Case in Business Valuation of Physician-Owned Entities

Transcription

1 Case in Business Valuation of Physician-Owned Entities Presented by Stuart Neiberg, MAcc, CPA/ABV, CFA Partner HealthCare Appraisers, Inc. Jarrod Barraza, MSF Senior Associate Healthcare Appraisers, Inc. 1

2 Disclaimer HAI is not a law firm Priced higher in California and Hawaii Actual mileage may vary Objects in mirror are closer than they appear Don t put metal in a microwave Do not take if you are allergic to the ingredients Rendering is not to scale 2

3 HealthCare Appraisers, Inc. - Brief Company Background 17 years healthcare valuation experience Service lines: business valuation, compensation valuation, real estate, fixed asset and equipment Business valuation and consulting engagements: Ambulatory Surgery Center s ( ASC s ) Physician practices Hospitals Imaging centers Trade names, licenses, other intangible assets Options, warrants Distressed entities Litigation support 3

4 Theoretical Background Business valuation: process used to determine the economic value of a business, business interest, asset, or liability Value transaction price Three Approaches: Income Approach, Market Approach, Asset Approach Many Methods under each Approach, some Methods combine two Approaches Applications of business valuation: transactions/buy-in & buy-out, estate planning, tax planning, marital dissolution and litigation support, management planning, bankruptcy, obtaining financing, determining portfolio returns for closely held assets, etc. 4

5 Theoretical Background (cont.) Business Valuation in Healthcare Industry Fair Market Value standard of value Hypothetical willing and able purchaser and seller, both with equal access to all available information, neither under compulsion to transact, does not consider the volume or value of government referrals E.g., physicians cannot be compensated for volume and/or value of patient referrals to a hospital (Starke Law and Anti- Kickback Statute) Consequence of regulatory environment many healthcare entities obtain FMV appraisal of business operations, physician compensation, real estate, as part of due diligence process Interpretation - If physicians are paid higher than demonstrated FMV, it implies a kickback Physician-owned entities just as any closely-held business: business profit is a form of owner (physician) compensation 5

6 Theoretical Gibberish Background (cont.) Income Approach: Discounted Cash Flow Method formulae summary PPPP = FFFFFF 1 (1 + WWWWWWWW) 1 + FFFFFF 2 (1 + WWWWWWWW) 2 + FFFFFF 3 (1 + WWWWWWWW) 3 + In this case WACC is constant, growth between FCF 1, 2,3 need not be PPPP = nn=1 FFFFFF nn (1 + WWWWWWWW) nn Where FCF = free cash flow, WACC = weighted average cost of capital Often bifurcated into discrete projection period (5 10 years) and Terminal Year Terminal year assumes business has achieved stable growth and will continue to operate with only inflationary growth into perpetuity Thus, PV = FFFFFF 1 (1+WWWWWWWW) 1 + FFFFFF 2 (1+WWWWWWWW) 2 + FFFFFF 3 (1+WWWWWWWW) FFFFFF TT WWWWWWWW LLLLLLLL 6

7 More Gibberish lim nn FFFFFF nn(1+llllllll) nn (1+WWWWWWWW) nn FFFFFF nn+1 (WWWWWWWW LLLLLLLL) Thus if we assume growth and WACC are constant in perpetuity FFFFFF nn+1 (WWWWWWWW LLLLLLLL) Capitalization of Earnings or Excess Earnings Method All of this to say: value is a function of: cash flow, expected growth, and risk (via cost of capital) 7

8 Accounting Gibberish Free Cash Flow to Firm: NOPAT + NCE CapEx +/- (Inc)/Dec NWC Where KK dd = BBBB(1 tt) WWWWWWWW = WW dd KK dd + WW ee KK ee 8

