Surgery Partners, Inc. Q3 FY2023 Earnings Call

Good morning, ladies and gentlemen, and welcome to Surgery Partners' Third Quarter of 2023 Earnings Call. Currently, all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. It is now my pleasure to hand you over to Chief Financial Officer, Dave Doherty. Please go ahead, sir.

Good morning. My name is Dave Doherty, CFO of Surgery Partners, and I'm here with our CEO, Eric Evans, and our Executive Chairman, Wayne DeVeydt. Thank you for joining us for our third quarter 2023 earnings announcement. During our call, we will make forward-looking statements. There are risk factors that could cause future results to be materially different from these statements. These risk factors are described in this morning's press release and the reports we file with the SEC, each of which are available on our website at surgerypartners.com. The company does not undertake any duty to update these forward-looking statements. In addition, we will reference certain financial measures that are considered non-GAAP, which we believe can be useful in evaluating our performance. The presentation of this information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP. These measures are reconciled to the most applicable GAAP measure in this morning's press release. With that, I'll turn the call over to Wayne.

Thank you, Dave. Good morning, and thank you all for joining us today. We are pleased to report another quarter of consistent growth in revenue and adjusted EBITDA, exceeding our prior guidance. Including our non-consolidating facilities, we performed over 172,000 surgical cases this quarter. When adjusted for divested facilities and factoring in one less business day, this was nearly 6% more than 2022. Other than the impact of Hurricane Idalia, which marginally impacted our Florida and Georgia facilities mid-quarter, we did not experience any pressure from external factors, as we continue to produce steady, predictable growth in our key growth areas. This strong case growth combined with increased acuity and contributions from recent acquisitions, generated $674.1 million of net revenue and $105.5 million of adjusted EBITDA, resulting in a 15.7% margin. Dave will share more details regarding our financial results, but let me highlight a few. Net revenue of $674.1 million was almost 9% more than the prior year, with same facility revenue growth in excess of 14% in the quarter. On a year-to-date basis, same facility revenue growth was nearly 11%. Adjusted EBITDA was $105.5 million, representing nearly 10% growth over the prior year quarter and a 14% on a year-to-date basis. Adjusted EBITDA margins improved 70 basis points sequentially to 15.7%, as compared to the prior quarter. Finally, we completed the acquisition of two additional short-stay surgical facilities in the quarter and have deployed approximately $135 million year-to-date. The pipeline of future acquisitions is robust, which allows us to be highly selective and remain disciplined in our acquisition strategy. Specifically, we have well over $200 million currently under LOI and a significant number of additional opportunities in early conversations. We continue to be pleased with our balanced approach to growth, with all pillars of our long-term growth algorithm either meeting or exceeding our expectations. Based on the strength of our third quarter results, and our continued positive outlook on our numerous investments in the business, we are raising our full year adjusted EBITDA guidance to a range of $436 million to $440 million, with approximately $2.75 billion in consolidated revenue. Dave will discuss our guidance in more detail later in the call. With that, let me turn the call over to Eric to highlight some of our operational initiatives and recent investment activities.

