Surgery Partners, Inc. 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report and our 2022 Annual Report on Form 10-K. Unless the context otherwise indicates, the terms "Surgery Partners," "we," "us," "our" or the "Company," as used herein, refer to Surgery Partners, Inc. and its subsidiaries. Unless the context implies otherwise, the term “affiliates” means direct and indirect subsidiaries of Surgery Partners, Inc. and partnerships and joint ventures in which such subsidiaries are partners. The terms “facilities” or “hospitals” refer to entities owned and operated by affiliates of Surgery Partners, Inc. and the term “employees” refers to employees of affiliates of Surgery Partners, Inc. Cautionary Note Regarding Forward-Looking Statements This report contains forward-looking statements, which are based on our current expectations, estimates and assumptions about future events. All statements other than statements of current or historical fact contained in this report are forward-looking statements. These statements include, but are not limited to, statements regarding our future financial position, business strategy, budgets, effective tax rate, projected costs and plans and objectives of management for future operations. The words "projections," "believe," "continue," "drive," "estimate," "expect," "intend," "may," "plan," "will," "could," "would" and similar expressions are generally intended to identify forward-looking statements. These statements involve risks, uncertainties and other factors that may cause actual results to differ from the expectations expressed in the statements. Many of these factors are beyond our ability to control or predict. These factors include, without limitation, reductions in payments from government health care programs and private insurance payors, such as health maintenance organizations, preferred provider organizations, and other managed care organizations and employers; our ability to contract with private insurance payors; changes in our payor mix or surgical case mix; failure to maintain or develop relationships with physicians on beneficial or favorable terms, or at all; the impact of payor controls designed to reduce the number of surgical procedures; our efforts to integrate operations of acquired businesses and surgical facilities, attract new physician partners, or acquire additional surgical facilities; supply chain issues, including shortages or quality control issues with surgery-related products, equipment and medical supplies; competition for physicians, nurses, strategic relationships, acquisitions and managed care contracts; our ability to attract and retain qualified health care professionals; our ability to enforce non-compete restrictions against our physicians; our ability to manage material liabilities whether known or unknown incurred as a result of acquiring surgical facilities; the impact of future legislation and other health care regulatory reform actions, and the effect of that legislation and other regulatory actions on our business; our ability to comply with current health care laws and regulations; the outcome of legal and regulatory proceedings that have been or may be brought against us; changes in the regulatory, economic and other conditions of the states where our surgical facilities are located; our indebtedness; the social and economic impact of a pandemic, epidemic or outbreak of a contagious disease, such as COVID-19, on our business; and the risks and uncertainties set forth under the heading "Risk Factors" in our 2022 Annual Report on Form 10-K and discussed from time to time in our reports filed with the SEC. Considering these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur, and actual results could differ materially from those anticipated or implied in the forward-looking statements. When you consider these forward-looking statements, you should keep in mind these risk factors and other cautionary statements in this report. These forward-looking statements speak only as of the date made. Other than as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether because of new information, future events or otherwise. Executive Overview As of March 31, 2023, we owned or operated, primarily in partnership with physicians, a portfolio of 145 surgical facilities comprised of 127 ASCs and 18 surgical hospitals across 31 states. We owned a majority interest in 92 of these surgical facilities and consolidated 118 of these facilities for financial reporting purposes. Total revenues for the first quarter of 2023 increased 11.7% to $666.2 million from $596.2 million for the first quarter of 2022. Days adjusted same-facility revenues for the first quarter of 2023 increased 10.3% from the same period last year, with a 4.8% increase in revenue per case and a 5.3% increase in same-facility cases. Additionally, for the first quarter of 2023, Adjusted EBITDA increased 16.9% to $90.1 