Sound practices in imaging valuations: What a realistic buyer/seller would do

It’s no secret that freestanding imaging providers are expecting to see revenues decrease in 2014. The final rule for the 2014 Medicare Physician Fee Schedule, which was released by the Centers for Medicare and Medicaid Services (CMS) in November, announced significant reductions in reimbursement for imaging-heavy specialties, and these reimbursement cuts will have major effects on future revenue streams for imaging facilities all over the country.

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A noteworthy change in the 2014 final rule is that CMS has created separate cost-to-charge ratios for CT and MRI procedures and increased the utilization rate for CT and MRI from 75 percent to 90 percent. While this change has resulted in a positive reimbursement effect for many other diagnostic imaging modalities, it has a significant negative effect on CT and MRI reimbursement. This will result in an overall negative impact to revenue for all types of freestanding imaging providers but will have a more substantial impact on those imaging centers heavily dependent on CT and MRI.

When valuing a business with recent or expected declines in reimbursement, it is important to understand the operating expenses and capital requirements at the disposal of management that can (and we should assume will) be reduced in order to maintain positive margins. Assuming the business has competent managers, there will be a reaction to declining revenue, and the inputs available to management to maintain margin are numerous. Some of the ways to maintain positive margins are soundly described by Howard Berger, CEO of RadNet, when describing how the publicly traded imaging company is expecting to reduce costs by an estimated $30 million in response to expected reimbursement declines:

“First, we will be adjusting staffing levels at our centers and in the regional operations that support them … Second, our continuing information technology initiatives will reduce our costs and increase operating efficiencies … Third with a portion of our capital expenditures budget, we will look to opportunistically purchase some equipment, which we currently utilize through operating leases … Fourth, we are in the process of renegotiations with certain vendors who provide us medical supplies, office supplies and contrast materials. Our scale is paramount for success in these negotiations ... We are migrating our worker’s compensation insurance from a guaranty trust program to a modified self-insurance plan with stop loss reinsurance. Furthermore, we have renewed our property and casualty insurance at a significantly more favorable rate … In response to rising healthcare costs, we have modified our health insurance employee benefits … Lastly, we are in the process of consolidating all of our commercial banking business under one provider, the economies of scale from which will yield a significant banking fee savings.”
— S&P Capital IQ: RadNet, Inc. Q3 2013 Earnings Call

While RadNet is a larger, publicly traded company with significant economies of scale, the areas mentioned by Berger are areas in which many freestanding imaging centers can look to reduce costs to soften the impact of decreased reimbursement. A common mistake valuators make is to assume none of these adjustments would be made to a business with declining revenue. While academically it may make sense for expenses to continue to grow into the future, without thought given to realistic market participant behavior, projections result in exaggerated declining profits and cash flows such as those demonstrated in the charts below:

Scenario I: Academic projections

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Healthcare companies, to the best of their ability, respond accordingly to declining revenues. Management of public and private companies, for-profit and not for-profit, should be expected to perform accordingly. Because of this, the projections in Scenario I are not the most realistic way of looking at future costs when valuing imaging centers in this current environment. Although margins still may not remain at the same levels they were in the past, taking expected expense and capital requirement reductions into consideration when valuing imaging centers will result in more realistic projected profits and cash flows such as those in the following charts:

Scenario II: Realistic projections

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While there is no doubt that there is a deteriorating reimbursement environment surrounding freestanding imaging centers, managers at these centers should and will seriously look into ways to make strategic cost reductions in the future. Those that do not will most likely be forced to exit the market or be absorbed, resulting in accelerated opportunities for purchasing inexpensive assets and reduced competition for well-positioned freestanding imaging providers. Along with incorporating reduced expenses and capital requirements into projections, these other opportunies and factors also should be considered to make sound projections when valuing freestanding imaging providers. To assume no change in behavior given the current marketplace when making valuation projections under a discounted cash flow methodology would be unrealistic and would most likely generate valuation indications that are inconsistent with the way imaging centers are being transacted today.