Thanks, Wayne, and good morning, everyone. We are pleased with our third quarter results, which represent another quarter of consistent and predictable growth across all of our core service lines and consistent with our company's growth algorithm. From an operational perspective, our specialty case mix is right where we expected, and volume was in line with our expectations with over 146,000 consolidated surgical cases in the quarter. Our non-consolidated facilities, which are an increasing part of our portfolio, exceeded our expectations with almost 26,000 cases. In the quarter, our same-facility case growth was 2.9% when compared to the third quarter of 2022 and net revenue growth per case was 11%. We expect to continue to see both volume and rate growth, with rate growth in excess of our long-term guidance throughout 2023, due to the strength of our physician recruiting and case mix acuity. On the recruiting front, our various initiatives continue to drive strong year-over-year growth, fueling growth in MSK procedures, particularly total joint cases in ASCs. Year-to-date, we have recruited nearly 500 new positions to our short-stay surgical facilities, with approximately 40% representing MSK specialties, and we remain on pace to recruit more physicians than last year with an increasing focus on higher acuity procedures. To provide some context, we continue to see strong growth in total joint procedures performed at our ASCs, which have increased approximately 60% year-to-date compared to 2022. As Wayne mentioned, we have deployed approximately $135 million year-to-date on 15 transactions, which includes 3 additional facilities closed in October. We continue to rapidly integrate acquisitions into our operations, bringing the full benefit of our revenue cycle, procurement, managed care, and physician recruiting teams to yield significant synergies within the first 18 months of ownership. We remain committed to our annual capital deployment goal of at least $200 million. As it relates to divestitures, we have divested our interest in seven facilities as part of our disciplined portfolio management process. As previously discussed, the timing of these divestitures has an ongoing impact on our revenue as we redeploy the capital. Moving to our de novo activity, we have been intentionally focused on syndicating with surgeons that recognize the importance of moving high-cost procedures to a lower-cost, high-quality, purpose-built surgical facility. Based on deals we have under syndication, we have 17 short-stay surgical facilities in various stages of our pipeline, many of which are slated to open in 2024. These facilities include both consolidated majority-owned partnerships, as well as minority interest on consolidated partnerships. They include a mixture of two-way partnerships under development between us and physician partners, and three-way partnerships with our new health system partners. We expect this pipeline to grow significantly over the next two years and to provide us with future buy-up opportunities. Dave will share how we think about the financial performance of these unconsolidated facilities in his remarks. But our growth in this area further enhances confidence in our long-term mid-teens growth expectations. Before I turn the call over to Dave, I'd like to take a moment to address the current environment as it relates to anesthesia providers, as well as some of the questions we have received regarding the impact of GLP-1 on our long-term growth algorithm. Starting with anesthesia, I would like to point out that anesthesia availability and cost pressures are not new, but rather something that we have been managing for a few years. It's widely known that the current supply of anesthesia providers from MDs to CRNAs is constrained and that recent reimbursement changes for their services have impacted their profitability. Other than the limited number of providers that we employ, the anesthesiologist or CRNA is responsible for billing and collecting for their services performed in our facilities. These providers have chosen to work with us in our facilities for the same reason our surgeons and other stakeholders do, for the convenience, efficiency, and clinical quality we are known for. In other words, they generally prefer working with our surgeons in our facilities. With the pressure facing the service line, we have been working with our anesthesia providers to ensure they remain engaged and profitable. We have many opportunities to assist them, including realigning surgical schedules to maximize their OR time, working with our managed care teams on improved payer interactions, or in some cases, offering a revenue guarantee or stipend. These standard practices have been in place in certain markets for several years, and the financial impact is not material to the company's results. Despite the increased focus on this subject, we have not experienced any delays or canceled cases because of this issue, nor do we expect to see material changes to our operations or financial results in the future. We are, however, taking the opportunity to find innovative ways to partner with national and regional anesthesia groups to alleviate pressures, and these conversations have been very productive. To reiterate, this has not been a material issue for us, and I do not expect this will be a material issue for us in 2024. Moving on to GLP-1s, we are proponents of a healthier population and have high hopes for success in pharmaceutical and behavioral changes that benefit individuals affected by diabetes and obesity. While we are encouraged by the promise of these drugs, there is much to be learned about their overall effectiveness, long-term side effects, and other factors, including reimbursement. While we do not know the ultimate impact of these drugs, it is believed that such drugs will lead to fewer co-morbidities in a healthier, more active lifestyle, which generally bodes well for our short-stay surgical facilities. In short, we do not expect a change in our long-term growth algorithm due to the expected impact of GLP-1s and related treatments and would bias towards more upside for purpose-built, short-stay surgical facilities, due to the continued shift of procedures from the inpatient to the outpatient setting, particularly for healthier populations. In closing, I've been in this role for almost four years and have never been more optimistic regarding our future and the number of tailwinds impacting our business. The desire and need to move more procedures to purpose-built short-stay surgical facilities has never been greater. And our company has been positioning itself to capture industry-leading growth associated with these tailwinds. The combination of investments in both our existing facilities and new de novos, coupled with our entry into three-way joint ventures with high-quality health systems, gives me increased confidence in our ability to grow high single to low double digits organically. This growth, coupled with an existing and growing M&A pipeline and a talented, deep, and experienced leadership team, provides further optimism for long-term sustainable mid-teens adjusted EBITDA growth. With that, I will now turn the call over to Dave to provide additional color on our financial results, as well as the outlook for the remainder of the year.