million compared to $77.1 million for the same period last year. For the first quarter of 2023, the Company’s net loss attributable to Surgery Partners, Inc. was $24.9 million compared to net income of $12.2 million for the first quarter of 2022. A reconciliation of non-GAAP financial measures appears below under "Certain Non-GAAP Measures." We continue to focus on improving our same-facility performance, selectively acquiring established facilities, developing new facilities and other portfolio management initiatives. During the first quarter of 2023 we completed the following: • We acquired controlling interests in three surgical facilities, two of which were previously accounted for as equity method investments, and a physician practice for aggregate cash consideration of $40.7 million, net of cash acquired and non-cash consideration of $1.3 million. • We acquired non-controlling interests in an existing surgical facility and an in-development de novo surgical facility for an aggregate cash purchase price of $12.4 million, of which $2.8 million was deferred and was paid in April 2023. • We sold our interests in a surgical facility for net cash proceeds of $8.8 million, a portion of which will be held in escrow pursuant to the purchase agreement. 19 Table of Contents We had cash and cash equivalents of $245.5 million and $545.9 million of borrowing capacity under our revolving credit facility at March 31, 2023. Operating cash inflows were $74.5 million in the first quarter of 2023, compared to $79.8 million in the prior year period. Net operating cash inflows, including operating cash flows less distributions to non-controlling interests, were $32.6 million for the first quarter of 2023, compared to $43.6 million for the first quarter of 2022. Revenues Our revenues consist of patient service revenues and other service revenues. Patient service revenues consist of revenue from our surgical facility services and ancillary services segments. Specifically, patient service revenues include fees for surgical or diagnostic procedures performed at surgical facilities that we consolidate for financial reporting purposes, as well as for patient visits to our physician practices, anesthesia services, pharmacy services and diagnostic screens ordered by our physicians. Other service revenues include management and administrative service fees derived from our non-consolidated facilities that we account for under the equity method, management of surgical facilities and physician practices in which we do not own an interest and management services we provide to physician practices for which we are not required to provide capital or additional assets. The following table summarizes our revenues by service type as a percentage of total revenues for the periods indicated: Three Months Ended March 31, 2023 2022 Patient service revenues: Surgical facilities revenues 96.0 % 95.7 % Ancillary services revenues 2.5 % 2.9 % Total patient service revenues 98.5 % 98.6 % Other service revenues 1.5 % 1.4 % Total revenues 100.0 % 100.0 % Payor Mix The following table sets forth by type of payor the percentage of our patient service revenues generated at the surgical facilities which we consolidate for financial reporting purposes in the periods indicated: Three Months Ended March 31, 2023 2022 Private insurance payors 51.1 % 51.1 % Government payors 43.8 % 42.4 % Self-pay payors 2.4 % 2.9 % Other payors (1) 2.7 % 3.6 % Total 100.0 % 100.0 % (1) Other is comprised of anesthesia service agreements, automobile liability, letters of protection and other payor types. Surgical Case Mix We primarily operate multi-specialty surgical facilities where physicians perform a variety of procedures in various specialties. We believe this diversification helps to protect us from adverse pricing and utilization trends in any individual procedure type and results in greater consistency in our case volume. 20 Table of Contents The following table sets forth the percentage of cases in each specialty performed at the surgical facilities which we consolidate for financial reporting purposes for the periods indicated: Three Months Ended March 31, 2023 2022 Orthopedic and pain management 35.7 % 36.8 % Ophthalmology 24.1 % 24.6 % Gastrointestinal 23.5 % 22.7 % General surgery 3.0 % 3.0 % Other 13.7 % 12.9 % Total 100.0 % 100.0 % Critical Accounting Policies A summary of significant accounting policies is disclosed in our 2022 Annual Report on Form 10-K under the caption “Critical Accounting Policies” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section. There have been no material changes in the nature of our critical accounting policies or the application of those policies since December 31, 2022. Results of Operations Three Months Ended March 31, 2023 Compared to Three Months Ended March 31, 2022 The following table summarizes certain results from the statements of operations for the three months