Item 1.
Business.
The information provided in this Annual Report on Form 10-K for the year ended December 31, 2013, including the consolidated financial statements and notes thereto, is that of Aurora Diagnostics Holdings, LLC and its subsidiaries and affiliates. The terms “we,” “us,” “our,” “Aurora Diagnostics,” “Aurora Holdings,” and the “Company” typically refer to Aurora Diagnostics Holdings, LLC and its subsidiaries, as well as the professional associations and professional corporations which are separate legal entities that it controls through contractual arrangements.
Corporate History
We were organized in the State of Delaware as a limited liability company on June 2, 2006 to develop and operate as a diagnostic services company. We have grown our business significantly since our founding, driven largely by the acquisition of local and regional pathology laboratories across the United States and organic growth within these acquired operations. Since our formation, we have completed 22 acquisitions of diagnostic services companies and opened two de novo laboratories. We currently operate 19 primary laboratory locations across the United States.
Overview
We are a specialized diagnostics company providing services that play a key role in the diagnosis of cancer and other diseases. Our experienced pathologists deliver comprehensive diagnostic reports of a patient’s condition and consult frequently with referring physicians to help determine the appropriate treatment. Our diagnostic reports often enable the early detection of disease, allowing referring physicians to make informed and timely treatment decisions that improve their patients’ health in a cost-effective manner.
We are a leading specialized diagnostics company, focused on the anatomic pathology market. We are well-positioned in the higher-growth subspecialties of anatomic pathology, with a leading market position in dermatopathology and in the women’s health pathology subspecialty, and a growing market position in urologic pathology, hematopathology and general surgical pathology. Our strengths in anatomic pathology are complemented by our specialized clinical and molecular diagnostics offerings, which enable us to provide a broad selection of diagnostic services to our referring physicians.
Substantially all of our consolidated net revenue for each of the years ended December 31, 2011, 2012 and 2013 resulted from providing diagnostic related services to our clients. The majority of our revenue in 2013 was derived from providing diagnostic related services in the non-hospital outpatient channel of the anatomic pathology market. We also maintain contracts with 58 hospitals under which we provide inpatient and outpatient professional anatomic pathology services. For some of our hospital contracts, we also provide medical director services and technical slide preparation services.
Our business model builds upon the expertise of our experienced pathologists to provide seamless, reliable and comprehensive pathology and molecular diagnostics offerings to referring physicians. We typically have established long-standing relationships with our referring physicians as a result of focused localized delivery of diagnostic services, personalized responses and frequent consultations, and flexible information technology, or IT, solutions that are customizable to our clients’ needs. Our IT and communications platform enables us to deliver routine diagnostic reports to our clients generally within 24 hours of specimen receipt, helping to improve patient care. In addition, our IT platform enables us to track and monitor volume trends from referring physicians.
Through a combination of organic growth and strategic acquisitions, we have achieved a national footprint and a leading presence in our local markets, upon which we are building a more integrated and larger-scale diagnostics company. Currently, with 19 primary laboratories across the United States, we have reached a scale that has enabled us to process approximately 2.1 million accessions for the year ended December 31, 2013.
Our Services
Anatomic pathology typically requires a pathologist to make a specific diagnosis. Anatomic pathologists are medical doctors who specialize in the study of disease. Anatomic pathologists do not treat patients, but rather assist other physicians in determining the correct diagnosis of their patient’s ailments. A pathologist’s diagnosis represents a critical factor in determining a patient’s future care. In addition, anatomic pathologists may consult with attending physicians regarding treatment plans. In these capacities, the anatomic pathologist often serves as the “physician’s physician,” thereby creating long-term relationships.
Anatomic pathologists perform their duties in laboratories, including independent free-standing local laboratories, hospital laboratories, regional and national laboratories, in ambulatory surgery centers and in a variety of other settings. Referring physicians take specimens from patients, and those specimens are transported to a laboratory by courier or an overnight delivery service. Once received at the laboratory, a specimen is processed and mounted onto a slide by laboratory technologists for examination by a pathologist. Once the pathologist examines a specimen, the pathologist typically records the results of testing performed in the form of a report to be transmitted to the referring physician. Since specimens are transportable and technology facilitates communication, samples can be diagnosed by a pathologist from a remote location. Therefore, pathologists are generally not needed “on-site” to make a diagnosis. This enhances utilization of available capacity in outpatient and inpatient laboratories and allows the practice to service a wider geographic area.
An anatomic pathologist must have an understanding of a broad range of medicine. An anatomic pathologist may perform diagnostic testing services for a number of subspecialty testing markets such as dermatopathology, urologic pathology, women’s health pathology, gastrointestinal pathology, hematopathology or surgical pathology. While physical examination or radiology procedures may suggest a diagnosis for many diseases, the definitive diagnosis is generally established by the anatomic pathologist.
As a result of recent emphasis on personalized medicine and the resultant successes of targeted therapies, Human biospecimens are in high demand and now required for most phases of the drug and diagnostic development process - from preclinical discovery experiments through late-stage clinical validation studies . Launched in April of 2013, the Aurora Research Institute (ARI) leverages Aurora’s nationwide network of 115 pathologists, 19 specialty laboratories, and 58 hospital affiliates to further therapeutic and diagnostic research and development efforts in markets across the United States. ARI facilitates the biospecimen collection process by providing access to well annotated fresh tissue biospecimens, formalin fixed paraffin embedded tissues, and biofluids. This access along with expert pathologist consultations in all subspecialties of pathology is a valuable resource to pharmaceutical, biotech, and medical device companies engaged in research or product validation studies. ARI has completed more than 75 projects for Biotech and Pharmaceutical companies in 2013 and contributed approximately $0.8 million in revenue for the year ended December 31, 2013.
Sales and Marketing; Client Service
The selection of a pathologist to perform diagnostic testing services is primarily made by individual referring physicians. We maintain a sales and marketing team of 70 professionals who are highly-trained and organized by subspecialty to better meet the needs of our referring physicians. We have designed our compensation structure to incentivize our sales representatives to not only secure new physician clients, but also to maintain and enhance relationships with existing physician clients. As a result, our sales and marketing team has enabled us to expand nationally and leverage our extensive offering of diagnostic services across our markets.
We currently focus our marketing and sales efforts primarily on dermatologists, urologists and gynecologists, as well as gastroenterologists, hematologists and oncologists. The physicians on which our marketing and sales efforts are focused include both non-hospital-based and hospital-based physicians. Our sales representatives concentrate on a geographic area based on the number of existing clients and client prospects, which we identify using several national physician databases that provide physician address information, patient demographic information and other data.
At the beginning of a new client relationship, one of our sales representatives visits a prospective physician client and describes in detail our differentiated service offerings, focusing on our experienced pathologists, local presence, rapid turn-around times, comprehensive diagnostic reports, client service and IT solutions. Our sales representatives focus on the specialties offered by their respective divisions, which allows them not only to discuss our specialized diagnostic services, but also to describe diagnostic developments and new products and technologies in their practice areas.
We also maintain a client service team of 56 professionals who are highly-trained and organized by subspecialty. Our dedicated client service team provides ongoing support to our clients and, in particular, the office staff of our referring physicians. Our client service team enables us to augment the long-standing relationships between our pathologists and their clients to maintain a more stable base of referrals. These service teams provide our clients with a personal, knowledgeable and consistent point of contact within our company. Client service team members coordinate the provision of services, ensure testing supplies are replenished, answer administrative and billing questions, and resolve service issues. We believe these additional client contacts greatly enhance client satisfaction and strengthen overall client relationships.
We currently focus our marketing and sales efforts by subspecialty. Our representatives are extensively trained in the specific subspecialty they service and they are knowledgeable about our test offerings and new diagnostic technologies available in the market by subspecialty. This provides additional value to our physician clients and their staff, as our representatives become a resource to our client’s practice. Our product offerings which have been developed to meet the unique needs of each subspecialty are branded under the following names:
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DermDX (dermatopathology services for the dermatology market);
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Women’sDX (Women’s Health Services for the OB/GYN market);
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UroDX (for the Urology market);
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GastroDX (for the Gastroenterology market); and
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HemaDX (for the Hematology and Oncology market).
The offerings provide a comprehensive test menu so each physician specialist can order the best test available to make an accurate diagnosis and appropriate treatment decisions.
Dermatopathology accounted for approximately 40 percent of our revenue in 2013, and the remaining 60 percent of our revenue primarily consisted of other subspecialties, including urology and women’s health pathology, and clinical laboratory services. Our operational, marketing and sales efforts are, in general, organized and focused on subspecialties.
Relationships with Referring Physicians and Third-Party Payors
Substantially all of our revenue consists of payments or reimbursements for specialized diagnostic services rendered to referring physicians. Our referring physicians, whom we refer to as our clients, are our primary customers. No single group of our clients accounted for a number of referrals in 2013 that was material to us. Accordingly, we are not dependent on any single or small group of our clients for referrals, revenue or otherwise. We receive referrals at the discretion of our clients, and our clients are under no obligation to make referrals to us. Furthermore, we generally have no contractual or other formalized legal arrangements with our clients.
We receive most of our revenue in the form of reimbursement from third-party payors. While third-party payors are not our clients or customers, our contractual arrangements with third-party payors, along with the customer relationships and the specific services we provide, enable the generation of our revenue. Accordingly, such arrangements are, in the aggregate, material to us.
For the year ended December 31, 2013, based on cash collections, we derived approximately 60 percent of our revenue from private insurance, including managed care organizations and other healthcare insurance providers. For the year ended December 31, 2013, none of these sources individually accounted for more than 10 percent of our revenue. While our reimbursements from private insurance sources are material to our business in the aggregate, we do not consider any individual private insurance source to be material to us.
We generally receive reimbursements from private third-party payors on a laboratory-by-laboratory basis. We have not entered into contracts with private insurance companies on a nationwide basis. Our laboratories typically enter contracts with third-party payors that provide for us to be reimbursed at agreed-upon rates based on the services we perform. Our laboratories’ contracts with private insurers are typically subject to termination by the insurers for cause, including, among other things, upon our laboratories’ exclusion from government payor programs, and, in some cases, without cause. The insurers under such contracts typically have a right to change the applicable reimbursement rates we receive under the contract. In cases where our laboratories do not have contracts with particular private third-party payors, we receive reimbursements for services we perform at rates and on terms applicable to such payors’ out-of-network providers.
For the year ended December 31, 2013, based on cash collections, we derived approximately 23 percent of our revenue from government payor programs, including Medicare and Medicaid. Accordingly, reimbursements from government payor programs are material to our business. This makes our business dependent on our ability to participate in the government programs and on the reimbursement rates we receive under such programs.
We generally receive reimbursements from government third-party payors on a laboratory-by-laboratory basis. Our laboratories typically participate with government third-party payors that provide for us to be reimbursed at applicable rates based on the services we perform and other factors. Our laboratories’ participation with governmental payors are typically subject to termination by the government for cause, and our governmental payors have a right to change the applicable reimbursement rates we receive under such programs.
Competition
The anatomic pathology market is highly competitive. Competition in our industry is based on several factors, including price, clinical expertise, quality of service, client relationships, breadth of testing menu, speed of turnaround of test results, reporting and IT systems, reputation in the medical community and ability to employ qualified personnel. Our competitors include local and regional pathology groups, national laboratories, hospital-based pathology groups and specialty physician groups.
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Local and Regional Pathology Groups. Local and regional pathology groups typically provide a relatively narrow menu of test services to community physicians and, in certain cases, to hospital-based pathologists.
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National Laboratory Companies. National laboratories typically offer a full suite of tests for a variety of medical professionals, including general practitioners, hospitals and pathologists. National laboratories have identified anatomic pathology as a focus area for future growth and will continue to be a competitive challenge going forward.
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Hospital Pathologists. Pathologists working in hospitals typically provide most of the diagnostic services required for hospital inpatients and, sometimes, hospital outpatients. Hospital pathologists act as medical directors for the hospital’s clinical and histology laboratories. Typically, hospital pathologists provide these services to hospitals under exclusive and long-term contractual arrangements.
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Specialty Physician Groups. Over the last few years a number of specialty physician groups (dermatologists, urologists and gastroenterologists in particular) have built their own laboratories and in-sourced pathology services. This has been a significant source of competition and may continue to impact the anatomic pathology landscape in the future. However, decreased reimbursement rates in 2013 and 2014 could diminish this trend.
There is an evolving trend among pathologists to form larger practices to provide a broader range of outpatient and inpatient services and enhance the utilization of the practices’ pathologists. We believe this trend can be attributed to several factors, including cost containment pressures by governmental and other third-party payors, increased competition, managed care and the increased costs and complexities associated with operating a medical practice. Moreover, given the current trends of increasing outpatient services, outsourcing and the consolidation of hospitals, pathologists are seeking to align themselves with larger practices that can assist providers in the evolving health care environment. Larger practices can offer pathologists certain advantages, such as obtaining and negotiating contracts with hospitals and other providers, managed care providers and national clinical laboratories; marketing and selling of professional services; providing continuing education and career advancement opportunities; making available a broad range of specialists with whom to consult; providing access to capital and business and management experience; establishing and implementing more efficient and cost effective billing and collection procedures; and expanding the practice’s geographic coverage area. Each of these factors supports the pathologists in the efficient management of the complex and time-consuming non-medical aspects of their practice. As a result, we believe that there are substantial consolidation opportunities in the anatomic pathology market as smaller pathology providers seek access to the resources of diagnostics companies with a more comprehensive selection of services for referring physicians.
Seasonality
Our business is affected by seasonal trends and generally declines during the winter months, the year-end holiday period and other major holidays. Adverse weather conditions can also influence our business.
Information Systems
We implement IT systems that serve to streamline internal operations and provide customized IT solutions to meet the needs of our clients. We offer our IT solutions primarily through our proprietary system ConnectDx and through the doc2MD system for which we have an exclusive, long-term license.
We developed ConnectDx, which is a customizable application platform to provide a gateway for delivering and printing our reports and communicating with our clients. A number of our IT solutions provide an immediate impact to referring physicians and their offices. The most common connectivity tools include electronic interfaces, client EMR interfacing, internet report delivery (web portal), printed reports, patient education document, auto fax, patient data from client’s office system requisitions, color remote printing hardware, and secure remote printing software.
Electronic interfaces provide a means through which we and our clients can share data efficiently and accurately. These customized interfaces can transfer patient information such as demographics, requisitions and diagnostic results between our IT system and the IT system of our referring physicians.
ConnectDx was created to accommodate flexibility, customizations such as delivering reports to specified client system directories or printing multiple copies of reports at physician offices during particular times each day. This functional flexibility is achievable as a result of our IT solution’s layered and adaptable design. We continue to install ConnectDx to provide additional value to our customers and plan to expand the products offered through ConnectDx to include utilization and patient education reports as well as practice-specific solutions.
Most of our IT solutions are implemented on a laboratory by laboratory basis. After an acquisition, we generally transition our acquired laboratories to a common accounting system and software package for financial processing and reporting within 60 days of closing. Generally, the LIS and billing platforms of our acquired laboratories, as well as all their day-to-day laboratory operations, continue to operate as they did pre-acquisition. We bill for our services using the existing billing systems of the acquired laboratories or, in some locations, we use an outsourced vendor to provide billing services.
Corporate Structure
We derive our revenue from our laboratory practices, which we own either directly through our wholly owned subsidiaries or through contractual arrangements with our affiliated practices. The manner in which we acquire and operate a particular practice is determined primarily by the corporate practice of medicine restrictions of the state in which the practice is located and other applicable regulations. We exercise diligence and care in structuring our practices and arrangements with providers in an effort to comply with applicable federal and state laws and regulations, and we believe that our current practices and arrangements comply in all material respects with applicable laws and regulations. However, due to uncertainties in the law, there can be no assurance that our practices and arrangements would be deemed to be in compliance with applicable laws and regulations, and any noncompliance could result in a material adverse effect on us.
In 2013, we derived 50 percent of our revenue from our affiliated practices. Through our contractual arrangements described below, our Board of Managers and management formulate strategies and policies which are implemented locally on a day-to-day basis by each of our affiliated practices. The following descriptions of our contractual arrangements with our affiliated practices are only summaries, which do not contain all of the information that may be important to you. For additional information, you should refer to the forms of our management, nominee, non-alienation and services agreements, copies of which have been filed as exhibits to our Registration Statement on Form S-4 filed with the SEC on September 12, 2011.
We have entered into long-term management agreements with each of our ten affiliated practices, which are located in Michigan, Minnesota, Nevada, Texas, North Carolina, South Carolina and Florida. Pursuant to these management agreements, we manage and control the non-medical functions of our affiliated practices, including:
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recruiting, training, employing and managing the technical and support staff;
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developing and equipping laboratory facilities;
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establishing and maintaining courier services to transport specimens;
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negotiating and maintaining contracts with hospitals, managed care organizations and other payors;
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providing financial reporting and administration, clerical, purchasing, payroll, billing and collection, information systems, sales and marketing, risk management, employee benefits, legal, tax and accounting services; and
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monitoring compliance with applicable laws and regulations.
Accordingly, our management agreements effectively give us total control over the operations of our affiliated practices, except with respect to decisions involving the medical judgment of our affiliated practices’ physicians. We do not control the medical diagnoses, medical treatments or other activities involving the exercise of medical judgment by our affiliated practices’ physicians.
From an operational standpoint, we typically prepare an annual operating plan for each of our affiliated practices pursuant to which the practice’s capital and operating budgets, scope and pricing of services, staffing and compensation of employees, support services, billing and collection procedures, patient acceptance policies and procedures, quality assurance and utilization assessment programs, compliance policies and risk management programs, and financial and strategic growth planning are established.
The scope of services for each affiliated practice is established in connection with the preparation of the practice’s annual operating plan, which we establish in consultation with and with the assistance of the practice’s laboratory director, who implements the practice’s operating plan and performs such other duties or requirements assigned by us.
The compensation of each affiliated practice’s licensed medical professionals is a component of the respective practice’s annual operating plan, which we prepare with the practice’s laboratory director as set forth above. The practice’s policies with respect to the retention of employees are also established by us and the practice’s laboratory director, provided that additional affiliated practice professionals may only be retained with our consent.
Each of our management agreements are long term contractual arrangements and cannot be terminated by our affiliated practice without cause. We receive a management fee from each of our affiliated practices for the services we provide pursuant to the management agreements. For eight of our affiliated practices, our management fee is equal to the practice’s net revenue less its expenses, which include physician salaries and other professional expenses. For the remaining two affiliated practices, our management fee is determined annually based on our estimate of each practice’s demand for management services during the upcoming year. For these practices, we may adjust the fee in the event that the services we provided were greater or less than the services that were anticipated. Subject to the requirements of applicable law, the adjustment of our management fees is entirely at our discretion.
We bear the economic risk associated with our affiliated practices. Under the provisions of our management agreements, we are generally obligated to pay all expenses of our affiliated practices, including any management fees, a portion of corporate overhead or other costs. We must absorb all losses of our affiliated practice entities. We are not entitled to recover, from the affiliated practices’ nominee owners, physicians or other parties, any losses incurred by our affiliated practices.
In addition, we have entered into contractual arrangements with the licensed physicians that own our affiliated practices. These contractual arrangements, which consist of nominee agreements and non-alienation agreements, govern the ownership of our affiliated practices by our physicians. These physicians may not vote or transfer their ownership interests in our affiliated practices or distribute or encumber the assets of our affiliated practices without our prior authorization. In addition, we have the irrevocable and unconditional right to cause the physicians to transfer their ownership interests in our affiliated practices to our designee for nominal consideration. Through these contractual arrangements, we maintain controlling voting and financial interests in our affiliated practices. Each of our affiliated practices is owned by physicians pursuant to these agreements with the exception of our laboratory in Nevada, where each of our affiliated practices is owned by a trust of which one of our wholly owned subsidiaries is the sole beneficiary.
We have acquired practices in Michigan and in Texas, where the corporate practice of medicine is restricted by state law. In each case, we entered into a nominee agreement with one of the selling physicians, pursuant to which such physician holds the practice’s equity interest as our designated nominee on our behalf. We also, either directly or through one of our wholly owned subsidiaries, entered into a long-term management agreement with each of the affiliated practices on the terms described above, pursuant to which we manage and control the non-medical functions of the practices.
In Florida, which does not prohibit the corporate practice of medicine, we, through one of our wholly owned subsidiaries, directly purchased substantially all of the assets of a practice, including the fixed assets, customer lists, contract rights and goodwill and other intangibles of the practice. After consummation of the acquisition, we determined to enter into a non-alienation agreement with the shareholders of the professional entity from which we previously purchased assets, pursuant to which we acquired controlling voting and financial interests in the professional entity on terms substantially the same as our nominee agreements in Michigan and Texas. We also, through one of our wholly owned subsidiaries, entered into a long-term management agreement with the affiliated practice on terms substantially the same as our management agreements in Michigan and Texas.
We have practices in North Carolina, South Carolina and Minnesota, each of which restricts the corporate practice of medicine. In each case, we, through a wholly owned subsidiary, directly acquired the laboratory. Because we cannot directly employ physicians in these states, in each case the selling physicians formed a de novo physician group that employs our pathologists. Similar to our contractual arrangements with our affiliated practices in Michigan and Texas, we entered into nominee agreements with the physicians who hold the equity interests in the physician groups on our behalf, and we entered into long-term management agreements with the physician groups. In addition, each laboratory that we acquired entered into a long-term services agreement with the physician group, pursuant to which the physician group provides professional pathology services to our laboratory on an exclusive basis. Each of our services agreements has an initial term of 50 years and cannot be terminated by the physician group without cause. Under these services agreements, we pay each physician group a service fee approximately equal to the compensation and professional expenses attributable to our pathologists employed by the group.
In Nevada, where the corporate practice of medicine is restricted, we acquired all of the common stock of our affiliated practices through trusts. We, through one of our wholly owned subsidiaries, are the sole beneficiary of the trusts and receive all income from the trusts. We generally have the right, at our sole discretion, to replace the trustees, withdraw assets from the trusts, modify the terms of the trust agreements, or terminate the trusts and direct the trustees to distribute the income and any assets from the trusts. No assets of the trusts can be sold or otherwise disposed of without our consent. In addition, we entered into a long-term management agreement with each of our affiliated practices that are owned directly by the trusts. These agreements are substantially the same as our management agreements in other states.
In addition to the foregoing affiliated practices, in Alabama, which does not prohibit the corporate practice of medicine, we, through a wholly owned subsidiary, directly acquired a laboratory. Although we can directly employ physicians in Alabama, we contract with an unaffiliated de novo entity formed by the selling physicians that employs our pathologists. Similar to our practices in North Carolina, South Carolina and Minnesota, our laboratory entered into a long-term services agreement with the unaffiliated physician group, pursuant to which the physician group provides professional pathology services to our laboratory on an exclusive basis. In contrast to our practices in North Carolina, South Carolina and Minnesota, however, we did not enter into a nominee or management agreement with the physician group. While we do not have a controlling voting or financial interest in the physician group, we have the right to consult with the physician group regarding business decisions and to approve or disapprove the retention or discharge of all employees by the physician group. The services agreement has an initial term of 25 years and cannot be terminated by the physician group without cause. We currently pay the physician group a service fee based upon a percentage of revenue, subject to a minimum, as defined in the agreement.
Our affiliated practice entities are included in our consolidated financial statements, which can be found in Part II, Item 8 of this Annual Report.
Contracts and Relationships with Providers
We employ our pathologists, control the practice entities that employ our pathologists or contract with pathologists on an independent contractor basis to provide diagnostic services in our laboratories. While we exercise legal control over our practices, we do not exercise control over, or otherwise influence, the medical judgment or professional decisions of any pathologist associated with our practices.
Our pathologist employment agreements typically have terms of between 3 and 5 years and generally can be terminated by either party without cause upon between 90 and 180 days notice. Our pathologists generally receive base compensation, health and welfare benefits generally available to our employees and, in some cases, annual performance bonuses. Our pathologists are required to hold a valid license to practice medicine in the jurisdiction in which they practice. We are responsible for billing patients, physicians and payors for services rendered by our pathologists. Most of our pathologist employment agreements contain restrictive covenants, including non-competition, non-solicitation and confidentiality covenants.
Our business is dependent on the recruitment and retention of pathologists, particularly those with subspecialties like dermatopathology. While we have generally been able to recruit and retain pathologists in the past, no assurance can be given that we will be able to continue to do so successfully or on terms similar to our current arrangements. The relationship between our pathologists and their respective local medical communities is important to the operation and continued profitability of our practices. In the event that a significant number of pathologists terminate their relationships with us or become unable or unwilling to continue their employment, our business could be materially harmed.
We manage and control all of the non-medical functions of our practices. We are not licensed to practice medicine. The practice of medicine is conducted solely by the physicians in our practices.
Billing and Reimbursement
Billing
Billing for diagnostic services is generally highly complex. Laboratories must bill various payors, such as private insurance companies, managed care companies, governmental payors such as Medicare and Medicaid, physicians, hospitals and employer groups, each of which may have different billing requirements. Additionally, the audit requirements we must meet to ensure compliance with applicable laws and regulations, as well as our internal compliance policies and procedures, add further complexity to the billing process, resulting in additional costs to us.
Reimbursement
Depending on the billing arrangement and applicable law, the party that reimburses us for our services may be:
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a third party who provides coverage to the patient, such as an insurance company, managed care organization or a governmental payor program;
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the physician or other authorized party (such as a hospital or another laboratory) who ordered the testing service or otherwise referred the services to us; or
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the patient.
For the year ended December 31, 2013, we derived approximately 60 percent of our revenue from private insurance, including managed care organizations and other healthcare insurance providers, 23 percent from governmental payor programs, including Medicare and Medicaid, and 17 percent from other sources.
In 2013, approximately 21 percent of our annual revenue was derived from the Medicare program, which is overseen by the Centers for Medicare & Medicaid Services, or CMS. Because a large percentage of our revenue is derived from the Medicare program, the Medicare coverage and reimbursement rules are significant to our operations. Reimbursement under the Medicare program for the diagnostic services that we offer is subject to either the national Medicare clinical laboratory fee schedule, which we refer to as the CLFS, or the national Medicare physician fee schedule, which we refer to as the PFS, each of which is subject to geographic adjustments and is updated annually. The PFS is designed to set compensation rates for those medical services provided to Medicare beneficiaries that require a degree of physician supervision. Clinical diagnostic laboratory tests furnished to non-hospital patients are paid according to the clinical laboratory fee schedule.
Most of the services that we provide are anatomic pathology services, which are reimbursed separately under the PFS, and beneficiaries are responsible for applicable coinsurance and deductible amounts. The PFS is based on assigned relative value units for each procedure or service, and an annually determined conversion factor is applied to the relative value units to calculate the reimbursement. The Sustainable Growth Rate (SGR) formula used to calculate the fee schedule conversion factor usually would result in a decrease in PFS payments, unless Congress acts to prevent such reductions. For example, the SGR formula was used to calculate the 2012 and 2013 PFS resulting in scheduled reimbursement cuts of 27 percent. However, in both years Congress took action to delay the implementation of these reductions. Congress passed legislation that prevented the implementation of these scheduled reductions and continued the existing payment levels through December 31, 2013. For 2014, CMS had projected the reimbursement cut resulting from the SGR formula would be approximately 20 percent, unless Congress acted to prevent the reduction. On December 18, 2013, Congress passed legislation that enacted a 0.5 percent increase in the conversion factor, which will be effective until March 31, 2014. Currently, Congress is considering a long-term change to the SGR formula, which could eliminate the need for annual Congressional action.
If Congress fails to act before March 31, 2014, or if it does not enact a long-term change to the SGR, then future decreases in the Medicare physician schedule are possible. Because the vast majority of our diagnostic services currently are reimbursed under the physician fee schedule, changes to the physician fee schedule could result in a greater impact on our revenue than changes to the Medicare clinical laboratory fee schedule.
Other services that we furnish are paid as clinical laboratory services and are reimbursed based on state-wide fee schedules that establish a price for each clinical laboratory CPT Code. These fees are supposed to be adjusted annually by changes in the Consumer Price Index For All Urban Consumers. However, these fees are frequently reduced as a result of other Congressional action. For example, the comprehensive health reform legislation passed by Congress and signed into law by the President in 2010 provided for two separate reductions in the reimbursement rates for our clinical laboratory services: a “productivity adjustment” (which was 0.9 percent for 2013), and an additional 1.75 percent reduction. Each of these reduces the annual Consumer Price Index-based update that would otherwise determine our reimbursement for clinical laboratory services. CMS has projected that payment for clinical laboratory services will be reduced by approximately 0.8 percent for 2014 as a result of these two adjustments. In addition, in the Middle Class Tax Relief and Job Creation Act of 2012, Congress mandated an additional change in the reimbursement for clinical laboratory services. That legislation required CMS to rebase on a one-time basis the clinical laboratory fee schedule to effect an additional two percent reduction in clinical laboratory fees.
Finally, the Budget Control Act of 2011 created a Joint Select Committee on Deficit Reduction, which was tasked with recommending proposals to reduce spending. Because the Joint Committee was unable to achieve a targeted deficit reduction of at least $1.5 trillion for the years 2013 through 2021, the law required automatic across-the-board cuts to most discretionary programs to be triggered. In addition, automatic cuts to Medicare providers of up to two percent per fiscal year began on March 1, 2013, effective for services provided after April 1, 2013. These cuts affect both our physician services and our clinical lab services. This reduction is currently scheduled to continue through 2023.
Our reimbursement is also affected by policies that are enacted by CMS, which oversees the Medicare Program. In 2013, CMS announced its process for pricing over 100 new CPT codes for molecular diagnostics, which the American Medical Association had adopted in 2012. CMS stated it would pay for the new molecular codes based on the CLFS, rather than the PFS, as some stakeholders had urged. CMS also required that the Medicare Administrative Contractors “gapfill” the new codes and set an appropriate price for them. That “gapfilling” process took place during 2013, and CMS announced the new prices for these codes in September 2013. The median of the prices set by the contractors become the new prices for these codes, effective January 1, 2014.
In early 2014, CMS also made two proposals that could affect the reimbursement for our laboratory services. First, CMS proposed a change in how it calculated the Relative Value Units (RVUs) used to calculate payments under the PFS. Under this proposal, where a service was paid at a lower rate in the hospital based on the hospital Outpatient Prospective Payment System than it was under the PFS, CMS proposed to reduce the RVUs for that service in order to equalize the payment between the two systems. This change, if implemented, would have resulted in an approximate cut of 25 percent in aggregate payments to independent laboratories. In the Final Physician Rule for 2014, however, CMS chose not to implement this proposal, although it stated that it would develop a revised proposal that it would propose in the future.
In addition, in early 2014, CMS also expressed concern about the fact that payments for many codes paid under the CLFS have not been revised to reflect technological advances that have occurred since the CLFS was first developed in 1984. CMS therefore stated that it would begin to review all codes on the CLFS and adjust them to reflect technological changes, a process that it expected would take about five years. CMS stated that it could either increase or decrease payment levels based on this review, however, it expected that most payments were likely to decrease. CMS adopted this proposal in the Final 2014 Physician Fee Rule; therefore, this review process will begin in 2014.
Emerging Growth Company
We qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 (JOBS Act). As an emerging growth company, we are subject to reduced reporting and other obligations generally applicable to public companies, including reduced disclosure about our executive compensation arrangements and exemption from the auditor attestation requirement in the assessment of our internal control over financial reporting. In addition, we may take advantage of an extended transition period for complying with new or revised accounting standards under the JOBS Act. We have elected to take advantage of the benefits of this extended transition period. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies.
The information that we provide may be different than what is available with respect to other public companies due to these reduced reporting burdens.