Thanks, Eric. I will focus on our third quarter financial results, key metrics for our unconsolidated and managed facilities, and our outlook for the remainder of the year. Starting with the top line, we performed over 146,000 surgical cases at the facilities we consolidated in the third quarter. When combined with facilities we don't consolidate, we performed over 172,000 cases, representing a slight increase over last year. Adjusting for divested facilities and one less business day in the quarter, total cases grew nearly 6%. These cases spanned across all our specialties with an increasing focus on higher acuity procedures, which is reflected in our double-digit same-facility growth this quarter. The combined case growth in higher acuity specialties, specific managed care actions, and the continued impact of acquisitions supported consolidated revenue growth of 8.6% over the prior year. This growth was accomplished despite revenue headwinds associated with the facilities invested in 2023. On a same-facility basis, total revenue increased 14.2% in the third quarter, with case growth at 2.9%. Net revenue per case was 11.0%, higher than last year, primarily driven by higher acuity procedures. There were no unusual events that affected the third quarters of both 2022 and 2023. Adjusted EBITDA was $105.5 million for the third quarter, giving us a margin of 15.7%, in line with our expectations of continued margin expansion. Inflationary pressures related to labor and supply costs have moderated this year. But we remain vigilant in monitoring these factors across our portfolio. Consistent with prior quarters this year, the third quarter labor and supply costs are a lower percentage of revenue than the prior year. As we mentioned in prior comments, we have increased investments in facilities that are not consolidated, including both de novos and acquisitions. Because they are not consolidated, the earnings of these facilities are reflected in equity earnings of unconsolidated affiliates and management fee revenue, a component of revenue in our income statement. To provide some context on our non-consolidated activities, we have ownership interest in 23 facilities that are not consolidated. Revenue from these unconsolidated facilities grew 71% in the third quarter over last year, representing growth of over $66 million. This revenue growth is a combination of acquired minority interests and the value proposition we bring to these partnerships. We benefit from this growth in two ways: management fees, which are based on revenue and our share of the income generated at the facility. The adjusted EBITDA contribution from the unconsolidated and managed-only facilities was $10.2 million in the third quarter, which is approximately 30% higher than last year. In addition to our existing facilities, we have 17 de novos in various stages of development, with 10 that are expected to open over the next 18 months. Based on our robust de novo pipeline and momentum, we would anticipate opening double-digit de novo facilities annually for the foreseeable future. The development costs for de novos are not material to the company. In the quarter, we incurred approximately $200,000 of development costs associated with de novos. Moving to cash flow and our balance sheet. As we've noted in the past, we expect to produce at least $140 million of free cash flow in 2023. In the third quarter, we generated free cash flow of $63.2 million. And on a year-to-date basis, we have generated $91.4 million. We remain confident in our ability to meet our target of at least $140 million of free cash flow in 2023. Based on our current growth algorithm, we anticipate free cash flow to exceed $200 million annually by 2025. We ended the quarter with $236 million in consolidated cash and an untapped revolver of $545 million. When combined with the free cash flow we are projecting, we believe our current and future liquidity position us well in this macroeconomic environment while giving us flexibility to maintain our long-term acquisition posture of deploying at least $200 million per year for M&A. As a reminder, our corporate debt is less than $1.9 billion, with an average fixed interest rate of 6.7%, with no material debt maturing until 2026. We are continually reviewing our debt stack for opportunities to extend our maturities well past 2026 while minimizing the impact on our projected free cash flow. We are monitoring the rate environment and forward interest rate curve as we consider both factors for any potential refinancing and the ability to limit interest costs through an appropriate hedging strategy. Our third quarter ratio of total net debt-to-EBITDA, as calculated under our credit agreement, was 4.1 times. With the earnings growth we expect, we are confident this ratio will continue to decline. Airing the momentum of our third quarter results, we remain optimistic and confident about the company's growth and are raising our outlook for 2023 adjusted EBITDA to a range of $436 million to $440 million, with the midpoint representing over 15% growth compared to 2022. Further, our outlook for consolidated revenue is approximately $2.75 billion, representing over 8% growth from 2022 and is inclusive of overcoming more than $100 million of divested revenue. As we've discussed previously, our revenue and adjusted EBITDA guidance is impacted by the timing of acquisitions and divestitures. We are currently in the midst of our planning process for 2024, but wanted to provide investors with some thoughts on the factors we are considering for our 2024 growth goals, with our senior leadership team and Board of Directors. At this time, we do not foresee any material headwinds as we head into 2024. We believe the consistent momentum of our business that we have been experiencing will continue in 2024. Specifically, we expect organic growth above our long-term growth algorithm, supported by continued surgical case migration from higher-cost settings and efficiency initiatives, leading to top-line growth and continued margin expansion. Our margin expansion reflects ongoing investments in procurement and revenue cycle, as well as the integration benefits from recent acquisitions and de novos. Additionally, our 2024 contracted, managed care rates are already 90% negotiated, and we will continue to benefit from the compounding effect of physician recruiting as we enter 2024. Finally, our ongoing acquisition strategy, supported by a robust pipeline of potential acquisitions, combined with contributions from de novo facilities we expect to open in 2024, provides further tailwinds in support of our growth algorithm. At this early stage in our process, we remain confident in our ability to deliver mid-teen adjusted EBITDA growth. We look forward to providing greater visibility into our 2024 projections for revenue, adjusted EBITDA, free cash flow, and capital deployment targets in a future presentation. With that, I'd like to turn the call back over to the operator for questions.