ended March 31, 2023 and 2022 (dollars in millions): Three Months Ended March 31, 2023 2022 Revenues $ 666.2 $ 596.2 Operating expenses: Cost of revenues 532.2 471.4 General and administrative expenses 32.0 29.5 Depreciation and amortization 33.7 27.4 Transaction and integration costs 12.5 7.1 Grant funds (1.1) (1.2) Net loss (gain) on disposals, consolidations and deconsolidations 10.5 (0.1) Equity in earnings of unconsolidated affiliates (3.3) (3.1) Litigation settlements 3.0 (32.8) Other expense (income), net 0.3 (2.4) 619.8 495.8 Operating income 46.4 100.4 Interest expense, net (46.8) (56.3) (Loss) income before income taxes (0.4) 44.1 Income tax benefit (expense) 1.6 (1.3) Net income 1.2 42.8 Less: Net income attributable to non-controlling interests (26.1) (30.6) Net (loss) income attributable to Surgery Partners, Inc. $ (24.9) $ 12.2 21 Table of Contents Revenues. Revenues for the three months ended March 31, 2023 compared to the three months ended March 31, 2022 were as follows (dollars in millions): Three Months Ended March 31, 2023 2022 Patient service revenues $ 656.4 $ 587.7 Other service revenues 9.8 8.5 Total revenues $ 666.2 $ 596.2 Patient service revenues increased 11.7% to $656.4 million for the first quarter of 2023 compared to $587.7 million for the first quarter of 2022. The increase was driven by an 10.3% increase in days adjusted same-facility revenues and acquisitions completed in 2023 and 2022. The increase in days adjusted same-facility revenues was attributable to a 4.8% increase in same-facility revenue per case and a 5.3% increase in same-facility case volumes. Cost of Revenues. Cost of revenues was $532.2 million for the first quarter of 2023 compared to $471.4 million for the first quarter of 2022. The increase was primarily driven by acquisitions completed since the prior year period. As a percentage of revenues, cost of revenues were 79.9% for the 2023 period and 79.1% for the 2022 period. General and Administrative Expenses. General and administrative expenses were $32.0 million for the first quarter of 2023 compared to $29.5 million for the first quarter of 2022. As a percentage of revenues, general and administrative expenses were 4.8% for the 2023 period and 4.9% for the 2022 period. Depreciation and Amortization. Depreciation and amortization expenses were $33.7 million for the first quarter of 2023 compared to $27.4 million for the first quarter of 2022. As a percentage of revenues, depreciation and amortization expenses were 5.1% for the 2023 period compared to 4.6% for the 2022 period. Transaction and Integration Costs. We incurred $12.5 million of transaction and integration costs for the first quarter of 2023 compared to $7.1 million for the first quarter of 2022. The costs for both periods primarily relate to ongoing development initiatives and the integration of acquisitions. Net Loss (Gain) on Disposals, Consolidations and Deconsolidations. The net loss on disposals, consolidations and deconsolidations in the first quarter of 2023 was partially attributable to activity discussed in Note. 2. "Acquisitions and Disposals" to our condensed consolidated financial statements included elsewhere in this report. The remaining net loss was attributable to disposals of other long-lived assets. Litigation Settlements. Litigation settlements in first quarter of 2022 was primarily attributable to the resolution of the stockholder litigation matter, as discussed in Note 8. "Commitments and Contingencies" to our condensed consolidated financial statements included elsewhere in this report. Interest Expense, Net. As a percentage of revenues, interest expense, net decreased to 7.0% for the 2023 period compared to 9.4% for the 2022 period. The decrease is attributable to the pay down of certain long-term debt in the fourth quarter of 2022. Income Tax Benefit (Expense). The income tax benefit was $1.6 million for the three months ended March 31, 2023 compared to income tax expense of $1.3 million for the three months ended March 31, 2022. The effective tax rate was 400.0% for the three months ended March 31, 2023 compared to 2.9% for the three months ended March 31, 2022. For the three months ended March 31, 2023, the effective tax rate differed from 21% primarily due to earnings attributable to non-controlling interests, an increase in the Company’s valuation allowance attributable to interest expense limitations, and a discrete tax benefit of $1.8 million related to the vesting of restricted stock awards. For the three months ended March 31, 2022, the effective tax rate differed from 21% primarily due to earnings attributable to non-controlling interests, an increase in the Company’s valuation allowance attributable to interest expense limitations, and discrete tax benefits of (a) $4.6 million related to the vesting of restricted stock awards, (b) $1.8 million attributable to non-recurring earnings’ impact on the Company’s valuation allowance, and (c) $1.0 million related to entity divestitures. Based upon the application of interim accounting guidance, the tax rate as a percentage of net income after income attributable to non-controlling interests will vary based upon the relative net income from period to period. Net Income Attributable to Non-Controlling Interests. As a percentage of revenues, net income attributable to non-controlling interests was 3.9% for the 2023 period and 5.1% for the 2022 period. 