Government Regulation and Compliance Infrastructure
The services that we provide are heavily regulated by both federal and state governmental authorities. Failure to comply with the applicable regulations can subject us to significant civil and criminal penalties, loss of license, or the requirement that we repay amounts previously paid to us. The significant areas of regulation include the following:
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the federal Anti-Kickback Statute, which prohibits persons from knowingly and willfully soliciting, receiving, offering or providing remuneration, directly or indirectly, in cash or in kind, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any goods or service for which payment may be made under governmental payor programs such as Medicare and Medicaid;
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the federal False Claims Act, which prohibits individuals or entities from knowingly presenting to, or causing to be presented to, the federal government, claims for payment that are false or fraudulent;
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the Health Insurance Portability and Accountability Act, or HIPAA, which established comprehensive federal standards with respect to the use and disclosure of protected health information;
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the Health Information Technology for Economic and Clinical Health Act, or HITECH Act, which was passed as part of the American Recovery and Reinvestment Act and which strengthens many of the requirements applicable to privacy and security, among other things;
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the Stark Law, which prohibits a physician from making a referral to an entity for certain designated health services reimbursed by Medicare or Medicaid if the physician (or a member of the physician’s family) has a financial relationship with the entity and which also prohibits the submission of any claim for reimbursement for designated health services furnished pursuant to a prohibited referral;
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the federal Civil Monetary Penalty Law, which prohibits the offering of remuneration or other inducements to beneficiaries of federal health care programs to influence the beneficiaries’ decisions to seek specific governmentally reimbursable items or services or to choose particular providers;
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the Clinical Laboratory Improvement Amendments, which requires that laboratories be certified by the federal government or by a federally-approved accreditation agency;
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the anti-markup rule, which prohibits a physician or supplier billing the Medicare program from marking up the price of a purchased diagnostic service performed by another physician or supplier who does not “share a practice” with the billing physician or supplier;
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state law equivalents of the above, such as anti-kickback and false claims laws that may apply to items or services reimbursed by any third-party payor, including commercial insurers;
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state laws that prohibit the corporate practice of medicine and the splitting or sharing of fees between physicians and non-physicians;
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state laws that govern the manner in which licensed physicians can be organized to perform and bill for medical services;
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the reassignment rules, which preclude Medicare payment for covered services to anyone other than the patient, physician, or other person who provided the service, with limited exceptions; and
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state laws that prohibit other specified practices, such as billing an entity that does not have ultimate financial responsibility for the service, waiving coinsurance or deductibles, billing Medicaid a higher charge than the lowest charge offered to another payor, and placing professionals who draw blood, or phlebotomists, in the offices of referring physicians.
Compliance with government rules and regulations is a significant concern throughout our industry, in part due to evolving interpretations of these rules and regulations. We seek to conduct our business in compliance with all statutes and regulations applicable to our operations. To this end, we have created a Compliance Committee and have designated a Compliance Officer to assist with reviews of regulatory compliance procedures and policies throughout our business. Our executive management team is responsible for the oversight and operation of our compliance efforts. The Compliance Officer is responsible for administering and monitoring compliance with our Standards of Conduct. We provide periodic training programs to our personnel to promote the observance of our policies, which are designed to ensure compliance with the statutes and regulations applicable to us.
Intellectual Property
Our intellectual property consists primarily of trademarks and trade secrets. The marks AURORA DIAGNOSTICS and CONNECTDX THE INFORMATION GATEWAY & Design are our most recognizable trademarks. Those trademarks are registered with the U.S. Patent and Trademark Office along with the marks CAREDX, DERMDX, GASTRODX, HEMADX, TREATMENTDX, URODX, WOMEN’SDX and CUNNINGHAM PATHOLOGY ASSOCIATES P.A. & Design. In addition, we have pending federal applications for the marks NOVADX and NOVADX & DESIGN. We also own a state registration in Alabama for the mark CUNNINGHAM PATHOLOGY, LLC & Design. We institute legal action where necessary to prevent others from using or registering confusingly similar trademarks. Our intellectual property also includes the copyright in and to our Tiger TCPC software, which is registered with the U.S. Copyright Office.
Segment Reporting and Geographic Areas
Our operations consist of one reportable segment. All of the Company’s revenue is attributable to customers located in the United States, and all of the Company’s long-lived assets are located in the United States.
Employees
As of December 31, 2013, we had 1,023 employees, which consisted of 99 pathologists, 745 laboratory technicians and staff, 53 corporate office personnel and 126 sales, marketing and client service personnel. In addition to our 99 employed pathologists, we have contractual arrangements with a physician practice that, as of December 31, 2013, employed 16 pathologists, each of which exclusively provides pathology services to our Alabama laboratory. None of our employees are subject to collective bargaining agreements. We consider our relationships with our employees to be good.
Item 1A.
Item 1A.
Risk Factors.
The statements under this heading describe the most significant risks to the Company’s business identified by management and should be considered carefully in conjunction with the discussion under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Notes to Consolidated Financial Statements” included in Part II, Item 7 and Part II, Item 8, respectively, of this Annual Report on Form 10-K.
The following is a discussion of risks and uncertainties that the Company believes could, individually or in the aggregate, cause its actual results to differ materially from expected and past results. However, predicting or identifying all such risks and uncertainties is not possible. As a result, the following factors should not be considered to be a complete discussion of the Company’s risks and uncertainties.
Risks Relating to Our Business
Changes in medical treatment, reimbursement rates and other market conditions in the dermatopathology market could adversely affect our business.
We derive a significant portion of our revenue from our dermatopathology subspecialty, which makes us particularly sensitive to changes in medical treatment, reimbursement rates and other market conditions in the dermatopathology market. Our revenue is particularly sensitive to changes that affect the number of or reimbursement for dermatopathology-related services. In 2013, we derived approximately 40 percent of our revenue from our dermatopathology subspecialty services, primarily from biopsies of the skin. If there is a significant development in the prevention of skin cancer, or an adverse development in the reimbursement rate for skin biopsies, it could have a material adverse effect on our business.
Changes in governmental reimbursement policies may adversely affect reimbursement for diagnostic services and could have a material adverse impact on our business.
Reimbursement levels for health care services are subject to continuous and often unexpected changes in policies, and we face a variety of efforts by government payors to reduce utilization and reimbursement for diagnostic testing services. Changes in governmental reimbursement may result from statutory and regulatory changes, retroactive rate adjustments, administrative rulings, competitive bidding initiatives, and other policy changes.
In 2010, the U.S. Congress passed legislation relating to health care reform, including the Patient Protection and Affordable Care Act, or PPACA, and the Health Care and Education Affordability Reconciliation Act of 2010, or HCEARA. While the comprehensive health reform legislation passed by the U.S. Congress and signed into law by the President in 2010 did not adversely affect reimbursement for our anatomic pathology services, this legislation provides for two separate reductions in the reimbursement rates for our clinical laboratory services: a “productivity adjustment” (which was 0.9 percent for 2013), and an additional 1.75 percent reduction. Each of these would reduce the annual Consumer Price Index-based update that would otherwise determine our reimbursement for clinical laboratory services. In addition, in the recently passed Middle Class Tax Relief and Job Creation Act of 2012, Congress mandated an additional change in the reimbursement for clinical laboratory services. That legislation required CMS to rebase the CLFS to effect an additional two percent reduction in clinical laboratory fees.
The U.S. Congress has considered, at least yearly in conjunction with budgetary legislation, changes to one or both of the Medicare fee schedules under which we receive reimbursement, which include the PFS and CLFS. For example, currently there is no copayment or coinsurance required for clinical laboratory services, although there is for our physician services. However, Congress has periodically considered imposing a 20 percent coinsurance on clinical laboratory services. If enacted, this would require us to attempt to collect this amount from patients, although in many cases the costs of collection would exceed the amount actually received.
Reimbursement for our anatomic pathology services is governed by the SGR formula. As the use of this formula often results in a significant reduction in reimbursement for all physician services, Congress usually acts each year to prevent the full amount of such reductions from taking effect. In 2010, Congress acted to prevent reductions in reimbursement through December 31, 2011. The SGR formula was used again to calculate the 2012 Medicare physician fee schedule resulting in scheduled reimbursement cuts of 27 percent. However, on December 23, 2011, Congress took action to delay the implementation of these reductions through February 29, 2012. Once again, before that implementation delay expired on February 29, 2012, Congress passed legislation late in February that prevented the implementation of these scheduled reductions and continued existing rates for an additional 10 months, through December 31, 2012. In the 2013 Physician Fee Schedule Final Rule, CMS called for a reduction of approximately 26.5 percent in reimbursement levels as a result of the SGR formula. However, on January 1, 2013, Congress passed the American Tax Relief Act, which reversed the proposed cut and kept in place the current rates until December 31, 2013. For 2014, CMS had projected the cut resulting from the SGR would be about 20.1 percent, unless Congress acted. On December 18, 2013, Congress passed legislation that enacted a 0.5 percent increase in the conversion factor, which will be effective until March 31, 2014. Currently, Congress is considering a long-term change to the SGR, which could eliminate the need for annual Congressional action, if enacted. At this time, it is impossible to know whether or not Congress will enact such a change or what form it may take.
Other legislative changes have been proposed since the adoption of health care reform that could also affect reimbursement for our services. The Budget Control Act of 2011 created a Joint Select Committee on Deficit Reduction, which was tasked with recommending proposals to reduce spending. If the Joint Committee was unable to achieve a targeted deficit reduction of at least $1.5 trillion for the years 2013 through 2021, or if Congress did not pass the Committee’s recommendations without amendment by December 23, 2011, the law called for automatic across-the-board cuts to most discretionary programs to be triggered. Because the Joint Committee did not agree on recommendations, automatic cuts in federal spending began on March 1, 2013. These cuts include automatic cuts to Medicare providers of up to two percent per fiscal year, starting in 2013. This reduction was recently renewed and is currently scheduled to continue through 2023.
A substantial portion of our anatomic pathology services are billed under a few codes (CPT 88305, 88305TC and 88305-26) and our revenue and business may be adversely affected if the reimbursement rates associated with these codes are reduced. For example, in the Final 2012 Rule, CMS requested that the American Medical Association’s RVS Update Committee (RUC) reexamine the relative value units (RVUs) for certain common pathology codes, including these codes. The 2013 Final Rule included a reduction of approximately 33 percent in the global billing code for 88305 and a 52 percent reduction in the technical component of that code.
Our reimbursement is also affected by policies that are enacted by CMS, which oversees the Medicare Program. In 2013, CMS announced its process for pricing over 100 new CPT codes for molecular diagnostics, which the American Medical Association had adopted in 2012. CMS stated it would pay for the new molecular codes based on the CLFS, rather than the PFS as some stakeholders had urged. CMS also required that the Medicare Administrative Contractors “gapfill” the new codes and set an appropriate price for them. That “gapfilling” process took place over 2013 and CMS announced the new prices for these codes in September, 2013. The median of the prices set by the contractors become the new prices for these codes, effective January 1, 2014.
In early 2014, CMS also made two proposals that could affect the reimbursement for our laboratory services. First, CMS proposed a change in how it calculated the relative value units used to calculate payments under the PFS. Under this proposal, where a service was paid at a lower rate in the hospital based on the hospital Outpatient Prospective Payment System than it was under the PFS, CMS proposed to reduce the RVUs for that service in order to equalize the payment between the two systems. This change, if implemented, would have resulted in an approximate cut of 25 percent in aggregate payments to independent laboratories. In the Final Physician Rule for 2014, however, CMS chose not to implement this proposal, although it stated that it would develop a revised proposal that it would propose in the future.
In addition, in early 2014, CMS also expressed concern about the fact that payments for many codes paid under the CLFS have not been revised to reflect technological advances that have occurred since the CLFS was first developed in 1984. CMS therefore stated that it would begin to review all codes on the CLFS and adjust them to reflect technological changes, a process that it expected would take about five years. CMS stated that it could either increase or decrease payment levels based on this review, however, it expected that most payments were likely to decrease. CMS adopted this proposal in the Final 2014 Physician Fee Rule; therefore, this review process will begin in 2014.
In addition, CMS made several other changes in 2014 Physician Fee Schedule Rule that could impact our business. First, CMS implemented a policy that will set the payment for the examination of 10 or more prostate biopsies into a single “bundled” payment amount, rather than paying separately for each individual procedure as had been done previously. This will result in a significant reduction in reimbursement on each of these procedures. In addition, CMS also has developed new codes applicable to billing for Immunohistochemistry procedures, which are a common staining procedure used in pathology. Those codes will reduce the reimbursement that the Company will receive when it provides these services. Finally, CMS has also implemented a set of edits under its National Correct Coding Initiative, which will only pay for a single unit of service when the Company performs a FISH (Fluorescent In Situ Hybridization) test. As many FISH tests require two or more probes, this change will also reduce the reimbursement received by the Company.
Even when reimbursement rates are not reduced, policy changes add to our costs by increasing the complexity and volume of administrative requirements. Medicaid reimbursement, which varies by state, is also subject to administrative and billing requirements and budget pressures. Recently, state budget pressures have caused states to consider several policy changes that may impact our financial condition and results of operations, such as delaying payments, reducing reimbursement, restricting coverage eligibility and service coverage, and imposing taxes on our services.
Non-governmental third-party payors have taken steps to control the utilization and reimbursement of diagnostic services.
We also face efforts by non-governmental third-party payors, including health plans, to reduce utilization of diagnostic testing services and reimbursement for diagnostic services. For instance, third-party payors often use the payment amounts under the Medicare fee schedules as a reference in negotiating their payment amounts. In some cases, our fee schedules with third-party payors are linked to the current Medicare fee schedules, and therefore reductions in the Medicare fee schedules could lead to reductions in reimbursement from some of our third-party payors. As described above, CMS’ 2013 Final Rule included a reduction in the Medicare fee schedules of approximately 33 percent in the global billing code for 88305 and a 52 percent reduction in the technical component of that code, which resulted in a significant reduction in our reimbursement from Medicare. We have experienced isolated reductions in reimbursement from non-governmental third-party payors tied to the Medicare reductions. However, the recent reduction in Medicare reimbursement rates, and future reductions in Medicare reimbursement rates, could result in a reduction in the reimbursements we receive from such third-party payors and have a material adverse impact on our business.
In addition, changes in test coverage policies of and reimbursement from other third-party payors may also occur independently from changes in Medicare. Such reimbursement and coverage changes in the past have resulted in reduced prices, added costs and reduced accession volume and have added more complex and new regulatory and administrative requirements.
The health care industry has also experienced a trend of consolidation among health insurance plans, resulting in fewer, larger health plans with significant bargaining power to negotiate fee arrangements with health care providers like us. Some of these health plans, as well as independent physician associations, have demanded that laboratories accept discounted fee structures or assume a portion or all of the financial risk associated with providing diagnostic testing services to their members through capitated payment arrangements. In addition, some health plans have limited the preferred provider organization or point-of-service laboratory network to only a single national laboratory to obtain improved fee-for-service pricing. The increased consolidation among health plans also has increased the potential adverse impact of ceasing to be a contracted provider with any such insurer.
We expect that efforts to reduce reimbursements, impose more stringent cost controls and reduce utilization of diagnostic testing services will continue. These efforts may have a material adverse effect on our business and results of operations.
Changes in the BlueCard Program may adversely affect reimbursement for diagnostic services and could have a material adverse impact on our business.
The Blue Cross and Blue Shield Association, or BCBS, is a large, non-governmental third-party payor that insures over 100 million Americans through more than 30 independent regional plans. BCBS operates the BlueCard program, which allows BCBS members from any regional BCBS plan to obtain health care services when travelling or residing outside of the region covered by the plan in which they are enrolled. Historically, the BlueCard program has permitted independent laboratories that provide services to members under the BlueCard program to submit claims for reimbursement on an “in-network” basis to the regional BCBS plan in which the laboratory is located.
Effective October 14, 2012, BCBS adopted changes to the BlueCard program that require each independent laboratory to submit claims for reimbursement to the regional BCBS plan covering the state in which the specimen was collected, regardless of whether the laboratory has contracted separately with such regional BCBS plan to attain “in-network” status. In some instances, reimbursement rates under regional BCBS plans where specimens are collected may be lower than reimbursement rates under the regional BCBS plan where the laboratory is located. In addition, if the laboratory does not have a separate contract with the regional BCBS plans where specimens are collected, the laboratory may be required to submit claims for reimbursement on an “out-of-network” basis, which may make it more difficult for the laboratory to collect for the services.
Given the number of members that participate in the BlueCard program, changes to the BlueCard program may result in disruptions in how claims for our services are filed and reimbursed by BCBS plans, may result in a decrease in the overall reimbursement that we receive for services provided to BCBS members under the BlueCard program, and may have a material adverse effect on our business and results of operations.
Increased internalization of diagnostic testing by our clients or patients, including the use of new testing technologies by our clients or patients, could adversely affect our business.
Our clients, such as referring physicians and hospitals, may internalize diagnostic testing or technologies that have historically been performed by diagnostic laboratory companies like us. Our industry has experienced a recent market trend in which physicians and hospitals perform the technical and/or professional components of their laboratory testing needs in their own offices. If this trend continues or becomes more pronounced and our clients internalize diagnostic testing functions or technologies that we currently perform or use, and we do not develop new or alternative functions or technologies that are attractive to our clients, it may reduce the demand for our diagnostic testing services and adversely affect our business.
In addition, advances in technology may lead to the development of more cost-effective tests that can be performed outside of a commercial laboratory, such as point-of-care tests that can be performed by physicians in their offices; tests that can be performed by hospitals in their own laboratories; or home testing that can be performed by patients in their homes. Any advance in technology could reduce demand for our services or render them obsolete.
Compliance costs associated with the Clinical Laboratory Improvement Amendments of 1988, or CLIA, make it cost-prohibitive for many physicians to operate clinical laboratories in their offices. However, diagnostic tests approved or cleared by the U.S. Food and Drug Administration, or FDA, for home use are automatically deemed to be “waived” tests under CLIA and may be performed by our referring physicians and their patients with minimal regulatory oversight under CLIA. Test kit manufacturers could seek to increase sales to both our referring physicians and their patients of test kits approved by the FDA for point-of-care testing or home use. Development of such technology and its use by our clients.
Failure to timely or accurately bill for our services or collect outstanding payments could have a material adverse effect on our business.
Billing for diagnostic services is complex. We bill numerous payors, including physicians, patients, insurance companies, Medicare, and Medicaid, according to applicable law, billing requirements and, as applicable, contractual arrangements. This complexity is further compounded by the fact that we currently generate bills using multiple billing systems and are subject to rapidly changing requirements for auditing, external compliance, and internal compliance policies and procedures. Furthermore, in the future, we may convert the legacy billing systems of businesses we have acquired to one or more common platforms.
Most of our provision for doubtful accounts in 2013, which totaled 6.8 percent of revenue, resulted from the failure of patients to pay their bills, including copayments and deductibles. Failure to timely or correctly bill could lead to lack of reimbursement for services or an increase in the aging of our accounts receivable, which could adversely affect our results of operations. Increases in write-offs of doubtful accounts, delays in receiving payments, potential retroactive adjustments, and penalties resulting from audits by payors would also adversely affect our financial condition. Failure to comply with applicable laws relating to billing governmental health care programs could also lead to various penalties, including exclusion from participation in Medicare or Medicaid programs, asset forfeitures, civil and criminal fines and penalties, and the loss of various licenses, certificates, and authorizations necessary to operate our business, any of which could have a material adverse effect on our business.
Our use of multiple billing systems and the potential conversion of legacy systems of businesses we have acquired may result in inconsistent data, slower collections, exposure to billing compliance violations and unexpected down times for releasing bills for payment.
Changes in payor mix may adversely affect reimbursement for diagnostic services and could have a material adverse impact on our business.
Most of our services are billed to a party other than the physician that ordered the test. In 2011, 2012 and 2013, based on cash collections, we estimate that we received 27 percent, 26 percent and 23 percent, respectively, of our revenue from Medicare and Medicaid. In 2013, based on cash collections, we estimate that 60 percent of our revenue was paid by non-governmental third-party payors, including health plans. If we bill a higher percentage of our services to payors who reimburse at rates lower than our current payors, our results of operations and financial condition would suffer.
Changes in the mix of diagnostic testing services that we provide have and could continue to negatively impact our net revenue per accession and our profitability.
We typically provide global pathology services in which we provide both the technical component and the professional component of services with respect to our accessions. Recently, increasing numbers of referring physicians have converted to arrangements in which we perform only the technical component or the professional component of services with respect to our accessions, as opposed to global pathology services. In these cases, our net revenue per accession has declined due to the fact that we no longer receive the entire global fee for the service, but instead receive fees for only the technical component or the professional component of each accession. If the volume or percentage of accessions for which we perform global pathology services decreases, it could continue to decrease our average net revenue per accession and gross profit percentage.
Diagnostic testing services that we perform in certain subspecialties involving clinical lab services, such as women’s health pathology, have lower average net revenue per accession and gross profit percentage than those in other subspecialties. A change in our service mix that resulted in an increase in the percentage of services we perform in women’s health pathology could result in a decrease in our average net revenue per accession and gross profit percentage. We expect the average revenue per accession of our organic business to continue to decline primarily as the result of changes in service mix, including our growth in women’s health pathology services. In addition, our growth rates and average revenue per accession may be positively or negatively impacted by the reimbursement market, service mix and average revenue per accession of acquisitions completed in the future.
Our financial and billing systems limit our ability to monitor and precisely report historical revenue by subspecialty. This inability, which could continue into future periods, may make it difficult or impossible for us to accurately assess changes in our service mix or the impact of such changes.
Integration of our operations with newly acquired businesses may be difficult and costly.
Since our inception, we have acquired 22 existing diagnostic services businesses. We expect to evaluate potential strategic acquisitions of diagnostic services and other businesses that might augment our existing specialized diagnostic testing services. These acquisitions have involved and could continue to involve the integration of a separate company that previously operated independently and had different systems, processes and cultures. As such, many of our systems, such as our laboratory information systems and billing systems, are not standardized and some aspects of the day-to-day operations of our laboratories continue to be conducted on a decentralized basis.
The process of integrating businesses we acquire may substantially disrupt both our existing businesses and the businesses we acquire. This disruption may divert management from the operation of our business or may cause us to lose key employees or clients. Additionally, we may have difficulty consolidating facilities and infrastructure, standardizing information and other systems and coordinating geographically-separated facilities and workforces, resulting in a decline in the quality of services.
Any past or future acquisitions, and the related integration efforts, may be difficult, costly or unsuccessful. In each case, our existing business and the businesses we acquire may be adversely affected. Even if we are able to successfully integrate businesses we have acquired, we may not be able to realize the benefits that we expect from them.
Businesses we acquire or have acquired may have significant unknown or contingent liabilities that could adversely impact our operating results.
Businesses we acquire or have acquired may have unknown or contingent liabilities or liabilities that are in excess of the amounts that we originally estimated. Although we generally seek indemnification from the sellers of businesses we acquire for matters that are not properly disclosed to us, we may not successfully obtain indemnification. Even in cases where we are able to obtain indemnification, we may be subject to liabilities greater than the contractual limits of our indemnification or the financial resources of the indemnifying party. In the event that we are responsible for liabilities substantially in excess of any amounts recovered through rights to indemnification, this could adversely impact our operating results.
We have recorded a significant amount of intangible assets, which may never generate the returns we expect.
Our acquisitions have resulted in significant increases in net identifiable intangible assets and goodwill. Net identifiable intangible assets, which include customer relationships, healthcare facility agreements and non-compete agreements acquired in acquisitions, were approximately $78.5 million at December 31, 2013, representing 24 percent of our total assets. Goodwill, which relates to the excess of cost over the fair value of the net assets of the businesses acquired, was $194.0 million at December 31, 2013, representing approximately 59 percent of our total assets. Goodwill and net identifiable intangible assets are recorded at fair value on the date of acquisition and, under Financial Accounting Standards Board Statement (FASB) Accounting Standards Codification 350, will be reviewed at least annually for impairment. Impairment may result from, among other things, deterioration in performance of the acquired company, adverse market conditions, adverse changes in applicable laws or regulations, including changes that restrict the activities of the acquired business, and a variety of other circumstances. The amount of any impairment must be written off. We evaluated our recorded goodwill and identifiable intangible assets as of September 30, 2011, September 30, 2012, November 30, 2012 and November 30, 2013, which resulted in our recording impairment charges of $24.5 million, $114.6 million, $53.9 million and $53.9 million, respectively. We may never realize the full value of our intangible assets. Any future determination requiring the write-off of a significant portion of intangible assets would have an adverse effect on our financial condition and results of operations.
Failure of our IT or communication systems, or the failure of these systems to keep pace with technological advances or changes in regulation and policies related to our IT or communication systems, could adversely impact our business.
Our laboratory operations depend significantly on the uninterrupted performance of our IT and communication systems. Sustained system failures or interruption of our systems in one or more of our laboratories could disrupt our ability to process laboratory requisitions, handle client service, perform testing, provide our reports or test results in a timely manner, or bill the appropriate party for our services.
Our efforts to invest in new or improved IT systems and billing systems may be costly and require time and resources for implementation. While we have begun implementing a plan to standardize and improve our laboratory information systems and billing systems, we expect that it will take several years to complete full implementation. Our efforts to invest in new or improved IT systems and billing systems may not ultimately be successful, and our failure to properly implement our plan to standardize and improve our laboratory information systems and billing systems could adversely impact our business.
Public and private initiatives to create electronic medical record standards and to mandate standardized coding systems for the electronic exchange of information, including test orders and test results, could require costly modifications to our existing IT systems. We expect that any standards that might be adopted or implemented would allow us adequate time to comply with such standards. However, any failure or delay in implementing standards may result in a loss of clients and business opportunities, which could adversely impact our business.
Failure to adequately safeguard data, including patient data that is subject to regulations related to patient privacy, could adversely impact our business.
The success of our business depends on our ability to obtain, process, analyze, maintain and manage data, including sensitive information such as patient data. If we do not adequately safeguard that information and it were to become available to persons or entities that should not have access to it, our business could be impaired, our reputation could suffer and we could be subject to fines, penalties and litigation. Although we have implemented security measures, our infrastructure is vulnerable to computer viruses, break-ins and similar disruptive problems caused by our clients or others that could result in interruption, delay or cessation of service. Break-ins, whether electronic or physical, could potentially jeopardize the security of confidential client and supplier information stored physically at our locations or electronically in our computer systems. Such an event could damage our reputation, cause us to lose existing clients and deter potential clients. It could also expose us to liability to parties whose security or privacy has been infringed, to regulatory actions by CMS or the U.S. Department of Health and Human Services (HHS), or to civil or criminal sanctions. The occurrence of any of the foregoing events could adversely impact our business.
The American Recovery and Reinvestment Act of 2009 imposed additional obligations on health care entities with respect to data privacy and security, including new notifications in case of a breach of privacy and security standards. We are unable to predict the extent to which these new obligations may prove technically difficult, time-consuming or expensive to implement.
Failure to attract and retain experienced and qualified personnel could adversely affect our business.
Our success depends on our ability to attract, retain and motivate experienced anatomic pathologists, histotechnologists, cytotechnologists, skilled laboratory and IT staff, experienced sales representatives and other personnel. Competition for these employees is strong, and if we are not able to attract and retain qualified personnel it would have a material adverse effect on our business.
We are dependent on the expertise of our local medical directors and our executive officers. The loss of these individuals could have a material adverse effect on our business.
Our sales representatives have developed and maintain close relationships with a number of health care professionals, and our specialized approach to marketing our services positions our sales representatives to have a deep knowledge of the needs of the referring physicians they serve. Given the nature of the relationships we seek to develop with our clients, losses of sales representatives may cause us to lose clients.
Failure to adequately scale our infrastructure to meet demand for our diagnostic services or to support our growth could create capacity constraints and divert resources, resulting in a material adverse effect on our business.
Increases in demand for our diagnostic services, including unforeseen or significant increases in demand due to client or accession volume, could strain the capacity of our personnel and infrastructure. Any strain on our personnel or infrastructure could lead to inaccurate test results, unacceptable turn-around times or client service failures. Furthermore, although we are not currently subject to these capacity constraints, if demand increases for our diagnostic services, we may not be able to scale our personnel or infrastructure accordingly. Any failure to handle increases in demand, including increases due to client or accession volumes, could lead to the loss of established clients and have a material adverse effect on our business.
We may expand by establishing laboratories in additional geographic markets. In addition to acquisition or development costs, this will require us to spend considerable time and money to expand our infrastructure and to hire and retain experienced anatomic pathologists, histotechnologists, cytotechnologists, skilled laboratory and IT staff, experienced sales representatives, client service associates and other personnel for our additional laboratories. We will also need federal, state and local certifications, as well as supporting operational, logistical and administrative infrastructure. Even after new laboratories are operational, it may take time for us to derive the same economies of scale we have in our existing laboratories. Moreover, we may suffer reduced economies of scale in our existing laboratories as we seek to balance the amount of work allocated to each facility and expand those laboratories. An expansion of our laboratories or systems could divert resources, including the focus of our management, away from our current business.
Failure to effectively continue or manage our strategic and organic growth could have an adverse impact on our business.
Our business strategy may include continuing to selectively acquire existing diagnostic services businesses. Since our inception, we have acquired 22 existing diagnostic services businesses. To continue this strategic growth, we will need to continue to identify appropriate businesses to acquire and successfully undertake the acquisition of these businesses on reasonable terms. Consolidation and competition within our industry, among other factors, may make it difficult or impossible to identify businesses to acquire on a timely basis, or at all. Our inability to acquire additional independent labs could hinder our growth and have a material adverse effect on our business.
We may also seek to continue our organic growth through the expansion of our sales force, the development of de novo laboratories, strategic extension of our operations into markets such as long-term care, and the inclusion of new clinical and molecular tests in our testing menu. Because of limitations in available capital and competition within our industry, among other factors, we may not be able to implement any or all of these organic growth strategies on a reasonable schedule, or at all. Our failure to achieve organic growth could have a material adverse effect on our business.
Our net revenue has grown from $3.5 million in 2006 to $248.2 million in 2013. To manage our growth, we must continue to implement and improve our operational and financial systems and to expand, train, manage and motivate our employees. We may not be able to effectively manage the expansion of our operations, and our systems, procedures or controls may not be adequate to support our operations. Our management may not be able to rapidly scale the infrastructure necessary to exploit the market opportunity for our services. Our inability to manage growth could have a material adverse effect on our business.
Failure to participate as a provider with payors or operating as a non-contracted provider could have a material adverse effect on our business.
The health care industry has experienced a trend of consolidation among health care insurers, resulting in fewer, larger insurers with significant bargaining power in negotiating fee arrangements with health care providers like us. Managed care providers often restrict their contracts to a small number of laboratories that may be used for tests ordered by physicians in the managed care provider’s network. If we do not have a contract with a managed care provider, we may be unable to gain those physicians as clients, and it could adversely affect our business.
In cases in which we do contract with a specified insurance company as a participating provider, we are considered “in-network,” and the reimbursement of third-party payments is governed by contractual relationships.
In cases in which we do not have a contractual relationship with an insurance company or we are not an approved provider for a government program, we have no contractual right to collect for our services and such payors may refuse to reimburse us for our services. This could lead to a decrease in accession volume and a corresponding decrease in our revenue. In instances where we are an out-of-network provider, reductions in reimbursement rates for non-participating providers could also adversely affect us. Third-party payors with whom we do not participate as a contracted provider may also require that we enter into contracts, which may have pricing and other terms that are materially less favorable to us than the terms under which we currently operate. While accession volume may increase as a result of these contracts, our revenue per accession may decrease.
Use of our diagnostic services as a non-participating provider also typically results in greater copayments for the patient unless we elect to treat them as if we were a participating provider in accordance with applicable law. Treating such patients as if we were a participating provider may adversely impact results of operations because we may be unable to collect patient copayments and deductibles. In some states, applicable law prohibits us from treating these patients as if we were a participating provider. As a result, referring physicians may avoid use of our services, which could result in a decrease in accession volume and adversely affect revenue.
Our revenues are dependent on us receiving reimbursements from third-party payors and our failure to qualify for or obtain reimbursements from third-party payors could have a material adverse effect on our business.
Our ability to qualify for or obtain reimbursement from third-party payors is dependent on factors that may include, among other things, our compliance with the terms of applicable agreements with such third-party payors, our compliance with applicable laws, our participation in government payor programs and our satisfaction of necessary billing standards. Our failure to qualify for or obtain reimbursements from third-party payors could undermine our ability to generate revenue and have a material adverse effect on our business.
Failure to raise additional capital or generate the significant capital necessary to continue our growth could reduce our ability to compete and could harm our business.
We currently expect that our existing cash and cash equivalents, together with the availability under our amended senior secured credit facility, will be sufficient to meet our anticipated cash needs through 2014. After that, we may need to raise additional funds, and we may not be able to obtain additional debt or equity financing on favorable terms, if at all. If we need additional capital and cannot raise it on acceptable terms, we may not, among other things, be able to:
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continue to expand our sales and marketing;
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develop or acquire complementary technologies, services, products or businesses;
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expand operations both organically and through acquisitions;
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hire, train and retain employees;
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service our existing debt obligations or continue to comply with compliance covenants thereunder; or
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respond to competitive pressures or unanticipated working capital requirements.