Thank you, sir. Ladies and gentlemen, we will now be conducting the question-and-answer session. Our first question comes from Kevin Fischbeck of Bank of America. Please go ahead.

Great. Thank you. I guess maybe to start off, the pricing number looked really strong in the quarter. Can you just remind us kind of where the actual core pricing is versus kind of the acuity benefits and payer mix shift that might happen year-over-year? And was there anything unusual in the quarter on the revenue per case side?

Hey, Kevin. Good morning. I'd start by saying, no, nothing unusual other than we continue to bias towards the higher acuity cases. As you saw in the prepared remarks, the total hips and joints done in our outpatient settings were up over 60% against the prior year backdrop, which, as you know, had strong growth that year as well. So I'd put it more in the 50-50 bucket of how much is acuity mix impacting the revenue component versus how much is really just the core growth and managed care rates that we're getting along the way.

And then I guess in your prepared remarks, you guys made a comment that the consolidated cases were basically as expected, but the unconsolidated cases came in better than expected. Is there something behind that? Is there a point that you're making there about the kind of the power of having maybe a three-way joint venture or more syndication? Or is there anything else to that?

Well, I think it's fair to say that part of the reason we've been biasing to this additional growth lever is we think it's an untapped opportunity for employee doctors that are part of systems, and it gives us a unique way of bringing kind of our chassis and our playbook to it. So I wouldn't say we're over-indexing on that. But I think, ultimately, we wanted our investors to understand the strategy is working out, and it's slightly better than we had expected so far. And we don't really see those trends diminishing at this point. I think the key thing is, Kevin, because they're not consolidated, those metrics do not end up in our same store either in terms of the volume component. And so ultimately, just feel very good about how we're kind of running into the new year with the M&A pipeline as well as with the same-store metrics.

I would like to add that while we are highlighting the strong growth, part of that is due to bringing on new opportunities and leveraging synergies. We anticipate experiencing significant growth early on, and we are pleased with how well these initiatives have performed. This is definitely an important part of our overall growth narrative.

All right. Great. And then maybe just last question. I appreciate the commentary on the professional fees; it seems to be a hot topic. Can you help just size that for us? Like, what was the professional fee spending in the quarter?