22 Table of Contents Liquidity and Capital Resources Cash and cash equivalents were $245.5 million at March 31, 2023 compared to $282.9 million at December 31, 2022. The primary source of our operating cash flows is the collection of accounts receivable from federal and state agencies (under the Medicare and Medicaid programs), private insurance companies and individuals. Our cash flows provided by operating activities was $74.5 million for the first quarter of 2023 compared to $79.8 million in the first quarter of 2022. The $5.3 million decrease was primarily driven by operating cash flows in the first quarter of 2022 that did not repeat in the current year, including the receipt of stockholder litigation proceeds of $32.8 million partially offset by repayments of $18.0 million of Medicare advanced payments provided through the CARES Act. Net cash used in investing activities during the first quarter of 2023 was $70.7 million compared to $47.1 million for the first quarter of 2022. Key factors contributing to the change include: • An aggregate increase in payments for acquisitions (net of cash acquired) and purchases of equity method investments of $19.2 million; • An aggregate decrease of $3.5 million in proceeds from sales of facilities and equity method investments; • An increase in purchases of property and equipment of $6.1 million; • A decrease in cash used of $5.2 million related to other investing activities. Net cash used in financing activities during the first quarter of 2023 was $41.2 million compared to cash used in financing activities of $43.7 million for the first quarter of 2022. Key factors contributing to the change include: • An increase of $4.0 million in borrowings of long-term debt; • An increase in proceeds related to ownership transactions with non-controlling interest holders of $8.2 million, partially offset by an increase in distributions to non-controlling interest holders of an $5.7 million; • An increase in cash used of $3.8 million related to other financing activities. Capital Resources Net working capital was approximately $393.8 million at March 31, 2023 compared to $427.6 million at December 31, 2022. The decrease is primarily due to a decrease in cash, as discussed above, partially offset by a decrease in accounts payable. In addition to cash flows from operations and available cash, other sources of capital include amounts available on our Revolver as well as anticipated continued access to the capital markets. Material Cash Requirements There have been no material changes outside of the ordinary course of business to our upcoming cash obligations during the three months ended March 31, 2023 from those disclosed under “Material Cash Requirements” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2022 Annual Report on Form 10-K. Summary Broad economic factors, including recent increases in interest rates, inflation and supply chain risks and market volatility, could negatively affect our payor mix, increase the relative proportion of lower margin services we provide and reduce patient volumes, as well as diminish our ability to collect outstanding receivables. Any increase in the amount or deterioration in the collectability of patient accounts receivable will adversely affect our cash flows and results of operations, requiring an increased level of working capital. If general economic conditions continue to deteriorate or remain uncertain for an extended period of time, our ability to access capital could be harmed, which could negatively affect our liquidity and ability to repay our outstanding debt. Based on our current level of operations, we believe cash flows from operations, available cash, available capacity on our Revolver and continued anticipated access to capital markets, will be adequate to meet our short-term (i.e., 12 months) and long-term (beyond 12 months) liquidity needs. Certain Non-GAAP Measures Adjusted EBITDA and Adjusted EBITDA excluding grant funds are not measurements of financial performance under GAAP and should not be considered in isolation or as a substitute for net income, operating income or any other measure calculated in accordance with GAAP. The items excluded from these non-GAAP metrics are significant components in understanding and evaluating our financial performance. We believe such adjustments are appropriate, as the magnitude and frequency of such items can vary significantly and are not related to the assessment of normal operating performance. Our calculation of Adjusted EBITDA and Adjusted EBITDA excluding grant funds may not be comparable to similarly titled measures reported by other companies. We use Adjusted EBITDA and Adjusted EBITDA excluding grant funds as measures of financial performance. Adjusted EBITDA and Adjusted EBITDA excluding grant funds are key measures used by our management to assess operating performance, make business decisions and allocate resources. 