Our failure to do any of these things could seriously harm our business, financial condition and results of operations.
We may be unable to obtain, maintain or enforce our intellectual property rights and may be subject to intellectual property litigation that could adversely impact our business.
We may be unable to obtain or maintain adequate proprietary rights for our products and services or to enforce our proprietary rights successfully, and we cannot assure you that our products or methods do not infringe the intellectual property rights of third parties. Infringement and other intellectual property claims and proceedings brought against us, whether successful or not, could result in substantial costs and harm our reputation. Such claims and proceedings could also distract and divert management and key personnel from other tasks important to the success of our business. In the event of an adverse determination in an intellectual property suit or proceeding, or our failure to license essential technology, our sales could be harmed and/or our costs could increase, which would harm our financial condition.
We have a limited operating history, which may make it difficult to accurately evaluate our business and prospects.
We commenced operations in June 2006. As a result, we have a limited operating history upon which to accurately predict our potential revenue. Our revenue and income potential and our ability to expand our business into additional anatomic pathology specialties and markets are still unproven. As a result of these factors, the future revenue and income potential of our business is uncertain. Although we have experienced significant revenue growth since our inception, we may not be able to sustain this growth. Any evaluation of our business and our prospects must be considered in light of these factors and the risks and uncertainties often encountered by companies in our stage of development, some of which include our ability to:
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execute our business model;
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create brand recognition;
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respond effectively to competition;
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manage growth in our operations;
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respond to changes in applicable government regulations and legislation;
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access additional capital when required; and
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attract and retain key personnel.
Economic conditions in the United States could adversely impact our operating results and financial condition.
Economic recession in the United States could adversely affect our operating results and financial condition. Among other things, the potential decline in federal and state revenue that could result from these conditions could create additional pressures to contain or reduce reimbursements for our services from Medicare, Medicaid and other government sponsored programs. Increased job losses and elevated unemployment rates in the United States could result in a smaller percentage of our patients being covered by commercial payors and a larger percentage being covered by lower-paying Medicaid programs. To the extent that payors are adversely affected by a decline in the economy, we may experience further pressure on commercial rates, delays in fee collections and a reduction in the amounts we are able to collect. In addition, increases in interest rates could make it difficult to obtain credit in the future. Any or all of these factors, as well as other consequences of an economic recession, could adversely impact our operating results and financial condition.
Competition in our industry from existing or new companies and failure to obtain and retain clients could have a material adverse impact on our business.
Our success depends on our ability to obtain and retain clients and maintain accession volume. A reduction in the number of our clients, or in the tests ordered or specimens submitted by our clients, without offsetting increases or growth, could impact our ability to maintain or grow our business and could have a material adverse effect on our business.
While there has been significant consolidation in recent years in the diagnostic testing industry, the industry remains fragmented and highly-competitive both in terms of price and service. We primarily compete with various clinical test providers, anatomic pathology practices, hospital-affiliated laboratories, commercial clinical laboratories and physician-office laboratories. This competition is based primarily on price, clinical expertise, quality of service, client relationships, breadth of testing menu, speed of turnaround of test results, reporting and IT systems, reputation in the medical community and ability to employ qualified personnel. Some of our competitors may have greater technical, financial and other resources than we do. Our failure to successfully compete on any of these factors could result in a loss of clients and adversely affect our ability to grow.
Replication of our business model by competitors may adversely affect growth and profitability. Barriers to entry in anatomic pathology markets include the need to form strong relationships with referring physicians, hire experienced pathologists, make capital investments and acquire IT. These barriers may not be sufficient to prevent or deter new entrants to our market, and competitors could replicate or improve some or all aspects of our business model and either cause us to lose market share in the areas where we compete or inhibit our growth, which could have a material adverse effect on our business.
Failure to acquire rights to new technologies, products or tests, or discontinuations or recalls of existing technologies, products or tests, could negatively impact our testing volume and net revenues.
The diagnostic testing industry is characterized by rapid changes in technology, frequent introductions of new products and diagnostics tests and evolving industry standards and client demands for new diagnostic technologies. Other companies or individuals, including our competitors, may obtain patents or other intellectual property rights that could prevent, limit or interfere with our ability to develop, perform or sell our tests or operate our business or increase our costs. Advances in technology may result in the creation of enhanced diagnostic tools that enable other laboratories, hospitals, physicians, patients or third parties to provide specialized diagnostic services that are superior to ours or more patient-friendly, efficient or cost-effective. These developments may result in a decrease in the demand for our tests or cause us to reduce the prices for our tests. We may be unable to develop or introduce new tests on our own, which means that our success may depend, in part, on our ability to license new and improved technologies on favorable terms. We may be unable to continue to negotiate acceptable licensing arrangements, and arrangements that we do conclude may not yield commercially successful diagnostic tests. If we are unable to acquire rights to these testing methods at competitive rates, our research and development costs may increase as a result. In addition, if we are unable to develop and introduce, or acquire rights to, new tests, technology and services to expand our testing business, our testing methods may become outdated when compared with our competition and our testing volume and revenues may be materially and adversely affected.
From time to time, manufacturers discontinue or recall reagents, test kits or instruments we use to perform diagnostic services. Such discontinuations or recalls could adversely affect our costs, testing volume and revenues.
Our Principal Equityholders may have interests that differ from your interests.
Circumstances may occur in which the interests of our equityholders could be in conflict with those of our noteholders. For example, our equityholders, including KRG Capital Partners and Summit Partners, may have an interest in pursuing acquisitions, divestitures, financing or other transactions that, in their judgment, could enhance their equity investments, even though such transactions might involve risks to our noteholders. Additionally, certain of our equityholders, including KRG Capital Partners and Summit Partners, have significant knowledge of our business operations and strategy and are not prohibited from making investments in any of our competitors.
Regulatory Risks
New and proposed federal or state health care reform measures could adversely affect our operating results and financial condition.
The U.S. Congress and state legislatures continue to focus on health care reform. Together, the recently-enacted PPACA and HCEARA comprise a broad health care reform initiative, which is only beginning to be implemented, and changes to the legislation are being discussed in Congress. It is also unclear how the states will implement certain requirements that are applicable to them. On June 28, 2012, the Supreme Court upheld the constitutionality of the health care reform law, with the exception of certain provisions dealing with the expansion of Medicaid coverage under the law. Therefore, unless deferred, most of the law’s provisions will go into effect in 2014. Congress has also proposed a number of legislative initiatives, including possible repeal of the health reform law.
We cannot predict whether the federal and state health care reform legislation that has been enacted will have a material impact on us. Further, we cannot predict whether federal or state governments will enact any additional laws to effect health care reform and, if any such new laws were enacted, what their terms would be and whether or in what ways any new laws would affect us. However, it is possible that new laws could increase our costs, decrease our revenue, expose us to expanded liability or require us to revise the ways in which we conduct our business, any of which could adversely affect our operating results and financial condition.
If we fail to comply with the complex federal, state and local government laws and regulations that apply to our business, we could suffer severe consequences that could adversely affect our operating results and financial condition.
Our operations are subject to extensive federal, state and local government regulations, all of which are subject to change. These government laws and regulations currently include, among others, those described under the heading “Government Regulation and Compliance Infrastructure” in section Part I, Item 1. Business, in this Annual Report.
We believe that we operate in material compliance with these laws and regulations. However, these laws and regulations are complex and, among other things, practices that are permissible under federal law may not be permissible in all states. In addition, these laws and regulations are subject to interpretation by courts and enforcement agencies. Our failure to comply could lead to civil and criminal penalties, exclusion from participation in Medicare and Medicaid, and possible prohibitions or restrictions on our laboratories’ ability to provide diagnostic services, and any such penalties, exclusions, prohibitions or restrictions could have a material adverse effect on our arrangements with managed care organizations and private payors.
If we fail to comply with state corporate practice of medicine laws, we could suffer severe consequences.
The laws of many states prohibit business corporations, including us and our subsidiaries, from owning corporations that employ physicians, or from exercising control over the medical judgments or decisions of physicians. These laws and their interpretations vary from state to state and are enforced by both the courts and regulatory authorities, each with broad discretion. The manner in which we operate each practice is determined primarily by the corporate practice of medicine restrictions of the state in which the practice is located, other applicable regulations and commercial considerations.
We believe that we are currently in material compliance with the corporate practice of medicine laws in each of the states in which we operate. Nevertheless, it is possible that regulatory authorities or other parties may assert that we are engaged in the unauthorized corporate practice of medicine. If such a claim were successfully asserted in any jurisdiction, we could be subject to civil and criminal penalties, which could exclude us from participating in Medicare, Medicaid and other governmental health care programs, or we could be required to restructure our contractual and other arrangements.
Failure to comply with complex federal and state laws and regulations related to submission of claims for our services could result in significant monetary damages and penalties and exclusion from the Medicare and Medicaid programs.
Our failure to comply with applicable laws and regulations could result in our inability to receive payment for our services or result in attempts by third-party payors, such as Medicare and Medicaid, to recover payments from us that have already been made. Submission of claims in violation of certain statutory or regulatory requirements can result in penalties, including civil monetary penalties of up to $10,000 for each item or service billed to Medicare in violation of the legal requirement, and exclusion from participation in Medicare and Medicaid. Government authorities may also assert that violations of laws and regulations related to submission of claims violate the federal False Claims Act or other laws related to fraud and abuse, including submission of claims for services that were not medically necessary. We could be adversely affected if it was determined that the services we provided were not medically necessary and not reimbursable, particularly if it were asserted that we contributed to the physician’s referrals of unnecessary services to us. It is also possible that the government could attempt to hold us liable under fraud and abuse laws for improper claims submitted by an entity for services that we performed if we were found to have knowingly participated in the arrangement that resulted in submission of the improper claims.
Our business could be harmed by the loss or suspension of a license or imposition of a fine or penalties under, or future changes in, the law or regulations of the Clinical Laboratory Improvement Amendments or those of Medicare, Medicaid or other federal, state or local agencies.
The diagnostic testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. CLIA requires that laboratories be certified by the federal government or by a federally-approved accreditation agency every two years. CLIA mandates specific standards in the areas of personnel qualifications, administration, proficiency testing, patient test management, quality control, quality assurance and inspections. CLIA regulations include special rules applicable to cytology testing, such as pap smears, including workload limits, specialized proficiency testing requirements that apply not just to the laboratory, but also to the individuals performing the tests, specialized personnel standards and quality control procedures. A laboratory may be sanctioned based on its failure to participate in an acceptable proficiency testing program, unsatisfactory performance in proficiency testing or for prohibited activities related to proficiency testing, such as failing to test the proficiency testing samples in the same manner as patient specimens or communicating with other laboratories regarding proficiency testing results. The sanction for failure to comply with CLIA requirements, including proficiency testing violations, may be suspension, revocation or limitation of a laboratory’s CLIA certificate, as well as the imposition of significant fines and criminal penalties. While imposition of certain CLIA sanctions may be subject to appeal, few, if any, such appeals have been successful. A CLIA certificate is necessary to conduct business. As a result, any CLIA sanction or our failure to renew a CLIA certificate could have a material adverse effect on our business. Although each laboratory facility is separately certified by CLIA, if the CLIA certificate of any our laboratories is revoked, CMS could seek revocation of our other laboratories’ CLIA certificates based on their common ownership or operation with the laboratory facility whose certificate was revoked. Some states have enacted analogous state laws that are stricter than CLIA.
Changes in laws and regulations that address billing arrangements for our services could have a material adverse effect on our revenue.
While we do not bill referring physicians for our services when those services are covered under a government program, in some cases, we do, where permissible, bill referring physicians for services that are not covered under a government program. Laws and regulations in several states currently preclude us from billing referring physicians, either by requiring us to bill directly the third-party payor or other person ultimately responsible for payment for the service, or by prohibiting or limiting the referring physician’s or other purchaser’s ability to bill a greater amount than the amount paid for the service. An increase in the number of states whose laws prevent such arrangements could adversely affect us by encouraging physicians to furnish such services directly. Currently, Medicare does not require beneficiaries to pay coinsurance for clinical laboratory testing or subject such tests to a deductible. From time to time, legislation has been proposed that would subject diagnostic services to coinsurance and deductibles. Such legislation could be enacted in the future. Legislation subjecting diagnostic services to coinsurance or deductibles could adversely affect our revenue given the anticipated difficulty in collecting such amounts from Medicare beneficiaries. In addition, we could be subject to potential fraud and abuse violations if adequate procedures to bill and collect copayments were not established and followed.
We are increasingly subject to initiatives to recover improper payments and overpayments and such initiatives could result in significant monetary damages and penalties and exclusion from the Medicare and Medicaid programs.
Government payors have increased initiatives to recover improper payments and overpayments. For example, in March 2005, CMS initiated a demonstration project using Recovery Audit Contractors, or RACs, who are paid a contingent fee to detect and correct improper Medicare payments. As part of their duties, RACs collect overpayments from Medicare providers, including those providers who were paid for services that were not medically necessary or were incorrectly coded. As of January 1, 2010, the RAC program began to operate throughout the United States on a permanent basis, and they were granted the authority to pursue improper payments made on or after October 1, 2007. In addition, state Medicaid Programs will now also be required to have their own RAC programs. Furthermore, in 2011, CMS finalized a rule that will implement significant anti-fraud provisions included in the health care reform legislation, which will, among other things, strengthen current limits on who can enroll as a provider under Medicare, allow Medicare to suspend payments where a credible allegation of fraud exists, and permit Medicare and Medicaid to implement a temporary moratorium on new providers when necessary to prevent fraud and abuse.
Governmental investigations to which we may become subject could have a material adverse effect on our business.
Governmental investigations of laboratories have been ongoing for a number of years and are expected to continue. In fact, a substantial increase in funding of Medicare and Medicaid program integrity and anti-fraud efforts has been proposed. Investigations of our laboratories, regardless of their outcome, could damage our reputation and adversely affect important business relationships that we have with third parties, as well as have a material adverse effect on our business.
Failure to comply with environmental, health and safety laws and regulations could adversely affect our ability to operate and result in fines, litigation or other consequences.
We are subject to licensing and regulation under numerous federal, state and local laws and regulations relating to the protection of the environment and human health and safety. Our use, generation, manufacture, handling, transportation, storage and disposal of medical specimens, such as human tissue, infectious and hazardous waste, and radioactive materials, as well as the health and safety of our laboratory employees, are covered under these laws and regulations.
In particular, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers, including certain laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These requirements, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and the transmission of, bloodborne pathogens. In addition, the Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.
We cannot entirely eliminate the risk of accidental injury, contamination or sabotage from working with hazardous materials or wastes. Our general liability insurance or workers’ compensation insurance policies may not cover damages and fines arising from biological or hazardous waste exposure or contamination. In the event of contamination or injury, we could be held liable for damages or subject to fines in an amount exceeding our resources, and our operations could be suspended or otherwise adversely affected.
Failure to comply with federal, state and local laws and regulations could subject us to denial of the right to conduct business, fines, criminal penalties and/or other enforcement actions which would have a material adverse effect on our business. In addition, the current environmental, health and safety requirements applicable to our business, facilities and employees could be revised to become more stringent, and new laws and requirements could be adopted in the future. Thus, compliance with applicable environmental, health and safety laws and regulations could become both more costly and more difficult in the future.
Failure to comply with the Health Insurance Portability and Accountability Act security and privacy regulations may increase our costs.
HIPAA and related regulations establish comprehensive federal standards with respect to the use and disclosure of protected health information by health plans, health care providers and health care clearinghouses. Additionally, HIPAA establishes standards to protect the confidentiality, integrity and availability of protected health information.
Federal privacy regulations restrict our ability to use or disclose patient identifiable laboratory data, without patient authorization for purposes other than payment, treatment or health care operations, as defined by HIPAA. In February 2014, HIPAA was amended to require that laboratories make available to patients or the patient’s representative, upon request, copies of completed test reports that the laboratory can identify as belonging to the patient. These privacy and security regulations provide for significant fines and other penalties for wrongful use or disclosure of protected health information, including civil and criminal fines and penalties. We believe we are in substantial compliance with the privacy regulations. However, the documentation and process requirements of the privacy regulations are complex and subject to interpretation and our efforts in this respect are ongoing. Our failure to comply with the privacy regulations could subject us to sanctions or penalties. Although the HIPAA statute and regulations do not expressly provide for a private right of damages, we could also incur damages under state laws to private parties for the wrongful use or disclosure of confidential health information or other private information. We have policies and procedures to comply with the HIPAA regulations and state laws. In addition, we must also comply with non-U.S. laws governing the transfer of health care data relating to citizens of other countries.
Changes in regulations or failure to follow regulations requiring the use of “standard transactions” for health care services issued under the Health Insurance Portability and Accountability Act could adversely affect our profitability and cash flows.
Pursuant to HIPAA, the Secretary of HHS has issued final regulations designed to facilitate the electronic exchange of information in certain financial and administrative transactions. HIPAA transaction standards are complex and subject to differences in interpretation by payors. For instance, some payors may interpret the standards to require us to provide certain types of information, including demographic information not usually provided to us by physicians. As a result of inconsistent application of transaction standards by payors or our inability to obtain certain billing information not usually provided to us by physicians, we could face increased costs and complexity, a temporary disruption in receipts and ongoing reductions in reimbursements and revenues. Any future requirements for additional standard transactions, such as claims attachments or use of a national provider identifier, could prove technically difficult, time-consuming or expensive to implement.
Our business could be adversely impacted by the Centers for Medicare & Medicaid Services’ adoption of the new coding set for diagnoses.
CMS has adopted a new coding set for diagnosis, commonly known as ICD-10, which significantly expands the coding set for diagnoses. The new coding set is expected to be implemented by October 1, 2014. We may be required to incur significant expense in implementing the new coding set, and if we do not adequately implement it, our business could be adversely impacted. In addition, if as a result of the new coding set physicians fail to provide appropriate codes for desired tests, we may not be reimbursed for tests we perform.
We may be subject to liability claims for damages and other expenses not covered by insurance that could adversely impact our operating results.
The provision of diagnostic testing services to patients may subject us to litigation and liability for damages based on an allegation of malpractice, professional negligence in the performance of our treatment and related services, the acts or omissions of our employees, or other matters. Our exposure to this litigation and liability for damages increases with growth in the number of our laboratories and tests performed. Potential judgments, settlements or costs relating to potential future claims, complaints or lawsuits could result in substantial damages and could subject us to the incurrence of significant fees and costs. Our insurance may not be sufficient or available to cover these damages, costs or expenses. Our business, profitability and growth prospects could suffer if we face negative publicity or if we pay damages or defense costs in connection with a claim that is outside the scope of any applicable insurance coverage, including claims related to contractual disputes and professional and general liability claims.
Our insurance costs may increase over the next several years, and our coverage may not be sufficient to cover claims and losses.
We maintain a program of insurance coverage against a broad range of risks in our business. In particular, we maintain professional liability insurance, subject to deductibles. The premiums and deductibles under our insurance may increase over the next several years as a result of general business rate increases, coupled with our continued growth. We are unable to predict whether such increases in premiums and deductibles will occur and the amount of any such increases, but such increases could adversely impact our earnings. The liability exposure of operations in the health care services industry has increased, resulting not only in increased premiums, but also in limited liability on behalf of the insurance carriers. Our ability to obtain the necessary and sufficient insurance coverage for our operations upon expiration of our insurance policies may be limited, and sufficient insurance may not be available on favorable terms, if at all. We could be materially and adversely affected by any of the following: our inability to obtain sufficient insurance for our operations; the collapse or insolvency of one or more of our insurance carriers; further increases in premiums and deductibles; and an inability to obtain one or more types of insurance on acceptable terms.
Risks Relating to Our Indebtedness
Our failure to comply with the financial tests and ratios contained in the agreements governing our amended senior secured credit facility and senior notes could result in an acceleration of our indebtedness.
We currently expect to meet the financial tests and ratios contained in the agreements governing our amended senior secured credit facility and senior notes at least through the end of 2014. Nonetheless, we may not achieve all of our business goals and objectives and events beyond our control could affect our ability to meet these financial tests and ratios. Any failure by us to meet all applicable financial tests and ratios could result in an event of default with respect to our amended senior secured facility or our senior notes. This could lead to the acceleration of the maturity of our outstanding loans or notes and the termination of the commitments to make further extensions of credit. Each of these would have a material adverse effect on our business.
We are highly leveraged, and our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or in our industry, and prevent us from meeting our debt obligations, including our obligations under our amended senior secured credit facility, our senior notes and our contingent notes issued in acquisitions.
As of December 31, 2013, our total indebtedness was $326.5 million, including $124.7 million outstanding under our amended senior secured credit facility and $200.0 million outstanding under our senior notes. In addition, as of December 31, 2013, the fair value of contingent consideration issued in our acquisitions was $7.6 million and we had $37.8 million available to be borrowed under our revolving credit facility. For the period from January 1, 2014 through March 23, 2014, we have borrowed a net additional $10.7 million under our revolving credit facility to fund seasonal working capital requirements and, as of March 23, 2014, $27.1 million was available under our revolving credit facility. Our indebtedness could have important consequences, which could adversely impact our business, results of operations and financial condition, including:
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increase our vulnerability to general adverse economic and industry positions;
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subject us to covenants that limit our ability to fund future working capital, capital expenditures, research and development costs and other general corporate requirements;
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require us to devote a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, research and development efforts and other general corporate purposes;
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limit our ability to obtain additional financing to fund future acquisitions;
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limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
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impede our ability to obtain the necessary approvals to operate our business in compliance with the numerous laws and regulations to which we are subject;
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place us at a competitive disadvantage relative to our competitors that have less debt outstanding; and
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limit our ability to borrow additional funds for operational or strategic purposes (including to fund future acquisitions), among other things, under the financial and other restrictive covenants in our indebtedness.
Our revolving credit facility bears interest at variable rates that are linked to changing market interest rates. As a result, an increase in market interest rates would increase our interest expense and our debt service obligations.
Despite our current indebtedness levels, we and our subsidiaries may be able to incur substantially more debt.
We and our subsidiaries may be able to incur substantially more additional indebtedness in the future, including our access to approximately $37.8 million additional borrowing capacity under our amended senior secured revolving credit facility. Although the terms of our debt agreements contain covenants limiting indebtedness, these covenants are subject to a number of significant exceptions and qualifications, and if we incur additional debt, secure existing or future debt, or recapitalize our debt, we might further exacerbate the risks associated with our substantial indebtedness.
The computation of amounts owed under the contingent notes could lead to disputes that could disrupt our operations and damage our relationships with our pathologists.
In connection with our acquisitions, we agreed to pay additional consideration in future periods based upon the attainment of stipulated levels of operating earnings by each of the acquired entities. The computation of the annual operating earnings and the amount owed under such agreements is subject to review and approval by sellers prior to payment. This computation could lead to a dispute with the sellers who are often our pathologists. For example, as further described in Note 11 of our Consolidated Financial Statements in this Annual Report, certain sellers have claimed that we owed additional amounts in connection with contingent notes. These types of disputes could disrupt our operations, damage our relationships with our pathologists and have a material adverse effect on our business.
The agreements governing our amended senior secured credit facility and senior notes contains, and future debt agreements may contain, various covenants that limit our discretion in the operation of our business.
Our agreements and the related instruments governing borrowings under our amended senior secured credit facility and senior notes contain, and the agreements and instruments governing any future debt agreements of ours may contain, various restrictive covenants that, among other things, require us to comply with or maintain certain financial tests and ratios and restrict our ability to:
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incur more debt;
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redeem or repurchase stock, pay dividends or make other distributions;
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make certain investments;
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create liens;
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enter into transactions with affiliates;
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make acquisitions;
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merge or consolidate;
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transfer or sell assets; and
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make fundamental changes in our corporate existence and principal business.
Any failure by us to comply with all applicable covenants could result in an event of default with respect to our amended senior secured facility, our senior notes or future debt agreements. This could lead to the acceleration of the maturity of our outstanding loans or notes and the termination of the commitments to make further extensions of credit. Even if we are able to comply with all applicable covenants, the restrictions on our ability to operate our business at our sole discretion could harm our business by, among other things, limiting our ability to take advantage of financing, mergers, acquisitions and other corporate opportunities.
Item 1B.
Item 1B.
Unresolved Staff Comments.
Not applicable.
Item 2.
Item 2.
Properties.
We lease our corporate headquarters at 11025 RCA Center Drive, Suite 300, Palm Beach Gardens, FL 33410 (approximately 12,700 square feet), and we lease 28 other facilities: four in Florida, six in Alabama, one in Arizona, two in Massachusetts, three in Michigan, one in Minnesota, two in Nevada, one in New Hampshire, one in New Jersey, one in New York, two in North Carolina, one in South Carolina, one in Texas and two in Virginia. These facilities are used for laboratory operations, administrative, billing and collections operations and storage space. The 29 facilities have lease terms expiring from 2014 to 2022.
Item 3.
Item 3.
Legal Proceedings.
We are not currently a party to any material legal proceedings. We may be named in various claims, disputes, legal actions and other proceedings involving malpractice, employment and other matters from time to time. A negative outcome in certain of the ongoing litigation could harm our business, financial condition, liquidity or results of operations. Further, prolonged litigation, regardless of which party prevails, could be costly, divert management’s attention or result in increased costs of doing business.
Item 4.
Item 4.
Mine Safety Disclosures.
None.
PART II
Item 5.
Item 5.
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
We are a privately held company and do not currently have any securities listed on any securities exchange. As of March 23, 2014, we have 14 holders of record of our common membership units. We have made distributions to our members in accordance with the LLC Agreement as described under the heading “Notes to Consolidated Financial Statements” included in Part II, Item 8 of this Annual Report.
Item 6.
Item 6.
Selected Financial Data.
The following selected historical consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the related notes included in this Annual Report. The selected historical consolidated financial data included in this section are not intended to replace the consolidated financial statements and the related notes included in this Annual Report.
The consolidated statements of operations data for the fiscal years 2011, 2012 and 2013, and consolidated balance sheet data as of fiscal year end 2012 and 2013, were derived from Aurora Holdings’ audited consolidated financial statements that are included elsewhere in this Annual Report. The consolidated statements of operations data for the fiscal years ended December 31, 2009 and 2010 and consolidated balance sheet data as of December 31, 2009, 2010 and 2011, were derived from Aurora Holdings’ audited consolidated financial statements not included in this Annual Report. As indicated in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and disclosed in the audited consolidated financial statements included in this Annual Report we have made a number of acquisitions. The selected historical consolidated financial data includes the results of operations of those acquisitions subsequent to the acquisition date. The historical results presented below are not necessarily indicative of financial results to be achieved in future periods.
(1)
In July 2011, we adopted the Aurora Diagnostics Holdings, LLC 2011 Equity Incentive Plan, which we refer to as the 2011 Plan. The 2011 Plan provides for the grant of options to purchase units of Aurora Holdings to eligible participants. Through December 31, 2013, we have granted a total of 3,275,119 options to employees under the 2011 Plan, of which 1,492,619 have been forfeited since the grant date. For the years ended December 31, 2011, 2012 and 2013, selling general and administration expenses included compensation costs of $1.4 million, $1.1 million and $0.3 million, respectively, for these awards.
(2)
We test goodwill for impairment annually, or more frequently if circumstances indicate our goodwill may have been impaired. As a result of our testing we recorded non-cash impairment charges to write-down our recorded goodwill by $6.6 million, $2.0 million, $19.2 million, $0.9 million, $93.0 million, $46.0 million and $52.9 million as of September 30, 2009, September 30, 2010, September 30, 2011, June 30, 2012 September 30, 2012, November 30, 2012 and 2013, respectively.
We also test for impairment of our other intangible assets whenever events occur indicating the recorded balances of our other intangible assets may not be recoverable. As a result of our testing we recorded non-cash impairment charges to write-down our other intangible assets by $1.4 million, $2.9 million, $5.3 million, $0.2 million, $21.6 million, $7.9 million and $1.0 million as of September 30, 2009, September 30, 2010, September 30, 2011, June 30, 2012 September 30, 2012, November 30, 2012 and 2013, respectively.
(3)
During the year ended December 31, 2011, we decided to delay the completion of our initial public offering. As a result, we recognized a non-cash charge of $4.4 million to write off the previously deferred offering costs.
(4)
In May 2010, we refinanced our credit facility and recorded a non-cash charge to write off unamortized deferred debt issue costs and original issue discount of $4.5 million and incurred a $2.3 million prepayment penalty. In December 2010, we issued $200.0 million of unsecured Senior Notes and amended and restated our May 2010 credit facility. Approximately $110.0 million of the proceeds from the Senior Notes was used to repay a portion of the term loan. As a result, we recorded a non-cash charge of approximately $4.7 million to write off a pro rata portion of the unamortized deferred debt issue costs and original issue discount recorded in connection with the May 2010 refinancing.
During 2012, we entered into a second amendment to our credit facility. In connection with the second amendment, we repaid approximately $11.9 million of $114.4 million then outstanding under our term loan credit facility and elected to reduce the maximum amount available under the revolving credit facility from $110 million to $60 million. As a result, we recorded a non-cash write-off of the pro rata portion of unamortized original issue discount and debt issue costs of approximately $0.8 million.
(5)
Aurora Holdings is a Delaware limited liability company taxed as a partnership for federal and state income tax purposes in accordance with the applicable provisions of the Internal Revenue Code. Accordingly, Aurora Holdings was not generally subject to income taxes. The income attributable to Aurora Holdings was allocated to the members of Aurora Holdings in accordance with the terms of the existing Aurora Holdings limited liability company agreement, which we refer to as the LLC Agreement. However, certain of our subsidiaries are corporations, file separate returns and are subject to federal and state income taxes. The provision for income taxes for these subsidiaries is reflected in our consolidated financial statements and includes federal and state taxes currently payable and changes in deferred tax assets and liabilities, excluding the establishment of deferred tax assets and liabilities related to the acquisitions.
Adjusted EBITDA is defined as earnings before interest, taxes, depreciation and amortization (EBITDA), further adjusted to exclude unusual items and other cash or non-cash adjustments. We believe that disclosing Adjusted EBITDA provides additional information to investors, enhancing their understanding of our financial performance and providing them an important financial metric used to evaluate performance in the health care industry. Our amended senior secured credit facility contains financial covenants measured against Adjusted EBITDA. Our definition and calculation of Adjusted EBITDA in this Annual Report is consistent with the definition and calculation contained in our amended senior secured credit facility and the indenture governing our Senior Notes.
Adjusted EBITDA does not represent net income or cash flow from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. As a result, the measure can be disproportionately affected by a particularly strong or weak quarter. Further, it may not be comparable to the measure for any subsequent four-quarter period or any complete fiscal year.
Adjusted EBITDA is not a recognized measurement under GAAP and should not be considered as a substitute for measures of our financial performance as determined in accordance with GAAP, such as net income and operating income. Because other companies may calculate Adjusted EBITDA differently than we do, Adjusted EBITDA may not be comparable to similarly titled measures reported by other companies. Adjusted EBITDA has other limitations as an analytical tool when compared to the use of net income, which we believe is the most directly comparable GAAP financial measure, including:
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Adjusted EBITDA does not reflect the provision of income tax expense in our various jurisdictions;
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Adjusted EBITDA does not reflect the interest expense we incur;
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Adjusted EBITDA does not reflect any attribution of costs to our operations related to our investments and capital expenditures through depreciation and amortization charges;
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Adjusted EBITDA does not reflect the cost of compensation we provide to our employees in the form of stock option awards; and
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Adjusted EBITDA excludes expenses that we believe are unusual or non-recurring, but which others may believe are normal expenses for the operation of a business.
The following is a reconciliation of net income to Adjusted EBITDA:
(A)
In accordance with our amended senior secured credit facility and the indenture governing our Senior Notes, management fees payable to affiliates are excluded from Adjusted EBITDA.
(B)
For the years ended December 31, 2010, 2011 and 2013, we recorded charges of $1.0 million, $12.5 million and $1.1 million, respectively, and for the year ended December 31, 2012, we recorded a gain of $4.2 million, in each case related to non-cash changes in the estimated fair value of contingent consideration issued in connection with our acquisitions completed after January 1, 2009. These changes in the estimate of the fair value relate to numerous variables such as the discount rate, remaining pay out period and the projected performance for each acquisition.