9 Example Discounted Cash Flow Actual Annualized Adjusted Projected Common Sized (Shown as % of Net Revenue) Twelve-Month Periods Ending 12/31/15 11/30/16 Base Year 12/31/16 12/31/17 12/31/18 12/31/19 12/31/20 12/31/15 12/31/16 12/31/17 12/31/18 12/31/19 12/31/20 Case Volume 7,554 8,941 8,863 8,863 8,041 8,303 8,532 8,725 Net Revenue / Case $1, $1, $1, $1, $1, $1, $1, $1, Net Revenue $8,892,640 $11,041,991 $10,993,052 $10,993,052 $10,845,472 $11,268,334 $11,665,281 $12,037, % 100.0% 100.0% 100.0% 100.0% 100.0% Payroll and Benefits 2,743,768 3,029,163 3,015,950 3,015,950 2,933,614 3,041,036 3,144,631 3,243, % 27.4% 27.0% 27.0% 27.0% 26.9% Drugs and Medical Supplies 2,360,515 3,117,722 3,090,523 3,090,523 2,859,970 3,012,219 3,157,204 3,293, % 28.1% 26.4% 26.7% 27.1% 27.4% Management Fees 417, , , , , , , , % 5.0% 5.0% 5.0% 5.0% 5.0% Occupancy Expenses 741, , , , , , , , % 7.8% 8.1% 7.9% 7.8% 7.7% Equipment 567, , , , , , , , % 5.4% 5.5% 5.4% 5.4% 5.3% Contract Labor 351, , , , , , , , % 3.5% 3.6% 3.6% 3.6% 3.6% Professional Fees 70,388 77,544 77,544 77,544 79,095 80,677 82,290 83, % 0.7% 0.7% 0.7% 0.7% 0.7% Insurance 71,225 78,023 78,023 78,023 81,143 84,389 87,765 91, % 0.7% 0.7% 0.7% 0.8% 0.8% All Other Operating Costs 474, , , , , , , , % 4.1% 4.2% 4.0% 3.9% 3.8% Total Operating Costs 7,798,202 9,125,001 9,087,831 9,087,831 8,808,422 9,141,224 9,462,246 9,769, % 82.7% 81.2% 81.1% 81.1% 81.2% Operating Margin 1,094,438 1,916,990 1,905,221 1,905,221 2,037,050 2,127,109 2,203,035 2,268, % 17.3% 18.8% 18.9% 18.9% 18.8% Other (Income) / Expense (1,024) (227) (208) (208) % 0.0% 0.0% 0.0% 0.0% 0.0% EBITDA 1,095,462 1,917,217 1,905,429 1,905,429 2,037,050 2,127,109 2,203,035 2,268, % 17.3% 18.8% 18.9% 18.9% 18.8% (Gain) / Loss from Sales of Assets (2,787) 1,115 1,023 1, % 0.0% 0.0% 0.0% 0.0% 0.0% Depreciation 527, , , , , , , , % 7.1% 6.6% 4.2% 2.8% 2.7% Amortization % 0.0% 0.0% 0.0% 0.0% 0.0% EBIT 570, ,500 1,125,542 1,125,542 1,322,981 1,649,187 1,880,749 1,948, % 10.2% 12.2% 14.6% 16.1% 16.2% 9

10 Actual Projected Terminal Summary Income Statement Year EBITDA 1,095,462 1,905,429 2,037,050 2,127,109 2,203,035 2,268,351 2,302,377 Example Discounted Cash Flow (Gain) / Loss from Sales of Assets (2,787) 1, Depreciation 527, , , , , , ,000 EBIT 570,326 1,125,542 1,322,981 1,649,187 1,880,749 1,948,978 1,627,377 Interest (Income) (58) (119) (119) (119) (119) (119) (119) EBIT 570,383 1,125,661 1,323,100 1,649,306 1,880,868 1,949,097 1,627,496 Income 20.7% 233, , , , , ,892 Net Operating Income After Tax 892,649 1,049,219 1,307,900 1,491,528 1,545,634 1,290,604 Adjustments to Determine Cash Flow Plus: Depreciation 778, , , , , ,000 Less: Capital Expenditures (56,250) (675,000) (675,000) (675,000) (675,000) (675,000) (Increases)/Decreases in Working Capital (189,037) 13,282 (38,058) (35,725) (33,511) (16,251) Free Cash Flow 1,426,227 1,101,569 1,072,765 1,103,089 1,156,496 1,274,354 Partial Period Factor 0.08 Discounting Periods (mid-point) Present Value 12.7% Present Value of Cash Flow 66,953 1,027, , , ,457 Present Value of Projected Cash Flows 3,545,446 Terminal Value Calculation Present Value of Terminal Value Calculation 7,412,869 Indicated Market Value of Total Capital $10,958,315 Free Cash Flow in Terminal Year 1,274,354 Divided by Capitalization Rate (WACC - LTGR of 1.50%) 11.20% Less: Debt (3,517,307) Equals Terminal Value in ,378,157 Indicated Market Value of Equity (Rounded) $7,441,000 Present Value Factor for (control, marketable) Present Value of Terminal Value $7,412,869 10

11 Motivation of Monte Carlo Simulation of Business Valuation Context Prediction is difficult, especially about the future Neils Bohr Under the Income Approach, the value of a business today involves estimating economic benefits the business will generate in the future i.e., present value of future free cash flows from operations Uncertainty in future operations Revenue, expenses, capital expenditures, taxes, costs of capital, expansions, mergers, etc. More so in healthcare: rapidly shifting regulatory environment 11