23 Table of Contents The following table reconciles Adjusted EBITDA and Adjusted EBITDA excluding grant funds to (loss) income before income taxes, the most directly comparable GAAP financial measure (in millions and unaudited): Three Months Ended March 31, 2023 2022 Condensed Consolidated Statements of Operations Data: (Loss) income before income taxes $ (0.4) $ 44.1 Plus (minus): Net income attributable to non-controlling interests (26.1) (30.6) Interest expense, net 46.8 56.3 Depreciation and amortization 33.7 27.4 Equity-based compensation expense 4.2 3.7 Transaction, integration and acquisition costs (1) 12.8 7.1 Net loss (gain) on disposals, consolidations and deconsolidations 10.5 (0.1) Litigation settlements and regulatory change impact (2) 8.0 (30.8) Undesignated derivative activity 0.6 — Adjusted EBITDA $ 90.1 $ 77.1 Less: Impact of grant funds (3) (1.1) (1.0) Adjusted EBITDA excluding grant funds $ 89.0 $ 76.1 (1) This amount includes transaction and integration costs of $12.5 million and $7.1 million for the three months ended March 31, 2023 and 2022, respectively. This amount further includes start-up costs related to de novo surgical facilities of $0.3 million for the three months ended March 31, 2023, with no comparable costs for the three months ended March 31, 2022. (2) This amount includes a litigation settlement loss of $3.0 million and a gain of $32.8 million for the three months ended March 31, 2023 and 2022, respectively. This amount also includes other litigation costs of $0.6 million and $2.0 million for the three months ended March 31, 2023 and 2022, respectively. Additionally, the three months ended March 31, 2023, includes $4.4 million related to the impact of recent changes in Florida law regarding the use of letters of protection. (3) Represents the impact of grant funds recognized, net of amounts attributable to non-controlling interests. We use Credit Agreement EBITDA as a measure of liquidity and to determine our compliance under certain covenants pursuant to our credit facilities. Credit Agreement EBITDA is determined on a trailing twelve-month basis. We have included it because we believe that it provides investors with additional information about our ability to incur and service debt and make capital expenditures. Credit Agreement EBITDA is not a measurement of liquidity under GAAP and should not be considered in isolation or as a substitute for any other measure calculated in accordance with GAAP. The items excluded from Credit Agreement EBITDA are significant components in understanding and evaluating our liquidity. Our calculation of Credit Agreement EBITDA may not be comparable to similarly titled measures reported by other companies. When we use the term “Credit Agreement EBITDA,” we are referring to Adjusted EBITDA, as defined above, further adjusted for acquisitions and synergies. These adjustments do not relate to our historical financial performance and instead relate to estimates compiled by our management and calculated in conformance with the definition of “Consolidated EBITDA” used in the credit agreements governing our credit facilities. 24 Table of Contents The following table reconciles Credit Agreement EBITDA to cash flows from operating activities, the most directly comparable GAAP financial measure (in millions and unaudited): Twelve Months Ended March 31, 2023 Cash flows from operating activities $ 153.5 Plus (minus): Non-cash interest expense, net (26.3) Non-cash lease expense (35.2) Deferred income taxes (19.1) Equity in earnings of unconsolidated affiliates, net of distributions received 1.1 Other non-cash income 7.5 Changes in operating assets and liabilities, net of acquisitions and divestitures 140.5 Income tax expense 20.4 Net income attributable to non-controlling interests (137.1) Interest expense, net 225.4 Transaction, integration and acquisition costs 54.3 Litigation settlements and regulatory change impact 14.1 Hurricane-related impacts 1.5 Undesignated derivative activity (7.4) Acquisitions and synergies (1) 92.3 Credit Agreement EBITDA $ 485.5 (1) Represents impact of acquisitions as if each acquisition had occurred on April 1, 2022. Further this includes revenue and cost synergies from other business initiatives and de novo facilities and an adjustment for the effects of adopting the new lease accounting standard, as defined in the credit agreement governing the Senior Secured Credit Facilities.