(C)
During the years ended December 31, 2009, 2010, 2011, 2012 and 2013, we recorded non-cash impairment charges of $8.0 million, $4.9 million, $24.5 million, $169.6 million and $53.9 million, respectively, related to goodwill and other intangible assets. During the year ended December 31, 2012, the non-cash impairment charges of $169.6 million included $1.1 million related to our discontinued operation. During the year ended December 31, 2011, we decided to delay the completion of our initial public offering. As a result, we recognized a non-cash charge of $4.4 million to write off the previously deferred offering costs.
(D)
Unusual charges also includes an add-back for acquisition and business development costs as reported in our consolidated statements of operations.
(E)
For the year ended December 31, 2010, net loss included $9.3 million for write-offs of deferred debt issue costs and a $2.3 million loss on extinguishment of debt related to the refinancing and amendment of our credit facilities. For the year ended December 31, 2012, net loss included $0.8 million for write-offs of deferred debt issue costs.
(F)
Amount represents EBITDA of our discontinued operation, which was sold on August 31, 2012. The year ended December 31, 2012 includes $1.0 million for the loss on the sale of the discontinued operation.
(G)
The Adjusted EBITDA for the year ended December 31, 2010 excludes the results of operations of acquisitions completed in 2010 prior to their acquisition date. For purposes of calculating compliance ratios for our amended senior secured credit facility, the Adjusted EBITDA for the year ended December 31, 2010 would include approximately $11.0 million of additional Adjusted EBITDA related to operations of our 2010 acquisitions and the 2011 acquisitions completed on January 1, 2011 as if they were acquired on January 1, 2010. The Adjusted EBITDA for the year ended December 31, 2010 does not reflect any adjustment to add back $1.1 million of severance and settlement charges as prescribed by our amended senior secured credit facility and the indenture governing our Senior Notes.
The Adjusted EBITDA for the year ended December 31, 2011 excludes the results of operations of acquisitions completed in 2011 prior to their acquisition date. For purposes of calculating compliance ratios for our amended senior secured credit facility, the Adjusted EBITDA for the year ended December 31, 2011 would include approximately $4.6 million of additional Adjusted EBITDA related to operations of our 2011 acquisitions as if they were acquired on January 1, 2011. The Adjusted EBITDA for the year ended December 31, 2011 does not reflect any adjustments to add back $1.6 million of severance and other charges as prescribed by our amended senior secured credit facility and the indenture governing our Senior Notes.
The Adjusted EBITDA for the year ended December 31, 2012 does not reflect any adjustments to add back $2.5 million of severance and other charges as prescribed by our amended senior secured credit facility and the indenture governing our Senior Notes.
The Adjusted EBITDA for the year ended December 31, 2013 does not reflect any adjustments to add back $8.7 million of other amounts as prescribed by our amended senior secured credit facility and the indenture governing our Senior Notes, including approximately $4.8 million for pro forma adjustments related to reduction in force initiatives.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Some of the statements made in this Annual Report are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements other than statements of historical facts contained in this Annual Report on Form 10-K, including statements regarding our future results of operations and financial position, or that describe our plans, goals, intentions, objectives, strategies, expectations, beliefs and assumptions, are forward-looking statements. The words “believe,” “may,” “might,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “project,” “plan,” “objective,” “could,” “would,” “should” and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives, and financial needs. We caution that the forward-looking statements in this Annual Report are subject to a number of known and unknown risks, uncertainties and assumptions that may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. Factors that could contribute to these differences include, among other things:
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changes in medical treatment or reimbursement rates or utilization for our anatomic and clinical pathology markets;
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changes in payor regulations, policies or payor mix;
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changes in regulation or regulatory policies;
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competition for our diagnostic services, including the internalization of testing functions and technologies by our clients;
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the failure to successfully collect for our services;
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payor efforts to reduce utilization and reimbursement rates;
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changes in product mix;
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failure to successfully integrate or fully realize the anticipated benefits from our acquisitions within the expected time frames;
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the discovery of unknown or contingent liabilities from acquired businesses;
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the failure of our acquired assets to generate the level of expected returns;
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disruptions or failures of our IT solutions or infrastructure;
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the failure to adequately safeguard data;
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loss of key executives, pathologists and technical personnel;
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growth in demand for our services that exceeds our ability to adequately scale our infrastructure;
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a decline in our rate of strategic or organic growth;
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the loss of in-network status with or our the inability to collect from health care insurers;
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the availability of additional capital resources;
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increased competition in our industry or the failure to maintain relationships with clients, including referring physicians and hospitals, and with payors;
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the protection of our intellectual property;
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general economic, business or regulatory conditions affecting the health care and diagnostic testing services industries;
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the introduction of new or failure of old technologies, products or tests;
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federal or state health care reform initiatives;
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violation of, failure to comply with, or changes in federal and state laws and regulations related to, submission of claims for our services, fraud and abuse, patient privacy, corporate practice of medicine, billing arrangements for our services and environmental, health and safety;
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attainment of licenses required to test patient specimens from certain states or the loss or suspension of licenses;
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our inability to obtain liability insurance coverage or claims for damages in excess of our coverage;
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future increases in liability insurance coverage;
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our substantial level of indebtedness and ability to incur substantially more debt;
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covenants in our debt agreements; and
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the other risks and uncertainties discussed under the heading “Risk Factors” in Part I, Item 1A of this Annual Report and elsewhere in this Annual Report.
Moreover, we operate in a very competitive and rapidly changing environment, and new risks emerge from time-to-time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Annual Report may not occur, and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.
You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this Annual Report to conform these statements to actual results or changes in our expectations, unless otherwise required by law.
General
We are a specialized diagnostics company providing services that play a key role in the diagnosis of cancer and other diseases. Our experienced pathologists deliver comprehensive diagnostic reports of a patient’s condition and consult frequently with referring physicians to help determine the appropriate treatment. Our diagnostic reports often enable the early detection of disease, allowing referring physicians to make informed and timely treatment decisions that improve their patients’ health in a cost-effective manner. Through our pathologist-operated laboratory practices, we provide physician-based general anatomic and clinical pathology, dermatopathology, molecular diagnostic services and other esoteric testing services to physicians, hospitals, clinical laboratories and surgery centers. Our operations consist of one reportable segment.
Statement of Operations Overview
Net Revenue
Substantially all of our revenue consist of payments or reimbursements for specialized diagnostic services rendered to patients of our referring physicians, and these revenue are affected primarily by changes in case volume, which we refer to as accession volume, payor mix and reimbursement rates. Accessions are measured as the number of patient cases, and each accession may include multiple specimens. Net revenue per accession is impacted mainly by changes in reimbursement rates and test and payor mix. Accession volume varies from period to period based on the referral patterns of our referring physicians and the frequency of their ordering, the relative mix of the referring physicians’ anatomic pathology specialties, and the type and number of tests ordered. Accession volume is also affected by seasonal trends and generally declines during the summer and holiday periods. Furthermore, accession volume is also subject to declines due to weather conditions, such as severe snow storms and flooding or excessively hot or cold spells, which can deter patients from visiting our referring physicians. More recently, we believe the slowdown in the general economy and increase in unemployment has reduced the number of patients visiting our referring physician offices, resulting in a reduction of referrals.
Our billings for services reimbursed by third-party payors, including Medicare, and patients are based on a company-generated fee schedule that is generally set at higher rates than our anticipated reimbursement rates. Our billings to physicians, which are not reimbursed by third-party payors, represent less than 10 percent of net revenue and are billed based on negotiated fee schedules that set forth what we charge for our services. Reimbursement under Medicare for specialized diagnostic services is subject to a Medicare physician fee schedule and, to a lesser degree, a clinical laboratory fee schedule, both of which are updated annually. Our billings to insured patients include co-insurance and deductibles as dictated by the patient’s insurance coverage. Billings for services provided to uninsured patients are based on our company-generated fee schedule. Our revenue is recorded net of the estimated differences between the amount billed and the estimated payment to be received from third party payors, including Medicare. We do not have any capitated payment arrangements, which are arrangements under which we are paid a contracted per person rate regardless of the services we provide. We generally provide services on an in-network basis, where we perform services for persons within the networks of payors with which we have contracts. Services performed on an out-of-network basis, where we perform services for persons outside of the networks of payors with which we have contracts, comprised less than 15 percent of our 2013 revenue. We may face continuing pressure on reimbursement rates as government payors and private insurers have taken steps and may continue to take steps to control the cost, use, and delivery of health care services, including diagnostic testing services. Changes in payor mix could lead to corresponding changes in revenue based on the differences in reimbursement rates.
Compliance with applicable laws and regulations, as well as internal policies and procedures, adds further complexity and costs to our operations. Furthermore, we are generally obligated to bill in the specific manner prescribed by each governmental payor and private insurer, who may each have different billing requirements. Reimbursements for anatomic pathology services are received from governmental payors, such as Medicare and Medicaid; private insurance, including managed care organizations and commercial payors; and private payors, such as physicians and individual patients. For the year ended December 31, 2013, based on cash collections, we estimate approximately 60 percent of our revenue were paid by private insurance, including managed care organizations and commercial payors; approximately 23 percent of our revenue were paid by Medicare and Medicaid; and approximately 17 percent were paid by physicians and individual patients.
In most cases, we provide a global testing service which includes both the technical slide preparation and professional diagnosis. We also fulfill requests from physicians for only the technical component of our services, or TC, which principally includes technical slide preparation and the non-professional items associated with our diagnostic services, including equipment, supplies and technical personnel, or the professional component of our services, or PC, which principally includes review and diagnosis by a pathologist. If a physician requires only the TC services such as slide preparation, we prepare the slide and then return it to the referring physician for assessment and diagnosis.
Cost of Services
Cost of services consists of physician costs, including compensation, benefits and medical malpractice insurance and other physician related costs. In addition, cost of services includes costs related to the technical preparation of specimens and transcription of reports, depreciation, courier and distribution costs, and all other costs required to fulfill the diagnostic service requirements of our referring physicians and their patients.
Cost of services generally increases with accession volume and reflects the additional staffing, equipment, supplies and systems needed to process the increased volume and maintain client service levels. A major component of cost of services is physician costs which, for the year ended December 31, 2013, represented 40 percent of our total cost of services. In the future, we may experience increases in physician costs to retain existing physicians, to replace departing physicians or to hire new physicians to support accession growth. Therefore, we expect our cost of services will continue to increase commensurate with revenue growth.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist primarily of general lab and corporate overhead, billing, information technology, accounting, human resources, and sales and marketing expenses. We expect sales and marketing and IT expenses to increase faster than revenue as we hire additional personnel and invest in lab and billing information systems to support our efforts to achieve revenue growth and retain existing customer relationships. As our business matures and we attain a sufficient size and scope, we expect selling, general and administrative expenses as a percent of revenue to reduce over time.
Provision for Doubtful Accounts
The provision for doubtful accounts and the related allowance are adjusted periodically, based upon an evaluation of historical collection experience with specific payors for particular services, anticipated collection levels with specific payors for new services, industry reimbursement trends, accounts receivable aging and other relevant factors. The majority of our provision for doubtful accounts relates to our estimate of uncollectible amounts from patients who are uninsured or fail to pay their coinsurance or deductible obligations. Changes in these factors in future periods could result in increases or decreases in our provision for doubtful accounts and impact our results of operations, financial position and cash flows.
In an effort to maximize our collections of accounts receivable, we take a number of steps to collect amounts, including coinsurance and deductibles, owed by third party payors, government payors, referring physicians and patients. The process generally includes:
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verification of complete insurance information and patient demographics,
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active management and follow up on denials,
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delivery of scheduled statements to patients, and/or
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forwarding significant past due accounts to outside collection agencies.
Due to the fact that we operate on multiple billing platforms, we evaluate collectability and the related adequacy of our allowance for doubtful accounts using information from multiple sources. Not all of our systems produce the same level of information by payor or by aging classification and, therefore, we are unable to provide consolidated accounts receivable agings by payor class. However, we believe that sufficient information exists in each respective billing system to make reasonable estimates of our provision for doubtful accounts. In the future, we may convert legacy billing systems from businesses we have acquired to one or more common billing platforms. This could allow for the consolidation of billing data and information on a consistent basis.
Recent Developments
Health Care Regulatory and Reimbursement Changes
On November 1, 2012, the Centers for Medicare & Medicaid Services (CMS) issued its 2013 Physician Fee Schedule, which we refer to as the 2013 Fee Schedule. In the 2013 Fee Schedule, CMS called for a reduction of approximately 26.5 percent in the conversion factor that is used to calculate physician reimbursement. This cut was scheduled to become effective as of January 1, 2013; however, on January 1, 2013, Congress passed the American Tax Relief Act, which reversed the proposed cut and kept in place the 2012 conversion factor until December 31, 2013. For the year ended December 31, 2013, revenue from Medicare’s Physician Fee Schedule, based upon cash collections, was approximately 21 percent of our total revenue.
In addition, the 2013 Fee Schedule included the reduction of certain relative value units and geographic adjustment factors used to determine reimbursement for a number of our most commonly used pathology codes, including the components of code 88305, our most common code. In particular, the 2013 Fee Schedule implements a 52 percent reduction in the technical component of code 88305 and a 2 percent increase in the professional component of code 88305. These changes in the components of code 88305 result in a blended reduction of the global code 88305 of approximately 33 percent. Additional changes were also made to other surgical pathology codes. For the year ended December 31, 2012, revenue from Medicare’s Physician Fee Schedule, based upon cash collections, was approximately 24 percent of our total revenue. Our cash receipts from Medicare for the year ended December 31, 2013 declined to approximately 21 percent of our total collections primarily as a result of the lower reimbursement rates.
In 2013, CMS also announced its process for pricing over 100 new CPT codes for molecular diagnostics, which the American Medical Association had adopted in 2012. CMS stated it would pay for the new molecular codes based on the CLFS, rather than the PFS as some stakeholders had urged. CMS also required that the Medicare Administrative Contractors “gapfill” the new codes and set an appropriate price for them. That “gapfilling” process took place over 2013 and CMS announced the new prices for these codes in September, 2013. The median of the prices set by the contractors become the new prices for these codes, effective January 1, 2014.
In addition, CMS also noted in the 2014 Proposed Rule that it was concerned that Medicare often pays more for services performed outside the hospital in locations such as clinical laboratories than it does for the same services performed in the hospital. As a result, CMS proposed to change how it calculates the Relative Value Units (RVUs) used to calculate payments under the Physician Fee Schedule. Where a service is paid at a lower rate in the hospital based on the hospital Outpatient Prospective Payment System (OPPS) than it is under the Physician Fee Schedule, CMS proposes to reduce the RVUs for that service in order to equalize the payment between the two systems. According to CMS, the effect of this change, if implemented, would be a 25 percent reduction in aggregate payments to independent laboratories and a 6 percent reduction in payments to pathologists who work at hospitals or in group practices. In the Final Physician Rule for 2014, however, CMS chose not to implement this proposal, although it stated that it would develop a revised proposal that it would propose in the future.
On November 27, 2013, CMS issued its final 2014 Physician Fee Schedule. The 2014 conversion factor, as calculated by CMS using the Sustainable Growth Rate method, or SGR, represents a 20.1 percent reduction from the 2013 conversion factor. On December 18, 2013, Congress passed legislation that enacted a 0.5 percent increase in the conversion factor, which will be effective until March 31, 2014. Currently, Congress is considering a long-term fix to the SGR, which could eliminate the need for annual Congressional action. If Congress fails to act before March 31, 2014, or if it does not enact a long-term solution to the SGR, then future decreases in the Medicare physician schedule are possible. If we assumed no change from the conversion factor in effect for 2013, the reimbursement rate for CPT code 88305, which is the code we bill most frequently, would be reduced by approximately 4 percent, consisting of an 8 percent decrease in the Technical Component and a 1 percent decrease in the Professional Component. We estimate the impact of the change in the physician fee schedule for 2014 to be a reduction in annualized revenue of approximately $6 million, before any change in conversion factor. Alternatively, if Congress were to extend through December 31, 2014, the conversion factor in effect through March 31, 2014, we estimate the changes to the 2014 Fee Schedule would result in a reduction of our annualized Medicare revenue of approximately $3 million. We have experienced isolated reductions in reimbursement from non-governmental third-party payors tied to the Medicare reductions. However, at this time we are unable to predict the extent to which, non-governmental third-party payors will seek to reduce our reimbursement rates as a result of reductions in Medicare’s Physician Fee Schedule.
Finally, in the 2014 Proposed Rule, CMS also explains that it is concerned that payments for many codes paid under the CLFS have not been revised to reflect technological advances that have occurred since the CLFS was first implemented in 1984. As a result, beginning in 2014, it will propose codes to review and, if justified, it will adjust them to reflect technological changes. CMS notes that while payment levels could increase or decrease, it expects that most payments are likely to decrease. CMS states it expects it should take about five years to review all codes on the CLFS. CMS adopted this proposal in the Final 2014 Physician Fee Schedule Rule; therefore, this review process will begin in 2014.
The Budget Control Act of 2011 created a Joint Select Committee on Deficit Reduction, which was tasked with recommending proposals to reduce spending. Under the law, the Joint Committee’s failure to achieve a targeted deficit reduction, or Congress’ failure to pass the Committee’s recommendations without amendment by December 23, 2011, would result in automatic across-the-board cuts to most discretionary programs. Automatic cuts also would be made to Medicare and would result in aggregate reductions in Medicare payments to providers of up to two percent per fiscal year, starting in 2013 and continuing through 2021. Because the Joint Committee was not able to agree on a set of deficit reduction recommendations for Congress to vote on, cuts went into effect in April 2013. This reduction is currently scheduled to continue through 2023. We estimate the impact of the full two percent cut to be approximately $1.2 million in our annual Medicare revenue.
In addition, CMS made several other changes in 2014 Physician Fee Schedule Rule that could impact our business. First, CMS implemented a policy that will set the payment for the examination of 10 or more prostate biopsies into a single “bundled” payment amount, rather than paying separately for each individual procedure as had been done previously. This will result in a significant reduction in reimbursement on each of these procedures. In addition, CMS also has developed new codes applicable to billing for Immunohistochemistry procedures, which are a common staining procedure used in pathology. Those codes will reduce the reimbursement that the Company will receive when it provides these services. Finally, CMS has also implemented a set of edits under its National Correct Coding Initiative, which will only pay for a single unit of service when the Company performs a FISH (Fluorescent In Situ Hybridization) test. As many FISH tests require two or more probes, this change will also reduce the reimbursement received by the Company.
Also, under Medicare regulations, we are sometimes required to bill other entities for the services that we provide. In 1999, Medicare announced a policy that applies to anatomic pathology specimens for hospital patients. This policy would require us and other independent laboratories to bill the technical component to the hospital and the professional component to Medicare for all anatomic pathology services that we provide to hospital patients. However, in 2000, the U.S. Congress prevented this policy from going into effect for all “covered hospitals,” which were those hospitals that had arrangements with independent laboratories in effect as of July 22, 1999, the date that CMS had first announced the policy. That “grandfather provision” was originally scheduled to be effective for two years, but it has been extended repeatedly by the U.S. Congress. However, in the Middle Class Tax Relief and Job Creation Act of 2012, Congress eliminated the grandfather provision beginning with services provided after June 30, 2012. We estimate our annualized revenue associated with the “grandfather provision” was approximately $2.8 million and our annual revenue from these hospitals will be reduced by approximately $1.4 million.
Acquisitions
Through December 31, 2013, we have acquired 22 diagnostic services companies throughout the United States, with our most recent acquisition completed on August 1, 2011. The following summarizes the acquisitions we completed in 2011.
2011 Acquisitions
During 2011, we paid cash of $78.1 million to acquire four pathology practices. On January 1, 2011, we acquired 100 percent of the equity of two pathology practices for an aggregate cash purchase price of $36.9 million. These acquisitions were consummated on January 1, 2011 and, therefore, the cash paid in December 2010 totaling $36.9 million was included in deposits and other non-current assets as of December 31, 2010. On June 2, 2011, we acquired 100 percent of the equity of a third pathology practice for a cash purchase price of $14.7 million. On August 1, 2011, we acquired substantially all of the assets of a fourth pathology practice for a cash purchase price of $26.5 million. Each of the transactions included contingent consideration payable over three to five years based on the acquired practices’ future performance. We have estimated the fair value of the contingent consideration and recorded a related liability as of the date of acquisition. The maximum amount of the contingent consideration at the acquisition dates, assuming the acquisitions meet the maximum stipulated earnings level, was $53.2 million payable over three to five years.
As a result of the significant number and size of the acquisitions completed in 2011, many of the changes in our consolidated results of operations and financial position in 2012, compared to 2011, discussed below relate to the acquisitions completed in 2011.
Discontinued Operation
On August 31, 2012, we sold one hundred percent of our equity in one of our subsidiaries. This discontinued operation was a clinical laboratory, which provided services to assisted living facilities and skilled nursing facilities and had experienced declining revenue and increasing losses over the preceding quarters. All comparisons that follow exclude the results of our discontinued operation.
Results of Operations
The following table outlines, for the periods presented, our results of operations as a percentage of net revenue.
Our historical consolidated operating results do not reflect the results of operations of our 2011 acquisitions prior to the effective date of those acquisitions. As a result, our historical consolidated operating results may not be indicative of what our results of operations will be for future periods.
Comparison of the Year Ended December 31, 2013 and 2012
Net Revenue
Net revenue decreased approximately $29.7 million, or 10.7 percent, to $248.2 million for the year ended December 31, 2013, from $277.9 million for the year ended December 31, 2012.
Total accessions for continuing operations declined by 33,000 to 2,138,000 for the year ended December 31, 2013, compared to 2,171,000 for the year ended December 31, 2012. The average revenue per accession decreased 9.3 percent to approximately $116 for the year ended December 31, 2013, down from $128 in 2012. The decrease in net revenue and average revenue per accession was due primarily to Medicare reductions, including changes to the 2013 Fee Schedule, the grandfather provision rule change and sequestration, as well as lower reimbursement from private insurance and the BlueCard Program. Partially offsetting the decrease in revenue was approximately $0.8 million in revenue from the new Aurora Research Institute which specializes in providing paraffin blocks and fresh tissue to pharmaceutical and research companies conducting research studies.
Based on our current Medicare business, we estimate the impact of the change in the physician fee schedule for 2014 to be a reduction in annualized revenue of approximately $6 million, before any change in conversion factor. Alternatively, if Congress were to extend through December 31, 2014, the conversion factor in effect through March 31, 2014, we estimate the changes to the 2014 Fee Schedule, excluding any change in the or reduction due to sequestration, would result in a reduction of our annualized Medicare revenue of approximately $3 million. At this time we are unable to predict the extent to which, non-governmental third-party payors will seek to reduce our reimbursement rates as a result of the changes to the 2014 Fee Schedule.
Furthermore, we expect the average revenue per accession of our existing business to fluctuate primarily as the result of changes in service mix, including the conversion of more global fee arrangements to technical component (TC) or professional component (PC) arrangements and further growth in women’s health pathology services, which should result in an increase of the number of clinical tests. Women’s health services and clinical tests generally have lower revenue per accession and, therefore, may further decrease our average revenue per accession. In addition, our growth rates and average revenue per accession may be positively or negatively impacted by the reimbursement market, our service mix and the average revenue per accession of acquisitions completed in the future.
If we cannot offset the reductions in our reimbursement from governmental payors and potential reductions from our non-governmental payors by reducing our costs, increasing our accession volume, and/or improving our service mix, we believe it could have a material adverse impact on our revenue, profitability and cash flow.
Our pathology diagnostic testing services accounted for substantially all of our revenue for 2013 and 2012.
Cost of Services
Cost of services decreased approximately $0.8 million, or 0.6 percent, to $134.1 million for the year ended December 31, 2013 from $134.9 million for the year ended December 31, 2012. The decrease in costs of services primarily related to lower personnel related costs from a reduction in headcount, partially offset by higher expenses for medical liability insurance.
As a percentage of net revenue, cost of services was 54.0 percent and 48.5 percent for the years ended December 31, 2013 and 2012, respectively, and our gross margins were 46.0 percent and 51.5 percent for the years ended December 31, 2013 and 2012, respectively. We currently anticipate that our gross margin will continue to be negatively impacted by a combination of lower average revenue per accession, increases in pathologist compensation and replacement. Cost of services and our related gross profit percentages may be positively or negatively impacted by market conditions and our service mix.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased approximately $0.7 million, or 1.1 percent, to $64.9 million for the year ended December 31, 2013 from $64.2 million for the year ended December 31, 2012. Selling, general and administrative expenses at corporate increased by approximately $3.1 million while expenses at our labs decreased by approximately $2.4 million for the year ended December 31, 2013 compared to 2012. Selling, general and administrative expense reductions at our labs were attributable to lower personnel related costs associated with reduced headcount and lower billing fees primarily related to the decrease in revenue, partially offset by higher costs for client interfaces. Corporate selling, general and administrative costs reflected higher management services fees, consulting and legal fees and severance costs, partially offset by lower equity compensation costs.
As a percentage of net revenue, selling, general and administrative expenses were 26.2 percent and 23.1 percent for the years ended December 31, 2013 and 2012, respectively.
Provision for Doubtful Accounts
Our provision for doubtful accounts decreased $1.4 million, or 7.6 percent, to $16.9 million for the year ended December 31, 2013, from $18.3 million for the year ended December 31, 2012. The decrease in the provision for doubtful accounts primarily related to our lower net revenue. As a percentage of net revenue, the provision for doubtful accounts was 6.8 percent for the year ended December 31, 2013, compared to 6.6 percent for year ended December 31, 2012, primarily as a result of the reduction in the proportion of our revenue from Medicare. The Company’s provision for doubtful accounts could be positively or negatively impacted by changes in payor mix.
Intangible Asset Amortization Expense (Amortization)
Amortization expense decreased by approximately $3.7 million, to $18.6 million for the year ended December 31, 2013, from $22.3 million for the year ended December 31, 2012 as a result a total of $30.5 million of impairments of finite lived intangible assets recorded in September 2012, November 2012 and November 2013. We amortize our intangible assets over weighted average lives ranging from 3 to 13 years.
Management Fees
Management fees decreased approximately $0.4 million, or 12.0 percent, to $2.5 million for the year ended December 31, 2013, compared to $2.9 million for the year ended December 31, 2012. Management fees are based on 1.0 percent of net revenue plus expenses. The majority of the decrease relates to the decrease in our net revenue. In connection with the third amendment to the Company’s credit facility in April 2013, the Company has agreed not make any payments of management or similar fees until payment in full of all loans under the credit facility, provided that such management or similar fees shall continue to accrue.
Impairment of Goodwill and Other Intangible Assets
As of June 30, 2012, we identified indications of impairment at one of our reporting units. Competitive pricing pressures at this location and significant erosion in its customer base had resulted in net losses at the reporting unit. We anticipated the reporting unit would continue to be unprofitable for the foreseeable future. We tested goodwill and intangible assets for potential impairment at this reporting unit and recorded non-cash impairment charges of $1.1 million to write down the carrying value of goodwill by $0.9 million and the carrying value of intangible assets by $0.2 million. We subsequently sold this reporting unit, and this impairment charge was included in the loss from discontinued operations.
As of September 30, 2012, we tested goodwill and intangible assets for potential impairment and recorded non-cash impairment charges of $114.6 million resulting from a write-down of $93.0 million in the carrying value of goodwill and a write-down of $21.6 million in the carrying value of intangible assets. The write-down of the goodwill and intangible assets related to eight of our nineteen reporting units, including the reporting unit we sold on August 31, 2012. The impairments at these reporting units were primarily the result of the loss of hospital contracts and/or customer relationships present at the acquisition date. Additionally, we were recognizing lower revenue from certain of our continuing customer relationships due to changes to client bill arrangements or the switch from global billing to billing only technical component (TC) or professional component (PC) services. These factors, combined with higher operating costs, including higher pathologist compensation, resulted in revenue and operating profit that was slower than projected, which adversely affected the current year and expected future revenues and operating profit of the affected reporting units.
At November 30, 2012, we tested goodwill and intangible assets for potential impairment and recorded non-cash impairment charges of $53.9 million resulting from a write-down of $46.0 million in the carrying value of goodwill and a write-down of $7.9 million in the carrying value of intangible assets. The write-down of the goodwill and intangible assets related to six of our eighteen reporting units. The impairments at these reporting units were primarily the result of the reduction in Medicare reimbursement rates effective for 2013.
At November 30, 2013, we tested goodwill and intangible assets for potential impairment and recorded non-cash impairment charges of $53.9 million resulting from a write-down of $52.9 million in the carrying value of goodwill and a write-down of $1.0 million in the carrying value of intangible assets. The write-down of the goodwill and intangible assets related to seven of our eighteen reporting units. The impairments at these reporting units were primarily the result of the reduction in Medicare reimbursement rates effective for 2014.
As of December 31, 2013, we had goodwill and net intangible assets of $272.5 million. Many factors, including competition, general economic conditions, health care reform, third party payment patterns and industry consolidation, could have a negative impact on one or more of our reporting units. Therefore, we may experience additional impairment charges in future periods.
Change in Fair Value of Contingent Consideration
For the year ended December 31, 2013, we recorded a non-cash charge of $1.1 million, compared to a non-cash gain of $4.2 million for the year ended December 31, 2012, to recognize changes in the estimated fair value of contingent consideration issued in connection with our acquisitions completed after January 1, 2009. The gain and charge relate to changes in the estimated fair value, including numerous variables such as the discount rate, remaining pay out period and the projected performance for each acquisition.
Acquisition and Business Development Costs
Transaction costs associated with our completed acquisitions and business development costs related to our prospecting and unsuccessful acquisition activity decreased to $0.2 million for the year ended December 31, 2013, compared to approximately $0.4 million for the year ended December 31, 2012, as a result of reduced acquisition activity and lower monthly fees under our acquisition target consulting agreement.
Interest Expense
Interest expense for the year ended December 31, 2013 was $32.8 million, compared to $32.5 million the year ended December 31, 2012. The higher interest expense related to higher average balances outstanding under our revolving credit facility, partially offset by lower average balances outstanding under our term loan facility.
Write-off of Deferred Debt Issue Costs
On October 26, 2012, we entered into a second amendment to our credit facility, which provided for the elimination of the interest coverage ratio requirements and the adjustment of the senior secured leverage ratio requirements from 2.75:1.00 to 3.00:1.00. In connection with the second amendment we elected to reduce the maximum amount available under the revolving credit facility from $110 million to $60 million. Furthermore, during 2012 we made repayments in the aggregate of approximately $11.9 million of the $114.4 million previously outstanding under our term loan. As a result of the repayments during 2012 and the reduction in the limit under the revolving credit facility we recorded a non-cash write-off of the pro rata portion of unamortized original issue discount and debt issue costs of approximately $0.8 million related to our prior credit facilities.
Provision (benefit) for Income Taxes
We are a Delaware limited liability company taxed as a partnership for federal and state income tax purposes, in accordance with the applicable provisions of the Internal Revenue Code. Accordingly, we generally have not been subject to income taxes, and the income attributable to us has been allocated to the members of Aurora Holdings in accordance with the terms of the LLC Agreement. We have made tax distributions to the members in amounts designed to provide such members with sufficient cash to pay taxes on their allocated income. However, certain of our subsidiaries are structured as corporations and therefore are subject to federal and state income taxes. The benefit for federal and state income taxes for these subsidiaries, as reflected in our consolidated financial statements, amounted to a benefit of $3.9 million and $5.1 million for the years ended December 31, 2013 and 2012, respectively.
Discontinued Operations and Loss on Sale of Subsidiary
On August 31, 2012, we sold one hundred percent of our equity in one of our subsidiaries. The subsidiary was a clinical laboratory, which provided services to assisted living facilities and skilled nursing facilities and had experienced declining revenue and increasing operating losses over the preceding quarters. In connection with the sale, we received proceeds of approximately $0.1 million from the sale of the subsidiary, incurred approximately $0.1 million of transaction related costs and recognized a loss on the sale of $1.0 million.
The loss of $2.2 million from operations of our discontinued operation for the year ended December 31, 2012 reflects operations through the date of sale, August 31, 2012, including a charge of $1.1 million for the impairment of goodwill and other intangible assets.
Comparison of the Year Ended December 31, 2012 and 2011
Net Revenue
Net revenue increased approximately $9.2 million, or 3.4 percent, to $277.9 million for the year ended December 31, 2012, from $268.7 million for the year ended December 31, 2011. The acquisitions completed after January 1, 2011 contributed approximately $18.0 million higher net revenue, while organic revenue decreased approximately $8.8 million, or 3.4 percent, from $255.6 million to $246.8 million.