12 Motivation of Monte Carlo Simulation of Business Valuation Context Limitations of DCF Static Prediction of Future Revenue, Volume, Expenses Ignores movement, correlation between variables Risk is (only) qualitatively considered in discount rate Downside vs. Upside Risk 12

13 Motivation of Monte Carlo Simulation of Business Valuation Context Path-dependent variables within healthcare BV context: Physician leaving or remaining in the practice New surgeon brining volume to ambulatory surgery center Expansion of oncology facility equipment to offer new procedures In-network vs. out-of-network negotiations Change in payor contracts Federal reimbursement uncertainty (i.e., Medicare, Medicaid) Another can of worms Determining FMV of business facing path-dependent scenarios poses challenges How to support the value determined? Does the discount rate accurately reflect downside and upside variability in projections? Scenario outcomes affect operating results affect free cash flow affect business value 13

14 Case Study ASC with multiple expansion options Ophthalmic (single-specialty) surgery center in Texas ~ 3,500-4,000 surgical cases per year, $3.5- $4.0 million annual revenue Historically mostly cataract surgeries but also offered Yag laser, cornea, glaucoma, plastics, and retina treatments Approximately 20 surgeons bring volume to center, some had ownership interests (direct financial incentive to maximize volume), others interested in purchasing ownership Center considering expanding into anesthesia and interventional pain management service lines Considering expansion of Yag and Fempto services Also considering relocation and construction (financed partially with debt) 2 doctors considering leaving the center, would bring their volume elsewhere Interested in offering equity interests to physicians to finance a portion of investments and replacement ownership interests of physician investors who planned to depart in the near future 14

15 15

16 General Overview Multiple path-dependent scenarios: used Bernoulli distribution to turn on/off each scenario Probabilities provided by management Within each scenario uncertainty in projections Used distributions for each variable according to economic assumptions Scenario output for each expense item to determine Adjusted Base Year 16

17 Scenario 1 ASC Relocation Impacts cost of sales, rent, depreciation, interest expense 90% likely to occur Cost of Sales normal distribution - 10% σ Rent Expense triangle distribution +/- 10% Interest Expense lognormal distribution 17

18 Tornado Graph - Revenue 18

19 Tornado Graph - EBITDA 19

20 Scenario 2 Anesthesia Service Expansion Impacts: Revenue, Salaries and Wages, Cost of Sales, Professional Fees 25% likely to occur Revenue Pert distribution +/- 20% Salaries and wages normal distribution - 5% σ Cost of Sales normal distribution - 10% σ Professional fees normal distribution - 10% σ 20

21 Normal Distribution Example 21

22 Pert Distribution Example 22

23 Lognormal Distribution Example 23

24 Triangle Distribution Example 24

25 Scenario 3 Yags Service Expansion Impacts: Revenue, Salaries and Wages, Professional Fees 25% likely to occur Revenue Pert distribution +/- 20% Salaries and Wages normal distribution - 5% σ Professional fees normal distribution - 10% σ 25

26 Scenario 4 Femptosecond Laser Expansion Impacts: Revenue, Cost of Sales, Professional Fees 50% likely to occur Revenue Pert distribution +/- 20% Cost of Sales normal distribution - 10% σ Professional fees normal distribution - 10% σ 26

27 Scenario 5 Interventional Pain Management Service Expansion Impacts: Revenue, Salaries and Wages, Cost of Sales, Professional Fees 80% likely to occur Revenue Pert distribution +/- 20% Salaries and Wages normal distribution - 5% σ Cost of Sales normal distribution - 10% σ Professional Fees normal distribution - 10% σ 27

28 Scenario 6 Dr. 1 leaving Center Impacts: Revenue, Salaries and Wages, Cost of Sales, Professional Fees 75% likely to occur Revenue Pert distribution +/- 20% Salaries and Wages normal distribution - 5% σ Cost of Sales normal distribution - 10% σ Professional Fees normal distribution - 10% σ 28

29 Scenario 7 Dr. 2 Leaving Center Impacts: Revenue, Salaries and Wages, Cost of Sales, Professional Fees 75% likely to occur Revenue Pert distribution +/- 20% Salaries and Wages normal distribution - 5% σ Cost of Sales normal distribution - 10% σ Professional Fees normal distribution - 10% σ 29

