011 authorized increases in the United States’ debt limit of at least $2.1 trillion, established caps on funding appropriations estimated to reduce federal spending by $917 billion over the next ten years, and created the Joint Committee, a bipartisan committee consisting of twelve Members of Congress instructed to develop legislation to reduce the federal deficit by at least another $1.5 trillion over the ten-year period of fiscal years 2012—2021. Because Congress and the President failed to enact legislation reducing the deficit by at least $1.2 trillion over the ten-year period of fiscal years 2012—2021 by the January 15, 2012 deadline, automatic spending reductions in fiscal years 2013—2021 through sequestration, the required cancellation of budgetary resources, were triggered. Under the budget sequestration, certain federal programs are protected, including Medicaid. However, effective April 1, 2013, the budget sequestration caused payments to Medicare providers and suppliers to be reduced by 2%. Unless Congress takes action to change the law, federal spending will be subject to sequestration until fiscal year 2022. These reductions, along with any further reductions in provider and supplier reimbursement rates under federal healthcare programs, could have a material adverse effect on our financial condition and results of