Total accessions for continuing operations grew by 159,000 to 2,171,000 for the year ended December 31, 2012, compared to 2,012,000 for the year ended December 31, 2011. Organic accessions grew by 32,000, or 1.7 percent, to 1,958,000 for the year ended December 31, 2012 compared to approximately 1,926,000 for the year ended December 31, 2011. The average revenue per accession for existing labs decreased 5.0 percent to approximately $126 for the year ended December 31, 2012, down from $133 in 2011, primarily due to a change in service mix, Medicare reductions, and Congress’ elimination of the “grandfather provision” for hospital contracts, which now requires us to bill hospitals for certain services provided to patients insured by Medicare.
Our pathology diagnostic testing services accounted for substantially all of our revenue for 2012 and 2011.
Cost of Services
Cost of services increased approximately $14.9 million, or 12.5 percent, to $134.9 million for the year ended December 31, 2012 from $119.9 million for the year ended December 31, 2011. Of the total increase, $6.6 million related to the acquisitions completed after January 1, 2011 and the remaining $8.3 million related to our existing business. The increase in costs of services for our existing business included approximately $2.1 million of higher physician compensation, $3.7 million for higher non-physician wages and salaries and payroll related costs primarily related to increased average headcount and $1.3 million for increased technical processing costs and labs supplies expense. In addition, distribution costs increased by $1.2 million related primarily to additional courier routes for territory expansion.
As a percentage of net revenue, cost of services was 48.5 percent and 44.6 percent for the years ended December 31, 2012 and 2011, respectively, and our gross margins were 51.5 percent and 55.4 percent for the years ended December 31, 2012 and 2011, respectively.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased approximately $0.9 million, or 1.4 percent, to $64.2 million for the year ended December 31, 2012 from $63.3 million for the year ended December 31, 2011. The total increase in selling, general and administrative included $3.1 million higher costs related to the acquisitions completed after January 1, 2011, partially offset by a decrease of $0.2 million at our existing business and reduction in corporate expenses of $2.0 million. Lower costs at our existing businesses were primarily attributable to lower billing costs, partially offset by higher sales and marketing costs, including costs associated with client electronic medical records systems and interfaces. Selling, general and administrative costs for corporate operations reflected approximately $1.1 million lower payroll related costs, primarily related to our performance incentive programs for corporate staff, $0.3 million lower equity compensation costs, and a $0.6 million gain from the settlement of an employment related matter.
As a percentage of net revenue, selling, general and administrative expenses were 23.1 percent and 23.6 percent for the years ended December 31, 2012 and 2011, respectively.
Provision for Doubtful Accounts
Our provision for doubtful accounts increased $0.2 million, or 1.1 percent, to $18.3 million for the year ended December 31, 2012, from $18.1 million for the year ended December 31, 2011. As a percentage of net revenue, the provision for doubtful accounts was 6.6 percent for the year ended December 31, 2012, compared to 6.8 percent for year ended December 31, 2011.
Intangible Asset Amortization Expense (Amortization)
Amortization expense decreased by approximately $0.5 million to $22.3 million for the year ended December 31, 2012, from $22.8 million for the year ended December 31, 2011 as a result of lower amortization for impaired assets, partially offset by increases in our amortizable intangible assets associated with the 2011 acquisitions.
Management Fees
Management fees increased $0.1 million, or 1.0 percent, to $2.9 million for the year ended December 31, 2012, compared to $2.8 million for the year ended December 31, 2011. Management fees are based on 1.0 percent of net revenue plus expenses. The majority of the increase relates to the increase in our net revenue.
Impairment of Goodwill and Other Intangible Assets
As of September 30, 2011, we tested goodwill and intangible assets for potential impairments and recorded non-cash impairment charges of $24.5 million, of which $10.3 million related to our discontinued operation. The impairment charges consisted of $19.2 million to write-down goodwill and $5.3 million to write-down other intangible assets. The write-down of the goodwill and intangible assets related to three reporting units.
As further described in the preceding section “Comparison of the Year Ended December 31, 2013 and 2012” during 2012, we recorded non-cash impairment charges of $168.5 million to write down the carrying value of goodwill by $139.0 million and the carrying value of intangible assets by $29.5 million. Non-cash impairment charges included $1.1 million related to the reporting unit sold on August 31, 2012, and were included in the loss from discontinued operations for the year ended December 31, 2012.
Write-off of public offering costs
During 2011, we decided to delay the completion of our initial public offering. As a result, we recognized a non-cash charge of $4.4 million to write off the previously deferred offering costs.
Change in Fair Value of Contingent Consideration
For the year ended December 31, 2012, we recorded a non-cash gain of $4.2 million, compared to a non-cash charge of $12.5 million for the year ended December 31, 2011, to recognize changes in the estimated fair value of contingent consideration issued in connection with our acquisitions completed after January 1, 2009. The gain and charge relate to changes in the estimated fair value, including numerous variables such as the discount rate, remaining pay out period and the projected performance for each acquisition.
Acquisition and Business Development Costs
For the years ended December 31, 2012 and 2011, we incurred $0.4 million and $0.9 million, respectively, of transaction costs associated with our completed acquisitions and business development costs related to our prospecting and unsuccessful acquisition activity.
Interest Expense
Interest expense for the year ended December 31, 2012 was $32.5 million, unchanged from the year ended December 31, 2011.
Write-off of Deferred Debt Issue Costs
On October 26, 2012, we entered into a second amendment to our credit facility, which provided for the elimination of the interest coverage ratio requirements and the adjustment of the senior secured leverage ratio requirements from 2.75:1.00 to 3.00:1.00. In connection with the second amendment we elected to reduce the maximum amount available under the revolving credit facility from $110 million to $60 million. Furthermore, during 2012 we made repayments in the aggregate of approximately $11.9 million of the $114.4 million previously outstanding under our term loan. As a result of the repayments during 2012 and the reduction in the limit under the revolving credit facility we recorded a non-cash write-off of the pro rata portion of unamortized original issue discount and debt issue costs of approximately $0.8 million related to our prior credit facilities.
Provision (benefit) for Income Taxes
We are a Delaware limited liability company taxed as a partnership for federal and state income tax purposes, in accordance with the applicable provisions of the Internal Revenue Code. Accordingly, we generally have not been subject to income taxes, and the income attributable to us has been allocated to the members of Aurora Holdings in accordance with the terms of the LLC Agreement. We have made tax distributions to the members in amounts designed to provide such members with sufficient cash to pay taxes on their allocated income. However, certain of our subsidiaries are structured as corporations and therefore are subject to federal and state income taxes. The benefit for federal and state income taxes for these subsidiaries, as reflected in our consolidated financial statements amounted to a benefit of $5.1 million and $0.7 million for the years ended December 31, 2012 and 2011, respectively.
Discontinued Operations and Loss on Sale of Subsidiary
On August 31, 2012, we sold one hundred percent of our equity in one of our subsidiaries. The subsidiary was a clinical laboratory, which provided services to assisted living facilities and skilled nursing facilities and had experienced declining revenue and increasing operating losses over the preceding quarters. In connection with the sale, we received proceeds of approximately $0.1 million from the sale of the subsidiary, incurred approximately $0.1 million of transaction related costs and recognized a loss on the sale of $1.0 million.
Operating results for our discontinued operation for the year ended December 31, 2012 reflect operations through the date of sale, August 31, 2012. The loss from operations of our discontinued operation amounted to $2.2 million for the year ended December 31, 2012, compared to a loss of $10.6 million for the year ended December 31, 2011. The results for the years ended December 31, 2012 and 2011, reflect charges for the impairment of goodwill and other intangible assets related to our discontinued operation of $1.1 million and $10.3 million, respectively.
Liquidity and Capital Resources
Since inception, we have primarily financed operations through capital contributions from our equityholders, long term debt financing and cash flow from operations. On May 26, 2010, we entered into a senior secured credit facility of $335.0 million with Barclays Bank PLC and certain other lenders. Our senior secured credit facility included a six-year $225.0 million senior secured term loan due in May 2016, which we refer to as the Term Loan, and a $110.0 million senior secured revolving credit facility that matures May 2015, which we refer to as the Revolver, of which $50.0 million became available immediately upon the closing of the credit facility and of which $60.0 million became available on December 20, 2010, when we amended the credit facility and issued the Senior Notes, as described below. Proceeds from the senior secured credit facility were primarily used to repay all amounts outstanding under the credit facilities we entered into in December 2007.
On December 20, 2010, in connection with the closing of our Senior Notes offering described below, we amended our senior secured credit facility and applied $129.0 million of the net proceeds that we received from the offering to repay $19.0 million in principal owed under our Revolver and $110.0 million of the $224.4 million principal then outstanding under our Term Loan. On October 26, 2012, we entered into a second amendment to the credit facility, which became effective on October 29, 2012 after the payment of certain required fees and expenses. The second amendment provided for the elimination of the interest coverage ratio requirements and the adjustment of the senior secured leverage ratio requirements from 2.75:1.00 to 3.00:1.00 beginning with the fiscal quarter ended September 30, 2012. In connection with the second amendment, we elected to reduce the maximum amount available under the Revolver from $110 million to $60 million.
Prior to the third amendment of the credit facility, as described below, the credit facility bore interest, at our option, at a rate initially equal to the prime rate plus 3.25 percent per annum or LIBOR (subject to a floor of 2.00 percent) plus 4.25 percent per annum. On April 24, 2013, we entered into a third amendment to the credit facility, which increased the applicable margin on certain term loans and revolving loans from 4.25 percent to 4.75 percent with respect to LIBOR rate loans and from 3.25 percent to 3.75 percent with respect to base rate loans. It also provided for the adjustment of the senior secured leverage ratio requirements from 3.00:1.00 to (i) 3.50:1.00 for any fiscal quarter ending during the period from September 30, 2013 to September 30, 2014, and (ii) 3.25:1.00 for any fiscal quarter ending December 31, 2014 and thereafter. In connection with the third amendment, we recorded approximately $0.6 million of additional debt discount related to the term loan facility and $0.3 million of deferred debt issue costs related to the revolving credit facility. As of December 31, 2013 the balance outstanding under the Term Loan was $102.5 million. As of December 31, 2013, we had $22.2 million outstanding and $37.8 million available under the Revolver and were in compliance with all loan covenants. For the period from January 1, 2014 through March 23, 2014, we have borrowed a net additional $10.7 million under our revolving credit facility to fund seasonal working capital requirements and, as of March 23, 2014, $27.1 million was available under our revolving credit facility.
On December 20, 2010, we issued $200.0 million in unsecured senior notes that mature on January 15, 2018, which we refer to as the Senior Notes. The Senior Notes bear interest at an annual rate of 10.75%, which is payable each January 15th and July 15th. The first payment was made on July 15, 2011. In accordance with the indenture governing the Senior Notes, we are subject to certain limitations on issuing additional debt and are required to submit quarterly and annual financial reports to the holders of our Senior Notes. The Senior Notes are redeemable at our option beginning on January 15, 2015 at 105.375 percent of par, plus accrued interest. The redemption price decreases to 102.688 percent of par on January 15, 2016 and to 100 percent of par on January 15, 2017. Under certain circumstances, prior to January 15, 2015, we may at our option redeem all, but not less than all, of the Senior Notes at a redemption price equal to 100 percent of the principal amount of the Senior Notes, plus accrued interest and a premium as defined in the Senior Notes indenture. The Senior Notes rank equally in right of repayment with all of our other senior indebtedness but are subordinated to our secured indebtedness to the extent of the value of the assets securing that indebtedness.
Long-term debt consists of the following as of December 31, 2013 (in thousands):
As of December 31, 2013, future maturities of long-term debt are as follows (in thousands):
Contingent Consideration for Acquisitions Prior to January 1, 2009
In connection with the majority of our acquisitions, we have agreed to pay additional consideration annually over future periods of three to five years based upon the attainment of stipulated levels of operating earnings by each of the acquired entities, as defined in their respective agreements. For acquisitions prior to January 1, 2009, we do not accrue contingent consideration obligations prior to the attainment of the objectives and the amount owed becomes fixed and determinable and is agreed to by the sellers. For the years ended December 31, 2011, 2012 and 2013, we paid consideration under contingent notes of $12.7 million, $8.3 million and $3.4 million, respectively, related to acquisitions prior to January 1, 2009, resulting in the recognition of additional goodwill. We have one contingent note for an acquisition prior to January 1, 2009, which remains to be fully settled, however we expect to make no further contingent payments related to this acquisition or any other acquisitions completed prior to January 1, 2009.
Contingent Consideration for Acquisitions Subsequent to January 1, 2009
We utilize a present value of estimated future payments approach to estimate the fair value of the contingent consideration. These estimates involve significant projections regarding future performance of the acquired practices. If actual future results differ significantly from current estimates, the actual payments for contingent consideration will differ correspondingly. For the years ended December 31, 2011, 2012 and 2013, we paid consideration under contingent notes of $7.9 million, $21.3 million and $18.1 million, respectively, related to acquisitions subsequent to January 1, 2009. As of December 31, 2013, the fair value of contingent consideration related to the acquisitions since January 1, 2009 was $7.6 million, representing the present value of approximately $8.8 million in estimated future payments over the next three years. For practices acquired since January 1, 2009, the potential maximum principal amount of contingent consideration payable over the next four years is $35.8 million. Lesser amounts will be paid for earnings below the maximum level of stipulated earnings or no payments will be made if the practices do not achieve the minimum level of stipulated earnings as outlined in their respective agreements. For acquisitions completed since January 1, 2009, future payments will be reflected in the change in the fair value of the contingent consideration.
As discussed in Note 11 of our Consolidated Financial Statements in this Annual Report, the computation of the annual operating earnings is subject to review and approval by sellers prior to payment. We are in discussions with certain sellers regarding additional contingent note payment amounts. These sellers have asserted we owe an aggregate of $2.2 million in excess of our calculations as of December 31, 2013. We believe our calculations are correct, but at this time we cannot estimate what additional amount, if any, will ultimately be paid in connection with these contingent notes.
Medical Malpractice Insurance
We are insured on a claims-made basis up to our policy limits through a third party malpractice insurance policy. We establish reserves, on an undiscounted basis, for self-insured deductibles, claims incurred and reported and claims incurred but not reported (IBNR) during the policy period. We had recorded medical malpractice liabilities of $4.6 million and $5.0 million as of December 31, 2012 and 2013, respectively, which were included in accounts payable, accrued expenses and other current liabilities. We also record a receivable from our insurance carrier for expected recoveries. Expected insurance recoveries, which are included in prepaid expenses and other current assets, were $4.0 million and $3.2 million as of December 31, 2012 and 2013, respectively. So long as we maintain third party malpractice insurance policies, the IBNR claims will be covered by such third party policy up to the policy limits.
Cash and Working Capital
As of December 31, 2013, we have cash and cash equivalents of $1.4 million. Our primary uses of cash are to fund our operations, service debt including contingent notes, make selected acquisitions and purchase property and equipment. Cash used to fund our operations excludes the impact of non-cash items, such as the allowance for doubtful accounts, depreciation, impairments of goodwill and other intangible assets, changes in the fair value of the contingent consideration and non-cash stock-based compensation, and is impacted by the timing of our payments of accounts payable and accrued expenses and collections of accounts receivable.
As of December 31, 2013, we had negative working capital of $5.3 million. We require significant cash flow to service our existing debt obligations. We believe that the reduction in Medicare reimbursement for 2014, and any corresponding reduction in reimbursement from non-governmental payors, together with any increases to our physician compensation and other operating costs for 2014, will have a significant negative impact on our free cash flow during 2014. Various cost savings initiatives we have undertaken over the preceding 18 months, including reductions in headcount and other cost saving programs could partially offset the above negative impacts on our cash flows. As of December 31, 2013, we had $37.8 million available under our Revolver. For the period from January 1, 2014 through March 23, 2014, we have borrowed a net additional $10.7 million under our revolving credit facility to fund seasonal working capital requirements and, as of March 23, 2014, $27.1 million was available under our revolving credit facility. We believe our current cash and cash equivalents, together with cash from operations and the amount available under our Revolver, will be sufficient to fund our working capital requirements through 2014. In order to access the amounts available under our Revolver, we must meet the financial tests and ratios contained in our senior secured credit facility. We currently expect to meet these financial tests and ratios at least through the end of 2014. We may undertake acquisitions which our management believes would add to earnings and performance with respect to the credit facility financial covenants. Furthermore, we are reviewing refinancing opportunities for the revolving credit facility due May 2015 and term loan facility due May 2016. Nonetheless, we may not achieve all of our business goals and objectives and events beyond our control could affect our ability to meet these financial tests and ratios and limit our ability to access the amounts otherwise available under our Revolver.
Cash From Operating Activities
Net cash provided by operating activities, inclusive of the discontinued operation, during the year ended December 31, 2013 was $8.0 million compared to $29.5 million during the year ended December 31, 2012. Net cash provided by operating activities for the year ended December 31, 2013 reflected a net loss of $73.0 million and certain adjustments for non-cash items, including $53.9 million for write-offs of goodwill and other intangible assets, $23.1 million of depreciation and amortization, $2.3 million of amortization of debt issue costs and original issue discount, $0.3 million of equity compensation costs, and a $1.1 million increase in the fair value of contingent consideration, partially offset by a $2.3 million decrease in deferred income taxes. Net cash provided by operating activities for the year ended December 31, 2013 also reflected a decrease of $1.0 million in net accounts receivable, a $1.3 million increase in prepaid income taxes, a $2.5 million increase in accounts payable, accrued expenses and other current liabilities and a $0.3 million increase in accrued compensation. As of December 31, 2013 our DSO (Days Sales Outstanding) were 42 days compared to 41 days as of December 31, 2012.
Cash Used in Investing Activities
Net cash used in investing activities during the year ended December 31, 2013 was $24.1 million compared to $33.3 million during the year ended December 31, 2012. Net cash used in investing activities during the year ended December 31, 2013 primarily consisted of $21.0 million for the payment of contingent notes and $2.8 million of purchases of property and equipment.
Cash Provided By (Used In) Financing Activities
Net cash provided by financing activities for the year ended December 31, 2013 was $6.7 million compared to $1.6 million of net cash used in financing activities for the year ended December 31, 2012. For the year ended December 31, 2013, we borrowed $8.2 million net borrowings under our revolving credit facility and paid $0.5 million under a subordinated note payable, approximately $0.9 million of debt issue costs and $0.1 million of principal on capital leases.
Contractual Obligations and Commitments
The following table sets forth our long-term contractual obligations and commitments as of December 31, 2013 (in thousands):
(1)
In connection with a contingent note issued in an acquisition we agreed to pay $2.0 million in 24 equal monthly installments, plus 8 percent interest on the unpaid balance, through June 2015. See Note 7 of our Consolidated Financial Statements in this Annual Report for additional information.
(2)
Estimated interest payments on our Term Loans calculated using the current effective interest rates (LIBOR (subject to a floor of 2.00 percent), plus 4.75 percent per annum) multiplied by the pro forma outstanding balances as of December 31, 2013.
Off Balance Sheet Arrangements
None.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reported periods. We have provided a description of all our significant accounting policies in Note 1 to our audited consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. We believe that of these significant accounting policies, the following may involve a higher degree of judgment or complexity.
Net Revenue and Accounts Receivable
Substantially all of our revenue consists of payments or reimbursements for specialized diagnostic services rendered to patients of our referring physicians. Our billings for services reimbursed by third-party payors, including Medicare, and patients are based on a company-generated fee schedule that is generally set at higher rates than our anticipated reimbursement rates. Our billings to physicians are billed based on negotiated fee schedules that set forth what we charge for our services. Reimbursement under Medicare for our services is subject to a Medicare physician fee schedule and, to a lesser degree, a clinical laboratory fee schedule, both of which are updated annually. Our billings to patients include co-insurance and deductibles as dictated by the patient’s insurance coverage. Billings for services provided to uninsured patients are based on our company-generated fee schedule. We do not have any capitated payment arrangements, which are arrangements under which we are paid a contracted per person rate regardless of the services we provide.
Our net revenue is recorded net of contractual allowances, which represent the estimated differences between the amount billed and the estimated payment to be received from third party payors, including Medicare. Adjustments to the estimated contractual allowances, which are based on actual receipts from third-party payors, including Medicare, are recorded upon settlement. Our billing is currently processed through multiple systems. We have an ongoing process to evaluate and record our estimates for contractual allowances based on information obtained from each of these billing systems. This information includes aggregate historical billing and contractual adjustments, billings and contractual adjustments by payor class, accounts receivable by payor class, aging of accounts receivable, historical cash collections and related cash collection percentages by payor and/or aggregate cash collections compared to gross charges. In addition, we may take into account the terms and reimbursement rates of our larger third party payor contracts and allowables under government programs in determining our estimates.
The process for estimating the ultimate collection of accounts receivable associated with our services involves significant assumptions and judgment. The provision for doubtful accounts and the related allowance are adjusted periodically, based upon an evaluation of historical collection experience with specific payors for particular services, anticipated collection levels with specific payors for new services, industry reimbursement trends, accounts receivable aging and other relevant factors. The majority of our provision for doubtful accounts relates to our estimate of uncollectible amounts from patients who are either uninsured and may fail to pay their coinsurance or deductible obligations. Changes in these factors in future periods could result in increases or decreases in our provision for doubtful accounts and impact our results of operations, financial position and cash flows.
The degree of information used in making our estimates varies based on the capabilities and information provided by each of our billing systems. Due to our multiple billing systems and the varying degree of billing information and system capabilities, the following should be noted regarding our estimates of allowances for contractual adjustments and doubtful accounts.
First, our billing systems are unable to quantify amounts pending approval from third parties. However, we generally operate in most markets as an in-network provider, and we estimate that approximately 87 percent of our diagnostic testing services are paid for by locally-focused in-network providers. As of December 31, 2013 our DSO (Days Sales Outstanding) averaged 42 days.
We also make our provisions for contractual adjustments based on our aggregate historical contractual write-off experience for a particular laboratory as recorded and reported in that laboratory’s billing system. This estimate is not done on a patient-by-patient or payor-by-payor basis. The actual aggregate contractual write-offs are recorded as a reduction in our allowance for contractual adjustments account in the period in which they occur. At the end of each accounting period, we analyze the adequacy of our allowance for contractual adjustments based on the information reported by our individual laboratories’ respective billing systems.
In addition, our current laboratory billing systems generally do not provide reports on contractual adjustments by date of service. Accordingly, we are unable to directly compare the aggregate estimated provision for contractual adjustments to the actual adjustments recorded in its various laboratory billing systems at the patient level. However, we do analyze the aggregate provision for contractual adjustments as a percentage of gross charges for each laboratory’s billing system compared to the last twelve months’ actual contractual writes-offs as a percentage of gross charges to determine that our estimated percentages are a reasonable basis for recording our periodic provisions for contractual adjustments.
Further, in determining the provision of doubtful accounts, we analyze the historical write-off percentages for each of our laboratories as recorded in our billing systems. We record an estimated provision for doubtful accounts for each accounting period based on our historical experience ratios. Actual charge-offs reduce our allowance for doubtful accounts in the period in which they occur. At each balance sheet date, we evaluate the adequacy of our allowance for doubtful accounts based on the information provided by the billing system for each of our laboratories. In conducting this evaluation, we consider, if available, the aging and payor mix of our accounts receivables.
Finally, in order to assess the reasonableness of the periodic estimates for the provision for contractual adjustments and doubtful accounts, we compare our actual historical contractual write-off percentages and our bad debt write-off percentages to the estimates recorded for each of our laboratories. In addition, at the end of each accounting period, we evaluate the adequacy of our contractual and bad debt allowances based on the information reported by the billing system for each of our laboratories to ensure that our reserves are adequate on a consolidated basis.
As of December 31, 2013, for each 1.0 percent change in our estimate for the allowance for contractual adjustments, net revenue would have increased or decreased approximately $0.8 million. As of December 31, 2013, for each 1.0 percent change in our estimate for the allowance for doubtful accounts, our provision for doubtful accounts would have increased or decreased by approximately $0.4 million.
Fair Value of Contingent Consideration Issued in Acquisitions
The fair value of contingent consideration is derived using valuation techniques that incorporate unobservable inputs. We utilize a present value of estimated future payments approach to estimate the fair value of the contingent consideration. Estimates for fair value of contingent consideration primarily involve two inputs, which are (i) the projections of the financial performance of the acquired practices that are used to calculate the amount of the contingent payments and (ii) the discount rates used to calculate the present value of future payments.
Projections of future performance of the acquired practices involve significant assumptions and judgment. If future results differ significantly from current projections, future payments for contingent consideration will differ correspondingly. In developing projections, we consider historical results and trends and factors that are likely to impact future results. On a quarterly basis, we review the actual results for the acquired practices in relation to our prior projections and assess whether current projections should be adjusted higher or lower in light of recent results. We also consider any events or changes in circumstances that may have occurred which could affect future performance.
The discount rates used in estimating the fair value of contingent consideration incorporate current market interest rates adjusted for company specific risks at the acquired labs. At December 31, 2013 the discount rates used ranged from 14.6 percent to 15.6 percent.
Annual Impairment Testing of Goodwill and Intangibles
Goodwill is our single largest asset. We evaluate the recoverability and measure the potential impairment of our goodwill annually. The annual impairment test is a two-step process that begins with the estimation of the fair value of the reporting unit. For purposes of testing goodwill for impairment, each of our acquired practices is considered a separate reporting unit. To estimate the fair value of the reporting units, we utilize a discounted cash flow model as the primary approach to value supported by a market approach guideline public company method, or the GPC Method, which is used as a reasonableness test. We believe that a discounted cash flow analysis is the most appropriate methodology to test the recorded value of long-term assets with a demonstrated long-lived value. The results of the discounted cash flow provide reasonable estimates of the fair value of the reporting units because this approach is based on each respective unit’s actual results and reasonable estimates of future performance, and also takes into consideration a number of other factors deemed relevant by management, including but not limited to, expected future market revenue growth and operating profit margins. We have consistently used these approaches in determining the value of goodwill. We consider the GPC Method as an adequate reasonableness test which utilizes market multiples of industry participants to corroborate the discounted cash flow analysis. We believe this methodology is consistent with the approach that any strategic market participant would utilize if they were to value one of our reporting units.
During the fourth quarter of 2012, we changed the date of our annual impairment test from September 30th to November 30th. The change was made to more closely align the impairment testing date with our long-range planning and forecasting process and the annual release of the Medicare Fee Schedule by the Centers for Medicare & Medicaid Services (CMS). We believe the change in accounting principle related to changing our annual impairment testing date did not delay, accelerate, or avoid an impairment charge. We determined that this change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively. During 2013, our annual impairment test was performed as of November 30, 2013.
The first step of the goodwill impairment process screens for potential impairment and the second step measures the amount of the impairment, if any. Our estimate of fair value considers (i) the financial projections and future prospects of our business, including its growth opportunities and likely operational improvements, and (ii) comparable sales prices, if available. As part of the first step to assess potential impairment, we compare our estimate of fair value for the reporting unit to the book value of the reporting unit. If the book value is greater than our estimate of fair value, we would then proceed to the second step to measure the impairment, if any. The second step compares the implied fair value of goodwill with its carrying value. The implied fair value is determined by allocating the fair value of the reporting unit to all of the assets and liabilities of that unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. If the carrying amount of the reporting unit’s goodwill is greater than its implied fair value, an impairment loss will be recognized in the amount of the excess.
On a quarterly basis, we perform a review of our business to determine if events or changes in circumstances have occurred which could have a material adverse effect on our fair value and the fair value of our goodwill. If such events or changes in circumstances were deemed to have occurred, we would perform an impairment test of goodwill as of the end of the quarter, consistent with the annual impairment test, and record any noted impairment loss.
We also consider the economic outlook for the healthcare services industry and various other factors during the testing process, including hospital and physician contract changes, local market developments, changes in third-party payor payments, and other publicly available information.
Intangible assets acquired as the result of a business combination are recognized at fair value, as an asset apart from goodwill if the asset arises from contractual or other legal rights, or if it is separable. Intangible assets, principally representing the fair value of customer relationships, health care facility agreements and non-competition agreements acquired, are capitalized and amortized on the straight-line method over their expected useful life, which generally ranges from 3 to 13 years.
We recognize impairment losses for intangible assets when events or changes in circumstances indicate the carrying amount may not be recoverable. We continually assesses whether an impairment in the carrying value of the intangible assets has occurred. If the undiscounted future cash flows over the remaining amortization period of an intangible asset indicate the value assigned to the intangible asset may not be recoverable, we reduce the carrying value of the intangible asset. We would determine the amount of any such impairment by comparing anticipated discounted future cash flows from acquired businesses with the carrying value of the related assets. In performing this analysis, we consider such factors as current results, trends and future prospects, in addition to other relevant factors.
Recent Accounting Pronouncements
New accounting pronouncements that we have recently adopted, as well as those that have been recently issued but not yet adopted by us, are included under the heading “Recent Accounting Standards Updates” in Note 1 to the Financial Statements in this Annual Report.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
We maintain our cash balances at high quality financial institutions. The balances in our accounts may periodically exceed amounts insured by the Federal Deposit Insurance Corporation, which insures deposits of up to $250,000 as of December 31, 2013. We do not believe we are exposed to any significant credit risk and have not experienced any losses.
As of December 31, 2013, we had outstanding balances of $22.2 million under our revolving credit facility maturing May 2015 and $102.5 million under our term loan maturing May 2016, each of which accrues interest at a variable rate of LIBOR (subject to a floor of 2.00 percent) plus 4.75 percent per annum. As of December 31, 2013, the short term LIBOR rate used as the base for calculating the interest rates for our revolving credit facility and term loan was approximately 0.25 percent. As such, changes in the LIBOR rates would not impact our interest expense until the 2.00 percent floor is exceeded. Based upon the balances outstanding under our revolving credit facility and term loan as of December 31, 2013, for every 100 basis point increase in the LIBOR rates over the 2.00 percent floor, we would incur approximately $1.2 million of additional annual interest expense.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Registered Public Accounting Firm
To the Members
Aurora Diagnostics Holdings, LLC
Palm Beach Gardens, FL
We have audited the accompanying consolidated balance sheets of Aurora Diagnostics Holdings, LLC and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of operations, members’ equity, and cash flows for each of the three years in the period ended December 31, 2013. Our audits also included the financial statement schedule of Aurora Diagnostics Holdings, LLC listed in Item 15(a). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Aurora Diagnostics Holdings, LLC and subsidiaries as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the three years in the period ended, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ McGladrey LLP
Fort Lauderdale, Florida
March 25, 2014
Aurora Diagnostics Holdings, LLC
Consolidated Balance Sheets
(in thousands)
See Notes to Consolidated Financial Statements.
Aurora Diagnostics Holdings, LLC
Consolidated Statements of Operations
Years Ended December 31, 2011, 2012 and 2013
(in thousands)
See Notes to Consolidated Financial Statements.
Aurora Diagnostics Holdings, LLC
Consolidated Statement of Members’ Equity
Years Ended December 31, 2011, 2012 and 2013
(in thousands, except for member units)
See Notes to Consolidated Financial Statements.
Consolidated Statements of Cash Flows
Years Ended December 31, 2011, 2012 and 2013
(in thousands)
(Continued)
Consolidated Statements of Cash Flows (Continued)
Years Ended December 31, 2011, 2012 and 2013
(in thousands)
See Notes to Consolidated Financial Statements.
Note 1.
Nature of Business; Working Capital; Discontinued Operation and Significant Accounting Policies
Nature of business
Aurora Diagnostics Holdings, LLC and subsidiaries (the “Company”) was organized in the State of Delaware as a limited liability company on June 2, 2006 to operate as a diagnostic services company. The Company’s practices provide physician-based general anatomic and clinical pathology, dermatopathology and molecular diagnostic services and other esoteric testing services to physicians, hospitals, clinical laboratories and surgery centers. The Company’s operations consist of one reportable segment.
The Company operates in a highly regulated industry. The manner in which licensed physicians can organize to perform and bill for medical services is governed by state laws and regulations. Businesses like the Company often are not permitted to employ physicians or to own corporations that employ physicians or to otherwise exercise control over the medical judgments or decisions of physicians.
