Overcoming reimbursement hurdles for single-site and multi-platform imaging operators

Greg Henderson, Senior Financial Analyst, VMG Health

Nationwide, imaging operators are beginning to feel the impact of reimbursement cuts from the 2014 Medicare Physician Fee Schedule (“MPFS”) primarily associated with Computed Tomography (“CT”) and Magnetic Resonance Imaging (“MRI”) modalities. The reimbursement changes reduce the technical component of imaging reimbursement in 2014 for MRI and CT from approximately 25 percent to 30 percent and 8 percent to 11 percent, respectively, depending on the types of scans performed.

For Single Site Operators (“SSO”) and Multi-Platform Operators (“MPO”) which rely heavily on government payors, these reimbursement changes have the potential to adversely impact profitability and sustainability in 2014 and beyond. As a result, it is conceivable to predict the number of acquisitions of the SSO, and potentially MPO, will accelerate over the next 12 to 18 months as operators are challenged with maintaining margins with a high fixed cost, high capital business model.

The following discussion highlights the potential risks each of these operators face in the changing landscape and illustrates the potential impacts to profitably and the likelihood of consolidation.

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The single site operator, defined as both freestanding and in-office, faces the greatest impact from the 2014 Medicare reimbursement cuts should its payor mix rely heavily on government payors.

As an illustration, consider an SSO with a scan mix of 35 percent MRI, 15 percent CT and 50 percent ultrasound and x-ray. The average payor mix observed in VMG’s internal transaction database is approximately 30 percent government payors (Medicare, Medicaid, Tricare), approximately 35 percent commercial payors, and approximately 35 percent other payors (managed care, self-pay, etc.). All else equal, the decrease in MRI and CT reimbursement could potentially have a negative impact to earnings of greater than 55 percent.

Coupled with the high fixed cost nature of the business, future capital requirements and the access to said capital, the slightest variability in an SSO’s business model can create dramatic impacts to underlying earnings and business value.

The potential impact is magnified under this scenario due to the realization that as compared to a reduction in volume whereby certain variable expenses trend with the level of scan volume, a reduction of reimbursement is a direct hit to the operator’s bottom line.

[[{"fid":"19161","view_mode":"media_original","type":"media","attributes":{"height":356,"width":460,"style":"line-height: 1.538em;","alt":" - Figure 2","title":"Figure 2ch","class":"media-element file-media-original"}}]]Based on VMG’s 2014 internal diagnostic imaging database, the median SSO operates at a 19 percent EBITDA margin with approximately 33.4 percent of total operating costs designated as fixed. Compared to the MPO where fixed costs represent approximately 24.4 percent of total operating costs, the SSO has marginal operating error when faced with reimbursement cuts.

[[{"fid":"19162","view_mode":"media_original","type":"media","attributes":{"height":294,"width":460,"style":"line-height: 1.538em;","alt":" - Figure 3","title":"Figure 3","class":"media-element file-media-original"}}]]The potential impact to reimbursement also affects the SSO’s access to capital to maintain and or enhance equipment and technology. Over the last 24 months, VMG has valued over 50 SSOs with the average age of major imaging equipment in the range of approximately 7 to 9 years, highlighting the need for many of these SSOs to consider replacement. Replacement is sourced either through internal equity or debt financing, and given the potential for lower profit margins and a marginal industry outlook for the SSO, the likely result will be a higher cost of debt (when able to debt finance) and or more reliance on the SSO’s internally generated equity; likely a depletion of retained earnings or a capital call from the independent owner. The inability to leverage purchases with favorable credit will drive down returns and increase investment risk should reimbursement impacts continue.

The SSO does have opportunities to combat reimbursement pressures by increasing scan volume and renegotiating rates with commercial payors given the trend towards consumer driven health plans. Of course the former requires an agggressive short-term investment in advertising and marketing; however, if implemented correctly, with a focus on primary referral base and new providers, long-term success stave off pending reimbursement pressures. Alternatively, commercial payors are continuing to look for opportunities to decrease the cost of services to the payor population and given the increase in consumer driven health plan; SSOs can make strong arguments for increase in commercial reimbursement rates given their lower cost structure compared to a hospital based provider.

In summary, over the next 12 to 18 months, the likelihood of consolidation of the SSO is high but will ultimately depend on the specific operator. The challenge of the SSO is to identify opportunities to mitigate pricing pressure and drive value through concerted business practices. If the SSO is unable to adapt and find opportunities such as marketing or negotiation with commercial payors, it is highly likely the SSO will trend towards discussion of potential joint venture models or buy outs by hospitals, multi-platform operators or management companies.

Multi-Platform Operators

Multi-platform operators are diagnostic imaging businesses with multiple locations and provide multiple imaging modalities at each location. As with the SSO, the MPO also will encounter hardships due to the 2014 Medicare reimbursement cuts, but with the potential of economies of scale, operational efficiencies, and access to capital the MPO will be in a better financial and operational position than the SSO to endure reimbursement pressures.

