Case Study 4 Unit 8 - Sooner Clinics

United Health Services Corporation

United Health Services Corporation (UHSC) is a large integrated healthcare business that

serves northern and central Oklahoma. In response to healthcare reform, UHSC has been

acquiring primary care practices to capture market share. The basic competitive strategy has been

to select geographically well-placed practices that will attract and retain patients. UHSC believes

this strategy is critical in the shift to population health management.

Initial acquisitions were not entirely successful, primarily because of overvaluation of

downstream revenue. In essence, UHSC overpaid for practices in anticipation of higher referrals

and revenue after acquisition. Most of these practices were small with only one physician. UHSC

quickly learned that, typically, these practices had insufficient patient volume to cover the

substantial fixed costs of running a practice, had a payer mix of more than half from less

profitable Medicare and Medicaid sources, included a physician who was not seeing an adequate

number of patients per day, and paid insufficient attention to the efficient operation of the

practice. On the plus side, they had a loyal patient base and were usually seen by their

communities as providing an important service.

Perhaps as a result of the less-than-successful experience with small primary care

practices, UHSC next acquired a much larger practice- Anderson Clinic. The large patient

volume, lucrative payer mix, and busy physicians have made Anderson Clinic a financial success

for UHSC. However, there have been substantial problems with this acquisition as well. Most

important, changing the culture of a large practice has been difficult. Most Anderson Clinic

physicians have been with the practice a long time and resisted many of the clinical and customer

processes introduced by UHSC. Many implementation problems have occurred, and complaints

from many physicians have required a lot of UHSC management time. One UHSC manager said,

''Anderson gives us most of our profit, but it also gives us most of our headaches."

This less-than-successful experience with small primary care practices and a large

practice prompted UHSC to review its practice acquisition strategy. After several months of

study, UHSC decided that, although it can help to reduce practice costs and increase efficiency,

the revenue side of the practice is most important. Thus, UHSC has established five criteria for

evaluating the acquisition of a practice:

1. Adequate patient volume for the number of providers

2. Viable payer mix

3. Physician productivity

4. Effective operations, including revenue cycle management, pricing of services, coding and

documentation, and service mix

5. Qualitative factors, including patient referrals from customer service, organizational culture,

quality improvement, and community relations

These criteria have resulted in UHSC adopting a strategy of acquiring "not-too-big and

not-too-small" primary care practices. These multi-physician practices are not as financially

lucrative as larger practices such as the Anderson Clinic, but incorporation of the practices into

the organization has been much easier. Thus, management has decided that this type of practice

works best for UHSC and has been looking to acquire more practices of this type.

In the Sooner region of central Oklahoma, UHSC has acquired several practices in the

southern end but does not yet have a practice in the northern end. UHSC practices provide

general primary care services only, but UHSC is exploring provision of some specialty services,

such as pain clinics. UHSC plans to try some specialty services in a few practices to determine

whether there is a business case to support an extensive rollout.

Sooner Clinics

One of the primary care practices that UHSC wants to acquire is Sooner Clinics, which is

located in the northern end of the Sooner region. Several years ago, UHSC had targeted Sooner

Clinics for acquisition but attempts to interest the two founding partners had failed. At the time,

the founders had no interest in being purchased by a larger organization.

Nevertheless, Sooner Clinics was too inviting a takeover target to be overlooked for long.

UHSC believes that acquisition of the practice would attract and retain new patients to the

network; increase referrals to other UHSC services; and better prepare UHSC for new value-

based payment models. Sooner would benefit from access to a larger network and greater net

revenue from the UHSC expertise in boosting physician productivity.In addition, some UHSC

senior managers know the two Sooner Clinics' founders, having served on various community

committees together. "The Sooner docs see things the way we see them," a UHSC senior

manager recently said. For these reasons, UHSC has continued to follow the physicians and

business activities of Sooner Clinics.

Today, Sooner Clinics operates two walk-in facilities and consists of five physicians-

three are board certified in family practice and two in internal medicine. Three work full-time

and two work part-time, resulting in four full-time equivalent (FTE) physicians. Sooner Clinics

is organized as a for-profit corporation, but for tax purposes the business is classified as an S

corporation. (In an S corporation, the business pays no taxes.Rather, the corporation's taxable

income is constructively distributed to the owners, who pay personal taxes on the income).

Sooner Clinics was founded ten years ago by two physicians (the part-timers) who

wanted to have more free time than their solo practices allowed.Initially, Sooner Clinics had

only one location, but a second was recently added. The downtown clinic, whose patients

predominantly come directly from work sites, is open Monday through Friday from 8am to 2pm

The midtown clinic, whose patients mostly come from home, is open Monday through Saturday

from 8am to 8pm, and also provides a few specialty services, including a diabetes care service.

Both downtown and midtown clinics are open 52 weeks per year. Exhibit 4.1 provides the

average number of visits by day for the two clinics, and exhibit 4.2 shows the current payer mix.

With the current medical and clerical staffs, as well as clinic space, Sooner Clinic's patient

volume can grow as much as 50 percent without the need for additional personnel or facilities.