In states where the Company is not permitted to directly own a medical services provider or for other commercial reasons, it performs only non-medical administrative and support services, does not represent to the public or its clients that it offers medical services and does not exercise influence or control over the practice of medicine. In those states, the Company conducts business through entities that it controls, and it is these affiliated entities that employ the physicians who practice medicine. In such states, the Company generally enters into a contract that restricts the owners of the affiliated entity from transferring their ownership interests in the affiliated entity and otherwise provides the Company or its designee with a controlling voting or financial interest in the affiliated entity and its laboratory operations. This controlling financial interest generally is obtained pursuant to a long-term management services agreement between the Company and the affiliated entity. Under the management services agreement, the Company exclusively manages all aspects of the operation other than the provision of medical services. Generally, the affiliated entity has no operating assets because the Company acquired all of its operating assets at the time it acquired the related laboratory operations. In accordance with the relevant accounting guidance, these affiliated entities are included in the consolidated financial statements of Aurora Diagnostics Holdings, LLC.
Working Capital
The Company requires significant cash flow to service its debt obligations. The reduction in Medicare reimbursement for 2013, and the corresponding reduction in reimbursement from non-governmental payors, together with increases in management services fees, consulting and legal fees, severance costs and other operating costs for 2013, have had a significant negative impact on its free cash flow during 2013. As of December 31, 2013, the Company had $37.8 million available under its revolving credit facility. For the period from January 1, 2014 through March 23, 2014, the Company has borrowed a net additional $10.7 million under its revolving credit facility to fund seasonal working capital requirements and, as of March 23, 2014, $27.1 million was available under its revolving credit facility. The Company’s management believes the Company’s cash and cash equivalents, together with cash from operations and the amount available under its revolving credit facility, will be sufficient to fund its working capital requirements through 2014. In order to access the amounts available under its revolving credit facility, the Company must meet the financial tests and ratios contained in its senior secured credit facility. The Company’s management currently expects to meet these financial tests and ratios at least through the end of 2014. The Company may undertake acquisitions which it believes would add to earnings and performance with respect to the credit facility interest coverage ratio. Furthermore, the Company is reviewing refinancing opportunities for the revolving credit facility due May 2015 and term loan facility due May 2016. Nonetheless, the Company may not achieve all of its business goals and objectives and events beyond its control could affect its ability to meet these financial tests and ratios and limit its ability to access the amounts otherwise available under its Company’s revolving credit facility.
Discontinued Operation
On August 31, 2012, the Company sold one hundred percent of its equity in one of its subsidiaries. This discontinued operation was a clinical laboratory, which provided services to assisted living facilities and skilled nursing facilities and had experienced declining revenue and increasing losses over the preceding quarters. The Company sold the subsidiary for $150,000 and incurred $141,000 of transaction related costs and recognized a loss on the sale of the subsidiary of $1.0 million.
The following is a summary of the operating results of the discontinued operation for the years ended December 31, 2011 and 2012 (in thousands):
(a) Operating results for the year ended December 31, 2012 reflect operations through the date of sale, August 31, 2012.
(b) The year ended December 31, 2012 reflects a $1.1 million impairment of goodwill and other intangible assets. The year ended December 31, 2011 reflects a $10.3 million impairment of goodwill and other intangible assets.
The following is a summary of the assets and liabilities of the discontinued operation as of the transaction date on August 31, 2012 (in thousands):
Summary of Significant Accounting Policies
Principles of consolidation: The accompanying consolidated financial statements of the Company include the accounts of Aurora Diagnostics Holdings, LLC, its wholly-owned subsidiaries and companies in which the Company has a controlling financial interest by means other than the direct record ownership of voting stock. All accounts and transactions between the entities have been eliminated in consolidation.
Accounting estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Due to the inherent uncertainties in this process, actual results could differ from those estimates.
Fair value of financial instruments: As of December 31, 2012 and 2013, the carrying amounts of cash, accounts receivable, accounts payable, accrued interest and accrued expenses approximate fair value based on the short maturity of these instruments. Refer to Note 12 for discussion of the fair value of the Company’s interest rate cap, contingent consideration issued in acquisitions and long-term debt.
Revenue recognition and accounts receivable: The Company recognizes revenue at the time services are performed. Unbilled receivables are recorded for services rendered during, but billed subsequent to, the reporting period. Revenue is reported at the estimated realizable amounts from patients, third-party payors and others for services rendered. Revenue under certain third-party payor agreements is subject to audit and retroactive adjustments. Provisions for estimated third-party payor settlements and adjustments are estimated in the period the related services are rendered and adjusted in future periods as final settlements are determined. The provision for doubtful accounts and the related allowance are adjusted periodically based upon an evaluation of historical collection experience with specific payors for particular services, anticipated collection levels with specific payors for new services, industry reimbursement trends, and other relevant factors. Changes in these factors in future periods could result in increases or decreases in the Company’s provision for doubtful accounts and impact its results of operations, financial position and cash flows. In 2011, 2012 and 2013, approximately 27 percent, 26 percent and 23 percent, respectively, of the Company’s consolidated net revenues were generated by Medicare and Medicaid programs.
Segment Reporting: The Company operates throughout the United States in one reportable segment, the medical laboratory industry. Medical laboratories offer a broad range of testing services to the medical profession. The Company’s testing services are categorized based upon the nature of the test: general anatomic pathology, clinical pathology, dermatopathology, molecular diagnostic services and other esoteric testing services to physicians, hospitals, clinical laboratories and surgery centers. Our revenue consists of payments or reimbursements for these services. For the year ended December 31, 2013, our revenue consisted of 60 percent from private insurance, including managed care organizations and commercial payors, 23 percent from Medicare and Medicaid and 17 percent from physicians and individual patients.
Cash and cash equivalents: The Company considers deposits and investments that have original maturities of less than three months, when purchased, to be cash equivalents. The Company maintains its cash balances at high quality financial institutions. At December 31, 2012 and 2013, the Company’s balances in its accounts exceeded amounts insured by the Federal Deposit Insurance Corporation, which insures amounts of up to $250,000. The Company does not believe it is exposed to any significant credit risk and has not experienced any losses.
Property and equipment: Property and equipment is stated at cost. Routine maintenance and repairs are charged to expense as incurred, while costs of betterments and renewals are capitalized. Depreciation is calculated on a straight-line basis, over the estimated useful lives of the respective assets, which range from 3 to 9 years. Leasehold improvements are amortized over the shorter of the term of the related lease, or the useful life of the asset.
Goodwill: Goodwill represents the excess of cost over the fair value of net tangible and identifiable intangible assets acquired. The Company reviews goodwill for impairment at the reporting unit level annually or, when events or circumstances dictate, more frequently. The impairment review for goodwill consists of a two-step process of first determining the fair value of the reporting unit and comparing it to the carrying value of the net assets allocated to the reporting unit. If the fair value of the reporting unit exceeds the carrying value, no further analysis or write-down of goodwill is required. If the fair value of the reporting unit is less than the carrying value of the net assets, the implied fair value of the reporting unit is allocated to all the underlying assets and liabilities, including both recognized and unrecognized tangible and intangible assets, based on their fair value. If necessary, goodwill is then written down to its implied fair value.
During the fourth quarter of 2012, the Company changed the date of its annual impairment test from September 30th to November 30th. The change was made to more closely align the impairment testing date with its long-range planning and forecasting process and the annual release of the Medicare Fee Schedule by the Centers for Medicare & Medicaid Services (CMS). The Company’s management believes that changing the annual impairment testing date did not delay, accelerate, or avoid any impairment charge and determined that this change in accounting principle was preferable under the circumstances. Furthermore, the change did not result in adjustments to its financial statements when applied retrospectively.
As further discussed in Note 5, the Company performed its latest annual impairment testing of goodwill and intangible assets as of November 30, 2013. Based on the results of its testing, the Company recorded non-cash impairment charges of $52.9 million to write down the carrying value of goodwill related to seven of its reporting units and $1.0 million to write down the carrying value of other intangible assets. Regarding these reporting units, the Company believes the reductions in the reimbursement rates under the 2014 Medicare Physician Fee Schedule, as issued by CMS on November 27, 2013, resulted in a reduction in the fair value of goodwill below its carrying value.
Intangible assets: Intangible assets acquired as the result of a business combination are recognized at fair value, as an asset apart from goodwill if the asset arises from contractual or other legal rights, or if it is separable. Intangible assets, principally representing the fair value of customer relationships, health care facility agreements and non-competition agreements acquired, are capitalized and amortized on the straight-line method over their expected useful life, which generally ranges from 3 to 13 years.
The Company reviews its intangible assets for impairment whenever events indicate the recorded value of the intangible assets may not be recoverable. If the undiscounted cash flows attributable to the intangible asset exceed the carrying value, no further analysis or write-down of the intangible asset is required. If the carrying value of the intangible asset exceeds the undiscounted cash flows attributable to the intangible asset, then the Company recognizes an impairment loss to reduce the recorded value down to, but not below, the estimated fair value of the intangible asset.
Long-lived assets: The Company recognizes impairment losses for long-lived assets when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable.
Deferred debt issue costs: The Company recognizes the direct costs of issuing debt financing as deferred debt issue costs, which are included in other assets in its consolidated balance sheets. Deferred debt issue costs are amortized to interest expense using the effective interest method over the term of the related debt.
On May 26, 2010, the Company entered into a $335.0 million credit facility and incurred $9.5 million of related costs. This credit facility consisted of a $225.0 million term loan, which we refer to as our Term Loan, and a $110.0 million revolving credit facility.
On December 20, 2010, the Company issued $200.0 million in unsecured senior notes, which we refer to as our Senior Notes, and incurred $6.5 million of related costs. The Company used a portion of the proceeds from the Senior Notes to repay $110.0 million of the $224.4 million principal then outstanding under the Term Loan. In connection with the repayment, the Company recorded a non-cash charge of approximately $4.7 million to write off the pro rata portion of unamortized original issue discount, prepaid administration fees, and debt issue costs related to the Term Loan.
On October 26, 2012, the Company entered into an amendment to the credit facility and incurred $0.6 million of related costs. In connection with the amendment, the Company elected to reduce the maximum amount available under the revolving credit facility from $110.0 million to $60.0 million. Furthermore, the Company made principal repayments totaling $11.9 million on the Term Loan. The Company recorded a non-cash charge of approximately $0.8 million to write off a pro rata portion of the unamortized deferred debt issue costs and original issue discount recorded in connection with the credit facility.
On April 24, 2013, the Company entered into a third amendment to the credit facility, which increased the applicable margin on certain term loans and revolving loans from 4.25 percent to 4.75 percent with respect to LIBOR rate loans and from 3.25 percent to 3.75 percent with respect to base rate loans. It also provides for the adjustment of the senior secured leverage ratio requirements from 3.00:1.00 to (i) 3.50:1.00 for any fiscal quarter ending during the period from September 30, 2013 to September 30, 2014, and (ii) 3.25:1.00 for any fiscal quarter ending December 31, 2014 and thereafter. In connection with the third amendment, the Company recorded approximately $0.6 million of additional debt discount related to the term loan facility and $0.3 million of deferred debt issue costs related to the revolving credit facility.
Interest expense from the amortization of deferred debt issue costs was $2.0 million, $2.1 million and $1.9 million for the years ended December 31, 2011, 2012 and 2013, respectively. The Company has $6.0 million in net deferred debt issue costs remaining at December 31, 2013, consisting of $2.2 million related to the May 26, 2010 credit facility, as amended and restated, and $3.8 million related to the Senior Notes. Deferred debt issue costs as of December 31, 2012 and 2013 consist of the following (in thousands):
Medical claims insurance: The Company is insured on a claims-made basis up to its policy limits through a third party malpractice insurance policy. The Company establishes reserves, on an undiscounted basis, for self-insured deductibles, claims incurred and reported and claims incurred but not reported (IBNR) during the policy period. The Company had recorded medical claims liabilities of $4.6 million and $5.0 million as of December 31, 2012 and 2013, respectively, which are included in accounts payable, accrued expenses and other current liabilities. The Company also records a receivable from its insurance carrier for expected recoveries. Expected insurance recoveries, which are included in prepaid expenses and other current assets were $4.0 million and $3.2 million, as of December 31, 2012 and 2013, respectively. Medical claims insurance costs were $2.1 million, $2.0 million and $1.9 million for the years ended December 31, 2011, 2012 and 2013, respectively, inclusive of adjustments to the Company’s reserves for medical claims.
Income taxes: The Company is a Delaware limited liability company taxed as a partnership for federal and state income tax purposes in accordance with the applicable provisions of the Internal Revenue Code. Accordingly, the Company is generally not subject to income taxes, and the income attributable to the limited liability company is allocated to the members in accordance with the terms of the Company’s Second Amended and Restated Limited Liability Company Agreement, dated July 6, 2011, which we refer to as the LLC Agreement. In addition, tax distributions related to the income allocated to each member are paid out quarterly. However, certain of the Company’s subsidiaries are structured as corporations, file separate returns, and therefore are subject to federal and state income taxes. The provision for income taxes for these subsidiaries is reflected in the Company’s consolidated financial statements and includes federal and state taxes currently payable and changes in deferred tax assets and liabilities excluding the establishment of deferred tax assets and liabilities related to acquisitions. Deferred income taxes represent the estimated future tax effects resulting from the temporary difference between the carrying values (as reflected in the financial statements) and the tax reporting basis of the related assets and liabilities. The Company does not recognize a tax benefit, unless the Company concludes that it is more likely than not that the benefit will be sustained on audit by the taxing authority based solely on the technical merits of the associated tax position. If the recognition threshold is met, the Company recognizes a tax benefit measured at the largest amount of the tax benefit that the Company believes has greater than a 50 percent likelihood of being realized. The Company records interest and penalties in income tax expense.
Concentration of credit risk: Financial instruments that potentially subject the Company to concentrations of credit risk are cash and accounts receivable. The Company’s policy is to place cash in highly-rated financial institutions. Concentration of credit risk with respect to accounts receivable is mitigated by the diversity of the Company’s payers and their dispersion across many different geographic regions. While the Company has receivables due from federal and state governmental agencies, the Company does not believe such receivables represent a credit risk since the related healthcare programs are funded by federal and state governments and given that payment is primarily dependent on the Company’s submission of appropriate documentation.
Derivative financial instruments: From time to time, the Company uses derivative financial instruments to manage its interest rate risk. The Company records derivatives as either an asset or liability measured at their fair value. The fair value is based upon quoted market prices obtained from third party institutions. Changes in fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction, based on the specific qualifying conditions as prescribed by the FASB Accounting Standards Codification on accounting for derivative instruments and hedging activities. If a derivative instrument is designated as a hedge transaction, the effective portion of changes in the fair value of the derivatives is recorded in accumulated other comprehensive (loss) income. If it is determined that the derivative ceases to be a highly effective hedge, the Company discontinues hedge accounting and any deferred gains or losses are recorded in the consolidated statements of operations.
Distributions to members and allocation of profits and losses: Profits and losses are allocated to the members in accordance with certain provisions contained in the LLC Agreement. Distributions are also made in accordance with the terms of the LLC Agreement.
Recent Accounting Standards Updates
In July 2012, the Financial Accounting Standards Board ("FASB") issued ASU No. 2012-02, “Intangibles - Goodwill and Other (Topic 350) - Testing Indefinite-Lived Intangible Assets for Impairment.” ASU 2012-02 allows an entity to first assess qualitative factors in determining whether events and circumstances indicate that it is more-likely-than-not that an indefinite-lived intangible asset is impaired. If an entity determines that it is not more-likely-than-not that the indefinite-lived intangible asset is impaired, then the entity is not required to perform a quantitative impairment test. ASU 2012-02 was effective for fiscal years beginning after September 15, 2012, with earlier adoption permitted. The adoption of ASU 2012-02 did not have a material effect on the Company’s financial position, results of operations or cash flows.
In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220)-Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 adds new disclosure requirements for amounts reclassified out of accumulated other comprehensive income (“AOCI”). The total changes in AOCI must be disaggregated between reclassification adjustments and current period other comprehensive income. This new standard also requires an entity to present reclassification adjustments out of AOCI either on the face of the income statement or in the notes to the financial statements based on their source and the income statement line items affected by the reclassification. This standard was effective for the Company for interim and annual periods beginning on January 1, 2013. The adoption of ASU 2013-02 did not have a material effect on the Company’s financial position, results of operations or cash flows.
In July 2013, the FASB issued ASU 2013-11, "Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists." The FASB's objective in issuing this ASU is to eliminate diversity in practice resulting from a lack of guidance on this topic in current U.S. GAAP. New recurring disclosures are not required because the ASU does not affect the recognition or measurement of uncertain tax positions under ASC 740. This ASU is effective for reporting periods beginning after December 15, 2013 with early adoption permitted. The Company did not early adopt this guidance for the year ended December 31, 2013. The adoption of ASU 2013-11 is not expected to have a material effect on the Company’s financial position, results of operations or cash flows.
Note 2.
Acquisitions
In connection with its acquisition and business development related activities during 2011, 2012 and 2013, the Company has expensed $0.9 million, $0.4 million and $0.2 million, respectively, of transaction costs associated with its completed acquisitions and business development costs in the accompanying consolidated statements of operations.
2011 Acquisitions
During 2011, the Company acquired four pathology practices. On January 1, 2011, the Company acquired 100 percent of the equity of two pathology practices for an aggregate cash purchase price of $36.9 million. These acquisitions were funded on December 31, 2010 and, therefore, the cash paid totaling $36.9 million was included in Deposits and other non-current assets as of December 31, 2010. On June 2, 2011, the Company acquired 100 percent of the equity of a third pathology practice for a cash purchase price of $14.7 million. On August 1, 2011, the Company acquired substantially all of the assets of a fourth pathology practice for a cash purchase price of $26.5 million. In each of the transactions, the Company issued contingent consideration payable over three to five years based on the future performance of the acquired practice. The total acquisition date fair value of the contingent consideration issued for the 2011 acquisitions was $20.5 million. The Company funded the cash portion of the January 1, 2011 and June 2, 2011 acquisitions using a portion of the proceeds from the Senior Notes offering on December 20, 2010. The Company funded the cash portion of the August 1, 2011 acquisition using cash on hand, as well as $14.0 million drawn on its revolving credit facility.
The following table summarizes the consideration for the acquisitions made in 2011, excluding contingent consideration payable (in thousands):
Contingent Consideration
In connection with its acquisitions, the Company has agreed to pay additional consideration in future periods based upon the attainment of stipulated levels of operating earnings by each of the acquired entities, as defined in their respective agreements.
For acquisitions completed prior to January 1, 2009, the Company did not accrue contingent consideration obligations prior to the attainment of the objectives and the amount owed becomes fixed and determinable. The Company paid consideration under contingent notes related to acquisitions completed prior to January 1, 2009 of $12.7 million, $8.3 million and $3.4 million for the years ended December 31, 2011, 2012 and 2013, respectively. The Company has one contingent note for an acquisition prior to January 1, 2009, which remains to be fully settled, however the Company expects to make no further contingent payments related to this acquisition or any other acquisitions completed prior to January 1, 2009.
As of December 31, 2013, assuming the practices acquired subsequent to January 1, 2009 achieve the maximum level of stipulated operating earnings, the maximum principal amount of contingent consideration payable over the next three years is $35.8 million. A lesser amount will be paid if the practices’ earnings are below the maximum level of stipulated earnings or no payments will be made if the practices do not achieve the minimum level of stipulated earnings as outlined in their respective agreements. For the years ended December 31, 2011, 2012 and 2013, the Company paid consideration under contingent notes related to acquisitions completed subsequent to January 1, 2009 of $7.9 million, $21.3 million and $18.1 million, respectively. Future payments for acquisitions completed subsequent to January 1, 2009 will be reflected in the change in the fair value of the contingent consideration. The total fair value of the contingent consideration reflected in the accompanying consolidated balance sheets as of December 31, 2012 and 2013 is $26.3 million and $7.6 million, respectively.
Note 3. Accounts Receivable
Accounts receivable consisted of the following as of December 31, 2012 and 2013 (in thousands):
Note 4. Property and Equipment
Property and equipment, including assets acquired under capital leases, as of December 31, 2012 and 2013 consisted of the following (in thousands):
Depreciation expense, inclusive of amortization of capital leases, was $4.2 million, $4.6 million and $4.5 million for the years ended December 31, 2011, 2012 and 2013, respectively.
Note 5. Goodwill and Intangible Assets
The following table presents adjustments to goodwill during the years ended December 31, 2012 and 2013 (in thousands):
(a)
Related to acquisitions completed prior to January 1, 2009.
(b)
The goodwill impairments for the year ended December 31, 2012 were primarily the result of reductions in Medicare reimbursement rates and profit erosion. The Company used assumptions for the projection period, discount rates and annual growth rates similar to the 2013 impairment testing and included $0.9 million for the impairment of goodwill recognized at the discontinued operation sold on August 31, 2012.
For the years ended December 31, 2011, 2012 and 2013, the Company recorded expense for the amortization of intangible assets expense of $22.8 million, $22.3 million and $18.6 million, respectively related to its continuing operations. For its discontinued operation the Company recorded amortization of intangible assets of $0.3 million and $25,000 for the years ended December 31, 2011 and 2012, respectively. The Company’s balances for intangible assets as of December 31, 2012 and 2013 and the related accumulated amortization are set forth in the table below (in thousands):
As of December 31, 2013, estimated future amortization expense is as follows (in thousands):
Impairment of Goodwill and Other Intangible Assets
For purposes of testing goodwill for impairment, with the exception of four practices for which operations have been combined into two reporting units, each of the Company’s acquired practices is considered a separate reporting unit. To estimate the fair value of the reporting units, the Company utilizes a discounted cash flow model as the primary approach to value, supported by a market approach guideline public company method (the “GPC Method”) which is used as a reasonableness test. The results of the discounted cash flow provide reasonable estimates of the fair value of the reporting units because this approach is based on each respective unit’s actual results and reasonable estimates of future performance, and because it also takes into consideration a number of other factors deemed relevant by management, including but not limited to, expected future market revenue growth and operating profit margins. The Company has consistently used these approaches in determining the value of goodwill. The Company considers the GPC Method as an adequate reasonableness test which utilizes market multiples of industry participants to corroborate the discounted cash flow analysis. The Company believes this methodology is consistent with the approach that any strategic market participant would utilize if they were to value one of the Company’s reporting units.
2013 Impairment Testing
On November 27, 2013, CMS issued its 2014 Medicare Physician Fee Schedule, which included reductions of certain relative value units and geographic adjustment factors used to determine reimbursement for a number of the most commonly used pathology codes, including the code used most by the Company. Additional changes were also made to other surgical pathology codes. Based on the Company’s current Medicare business mix, the Company’s management estimated the impact of the change in the physician fee schedule for 2014 to be a reduction in annualized revenue of approximately $6 million. Alternatively, if Congress were to extend through December 31, 2014, the conversion factor in effect through March 31, 2014, the Company’s management estimated the changes to the 2014 Fee Schedule would result in a reduction of our annualized Medicare revenue of approximately $3 million.
As of November 30, 2013, the Company tested goodwill at all of its reporting units for impairment and recorded a non-cash impairment charge of $52.9 million to write down the carrying value of goodwill. The write-down of the goodwill related to seven reporting units. Regarding these reporting units, the Company believes the reductions in the reimbursement rates under the 2014 Medicare Physician Fee Schedule, as issued by CMS on November 27, 2013, resulted in a reduction in the fair value of goodwill below its carrying value. As of December 31, 2012 and 2013, the Company had accumulated impairment charges related to goodwill of $167.7 million and $220.6 million, respectively.
The following assumptions were made by management in determining the fair value of the reporting units and related intangibles as of November 30, 2013: (a) the discount rates ranged between 13.9 percent and 16.9 percent, based on relative size and perceived risk of the reporting unit; and (b) an average compound annual growth rate (CAGR) of 2.2 percent during the five year forecast period. These assumptions are based on both the actual historical performance of the reporting units and management’s estimates of future performance of the reporting units.
In connection with the Company’s testing of goodwill as of November 30, 2013, the reporting units for which testing indicated there was no impairment, their calculated fair values exceeded their carrying values by a weighted average 29.0 percent. Three of the unimpaired reporting units were calculated to have fair values that were 1.7 percent, 3.6 percent and 6.4 percent in excess of their carrying values. As of November 30, 2013, the Company had goodwill of $13.6 million, $11.0 million and $18.8 million, respectively, recorded for these three reporting units. As noted above, assumptions were made regarding the revenue, operating expense, and anticipated economic and market conditions related to these reporting units as part of the impairment analysis. Assumptions made regarding future operations involve significant uncertainty, particularly with regard to anticipated economic and market conditions that are beyond the control of the Company’s management. Potential events or circumstance that could negatively impact future performance include, but are not limited to, losses of customers, changes in regulations or reimbursement rates and increased internalization of diagnostic testing by clients.
As of November 30, 2013, the Company tested certain of its intangible assets for impairment and recorded a non-cash impairment charge of $1.0 million to write down the carrying value of intangible assets at one of its reporting units.
Note 6.
Accounts Payable, Accrued Expenses and Other Current Liabilities
Accounts payable, accrued expenses and other current liabilities as of December 31, 2012 and 2013 consisted of the following (in thousands):
Note 7.
Long-Term Debt
On April 30, 2007, in conjunction with an acquisition transaction, the Company entered into a subordinated, unsecured contingent note with prior owners of one of the Company’s acquired practices. The payment amount was to be determined by the practice’s cumulative EBITDA over a five-year period, with a minimum payment not to be less than $15.0 million and a maximum payment not to exceed $30.0 million. Payment amounts included a 5.5 percent interest rate factor, thus the Company recorded the contingent note in the original purchase price at its minimum payment amount, discounted by the interest rate factor of 5.5 percent. The original discount of $2.2 million was amortized into interest expense over the term of the contingent note using the interest method. The Company made the final payment of $3.6 million under the contingent note in July 2012.
On May 26, 2010, the Company entered into a $335.0 million credit facility with Barclays Bank PLC and certain other lenders. This new credit facility, which is collateralized by substantially all of the Company’s assets and guaranteed by the Company’s subsidiaries, included a $225.0 million senior secured first lien term loan facility that matures May 2016, which we refer to as our Term Loan. The credit facility also included a $110.0 million senior secured first lien revolving credit facility that matures May 2015, of which $50.0 million became available upon the closing of the new credit facility and $60.0 million became available on December 20, 2010, when the Company amended the credit facility and issued $200.0 million unsecured Senior Notes, as described below. The Term Loan bears interest, at the Company’s option, at a rate initially equal to the prime rate plus 3.25 percent per annum or LIBOR (subject to a floor of 2.00 percent) plus 4.25 percent per annum. The Company’s 2010 credit facility was used to refinance the existing credit facilities, to redeem its Class Z capital plus accrued dividends, and for acquisitions, working capital and general corporate purposes. In connection with the issuance of the $200.0 million unsecured Senior Notes, the Company’s May 2010 credit facility was amended and restated December 20, 2010.
The credit facility, as amended December 20, 2010, requires the Company to comply on a quarterly basis with certain financial covenants, including a senior secured leverage ratio calculation and an interest coverage ratio which become more restrictive over time. Also, on an annual basis the Company must not exceed a specified maximum amount of consolidated capital expenditures. In addition, the Term Loan includes negative covenants restricting or limiting the Company’s ability to, among other things, incur, assume or permit to exist additional indebtedness or guarantees; incur liens and engage in sale leaseback transactions; make loans and investments; declare dividends, make payments or redeem or repurchase capital stock; engage in mergers, acquisitions and other business combinations; prepay, redeem or purchase certain indebtedness; amend or otherwise alter terms of its indebtedness; sell assets; enter into transactions with affiliates and alter the business it conducts without prior approval of the lenders.
On October 26, 2012, the Company entered into a second amendment to the credit facility, which became effective on October 29, 2012 after the payment of certain required fees and expenses. The second amendment provided for the elimination of the interest coverage ratio requirements and the adjustment of the senior secured leverage ratio requirements from 2.75:1.00 to 3.00:1.00 beginning with the fiscal quarter ending September 30, 2012. In connection with the second amendment, the Company elected to reduce the maximum amount available under the revolving credit facility from $110.0 million to $60.0 million. Furthermore, the Company made principal repayments totaling $11.9 million on the Term Loan. The Company recorded non-cash charges of approximately $0.8 million to write off a pro rata portion of the unamortized original deferred debt issue costs and original issue discount recorded in connection with the Term Loan.
On April 24, 2013, the Company entered into a third amendment to the credit facility, which increased the applicable margin on certain term loans and revolving loans from 4.25 percent to 4.75 percent with respect to LIBOR rate loans and from 3.25 percent to 3.75 percent with respect to base rate loans. It also provides for the adjustment of the senior secured leverage ratio requirements from 3.00:1.00 to (i) 3.50:1.00 for any fiscal quarter ending during the period from September 30, 2013 to September 30, 2014, and (ii) 3.25:1.00 for any fiscal quarter ending December 31, 2014 and thereafter. In connection with the third amendment, the Company recorded approximately $0.6 million of additional debt discount related to the term loan facility and $0.3 million of deferred debt issue costs related to the revolving credit facility. As of December 31, 2013 the balance outstanding under the term loan facility was $102.5 million. As of December 31, 2013 the Company had a balance of $22.2 million outstanding and $37.8 million available under its revolving credit facility and was in compliance with all loan covenants.
On December 20, 2010, the Company issued $200.0 million in unsecured Senior Notes that mature on January 15, 2018. The Senior Notes bear interest at an annual rate of 10.75%, which is payable each January 15th and July 15th. In accordance with the indenture governing our Senior Notes, the Company is subject to certain limitations on issuing additional debt and is required to submit quarterly and annual financial reports. The Senior Notes are redeemable at the Company’s option beginning on January 15, 2015 at 105.375 percent of par, plus accrued interest. The redemption price decreases to 102.688 percent of par on January 15, 2016 and to 100 percent of par on January 15, 2017. Under certain circumstances, prior to January 15, 2015, the Company may at its option redeem all, but not less than all, of the notes at a redemption price equal to 100 percent of the principal amount of the notes, plus accrued interest and a premium as defined in the indenture governing our Senior Notes. The Senior Notes rank equally in right of repayment with all of the Company’s other senior indebtedness, but are subordinated to the Company’s secured indebtedness to the extent of the value of the assets securing that indebtedness. The Company used a portion of the proceeds from the issuance of the Senior Notes to repay $110.0 million of the $224.4 million principal then outstanding under the term loan portion of its $335.0 million credit facility. In connection with the partial repayment, the Company recorded a non-cash charge of approximately $4.7 million for the write-off of the pro rata portion of unamortized original issue discount, prepaid administration fees, and deferred debt issue costs.
In connection with the final settlement of one of its contingent notes, effective June 26, 2013, the Company agreed to pay $2.0 million in 24 equal monthly installments, plus 8 percent interest on the unpaid balance, through June 2015. As of December 31, 2013, the unpaid principal balance under this subordinated note was $1.5 million.
Long-term debt consists of the following as of December 31, 2012 and 2013 (in thousands):
As of December 31, 2013, estimated future debt principal payments are as follows (in thousands):
Interest Rate Derivatives
On September 23, 2010, the Company purchased an interest rate cap instrument for $0.2 million as a hedge to reduce its exposure to increases in LIBOR above 2.00 percent. The interest rate cap, which had a notional amount of $112.5 million, was effective from September 28, 2010 through September 30, 2012. The interest rate applicable under the cap reset each fiscal quarter, as determined on the last day of the preceding fiscal quarter. The Company would have earned interest on the notional amount to the extent that the LIBOR rate exceeded 2.00 percent. For the years ended December 31, 2011 and 2012, the Company recorded interest expense of $0.2 million and $7,000, respectively, for the change in fair value of the interest rate cap agreement. The Company had no derivatives during 2013.
Note 8.
Related Party Transactions
Acquisition Target Consulting Agreement
On June 2, 2006, and as subsequently amended and restated on July 6, 2011, the Company and an entity owned by two members of the Company entered into a professional services agreement to provide certain acquisition target identification consulting services to the Company. In exchange for these services, the Company pays to the entity a monthly retainer of $23,000, plus reimbursable expenses. The entity also earns a success fee of $45,000 for each identified acquisition consummated by the Company. On August 28, 2012, the professional services agreement was amended and restated to reduce the monthly retainer to $12,000 and increase the success fee to $65,000. The entity also will be paid a fee of 8 percent of revenue for certain new business development efforts as outlined in the amended and restated agreement. During the years ended December 31, 2011, 2012 and 2013, a total of approximately $0.4 million, $0.3 million and $0.2 million, respectively, was paid to the entity. As of December 31, 2012, the Company owed $13,000 to the entity. No amounts were owed to the entity as of December 31, 2013.