Economies of scale and operational efficiencies are available in multiple facets of the MPO business. With multiple locations, MPO cost components, such as service contracts, administrative costs, and billing expense, can be diversified over multiple centers. As previously detailed, VMG’s 2014 internal diagnostic imaging database of SSO and MPO imaging centers depict a comparative operating cost structure that favors the size of the MPO, as indicated by a median EBITDA margin of 40.7 percent, approximately 22.0 percent higher than the SSO. As illustrated below, the MPO gains margin opportunities in almost every cost category, with particular efficiencies in repairs & maintenance and general & administrative expenses. While the former likely arise through "bulk" coverage on equipment contracts, the later highlights the operational efficiencies and ability for the MPO to consolidate business practices such as management oversight and billing. Staffing, as a percentage of revenue is higher under an MPO model, represents ample opportunities for the MPO to combat reimbursement pressure by leveraging operational staffing efficiencies which are not likely attainable in the SSO model. For instance, employed staff in the MPO model can potentially be utilized at multiple centers which will reduce the number of paid hours per scan. Although any decrease in reimbursement impacts the MPO’s net revenue, effective economies of scale and operational efficiencies can cut operating expenses resulting in minimal impact to the MPO’s bottom line.

[[{"fid":"19163","view_mode":"media_original","type":"media","attributes":{"height":268,"width":460,"style":"line-height: 1.538em;","alt":" - Figure 4","title":"Figure 4","class":"media-element file-media-original"}}]]Depending on the historical financial performance and historical capital structure, the MPO has a greater access to funding capital requirements than the SSO. The 2014 Medicare reimbursement cuts may impact cash flows from historical levels for the imaging industry as a whole. Maintenance and replacement costs of imaging equipment are significant capital commitments that an operator of center(s) must consider. To maintain working capital needs and the necessary capital needed for equipment maintenance or replacement, SSOs and MPOs will need access to capital. In consideration to the size of the asset base, MPOs have greater collateral to debt financing than SSOs. Additionally, with realized economies of scale and operational efficiencies equity financing may be a viable option for MPOs with sustainable profit margins.

Publicly traded imaging center companies serve as the closest barometer for the MPO model. The two publicly traded diagnostic imaging center companies that VMG has identified are RadNet, Inc. (NASDAQ: RDNT) and Alliance Healthcare Services, Inc. (NYSE: AIQ). While RadNet’s stock price has decreased over the last 12 months, the relative value of the stock compared to the multiple of EBITDA has remained relatively steady and is currently 6.3x Total Invested Capital / EBITDA. Alliance’s stock has performed very well over the last 12 months. Alliance’s multiple of EBITDA has increased to 6.3x Total Invested Capital / EBITDA. As outlines in Alliance’s 2013 fourth quarter earnings release, the positive performance of the company is attributable to thoughtful management decisions that have led to economies of scale and significant operational efficiencies.

[[{"fid":"19165","view_mode":"media_original","type":"media","attributes":{"height":299,"width":460,"style":"line-height: 1.538em;","alt":" - Figure 5","title":"Figure 5","class":"media-element file-media-original"}}]]

[[{"fid":"19166","view_mode":"media_original","type":"media","attributes":{"height":116,"width":460,"style":"line-height: 1.538em;","alt":" - Figure 6","title":"Figure 6","class":"media-element file-media-original"}}]]To limit the impact of reimbursement cuts on the MPO’s business value, the MPO must hinge on management’s ability to employ the benefits of operating a diverse business structure. The MPO’s future challenge is to realize and adapt new practices in order to create value through operational opportunities rather than merely combating reimbursement cuts with volume growth. If able to implement such opportunities, the MPO can withstand reimbursement cuts and position itself in a financial position that will translate to a favorable market value. With the advantages of the MPO model over the SSO model, the MPO will be in a position to expand the scope and size of its services as the expected industry landscape will benefit strong MPOs by giving them the flexibility in the market to acquire struggling SSOs at competitive prices.

Conclusion

The recent changes to Medicare reimbursement may have an impact to the profitability and value of the SSO and MPO in the short run. However, it is conceivable to assume that pricing pressures will eventually sustain themselves once utilization numbers level off. To that end, the end result will likely be that the SSO, more so than the MPO, will find it increasingly difficult to operate in a high fixed cost environment with low growth to declining margins.

While the Medicare reimbursement cuts are significant they have not in VMG’s opinion materially altered the transaction values of imaging centers overall.  VMG believes these cuts will create additional consolidation in the market, but more so for imaging centers with a higher than market average government patient mix. But whether or not these transactions are based on the future earnings of the business or simply the assets in place could be up to the timing of the SSO operator.