The five physicians who make up Sooner Clinics own the business.However, the two

founding partners control the business: Each has a 35 percent ownership stake. The remaining

three partners each own 10 percent of the business.Because the founding partners are looking to

fully retire in the near future, they would like to sell the business. The remaining partners are less

enthusiastic about selling out, but as minority owners their alternatives are limited.

The most recent income statement of the business is provided in exhibit 4.3. Note that the

statement uses the effective average tax rate applicable if Sooner Clinics were to file as a C

corporation. A condensed balance sheet is contained in exhibit 4.4. If UHSC acquires Sooner

Clinics, it would maintain the current debt ratio into the foreseeable future and has an agreement

with a lending institution to borrow funds at a rate of 6 percent. In addition to assets used in the

day-to-day operations of the business, Sooner Clinics holds non-operating assets (marketable

securities and investment properties). The marketable securities represent a rainy-day fund, and

the investment properties were acquired to diversify the asset holdings and revenue stream of

Sooner Clinics.

Sooner Clinic's cost structure, listed in exhibit 4.4, is expected to hold in the immediate

future, with fixed costs (including depreciation) increasing at a 2 percent annual rate.

Furthermore, Sooner Clinics would have to invest roughly $25,000 each year (in Year 1 dollars)

in new equipment. Inflation is expected to increase these capital investment amounts by 2

percent per year.

Wilde and Sullivan

To ensure that it did not overpay for a primary care practice again, UHSC retained the

services of Wilde and Sullivan, an Oklahoma firm that specializes in physician practice valuation

and appraisal. Heidi Wilde, the managing partner, had recently valued four practices in the

central Oklahoma region, so she decided to use this experience as a starting point in estimating

the value of Sooner Clinics to UHSC. Selected data for these acquisitions are shown in exhibit

4.5.

First, Heidi estimated the expected revenue growth rate for the short term (Years 1-5) and

the long term (Years 6 and beyond). In reviewing the data in exhibit 4.5, Heidi noted that Sooner

Clinics and all of the recent practice acquisitions are located in the same geographic area, so it is

reasonable to assume that Sooner Clinics faces the same estimated long-term (Years 6 and

beyond) revenue growth rate of 2 percent. However, Heidi has found that the short-term (Years

1- 5) revenue growth rate of a particular practice depends on the current level of physician

productivity: Clinics with relatively low physician productivity have higher short-term (Years 1-

5) revenue growth rates because of room for productivity increases.Heidi also believes that

there is an opportunity for improved coding and documentation, better revenue cycle

management, and an updated chargemaster at Sooner Clinics.

Next, Heidi assembled the information required for the discounted cash flow (DCF)

approach, including the estimated required rate of return on an equity investment in Sooner

Clinics. Little market data about primary care practices are available to offer guidance, but the

current yield on long-term Treasury bonds is 4 percent, and the historical risk premium on the

market, which reflects the premium on an average-risk common stock investment, is about 5

percent. Of course, significant risk and liquidity differences exist between direct ownership of a

relatively small group practice and ownership of the stock of a large, publicly traded corporation.

UHSC also informed Heidi that it estimates its tax rate will be 20 percent for the foreseeable

future.

In addition to the DCF approach, Wilde and Sullivan use three market multiple methods

to value medical practices: physician FTEs, net patient revenue, and EBITDA (earnings before

interest, taxes, depreciation, and amortization). In these methods, a proxy for value is multiplied

by a market-determined factor that best expresses the relationship of that proxy to equity value.

Instructions

With this information, Heidi started the task of estimating the value of Sooner Clinics to

UHSC and making a recommendation on whether UHSC should make the acquisition.Help

Heidi!

Questions for case.

Question 1

What are some reasons in favor of the acquisition of Sooner Clinics by UHSC? Are there concerns about the acquisition?

Question 2

As a baseline, what is the estimated value of Sooner Clinics using the free operating cash flow method, the free cash flow to equity holders method, and the market multiple method?

Explain any input data that you calculate.

Question 3

You should have found that the values produced by the five methods are relatively consistent, but there are differences.

a. What does each method assume about the source of value?

b. Which method(s) do you believe to be the best for Sooner Clinics? Justify your choice.

Question 4

Suppose another health system is interested in acquiring SoonerClinics. Does the value of Sooner Clinics depend on who makes the acquisition? Explain why or why not.

Question 5

a. Are taxes relatively important in determining the value of Sooner Clinics?

b. Suppose the Year 6+ revenue growth rate could be as low as 1 percent and as high as 3 percent.Is the 6+ revenue growth rate relatively important in determining the value of Sooner Clinics?

Question 6

Should all partners receive the same per share amount if the practice is sold? Explain.

Question 7

a. From the perspective of the target, how would the analysis change if the acquirer planned to finance half of the acquisition price with debt? No calculations are required.

b. From the perspective of the acquirer, how would the analysis change if the acquirer planned to finance half of the acquisition price with debt? No calculations are required.

c. Is the current percentage of debt in the capital structure of Sooner Clinics relatively high or low? Does this make it a more or less attractive acquisition target? Explain your answer.

Question 8

What is your single best estimate of the value of Sooner Clinics?

Question 9

In your opinion, what are three key learning points from this case?