Management and Financial Advisory Agreement
On June 2, 2006, the Company, through its wholly-owned subsidiary, and two members of the Company entered into a management services agreement. On June 12, 2009, the management agreement was amended to substitute a new member for one of the original members. The management agreement calls for the members and their affiliates to provide certain financial and management advisory services in connection with the general business planning and forecasting and acquisition and divestiture strategies of the Company. In exchange for the services, the Company pays the members management fees equal to 1.0 percent of revenues, plus expenses.
In connection with the third amendment to the Company’s credit facility in April 2013, the Company has agreed not make any payments of management or similar fees until payment in full of all loans under the credit facility, provided that such management or similar fees shall continue to accrue. As of December 31, 2012 and 2013, $1.1 million and $3.6 million, respectively, of these management fees are reflected in accounts payable and accrued expenses in the accompanying consolidated balance sheets. The consolidated statement of operations includes management fees of $2.8 million, $2.9 million and $2.5 million for the years ended December 31, 2011, 2012 and 2013, respectively. During the years ended December 31, 2011, 2012 and 2013, the Company paid management fees of $2.3 million, $3.3 million and $66,000, respectively.
Facilities Lease Agreements
The Company has leased certain of its facilities from entities owned by physician employees or affiliated physicians who are also former owners of the acquired practices. The Company currently leases five of its facilities from affiliated physicians or entities. These five leases terminate in December 2014, April 2017, December 2019, October 2020 and June 2022. The five continuing leases provide for monthly aggregate base payments of approximately $80,000. Rent paid to the related entities was $1.1 million, $1.1 million and $1.0 million for the years ended December 31, 2011, 2012 and 2013, respectively.
Executive Management Agreement
On March 12, 2013, Mr. Daniel D. Crowley was appointed as the Chief Executive Officer and President of the Company. In connection with the appointment of Mr. Crowley, the Company entered into an agreement with Dynamic Healthcare Solutions (“DHS”), of which Mr. Crowley is the founder and a principal. Pursuant to the agreement, the Company pays DHS a monthly fee of $100,000, plus reasonable out of pocket expenses and hourly fees for DHS staff (other than Mr. Crowley) that provide services under the agreement. The agreement may be terminated by the Company with thirty days notice, subject to the payment of termination fees in certain circumstances as prescribed in the agreement. In addition, the agreement requires the Company to pay DHS a success fee in the event that a change of control of the Company occurs at any time during the term of the agreement or the one-year period following the termination of the agreement. The amount of the success fee would be based on the valuation of the Company at the time of the change of control. Other than the agreement with DHS, Mr. Crowley does not receive any direct or indirect compensation or benefits from the Company. During the year ended December 31, 2013, the Company paid $1.8 million to DHS, including a retainer of $0.2 million, which is included in deposits and other non-current assets as of December 31, 2013.
Note 9.
Members’ Equity
Prior to April 1, 2011, the Company had multiple classes of membership interests, including Class A, A-1, B, C, X, D-1, D-2 and D-3 units. Effective as of April 1, 2011, the Company amended and restated its operating agreement in order to reclassify its existing limited liability company units as a single class of 23,549,812 units. The reclassification did not result in a material change in the unit holders’ ownership of the Company on a fully-diluted basis.
Profits and losses are generally allocated among the members in accordance with the methodology for computing capital accounts as described in the Company’s LLC Agreement. Proceeds distributable or payable to the members in connection with a liquidation or sale of the Company would be distributed or paid based on the number of units held by each member. The units would share in the proceeds of a liquidation or sale in different relative amounts based on the aggregate amount of the distributions and/or payments.
As of December 31, 2013, the Company had 23,549,812 common membership units issued and outstanding.
During 2012, certain members made contributions to the Company totaling $43,000.
The following is a table reflecting the member contributions (distributions) by type of membership interest for the years ended December 31, 2011, 2012 and 2013 (in thousands):
Note 10.
Equity-Based Compensation
On July 6, 2011, the Company adopted the Aurora Diagnostics Holdings, LLC 2011 Equity Incentive Plan for the grant of options to purchase units of Aurora Diagnostics Holdings, LLC to employees, officers, managers, consultants and advisors of the Company and its affiliates. As of December 31, 2013, the Company has authorized the grant of up to 1,931,129 options and reserved the equivalent number of units for issuance upon the future exercise of awards pursuant to the plan.
The Company uses the Black-Scholes method to value its options. The Company considered the volatility for comparable companies in deriving estimates of volatility. The expected life is estimated based upon the vesting period and contractual life of the option. The risk free interest rate is estimated using rates for United States Treasury securities with maturities closest to the estimated life of the option.
On August 1, 2013, the Company’s Board granted options to purchase 947,500 of the Company’s common units at an exercise price of $2.00. These options were granted to employees and will vest, contingent upon continued employment, in five equal annual installments commencing August 1, 2014. The Company valued the options using the Black-Scholes method with weighted average assumptions of 38 percent for volatility, 6.5 years for expected life and 1.99 percent for the risk free interest rate. In the absence of publicly traded information, the Company used a third party valuation specialist to calculate the fair value of the Company’s common units. Using the Company’s best estimates of future operating performance, the valuation specialist calculated a de minimis value for the Company’s common units. The Company’s indebtedness and negative pricing pressures related to lower Medicare reimbursement rates were key considerations in the valuation.
On August 1, 2013, the Company’s Board also approved the change in the exercise price of all previously granted and then outstanding options to $2.00. Due to the estimated de minimis fair value of the Company’s common units, the Company recognized no incremental equity compensation costs in connection with the change in the exercise price for the previously granted options.
The options, which have a contractual term of 10 years, vest annually on each anniversary of the grant date. Equity compensation expense is recognized only for those options expected to vest, with forfeitures estimated based on the Company’s historical employee turnover experience and future expectations. The grant date fair value of options expected to vest is being amortized over the vesting periods through May 2017. Equity compensation costs, which are included in selling, general and administrative expenses, were $1.4 million, $1.1 million and $0.3 million for the years ended December 31, 2011, 2012 and 2013, respectively. As of December 31, 2013, the remaining unamortized equity compensation cost was approximately $1.4 million and the weighted average period over which the non-vested options are expected to be recognized was 2.5 years.
The following table summarizes the option activity for the year ended December 31, 2013.
There were no options to purchase Company units granted prior to the adoption of the Aurora Diagnostics Holdings, LLC 2011 Equity Incentive Plan on July 6, 2011.
The following table shows the weighted average grant date fair values of options and the weighted average assumptions that the Company used to develop the fair value estimates for the years ended December 31, 2011, 2012 and 2013:
Note 11.
Commitments and Contingencies
During the ordinary course of business, the Company has become and may in the future become subject to pending and threatened legal actions and proceedings. The Company may have liability with respect to its employees and its pathologists. Medical malpractice claims are generally covered by insurance. While the Company believes the outcome of any such pending legal actions and proceedings, individually or in the aggregate, will not have a material adverse effect on the Company’s financial condition, results of operations or liquidity, if the Company is ultimately found liable under any medical malpractice claims, there can be no assurance the Company’s medical malpractice insurance coverage will be adequate to cover any such liability. The Company may also, from time to time, be involved with legal actions related to the acquisition of and affiliation with physician practices, the prior conduct of such practices, or the employment (and restriction on competition) of its physicians. There can be no assurance that any costs or liabilities for which the Company becomes responsible in connection with such claims or actions will not be material or will not exceed the limitations of any applicable indemnification provisions or the financial resources of the indemnifying parties. As described in Note 6, the Company had accrued $5.0 million and $4.6 million as of December 31, 2013 and December 31, 2012, respectively, for medical malpractice claims.
During 2011, the Company received claims of overpayments from one payor for a total of $1.6 million. In August 2013, the Company offered to settle claims from the payor for a net payment of $28,000 and accrued a current liability in this amount. However, at this time, the payor has not responded to the Company’s offer and the Company cannot reasonably estimate any additional potential loss above the $28,000 net payment reflected in its settlement offer.
Contingent Notes
As discussed in Note 2, in connection with certain of its acquisitions, the Company agreed to pay additional consideration in future periods based upon the attainment of stipulated levels of operating earnings by each of the acquired entities, as defined in their respective agreements. The computation of the annual operating earnings is subject to review and approval by sellers prior to payment. In the event there is a dispute, the Company will pay the undisputed amount and then take reasonable efforts to resolve the dispute with the sellers. If the sellers are successful in asserting their dispute, the Company could be required to make additional payments in future periods.
The Company is in discussions with certain sellers regarding additional contingent note payment amounts. These sellers have asserted the Company owes an aggregate of $2.2 million in excess of its calculations as of December 31, 2013. The Company’s management believes its calculations are correct, but at this time cannot estimate what additional amount, if any, will ultimately be paid in connection with these contingent notes.
As of December 31, 2013, no further amounts were expected to be paid for acquisitions completed prior to January 1, 2009, and the total maximum future payments for contingent consideration issued in acquisitions completed since January 1, 2009 was $35.8 million. Lesser amounts will be paid for earnings below the maximum level of stipulated earnings or no payments will be made if the practices do not achieve the minimum level of stipulated earnings as outlined in their respective agreements. Any future payments of contingent consideration will be reflected in the change in the fair value of the contingent consideration. As of December 31, 2013, the fair value of contingent consideration related to acquisitions completed since January 1, 2009 was $7.6 million, representing the present value of approximately $8.8 million in estimated future payments through 2016.
Purchase Obligation
The Company has entered into non-cancelable commitments to purchase reagents and other laboratory supplies. Under these agreements, the Company must purchase minimum amounts of reagents and other laboratory supplies through 2019.
At December 31, 2013, the remaining minimum purchase commitments are as follows:
In connection with these commitments, the Company received lab testing equipment, to which the Company has either received title, or will receive title upon fulfillment of its purchase obligations under the respective commitment. The Company recorded the obligation under purchase commitment for the fair market value of the equipment, reduced by the cash paid. The remaining obligations under purchase commitments included in other liabilities in the accompanying condensed consolidated balance sheets were $1.3 million and $0.9 million as of December 31, 2013 and 2012, respectively.
Employment agreements
The Company has employment agreements with its executive officers and certain physician employees, the terms of which expire at various times through 2015. Such agreements provide for minimum salary levels that may be adjusted annually for cost-of-living changes and may contain incentive bonuses that are payable if specified goals are attained. Under certain of the agreements, in the event employment is terminated (other than voluntarily by the employee, by the Company for cause, or upon the death of the employee), the Company is committed to pay certain benefits, including specified monthly severance for periods from six months to one year from the date of termination.
Self-insured health benefits
Effective June 1, 2009, the Company began providing health care benefits to the majority of its employees through a partially self-insured plan. The Company records its estimate of the ultimate cost of, and reserves for, health care benefits based on computations using the Company’s loss history as well as industry statistics. In determining its reserves, the Company includes reserves for estimated claims incurred but not reported. The amount reserved for estimated claims was $1.0 million and $1.1 million as of December 31, 2012 and 2013, respectively. The ultimate cost of health care benefits will depend on actual costs incurred to settle the claims and may differ from the amounts reserved by the Company for those claims.
Operating leases
The Company leases various office and medical laboratory facilities and equipment under non-cancelable lease agreements with varying terms through May 2021. The terms of some of the facility leases require the Company to pay for certain taxes or common utility charges. Rent expense, including these taxes and common utility charges, was $4.6 million, $4.9 million, and $4.7 million for the years ended December 31, 2011, 2012, and 2013, respectively. Rent expense associated with operating leases that include scheduled rent increases and tenant incentives are recorded on a straight-line basis over the term of the lease. Aggregate future minimum annual rentals under the lease agreements as of December 31, 2013 are as follows (in thousands):
Note 12.
Fair Value of Financial Instruments
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. A fair value hierarchy has been established based on three levels of inputs, of which the first two are considered observable and the last unobservable.
Level 1:
Quoted prices in active markets for identical assets or liabilities. These are typically obtained from real-time quotes for transactions in active exchange markets involving identical assets.
Level 2:
Inputs, other than quoted prices included within Level 1, which are observable for the asset or liability, either directly or indirectly. These are typically obtained from readily-available pricing sources for comparable instruments.
Level 3:
Unobservable inputs, where there is little or no market activity for the asset or liability. These inputs reflect the reporting entity’s own assumptions of the data that market participants would use in pricing the asset or liability, based on the best information available in the circumstances.
Recurring Fair Value Measurements
The interest rate cap, which was entered into in September 2010, was the Company’s only derivative financial instrument. The fair value of the interest rate cap was estimated by obtaining quotations from the financial institution that is a counter party to the instrument. The LIBOR rate is observable at commonly quoted intervals over the term of these derivatives and they are therefore considered Level 2 items. The fair value is an estimate of the net amount that the Company would have to pay or would receive on that date if the agreements were canceled or transferred to other parties. The Company’s interest rate cap agreement, which matured in September 2012, was included in deposits and other noncurrent assets at its fair value of approximately $7,000 as of December 31, 2011.
As of December 31, 2012 and December 31, 2013, the fair value of contingent consideration related to acquisitions since January 1, 2009 was $26.3 million and $7.6 million, respectively. The fair value of contingent consideration is derived using valuation techniques that incorporate unobservable inputs and are considered Level 3 items. We utilize a present value of estimated future payments approach to estimate the fair value of the contingent consideration. Estimates for fair value of contingent consideration primarily involve two inputs, which are (i) the projections of the financial performance of the acquired practices that are used to calculate the amount of the payments and (ii) the discount rates used to calculate the present value of future payments. Changes in either of these inputs will impact the estimated fair value of contingent consideration. At December 31, 2013, the discount rates ranged from 14.6 percent to 15.6 percent.
The following is a summary of the Company’s fair value instruments categorized by their fair value input level as of December 31, 2013 (in thousands):
The Company had no transfers of fair value instruments between Level 2 and Level 3 during 2012 or 2013. The following is a summary of the Company’s fair value instruments categorized by their fair value input level as of December 31, 2012 (in thousands):
The following is a roll-forward of the Company’s Level 3 fair value instruments for the years ended December 31, 2013 and 2012 (in thousands):
Non-Recurring Fair Value Measurements
Certain assets that are measured at fair value on a non-recurring basis, including property and equipment and intangible assets, are adjusted to fair value only when the carrying values are greater than their fair values. As described in Note 5, Goodwill and Intangible Assets, the Company completed its annual impairment evaluations as of September 30, 2012, November 30, 2012 and November 30, 2013, and recorded write-offs of goodwill and intangibles to reflect the current estimated fair value of the impaired reporting units. The fair value was derived with fair value models utilizing unobservable inputs that therefore are considered Level 3 items.
As of December 31, 2013 and 2012 the carrying amounts of cash, accounts receivable, accounts payable, accrued interest and accrued expenses approximate fair value based on the short maturity of these instruments. As of December 31, 2013 and 2012, the fair value of the Company’s long-term debt was $287.2 million and $292.7 million, respectively. The Company uses quoted market prices and yields for the same or similar types of borrowings in active markets when available to determine the fair value of the Company’s debt. These fair values are considered Level 2 items.
Note 13.
Write-off of Public Offering Costs
During the quarter ended September 30, 2011, the Company decided to delay the completion of its initial public offering. As a result, a non-cash charge of $4.4 million was recorded to write-off the previously deferred offering costs.
Note 14.
Defined Contribution Plan
The Company sponsors a salary deferral plan under Section 401(k) of the Internal Revenue Code. The plan allows eligible employees to defer up to 100 percent of their compensation in accordance with IRS guidelines. Such deferrals accumulate on a tax deferred basis until the employee withdraws the funds. The Company is required to match a portion of the employees’ contribution. For 2011, 2012 and 2013, the rate of the Company’s match was 25 percent, up to $1,000 per participating employee. Total expense recorded for the Company’s match was $0.3 million for each of 2011, 2012 and 2013.
Note 15.
Income Taxes
The benefit for federal and state taxes was $0.7 million, $5.1 million and $3.9 million for the years ended December 31, 2011, 2012 and 2013, respectively. Excluding the effect of the impairment charges, the benefit for federal and state taxes would have been $2.0 million, $25.7 million and $7.6 million for the years ended December 31, 2011, 2012 and 2013, respectively.
The provision for income taxes for certain of the Company’s subsidiaries structured as corporations and states that tax partnerships for the years ended December 31, 2011, 2012 and 2013 consist of the following (in thousands):
A reconciliation of the provision for income taxes with amounts determined by applying the statutory U.S. federal income tax rate of 34 percent to actual income taxes, primarily for the Company’s subsidiaries structured as corporations for the years ended December 31, 2011, 2012 and 2013 was as follows (in thousands):
The following is a summary of the Company’s deferred tax assets and liabilities as of December 31, 2012 and 2013, respectively (in thousands):
As of December 31, 2012 current deferred tax liabilities of $75,000 were included in accounts payable, accrued expenses and other current liabilities in the consolidated balance sheet. The Company’s $1.4 million deferred tax asset for net operating loss carryforwards as of December 31, 2013 expire in the year 2032.
Note 16.
Guarantor Subsidiaries
The following information is presented as required by regulations of the Securities and Exchange Commission in connection with the Company’s 10.75% Senior Notes due 2018. This information is not routinely prepared for use by management. The operating and investing activities of the separate legal entities included in the Company’s consolidated financial statements are fully interdependent and integrated. Accordingly, consolidating the operating results of those separate legal entities is not representative of what the actual operating results of those entities would be on a stand-alone basis. Operating expenses of those separate legal entities include intercompany charges for management fees and other services. Certain expense items that are applicable to the Company’s subsidiaries are typically recorded in the books and records of Aurora Diagnostics Holdings, LLC. For purposes of this footnote disclosure, such balances and amounts have been “pushed down” to the respective subsidiaries either on a specific identification basis or, when such items cannot be specifically attributed to an individual subsidiary, have been allocated on an incremental or proportional cost basis to Aurora Diagnostics Holdings, LLC and the Company’s subsidiaries.
The following tables present consolidating financial information as of December 31, 2012, and 2013 and for the years ended December 31, 2011, 2012 and 2013 for (i) Aurora Diagnostics Holdings, LLC, (ii) on a combined basis, the subsidiaries of the Company that are guarantors of the Company’s Senior Notes (the “Subsidiary Guarantors”) and (iii) on a combined basis, the subsidiaries of the Company that are not guarantors of the Company’s Senior Notes (the “Non-Guarantor Subsidiaries”). For presentation in the following tables, Subsidiary Guarantors includes revenue and expenses and assets and liabilities for those subsidiaries directly or indirectly 100 percent owned by the Company, including those entities that have contractual arrangements with affiliated physician groups. Essentially, all property and equipment reflected in the accompanying consolidated balance sheets collateralize the Company’s debt. As such, as of December 31, 2012 and 2013, $3.8 million and $3.1 million, respectively, of property and equipment held by Non-Guarantor Subsidiaries are reflected under Subsidiary Guarantors in the following tables.
Consolidating Balance Sheets (in thousands):
Consolidating Statements of Operations (in thousands):
Consolidating Statements of Cash Flows (in thousands):
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the 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 its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
As of the end of the period covered by this report, the Company’s management carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based upon that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures, as defined by Rule 15d-15(e) under the Exchange Act, were effective as of December 31, 2013.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting during the fourth quarter of the year ended December 31, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 15d-15(f). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only with proper authorizations; and (3) provide reasonable assurance regarding prevention of timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
There are inherent limitations in the effectiveness of internal control over financial reporting, including the possibility that misstatements may not be prevented or detected. Therefore, even those systems determined to be effective can provide only reasonable, not absolute, assurance that the control objectives will be met. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate over time.
Management, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, has evaluated the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013 based on the criteria established in a report entitled Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2013.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION.
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The following table sets forth the name, age and position of each of our executive officers and managers as of March 23, 2014.
Daniel D. Crowley
Chief Executive Officer,
President
Mr. Crowley has served as our Chief Executive Officer and President since March 12, 2013. He is the founder and principal of Dynamic Healthcare Solutions, a firm that provides executive management principally to healthcare companies, which he formed in 1997. Mr. Crowley has significant experience as a healthcare executive, senior management and board advisor and advisor to private investment firms.
Bruce C. Walton
Executive Vice President, Operations
Mr. Walton has served as our Executive Vice President, Operations since March 2013. Mr. Walton joined Aurora Diagnostics as Regional Vice President of Operations in December 2009, overseeing national operational initiatives and laboratories in the Northeast and Florida Regions. From 1999 through 2008, Mr. Walton was Senior Vice President of Sales And Marketing and subsequently Regional President of AmeriPath, Inc. Prior to that Mr. Walton spent 14 years in various sales management roles with surgical device manufacturer C.R. Bard, Inc.
Michael J. Null
Executive Vice President, Sales and Marketing
Mr. Null has served as our Vice President, Sales & Marketing since April 2007 and received the additional title of Executive Vice President in March 2012. Prior to joining us, Mr. Null served as the Vice President of Sales and Marketing at Asterand, a tissue-based research services provider for the pharmaceutical and biotechnology industry, from 2002 to 2007. He served as a senior account manager and business development manager at Renaissance, a global IT consulting and staffing company, from 1997 to 2002. Prior to joining Renaissance, Mr. Null was employed for four years by DIANON Systems, an anatomic and clinical pathology laboratory company.
Michael C. Grattendick
Vice President, Finance, Controller and Treasurer
Mr. Grattendick has served as our Vice President of Finance, Controller and Treasurer since May 2013. Mr. Grattendick joined Aurora Diagnostics as our Director of Finance in September 2006. Mr. Grattendick has over 15 years of experience in the health care industry.
Fred Ferrara
Senior Vice President and Chief Information Officer
Mr. Ferrara has served as our Chief Information Officer since 2006 and received the additional title of Senior Vice President in March 2012. Mr. Ferrara served as the Director of Information Technology at LabCorp Inc., an anatomic pathology laboratory company, from 2003 until he joined Aurora in 2006. Mr. Ferrara joined LabCorp upon its acquisition of DIANON Systems, where Mr. Ferrara had been employed since 1997.
Peter J. Connolly
Chairman of the Board of Managers
Mr. Connolly, the Chairman of our Board, has served as one of our managers since 2006 and currently serves as a Principal at Summit Partners, a growth equity firm. Prior to joining Summit Partners in 2004, Mr. Connolly was employed by Goldman, Sachs & Co., an investment banking firm, and Deloitte LLP, an accounting and consulting firm. The Board has concluded that Mr. Connolly should serve as a director because of his significant executive experience as well as the fact that his relationship with Summit Partners, which has a substantial ownership interest in us, aligns his interests with those of our other stakeholders.
James C. New
Manager
Mr. New has served as one of our managers since 2006. He also served as our Chief Executive Officer and President from 2006 until his retirement on September 1, 2011. Since his retirement, he has served as Special Advisor to our Board of Managers and Chief Executive Officer. Mr. New served as the President, Chief Executive Officer and Chairman of AmeriPath, an anatomic pathology laboratory company, from January 1996 through 2003. Prior to joining AmeriPath, Mr. New served as the President, Chief Executive Officer, and a director of RehabClinics, an outpatient rehabilitation company. The Board has concluded that Mr. New should serve as a manager because of his extensive experience in managing anatomic pathology companies, including his experience as our former Chairman, Chief Executive Officer and President.
Thomas S. Roberts
Manager
Mr. Roberts has served as one of our managers since 2006 and currently serves as a Managing Director of Summit Partners, a growth equity firm. Mr. Roberts joined Summit Partners in 1989. Mr. Roberts also served in the past as the Chairman and Director of AmeriPath, an anatomic pathology laboratory company. The Board has concluded that Mr. Roberts should serve as a director because of his significant executive experience as well as the fact that his relationship with Summit Partners, which has a substantial ownership interest in us, aligns his interests with those of our other stakeholders.
Christopher Dean
Manager
Mr. Dean has served as one of our managers since 2006 and currently serves as a Managing Director of Summit Partners, a growth equity firm. Mr. Dean joined Summit Partners in 2001. The Board has concluded that Mr. Dean should serve as a director because of his significant executive experience as well as the fact that his relationship with Summit Partners, which has a substantial ownership interest in us, aligns his interests with those of our other stakeholders.
Steven Neumann
Manager
Mr. Neumann has served as one of our managers since August 2012 and is a Managing Director of KRG Capital Partners, a private equity investment firm. Mr. Neumann joined KRG Capital Partners in 1998. The Board has concluded that Mr. Neumann should serve as a manager because of his significant executive experience as well as the fact that his relationship with KRG Capital Partners, which has a substantial ownership interest in us, aligns his interests with those of our other stakeholders.
Blair Tikker
Manager
Mr. Tikker has served as one of our managers since June 2009 and is a Managing Director of KRG Capital Partners, a private equity investment firm. Mr. Tikker joined KRG Capital Partners in 2007. Prior to joining KRG Capital Partners, Mr. Tikker was employed by a number of hospital systems, physician groups and managed care companies. Mr. Tikker served as the CEO of HMS Healthcare, a preferred provider organization, from 2001 until 2005. The Board has concluded that Mr. Tikker should serve as a director because of his significant executive experience as well as the fact that his relationship with KRG Capital Partners, which has a substantial ownership interest in us, aligns his interests with those of our other stakeholders.
Bennett R. Thompson
Manager
Mr. Thompson has served as one of our managers since August 2011 and has been a regular board observer since June 2009. Mr. Thompson is a Principal of KRG Capital Partners, a private equity investment firm. Mr. Thompson joined KRG Capital Partners in 2007. Prior to joining KRG Capital Partners in 2007, Mr. Thompson was employed by Heritage Partners, a private equity investment firm, and Harris Williams & Co., an investment banking firm. The Board has concluded that Mr. Thompson should serve as a manager because of his significant executive experience as well as the fact that his relationship with KRG Capital Partners, which has a substantial ownership interest in us, aligns his interests with those of our other stakeholders.
James Emanuel
Manager
Mr. Emanuel has served as one of our managers since June 2011. Mr. Emanuel has engaged in consulting and private investment activities since his retirement from Lincare, Inc., a national provider of respiratory therapy services for patients with pulmonary disorders, where he served as Chief Financial Officer from January 1984 to June 1997. Mr. Emanuel also served as Chief Financial Officer and a director of Lincare Holdings Inc. from November 1990 to June 1997. Mr. Emanuel served as a director of SRI/Surgical Express Inc. from 1996 to 2012, in addition to serving on private company boards. The Board has concluded that Mr. Emanuel should serve as a manager because of his significant executive experience.
Pursuant to the terms of the LLC Agreement, Messrs. Connolly, Roberts and Dean were designated to serve on our Board by Summit Partners, and Messrs. Neumann, Tikker and Thompson were designated to serve on our Board by KRG Capital Partners.
Board Committees
Our audit committee’s responsibilities include selecting, engaging and evaluating the qualifications, independence and performance our independent registered public accountant; reviewing, overseeing and monitoring the integrity of our financial statements and our compliance with legal and regulatory requirements as they relate to financial statements or accounting matters; and reviewing and discussing with management and our independent registered public accountant the results of our annual audit and the review of our quarterly unaudited financial statements.
In addition, our audit committee is responsible for reviewing the design, implementation, adequacy and effectiveness of our internal controls over financial reporting, our disclosure controls and procedures and our critical accounting policies; approving the audit and non-audit services to be performed by our independent registered public accountant; establishing procedures for the receipt and retention of accounting related complaints and concerns; and reviewing and approving any related person transactions.
Our audit committee is comprised of Messrs. Emanuel, Connolly and Thompson. Mr. Emanuel is the chairperson of the audit committee. Mr. Emanuel has been designated as the audit committee financial expert, as defined in Item 407(d) of Regulation S-K under the Securities Act.
Other than our audit committee, we have not established any other board committees at this time.
Code of Conduct and Ethics
Our Board of Managers has adopted a code of conduct and ethics applicable to our officers, managers and employees, including our principal executive officer, principal financial officer and principal accounting officer. The Company will provide to any person without charge, upon request, a copy of the code of conduct and ethics. Such requests shall be made in writing to the Company at 11025 RCA Center Drive, Suite 300, Palm Beach Gardens, FL 33410, Attention: Investor Relations.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION.
COMPENSATION DISCUSSION AND ANALYSIS
In the paragraphs that follow, we provide an overview and analysis of our compensation program and policies, the material compensation decisions we have made under those programs and policies with respect to our named executive officers, and the material factors that we considered in making those decisions. Following this Compensation Discussion and Analysis, you will find a series of tables containing specific data about the compensation earned or paid to the following individuals, whom we refer to as our named executive officers:
·
Daniel D. Crowley, our Chief Executive Officer and President;
·
Bruce C. Walton, our Executive Vice President, Operations;
·
Michael J. Null, our Executive Vice President, Sales and Marketing; and
·
Jon L. Hart, our former Chief Executive Officer and President.
On March 11, 2013, Mr. Hart resigned as the Chief Executive Officer and President of the Company and as a member of the Company’s Board of Managers. Effective March 11, 2013, the Company and Mr. Hart entered into a separation agreement, under which Mr. Hart is receiving $537,900 in severance from the Company in bi-weekly installments through March 2014. As a result of his resignation, Mr. Hart was no longer eligible to receive a bonus.
Objectives of Our Compensation Program; How We Set Compensation
Our compensation objectives as a privately-held company have been to recruit and retain a talented team of employees to grow and develop our business and to reward those employees for accomplishments related to our growth and development.
Historically, we have not had a compensation committee and our Board of Managers has determined the compensation for our Chief Executive Officer and, based on the recommendations of our Chief Executive Officer, the rest of our management team. In setting compensation, our Chief Executive Officer and our Board of Managers did not seek to allocate long-term and current compensation, or cash and non-cash compensation, in any particular percentage. Instead, they reviewed each element of compensation independently and determined the appropriate amount for each element, as discussed below. Neither management nor our Board of Managers engaged a compensation consultant during fiscal year 2013. We believe our historical compensation-setting processes have been effective for a privately-held company.
Compensation for Chief Executive Officer
On March 12, 2013, Mr. Daniel D. Crowley was appointed as our Chief Executive Officer and President. In connection with the appointment of Mr. Crowley, we entered into an agreement with Dynamic Healthcare Solutions (“DHS”), of which Mr. Crowley is the founder and a principal. Pursuant to the agreement, we pay DHS a monthly fee of $100,000, plus reasonable out of pocket expenses and hourly fees for DHS staff (other than Mr. Crowley) that provide services under the agreement. We can terminate the agreement with thirty days notice, subject to the payment of termination fees in certain circumstances as prescribed in the agreement. In addition, the agreement requires us to pay DHS a success fee in a change of control event that occurs at any time during the term of the agreement or the one-year period following the termination of the agreement. The amount of the success fee would be based on our valuation at the time of the change of control. Other than the agreement with DHS, we do not pay any direct or indirect compensation or provide any other benefits to Mr. Crowley. During 2013, we paid $1,200,000 to DHS for the services of Mr. Crowley, consisting of a retainer of $200,000, which is included in deposits and other non-current assets as of December 31, 2013, $1,000,000 of monthly fees including, $50,000 in advance for January 2014.
2013 Elements of Compensation for Messrs. Null and Walton
The key elements of compensation for our Messrs. Null and Walton in fiscal year 2013 were base salary, annual cash bonuses and long-term equity incentive awards in the form of stock options.
Set forth below is a summary of the salary and bonus program for Messrs. Null and Walton, including the changes to their titles and compensation during 2013. The Board approved these compensation increases after considering the value of each executive to the Company based on his role, skill, recent performance and overall contribution, as well as the date of his last increase to base salary.
Base Salaries. We intend for base salaries to reward core competence in the executive role relative to skill, experience and contributions to us. We negotiated the initial base salaries individually with each executive, with a focus on the executive’s experience in his respective field and expected contribution to us. In general, we adjust base salaries in connection with performance reviews and/or changes to the scope of an executive officer’s responsibilities.
On March 18, 2013, Mr. Walton was promoted from Senior Vice President of Operations to Executive Vice President of Operations. In connection with this promotion and increased responsibility, Mr. Walton’s annual salary was increased from $275,000 to $300,000. Additionally, in recognition of Mr. Walton’s performance in his new role of Executive Vice President, the Board further increased his salary to $350,000 effective November 1, 2013. Mr. Null did not receive any base salary increases in 2013.