30 TTM 2014 Expenses Office and Administrative Expenses Repairs and Maintenance Taxes & Insurance Other Expenses Normal distribution 5% σ 30

31 Correlation If Dr. 1 leaves, higher probability Dr. 2 will leave If center expands Yags, higher probability it will expand to fempto If salaries and wages increases for one scenario, higher probability salaries and wages will increase for other scenarios 31

32 Correlation Matrix Correlations Matrix Correlations SURGICAL FACILITIES REVENUE / Actual in $D$12 SURGICAL FACILITIES REVENUE / Anesthesia in $H$12 SURGICAL FACILITIES REVENUE / Yags in $J$12 SURGICAL FACILITIES REVENUE / Femto in $L$12 SURGICAL FACILITIES REVENUE / Pain Mgmt. in $N$12 SURGICAL FACILITIES REVENUE / Actual in $D$ SURGICAL FACILITIES REVENUE / Anesthesia in $H$ SURGICAL FACILITIES REVENUE / Yags in $J$ SURGICAL FACILITIES REVENUE / Femto in $L$ SURGICAL FACILITIES REVENUE / Pain Mgmt. in $N$ SURGICAL FACILITIES REVENUE / Impact in $P$ SURGICAL FACILITIES REVENUE / Impact in $R$ SALARIES, WAGES & BENEFITS / Actual in $D$ SALARIES, WAGES & BENEFITS / Anesthesia in $H$ SALARIES, WAGES & BENEFITS / Yags in $J$ SALARIES, WAGES & BENEFITS / Pain Mgmt. in $N$ SALARIES, WAGES & BENEFITS / Impact in $P$ SALARIES, WAGES & BENEFITS / Impact in $R$ MD/OD COMPENSATION / Actual in $D$ COST OF SALES AND SUPPLIES / Actual in $D$ COST OF SALES AND SUPPLIES / Relocation in $F$ COST OF SALES AND SUPPLIES / Anesthesia in $H$ COST OF SALES AND SUPPLIES / Femto in $L$ COST OF SALES AND SUPPLIES / Pain Mgmt. in $N$ COST OF SALES AND SUPPLIES / Impact in $P$ COST OF SALES AND SUPPLIES / Impact in $R$ OFFICE & ADMINISTRATIVE EXPENSES / Actual in $D$ PROFESSIONAL FEES / Actual in $D$ PROFESSIONAL FEES / Anesthesia in $H$ PROFESSIONAL FEES / Yags in $J$ PROFESSIONAL FEES / Femto in $L$ PROFESSIONAL FEES / Pain Mgmt. in $N$ PROFESSIONAL FEES / Impact in $P$ PROFESSIONAL FEES / Impact in $R$ RENT EXPENSE / Actual in $D$ RENT EXPENSE / Relocation in $F$ REPAIRS & MAINTENANCE / Actual in $D$ TAXES & INSURANCE / Actual in $D$ OTHER EXPENSES / Actual in $D$

33 Valuation Discussion Discount Rate Build-up Method Risk Free Rate of Interest ( pure time value of money) + market equity risk premium +/- industry risk premium (not relied upon, incorporated into CSRP below) +/- Size risk premium (smaller firms = higher risk) +/- Company Specific Risk Premium 33

34 Company Specific Risk Premium (cont.) Matrix approach weighted sum of risk factors Specific to entity being values Historical financial information, historical financial performance, asset base, leverage, technology, location, etc. Risk in financial projections uncertainty modeled into Monte Carlo Simulation output Lower Company Specific Risk Premium, thus, lower WACC Avoid double-counting risk in projections 34

35 Perceived Risk Level Risk Factor N/A Low Moderate Significant Severe Comments: Financial Considerations 1) Quality / Accuracy of Financial Information x 2) Historical Financial Performance x 3) Physician Base (ownership%, age, specialty, availability, etc.) x 4) Referral Base / Concentration x 5) Historical Payor Mix / Payor Trends/ Contract Terms x Center provided balance sheet and income statement data for the years ended December 31, 2011 through 2013 and the year-to-date period ended September 30, HAI has assumed these statements to be reliable, although no independent assurance was provided. Center has been historically profitable, maintaining favorable margins and expecting year-over-year growth from 2013 to Center has a large physician base comprised of multiple ophthalmologists. Additional risk associated with the fact that almost 40% of the volume in 2014 is from non-owner physicians with no material financial interest in the business. Center has a strong reputation in the local community and among physicians in the area. Center's Medicare cases reimburse far below its Commercial payors, and historically, approximately 40% of Center's cases are performed at Medicare reimbursement rates. 6) Asset Base x CapEx assumption includes normal turnover / replacement of assets. 7) Liquidity x No liquidity issues noted. Excess cash will be distributed prior to syndication. 8) Financial Leverage / Borrowing Capacity x No debt concerns noted. Some risk of technological obsolescence given the large number of 9) Technology x procedures that rely on lasers. Low risk associated with the financial projections, as we have utilized Monte Carlo software to develop an adjusted base year for the operations, and the Capitalization of Earnings Method assumes these results are maintainable going forward with minimal growth. Empirical studies have indicated that Monte Carlo simulations have effectively reduced the risk component 10) Perceived Risk in Financial Projections x associated with projection models. 35