Annual Cash Bonuses. Annual bonuses reward our executive officers for their contribution to our financial goals and focus our executive officers on both short- and long-term objectives. Annual bonuses are earned based on the achievement of certain pre-determined performance goals. On an annual basis, or at the commencement of an executive officer’s employment with us, our Board of Managers sets a target level of bonus compensation that is structured as a percentage of such executive officer’s annual base salary. For 2013, the target bonuses for Mr. Walton and Mr. Null were 50 percent. Our Board of Managers set such target bonuses after consideration of our Chief Executive Officer’s recommendation and the expected role of each of our executives. The actual amount of the bonus is based on the extent to which we and the executive meet or exceed predetermined financial goals and individual performance goals established for each executive. These goals are set by our Board of Managers prior to the beginning of the performance year and adjusted from time to time to take into consideration the impact of acquisitions completed during the year.
For 2013, annual cash incentive bonus opportunities for each of Messrs. Walton and Null were based on the achievement of a Company financial goal and individual performance goals. The Company financial component of the 2013 bonus opportunities was based on EBITDA, as adjusted for financial reporting. We selected EBITDA to focus the executive on supporting, improving and growing our business.
The Company financial goal sets the potential maximum amount of bonuses that could be paid out under the management incentive plan. For the year ended December 31, 2013 the financial goal to achieve the maximum bonus was set at EBITDA, as adjusted, of $41.7 million.
In addition to the Company financial goal, each executive must achieve their individual performance goals to receive their bonus. Therefore, for an executive to receive 100 percent of their target bonus, they must achieve 100 percent of their individual performance goals and the Company must attain 100 percent of the EBITDA goal of $41.7 million. Linear interpolation is used to determine payouts between the ranges. Individual performance goals are specific to each executive’s role and responsibilities and are assessed by our Board of Managers and Chief Executive Officer. Additional amounts may be added to the individual performance bonus at the discretion of our Board of Managers and Chief Executive Officer. After considering the Company’s financial results in relation to the targets for the year ended December 31, 2013, the Board decided that Messrs. Walton and Null would not receive bonuses for 2013.
Long-Term Equity Incentives. In determining the appropriate number of options to grant to each executive, our Board of Managers considered the equity holdings of each executive. On August 1, 2013, the Board granted options to purchase our member units under our 2011 Plan to Mr. Walton in the amount of 200,000 options and to Mr. Null in the amount of 90,000 options. The options vest in five equal annual installments beginning on the first anniversary of the date of grant or upon the earlier occurrence of a sale of the Company.
Other Benefits. Our named executive officers participate in various health and welfare programs that are generally made available to all salaried employees. Our named executive officers also participate in our executive-level life insurance program. We also provided a travel and housing allowance of approximately $4,000 per month to Mr. Hart to reimburse him for expenses incurred in connection with his personal travel, temporary housing and relocation from Boston to Palm Beach, Florida.
Board of Managers Report
The Board of Managers has reviewed and discussed with management the Company’s Compensation Discussion and Analysis and, based on such review and discussions, has recommended that the Compensation Discussion and Analysis be included in the Company’s 2013 Annual Report on Form 10-K.
Peter J. Connolly
James C. New
Thomas S. Roberts
Christopher Dean
Steven Neumann
Blair Tikker
Bennett Thompson
James Emanuel
Summary Compensation
The following table sets forth the cash and other compensation that we paid to our named executive officers, or that was otherwise earned by our named executive officers, for their services in all capacities during 2013 and 2012.
Summary Compensation Table
(1)
In connection with the Executive Management Agreement effective March 12, 2013, we paid a total of $1,200,000 to Dynamic Health Solutions during 2013 for the retainer for Mr. Crowley’s services as our CEO and President. Payments in 2013 include $200,000 at inception of the consulting agreement for prepaid retainer for last two months of agreement, as well as $50,000 paid in December 2013 as advance on January 2014 retainer. Other than the agreement with DHS, Mr. Crowley does not receive any direct or indirect compensation or benefits from the Company.
(2)
Mr. Hart resigned on March 11, 2013. The Company and Mr. Hart entered into a separation agreement, under which Mr. Hart is receiving $537,900 in severance from the Company in bi-weekly installments through March 2014.
(3)
Reflects the grant date fair value of options to purchase the Company’s member units granted in 2012 and 2013. The fair value was calculated in accordance with stock-based accounting rules (FASB ASC 718). The assumptions used by the Company to determine the fair value are described in Note 10 of the Consolidated Financial Statements included in this Annual Report. On August 1, 2013, the Company granted 200,000 options to Mr. Walton and 90,000 options to Mr. Null. Also on August 1, 2013, the Company modified the terms of previously-granted stock options to reduce the exercise price from $10.00 to $2.00. The Company estimated a de minimis value for the options granted and the modification of existing options and recognized no incremental equity compensation costs in connection with the change in the exercise price for the previously granted options.
(4)
The following items are included in the All Other Compensation column for 2012: (i) for each of Messrs. Hart, Walton and Null, $1,000 in matching contributions under our 401(k) plan; (ii) Company paid executive level life insurance premiums of $992 for Mr. Hart, $653 for Mr. Walton and $874 for Mr. Null; (iii) for Mr. Hart, $33,231 for reimbursement of temporary housing and travel expenses.
The following items are included in the All Other Compensation column for 2013 (i) for each of Messrs. Hart, Walton and Null, $1,000 in matching contributions under our 401(k) plan; (ii) Company paid executive level life insurance premiums of $228 for Mr. Hart, $645 for Mr. Walton and $723 for Mr. Null; (iii) for Mr. Hart, $411,700 for severance.
Employment Agreements. We maintain employment agreements with each of Messrs. Walton and Null, the term of which will continue until terminated by the executive or us. Prior to his resignation, we were party to an employment agreement with Mr. Hart. Pursuant to the agreements, the initial annual base salaries are subject to increases from time to time in the sole discretion of our Board of Managers, and the executives have the opportunity to earn performance bonuses on an annual basis as determined by our Board of Managers. The executives are also entitled to participate in any employee benefit plans that we may from time to time have in effect for our executive-level personnel. In addition, the employment agreements provide certain benefits to the executives upon their termination of employment by us without cause, by the executive for good reason, or by reason of their death or disability. For a description of such benefits, see “- Potential Payments Upon Termination of Employment” below.
Outstanding Equity Awards at 2013 Fiscal Year-End
The following table shows, for each of the named executive officers, all equity awards that were outstanding as of December 31, 2013.
(1)
The options vest in five equal annual installments beginning on the date of grant.
(2)
The options vest in five equal annual installments beginning on the first anniversary of the date of grant.
(3)
Mr. Hart’s options were forfeited in connection with his termination of employment on March 11, 2013.
Potential Payments upon Termination of Employment or Change in Control
As noted above, during 2013, we maintained employment agreements with Mr. Walton and Mr. Null. Prior to his resignation, we were party to an employment agreement with Mr. Hart.
Payments Made Upon Any Termination of Employment. Regardless of the manner in which an executive officer’s employment terminates, he is entitled to receive amounts earned during his term of employment including accrued but unpaid base salary through the date of termination, accrued but unpaid annual bonus, unreimbursed employment-related expenses owed to the executive officer under our policies and accrued but unpaid vacation pay. The executive is also entitled to all accrued benefits under any of our employee benefit programs (in accordance with the terms of such programs). These payments do not differ from payments made upon termination to all employees.
Payments Made Upon Termination Without Cause or Good Reason. Each of the employment agreements provides that if the executive is terminated without Cause, or the executive terminates his employment with us for Good Reason, the executive will be entitled to receive his base salary for 12 months and any unpaid bonus for the previous fiscal year and a pro rata portion of his bonus for the then-current fiscal year.
Cause generally means the executive’s (i) conviction or plea of no contest for or indictment on a felony or a crime involving moral turpitude or the commission of any other act or omission involving dishonesty or fraud, which involves a material matter, with respect to us or any of our customers or suppliers, (ii) substantial and repeated failure to perform his duties, (iii) gross negligence or willful misconduct that is harmful to us, (iv) conduct tending to bring us into substantial public disgrace or disrepute and (v) breach of the restrictive covenants in the employment agreement.
Good Reason generally means, without the executive’s prior written consent, (i) a reduction in, or failure to pay when due, the executive’s base salary, (ii) a material diminution in the executive’s titles or duties inconsistent with his position, (iii) failure to pay any annual bonus when due, (iv) a material reduction in the employee benefits offered to the executive that is not also applicable to our other executive employees and (v) a change in the executive’s principal office to a location more than 50 miles from Palm Beach Gardens, Florida.
Restrictive Covenants. Each of the agreements contains confidentiality and customer and employee nonsolicitation covenants that apply during the executive’s employment with us and for a period of 12 months after his termination of employment.
Separation Agreement with Mr. Hart. As discussed earlier, on March 11, 2013, Mr. Hart resigned as the Chief Executive Officer and President of the Company and as a member of the Company’s Board of Managers. Effective March 11, 2013, the Company and Mr. Hart entered into a separation agreement, under which Mr. Hart is receiving $537,900 in severance from the Company in bi-weekly installments through March 2014. Pursuant to Mr. Hart’s separation agreement, he is subject to confidentiality and customer and employee nonsolicitation covenants for a period of 12 months after his termination of employment.
Compensation Committee Interlocks and Insider Participation
None of our executive officers served on the board of directors or the compensation committee (or equivalent) of the board of directors of another entity whose executive officer served on our Board of Managers. Other than our Chief Executive Officer, none of our officers or employees participated in the deliberations of our Board of Managers concerning executive officer compensation.
Director Compensation During 2013
We compensate for service as managers only the members of our Board of Managers that are independent from the Company. Mr. Emanuel was the only independent manager during 2013.
(1)
Reflects fees received for service on our Board of Managers and Audit Committee.
(2)
Consists of $125,000 for monthly consulting fees and $3,347 for Company paid expenses.
(3)
As of December 31, 2013, Mr. Emanuel had 20,000 outstanding options to purchase member units.
Consulting Agreement with Mr. New. In connection with Mr. New’s retirement as Chief Executive Officer and President, effective September 1, 2011, we entered into an agreement with Mr. New. Pursuant to the agreement, Mr. New remains subject to confidentiality provisions and the non-compete and non-solicitation obligations set forth in his prior employment agreement through December 31, 2014. On March 1, 2013 the Company and Mr. New amended the agreement to extend the term for an additional three years and increased the consulting fee to $12,500 per month in lieu of any final consulting payment that would have otherwise been due under the agreement.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The following table sets forth information with respect to the beneficial ownership of outstanding membership interest units of the Company as of March 23, 2014 by (a) any person or group who beneficially owns more than five percent of such units, (b) each of our managers and executive officers and (c) all managers and executive officers as a group. On March 23, 2014, there were 23,549,812 units outstanding and 392,969 additional units issuable upon the exercise of vested options.
An asterisk (*) in the Percent of Class column indicates beneficial ownership of less than 1 percent.
(1)
Unless otherwise specified, the address of each beneficial owner listed in the table below is c/o Aurora Diagnostics, Inc. 11025 RCA Center Drive, Suite 300, Palm Beach Gardens, FL 33410.
(2)
Beneficial ownership is determined in accordance with Rule 13d-3 of the Exchange Act and generally includes voting and investment power with respect to securities, subject to community property laws, where applicable.
(3)
Represents 4,290,810 units held by Summit Ventures VI-A, L.P.; 1,789,329 units held by SV VI-B Aurora Holdings, L.P.; 137,061 units held by Summit VI Entrepreneurs Fund, L.P.; 89,255 units held by Summit VI Advisors Fund, L.P.; 48,088 units held by Summit Investors VI, L.P.; 3,939,915 units held by Summit Partners Private Equity Fund VII-A, L.P.; 2,366,540 units held by SPPE VII-B Aurora Holdings, L.P. Summit Partners, L.P. is the managing member of Summit Partners VI (GP), LLC, which is the general partner of Summit Partners VI (GP), L.P., which is the general partner of each of Summit Ventures VI-A, L.P., Summit Ventures VI-B, L.P., Summit VI Advisors Fund, L.P., Summit VI Entrepreneurs Fund, L.P. and Summit Investors VI, L.P. Summit Partners, L.P. is also the managing member of Summit Partners PE VII, LLC, which is the general partner of Summit Partners PE VII, L.P., which is the general partner of each of Summit Partners Private Equity Fund VII-A, L.P. and Summit Partners Private Equity Fund VII-B, L.P. Summit Partners, L.P., through an investment committee currently composed of Peter Y. Chung and Martin J. Mannion, has voting and dispositive authority over the shares held by each of these entities and therefore beneficially owns such shares. Each of the Summit Entities, Mr. Chung and Mr. Evans disclaim beneficial ownership of the shares, except, in each case, to the extent of each such Reporting Person’s pecuniary interest therein. The address of each of the Summit Partners entities is 222 Berkeley Street, 18th Floor, Boston, MA 02116.
(4)
KRG Capital Management, L.P. is the general partner of each of KRG Capital Fund IV, L.P., KRG Capital Fund IV-A, L.P., KRG Capital Fund IV (PA), L.P. and KRG Capital Fund IV (FF), L.P., each of which is a stockholder of KRG Aurora Blocker, Inc. KRG Capital Management, L.P., as the general partner of the KRG fund entities, through a nine person investment committee with respect to the Class IV series of funds, including Steven Neumann and Blair J. Tikker, has voting and dispositive authority over the shares held by KRG Aurora Blocker, Inc. and, therefore, beneficially owns such shares. Decisions of the investment committee are made by a vote of the majority of its members and no individual member of the investment committee has voting or dispositive authority over the shares. Steven Neumann, Blair J. Tikker and Bennett Thompson are members of KRG Capital, LLC with respect to the Class IV series of funds, which is the general partner of KRG Capital Management, L.P., and each disclaims beneficial ownership of the shares held by KRG Capital Management, L.P. Affiliates of Steven Neumann are members of KRG Co-Investment, LLC, and each disclaims beneficial ownership of the shares held by KRG Capital Management, L.P. The address of each of the KRG Capital Partners entities is 1800 Larimer St., Suite 2200, Denver 80202.
(5)
Includes 30,144 units held by Mr. Null individually. Also includes exercisable options to purchase 44,880 units by Mr. Walton and 81,762 units by Mr. Null.
(6)
Represents units held by Summit Partners.
(7)
Represents units held by KRG Capital Partners.
(8)
Includes exercisable options to purchase 13,000 units.
Equity Compensation Plan Information
The following table provides information as of December 31, 2013 regarding compensation plans under which the Company’s equity securities are authorized for issuance.
(1)
Consists of our 2011 Incentive Plan.
(2)
Consists of outstanding options to purchase Aurora Holdings Units granted under our 2011 Incentive Plan.
(3)
Weighted average exercise price of outstanding options to purchase Aurora Holdings Units.
(4)
The Company does not maintain any equity compensation plans that have not been approved by the Company’s security holders.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
Review, Approval or Ratification of Transactions with Related Persons
Our Board has adopted written policies and procedures for the review and approval or ratification of transactions involving us and related persons, which include our managers, executive officers, persons owning five percent or greater of our equity securities, their immediate family members and other related persons required to be reported under Item 404 of Regulation S-K. The policy governs all transactions between us and a related person in which the amount involved exceeds $10,000 and in which the related person has a direct or indirect material interest.
Related person transactions must be approved in advance by our audit committee whenever possible or ratified as promptly as possible thereafter. Each proposed transaction with a related person must be submitted to our audit committee, together with the facts and circumstances of the proposed transaction, including (i) the related person’s relationship to the Company and interest in the transaction, (ii) the material facts of the proposed transaction, (iii) the benefits to the Company of the proposed transaction, (iv) the availability of other sources of comparable products or services, and (v) an assessment of whether the transaction is on terms comparable to terms available to an unrelated third party or to employees generally.
The audit committee shall consider all relevant facts and circumstances available to it and shall approve or ratify only those related person transactions that are in, or not inconsistent with, the best interests of the Company and its members, as the audit committee determines in good faith, in accordance with our policies and procedures.
Second Amended and Restated Limited Liability Company Agreement of Aurora Holdings
The members and managers of Aurora Holdings have entered into a Second Amended and Restated Limited Liability Company Agreement, dated as of July 6, 2011, which we refer to as the LLC Agreement. Pursuant to the LLC Agreement, a board of managers of Aurora Holdings oversees the operations of Aurora Holdings and, subject to certain exceptions set forth below, manages the business and affairs of Aurora Holdings and exercises all rights and powers of Aurora Holdings.
The board of managers of Aurora Holdings currently consists of eight managers. The LLC Agreement provides for the appointment of at least eight managers, which are appointed as follows:
·
KRG Capital Partners has the right to appoint up to three managers, subject to the conditions provided in the LLC Agreement;
·
the Chief Executive Officer of our subsidiary Aurora Diagnostics, LLC is a manager;
·
Summit Partners and KRG Capital Partners have the right to appoint mutually one independent manager; and
·
Summit Partners has the right to appoint the other managers (which, as of the date hereof, consists of three managers).
In addition, Board has the authority to increase its size and fill additional positions, and the board has appointed Mr. New, our former Chief Executive Officer, as an additional manager. Mr. Crowley, our Chief Executive Officer, is not currently serving on the board.
The LLC Agreement provides that, so long as KRG Capital Partners and Summit Partners are each entitled to appoint an equal number of managers, the number and composition of the board of managers (or similar governing body) of each subsidiary of Aurora Holdings is to consist of an equal number of managers appointed by KRG Capital Partners and Summit Partners. The Chief Executive Officer of Aurora Diagnostics, LLC is also to be a manager on the board of managers (or similar governing body) of each subsidiary of Aurora Holdings.
Under the LLC Agreement, certain transactions between Aurora Holdings and its affiliates require the approval of a majority of the disinterested managers on the board of managers of Aurora Holdings. In addition, the following actions require the approval of both Summit Partners and KRG Capital Partners:
·
the dissolution or liquidation of Aurora Holdings or Aurora Diagnostics, LLC, except in connection with corporate conversions and reorganizations or a sale of the enterprise described below;
·
the sale of Aurora Holdings or Aurora Diagnostics, LLC, unless the transaction results in specified returns on investment for Summit Partners and KRG Capital Partners;
·
the acquisition, by Aurora Holdings or any subsidiary, of any business for consideration in excess of $20 million or any businesses for aggregate consideration in excess of $60 million;
·
the issuance of any equity except (i) for issuances pursuant to an equity incentive plan, (ii) in connection with a public offering of equity otherwise permitted by the LLC Agreement and (iii) for issuances to acquisition targets (or their equityholders) in connection with or related to acquisitions;
·
the incurrence, by Aurora Holdings or any subsidiary, of any new indebtedness or the refinancing of any existing indebtedness, except (i) for amounts of less than $5 million in the aggregate and (ii) to acquisition targets (or their equityholders) in connection with or related to acquisitions;
·
the sale, transfer, termination, assignment, or other disposal of, by Aurora Holdings or any subsidiary of any (i) equity interest of any subsidiary, or (ii) right to vote the equity interests of any affiliated physician-owned professional organization, except in connection with an initial public offering of equity or a sale of the enterprise described above;
·
the hiring, firing, material reduction of the employment responsibilities of, or taking of any other action that could give rise to a termination for “Good Reason” or other similar term under any employment agreement or equity agreement between Aurora Holdings and its Chief Executive Officer, Chief Operating Officer or Chief Financial Officer;
·
the increase of the number of managers serving on the board of managers of Aurora Holdings at any time when KRG Capital Partners has a right to appoint three managers to the board of managers of Aurora Holdings; or
·
the development or implementation of any strategic plan that would materially affect Aurora Holdings’ or Aurora Diagnostics, LLC’s business and business activities ancillary thereto, or materially alter Aurora Holdings’ or Aurora Diagnostics, LLC’s business tactics.
Further, subject to the approval requirements in connection with a sale of the enterprise described above, each of Summit Partners and KRG Capital Partners has a right to force a sale of Aurora Holdings or Aurora Diagnostics, LLC. The LLC Agreement requires Aurora Holdings to make certain tax distributions to its members each year, which distributions are designed to approximate and offset the tax liability resulting from membership in Aurora Holdings for the preceding fiscal year.
The LLC Agreement also contains customary transfer restrictions with respect to the Aurora Holdings Units, including rights of first refusal in favor of Aurora Holdings and certain equityholders. In addition, the LLC Agreement grants certain customary preemptive rights on new issuances of Aurora Holdings Units and customary tag-along or co-sale rights on certain transfers of Aurora Holdings Units.
Registration Rights Agreement
We are party to a Registration Rights Agreement with certain of our members. Under our Registration Rights Agreement, we have granted certain of our members demand, shelf and piggy-back registration rights subject to customary terms, conditions and limitations.
Management Services Agreement
On June 2, 2006, we, through a wholly-owned subsidiary of Aurora Holdings, and two members of Aurora Holdings, Summit Partners and GSO Capital Partners, entered into a Management Services Agreement, which we refer to as the Management Services Agreement. On June 12, 2009, the Management Services Agreement was amended to substitute KRG Capital Partners for GSO Capital Partners. Under the Management Services Agreement, Summit Partners and KRG Capital Partners provide certain financial and management advisory services in connection with the general business planning and forecasting and acquisition and divestiture strategies. In exchange for the services, we pay an annual fee equal to 1.0 percent of the revenue of Aurora Holdings, plus expenses. In connection with the third amendment to the Company’s credit facility in April 2013, the Company has agreed not make any payments of management or similar fees until payment in full of all loans under the credit facility, provided that such management or similar fees shall continue to accrue. As of December 31, 2012 and 2013, $1.1 million and $3.6 million, respectively, of management fees under the Management Services Agreement are reflected in accounts payable and accrued expenses in the accompanying consolidated balance sheets. The consolidated statement of operations includes management fees of $2.8 million, $2.9 million and $2.5 million for the respective years ended December 31, 2011, 2012 and 2013. During 2011, 2012 and 2013, we paid management fees totaling $2.3 million, $3.3 million and $66,000, respectively. In connection with the third amendment to the Company’s credit facility in April 2013, the Company has agreed not make any payments of management or similar fees until payment in full of all loans under the credit facility, provided that such management or similar fees shall continue to accrue.
Other Related Party Transactions
In connection with Mr. New’s retirement as the Company’s Chief Executive Officer effective September 1, 2011, the Company entered into a consulting agreement with Mr. New. See “Compensation Discussion and Analysis” in Part III, Item 11 of this Annual Report.
Board Independence
Of our eight managers, only Mr. Emanuel is independent (with independence being determined in accordance with the definition of independence under the NASDAQ Global Market standards, as if they applied to us), meaning
that he does not have, and has never had, a relationship that would interfere with the exercise of independent judgment in carrying out his responsibilities as a manager. None of our other current managers are independent.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Audit Fees and Services
McGladrey LLP served as the Company’s independent registered public accounting firm for the years ended December 31, 2012 and 2013. The following tables present fees for professional audit services rendered by McGladrey LLP for the audit of the Company’s annual financial statements for the years ended December 31, 2012 and 2013.
(1) Audit Fees consisted of professional services performed for the audit of the Company’s annual financial statements and the review of the Company’s quarterly financial statements.
Pre-approval Policies and Procedures
Our audit committee has adopted a policy requiring the pre-approval by the audit committee of all audit services, whether such services are to be provided by our principal independent auditor or other accounting firms. The policy also requires pre-approval by the audit committee of all other services (review, attest and non-audit) to be provided by our independent auditor; provided, however, that de minimis non-audit services may instead be approved in accordance with applicable SEC rules, although no non-audit services were approved pursuant to this exception in 2013.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a)
Documents Filed as Part of this Report. The following documents are filed as part of this Annual Report:
(1) Consolidated Financial Statements. Included in Part II, Item 8 are the consolidated financial statements, the notes thereto and the report of the Independent Registered Public Accounting Firm.
(2) Financial Statement Schedules. Schedule II - Valuation and Qualifying Accounts is filed as a part hereof. All other schedules have been omitted because the information required to be set forth therein is not applicable or is included in the consolidated financial statements or notes thereto.
Aurora Diagnostics Holdings, LLC
Schedule II-Valuation and Qualifying Accounts
Years Ended December 31, 2011, 2012 and 2013 (in thousands):
(1)
Represents the Allowance for Doubtful Accounts recorded in connection with the application of acquisition accounting for the 2011 acquisitions.
(3) Exhibits. The exhibits listed in the accompanying Exhibit Index are incorporated by reference as part of this Annual Report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name
Title
Date
/s/ Daniel D. Crowley
Daniel D. Crowley
Chief Executive Officer (principal
executive officer)
March 25, 2014
/s/ Michael C. Grattendick
Michael C. Grattendick
Vice President, Controller and Treasurer (principal financial and accounting officer)
March 25, 2014
/s/ Peter J. Connolly
Peter J. Connolly
Chairman of the Board of Managers
March 25, 2014
/s/ Thomas S. Roberts
Thomas S. Roberts
Manager
March 25, 2014
/s/ Christopher Dean
Christopher Dean
Manager
March 25, 2014
/s/ Bennett Thompson
Bennett Thompson
Manager
March 25, 2014
/s/ Steven Neumann
Steven Neumann
Manager
March 25, 2014
/s/ Blair Tikker
Blair Tikker
Manager
March 25, 2014
/s/ James C. New
James C. New
Manager
March 25, 2014
/s/ James Emanuel
James Emanuel
Manager
March 25, 2014
EXHIBIT INDEX
Exhibit
Number
Description
3.1
Certificate of Formation of Aurora Diagnostics Holdings, LLC (filed as Exhibit 3.1 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
3.2
Second Amended and Restated Limited Liability Company Agreement of Aurora Diagnostics Holdings, LLC (filed as Exhibit 3.2 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
3.3
First Amendment to the Second Amended and Restated Limited Liability Company Agreement of Aurora Diagnostics Holdings, LLC
4.1
Indenture, dated December 20, 2010, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics Financing, Inc., the guarantors named therein and U.S. Bank National Association (filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
4.2
First Supplemental Indenture, dated December 31, 2011, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics Financing, Inc., the guarantors named therein and U.S. Bank National Association (filed as Exhibit 4.2 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
4.3
Second Supplemental Indenture, dated December 31, 2011, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics Financing, Inc., the guarantors named therein and U.S. Bank National Association (filed as Exhibit 4.3 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
4.4
Third Supplemental Indenture, dated June 2, 2011, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics Financing, Inc., the guarantors named therein and U.S. Bank National Association (filed as Exhibit 4.4 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
4.5
Fourth Supplemental Indenture, dated August 12, 2011, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics Financing, Inc., the guarantors named therein and U.S. Bank National Association (filed as Exhibit 4.5 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
4.6
Form of 10.750% senior notes due 2018 (Included as Exhibit A to Exhibit 4.1 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
4.7
Amended and Restated Registration Rights Agreement, dated June 12, 2009, by and among Aurora Diagnostics Holdings, LLC and each of the signatories thereto (filed as Exhibit 4.8 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.1
Credit and Guaranty Agreement, dated May 26, 2010, by and among Aurora Diagnostics, LLC as Borrower, Aurora Diagnostics Holdings, LLC and certain subsidiaries and affiliates of Aurora Diagnostics, LLC as Guarantors, the various lenders party thereto, Barclays Bank PLC as Administrative Agent and Collateral Agent, Barclays Capital, Morgan Stanley Senior Funding, Inc. and UBS Securities LLC as Joint Lead Arrangers and Joint Bookrunners, Morgan Stanley Senior Funding, Inc. as Syndication Agent and UBS Securities LLC as Documentation Agent (filed as Exhibit 10.1 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.2
Amendment to Credit and Guaranty Agreement, dated December 20, 2010, by and among Aurora Diagnostics, LLC as Borrower, Aurora Diagnostics Holdings, LLC and certain subsidiaries and affiliates of Aurora Diagnostics, LLC as Guarantors, Barclays Bank PLC as Administrative Agent and Collateral Agent and the lenders party thereto (filed as Exhibit 10.2 to the Company’s Annual Report on Form 10-K filed on March 23, 2012 and incorporated herein by reference).
10.3
Amendment No. 2 to Credit and Guaranty Agreement, dated October 26, 2012, by and among Aurora Diagnostics, LLC as Borrower, Aurora Diagnostics Holdings, LLC and certain subsidiaries and affiliates of Aurora Diagnostics, LLC as Guarantors, Barclays Bank PLC as Administrative Agent and Collateral Agent and the lenders party thereto (filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed on November 13, 2012 and incorporated herein by reference)
Exhibit
Number
Description
10.4
Amendment No. 3 to Credit and Guaranty Agreement, dated April 24, 2013, by and among Aurora Diagnostics, LLC as Borrower, Aurora Diagnostics Holdings, LLC and certain subsidiaries and affiliates of Aurora Diagnostics, LLC as Guarantors, Barclays Bank PLC as Administrative Agent and Collateral Agent and the lenders party thereto (filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed on May 15, 2013 and incorporated herein by reference)
10.5
Senior Management Agreement, dated October 2006, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics, LLC, James C. New and Fred Ferrara* (filed as Exhibit 10.7 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.6
First Amendment to Senior Management Agreement, dated October 2006, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics, LLC, James C. New and Fred Ferrara* (filed as Exhibit 10.8 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.7
Senior Management Agreement, dated April 2007, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics, LLC, James C. New and Michael Null* (filed as Exhibit 10.9 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.8
Aurora Diagnostics Holdings, LLC 2011 Equity Incentive Plan* (filed as Exhibit 10.11 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.9
First Amendment to the Aurora Diagnostics Holdings, LLC 2011 Equity Incentive Plan* (filed as Exhibit 10.12 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.10
Form of Unit Option Award Certificate under the Aurora Diagnostics Holdings, LLC 2011 Equity Incentive Plan* (filed as Exhibit 10.13 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.11
Consulting Agreement, dated July 6, 2011, by and between Aurora Diagnostics, LLC and James C. New* (filed as Exhibit 10.14 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.12
First Amendment to Consulting Agreement, dated March 1, 2013, by and between Aurora Diagnostics, LLC and James C. New * (filed as Exhibit 10.23 to the Company’s Annual Report on Form 10-K filed on March 25, 2013 and incorporated herein by reference)
10.13
Management Consulting Agreement, dated March 15, 2013, between Dynamic Healthcare Solutions, LLC and Aurora Diagnostics Holdings, LLC * (filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed on May 15, 2013 and incorporated herein by reference)
10.14
Purchase Agreement, dated December 14, 2010, by and among Aurora Diagnostics Holdings, LLC, Aurora Diagnostics Financing, Inc., the Guarantors party thereto, Morgan Stanley & Co. Incorporated, Barclays Capital, Inc. and UBS Securities LLC (filed as Exhibit 10.15 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.15
Management Rights Agreement, dated June 2, 2006, by and among Aurora Diagnostics Holdings, LLC and each of the signatories thereto (filed as Exhibit 10.16 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.16
Management Rights Agreement, dated June 12, 2009, by and among KRG Capital Partners, L.L.C., KRG Aurora Blocker, Inc. and Aurora Diagnostics Holdings, LLC (filed as Exhibit 10.17 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.17
Amended and Restated Management Services Agreement, dated June 12, 2009, by and among Summit Partners, L.P., KRG Capital Management, L.P., and Aurora Diagnostics, LLC (filed as Exhibit 10.18 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.18
First Amendment to Amended and Restated Management Services Agreement, dated May 20, 2010, by and among Summit Partners, L.P., KRG Capital Management, L.P., and Aurora Diagnostics, LLC (filed as Exhibit 10.19 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
Exhibit
Number
Description
10.19
Form of Management Agreement by and between Aurora Diagnostics, LLC and certain of its affiliated practice subsidiaries (filed as Exhibit 10.20 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.20
Form of Nominee Agreement by and between Aurora Diagnostics, LLC and certain of its affiliated practice subsidiaries (filed as Exhibit 10.21 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.21
Form of Non-Alienation Agreement by and between Aurora Diagnostics, LLC and certain of its affiliated practice subsidiaries (filed as Exhibit 10.22 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
10.22
Form of Services Agreement by and between Aurora Diagnostics, LLC and certain of its affiliated practice subsidiaries (filed as Exhibit 10.23 to the Company’s Registration Statement on Form S-4, No. 333-176790, and incorporated herein by reference)
21.1
List of subsidiaries of Aurora Diagnostics Holdings, LLC
31.1
Certification of the Principal Executive Officer, pursuant Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of the Principal Financial Officer, pursuant Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of the Principal Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of the Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
*
Indicates management contracts and compensatory plans and arrangements