36 Geographical Considerations 11) Regulatory Environment x 12) Local Competitive Environment x The Healthcare industry is currently experiencing a period of high uncertainty. Though most of this risk pertains to reimbursement (accounted for in #10 above), there remain other challenges that increase risk (i.e., hospital employment of physicians). San Antonio, Texas and its surrounding area has a high volume of surgery centers, as it is heavily populated. 13) Local Population Demographics / Trends x No major population growth expected. 14) Location / Condition of Facility x No facility issues noted. 15) Availability/Ability to Attract and Retain Qualified Staff x No staffing issues noted. 16) Availability/Ability to Attract and Retain Qualified Physicians x Some recent physician turnover. Assigned Company Specific Risk Premium (CSRP) 5.0% Scoring Range Appropriate Range of CSRP Low Risk 1.0% to 5.0% Moderate Risk 6.0% to 10.0% Significant Risk 11.0% to 20.0% Severe Risk 21.0% to 30.0% + 36

37 Valuation Approach Conclusion TTM period + sum of scenarios = Adjusted Base Year FFFFFF nn+1 (WWWWWWWW LLLLLLLL) AAAAAA (WWWWWWWW LLLLLLLL) 37

38 Historical Annualized /30/14 Simulation Outputs Revenue $3,361,632 $3,700,208 $3,622,453 $4,532,281 $4,358,528 EBIT as Reported $1,117,635 $1,304,851 $1,114,367 $1,432,366 $1,108,518 Operating Expenses Salaries, Wages and Benefits 577, , , , ,286 MD/OD Compensation ,000 18,049 17,739 Cost of Sales and Supplies 1,006,046 1,084,269 1,169,866 1,549,418 1,332,534 Professional Fees 290, , , , ,532 Office and Administrative Expenses 62,322 84,536 75, ,127 89,008 Rent Expense 124, , , , ,388 Repairs & Maintenance 55,733 60,390 57,326 77,095 73,145 Taxes & Insurance 48,627 54,728 55,499 52,210 56,711 Other Expenses 4,960 4,501 3,392 3,895 1,896 Depreciation 73,592 53,256 33,040 22, ,771 Total Operating Costs 2,243,997 2,395,357 2,508,086 3,099,916 3,250,010 Adjustments to Eliminate Discretionary (Income) / Expenses Adjusted EBIT $1,117,635 $1,304,851 $1,114,367 $1,432,366 $1,108,518 Assigned Weighting (Relevance) to Future Maintainable Earnings 100% Estimated Future Maintainable Earnings $1,108,518 38

39 Calculation of Cash Flow Less: Income 20.7% (229,463) Plus: Depreciation and Other Non-Cash Charges 270,771 Less: Ongoing Capital Expenditures (270,771) Less: (Increases)/Decreases in Net Working Capital (66,247) Free Cash Flow (Invested Capital Basis) $812,808 Divided by Forward Period Capitalization Rate [(wacc-g)] 15.8% Indicated Market Value of Total Capital $5,144,355 Less: Debt (1,523,925) Indicated Market Value of Equity (Rounded) $3,620,000 (control, marketable) 39

40 Reflection Monte Carlo Simulation powerful tool when facing multiple pathdependent scenarios Many possible applications in business valuation of physician owned entities Case Study ambulatory surgical center facing multiple expansion (and two contraction) scenarios that will impact physician purchase price Modeling uncertainty of each scenario using Monte Carlo Simulation Simulation output = valuation input Discount rate company specific risk premium 40

41 Reflection (cont.) Thorny regulatory environment Lack of financial sophistication among management personnel Lack of financial sophistication among physician investors Bridging gap between statistical theory and real-world transactions Garbage In Garbage Out Relied heavily on management input for scenario financial impacts, likelihood 41

42 Questions? Jarrod Barraza, MSF Senior Associate Healthcare Appraisers, Inc Healthcareappraisers.com 42