Sure. I'll let Dave address that shortly. To revisit our physician services, we're not a traditional acute care company; we focus on short-stay surgical procedures. Our only exposure is in anesthesia since we don't operate hospitals. We have had this exposure for several years, and our facilities are actually the preferred choice for anesthesiologists. In my previous experience in traditional acute care, I utilized ASCs and surgical facilities to reduce subsidies or secure favorable agreements with anesthesiologists. Currently, we are in a favored position, although there are a few instances of pressure that are relatively minor. We are actively managing the pressures anesthesiologists face by assisting with scheduling, improving efficiency, and maintaining a positive partnership with them. However, the overall impact is minimal. Perhaps you could provide a general idea of the risk we anticipate for next year.

First off, as shown in our P&L in the press release this morning, we recorded just over $70 million in total professional fees this quarter. These fees encompass a variety of activities, including costs related to medical supplies, malpractice insurance, and others. The portion specifically related to anesthesia, which has been frequently discussed, is relatively minor, at under $10 million for the year. Thus, for this quarter, it was minimal. Looking ahead to next year, while it's still early in the budgeting process, we anticipate that any variance will be no more than a few million dollars, which we can easily manage. To reiterate a point Eric mentioned earlier, the pressures we observe regarding anesthesia costs and profitability have not affected our case schedule; we have not had to cancel any cases this past year due to anesthesia issues. Therefore, we don't see this as a significant concern compared to challenges seen in other areas of the services industry.

All right. Perfect. Thank you.

Thanks, Kevin.

The next question comes from Jason Cassorla of Citi. Please go ahead.

Great. Thanks, good morning. I just wanted to go back to the same facility revenue per case in the quarter. Did that include any benefit from insurance proceeds related to the cyber impact? And I guess, with that level of growth, it would imply perhaps a bit more margin expansion, just given the flow-through of rates to the bottom line. You said that 50% of that growth was related to acuity. But maybe can you just help on the pricing flow-through? And then the likely kind of margin offset that would come with the focus of higher acuity cases. Just any more color would be helpful. Thanks.

Yeah. So first, the short answer is no. The same-store did not benefit from any unusual items and did not have any cyber recoveries in it. In terms of the margin expansion, I would say that we're actually very pleased because sequentially, it’s up 70 basis points. I understand you're probably the math you're applying. I think you'll see further expansion going into Q4. We did make more additional investments in the quarter. Any time we see strength in the quarter, we're going to take advantage of that to make additional investments. And candidly, our compensation structure is reflective of the fact that our team continues to outperform expectations. And so additional accruals in the quarter related to bonus, etc. But no concerns on our end. And I think you'll see margins expand not only in Q4, but you'll continue to see that expansion as we go into 2024.

And Kevin, I’d like to clarify that Wayne's response was about evenly split. He’s mostly correct, leaning more towards acuity than rates. I want to emphasize that we’ve had a strong performance this quarter mainly due to significant growth in acuity. While we've seen some positive managed care rates, I wouldn't say that half of the 14 comes from managed care. We are making progress on that front, but the key to our success lies in finding and attracting high-end cases and bringing them into our facilities.

Great. Awesome. Thank you for the clarity. And then just a follow-up. I wanted to ask on capital deployment, I guess, relative to your $200 million plus for the redeployment of divestiture activity target. I guess given year-to-date spend at $135 million and your comments on your pipeline, just curious on the timing of that spend has seemed to slow a bit in the third quarter, is that just kind of timing related? And I guess, just broadly, any commentary or incremental commentary on the capital deployment environment would be helpful. Thanks.

Great. Let me start by saying, in the six years that this team has been together, the current pipeline of opportunity and what we have under LOI is greater than we've seen in any single year. And we don't see that slowing down as we head into the new year. Regarding timing, we actually anticipate with the over $200 million under LOI that some of these will get closed in the fourth quarter and still feel pretty confident about our targeted $200 million goal for the year. If it was to slip, we're really talking about slipping into the first half of next year, which we don't really see as a good turn towards our long-term growth algorithm. But actually, no concerns on our end. We continue to apply appropriate due diligence on all facilities. And Eric and Dave continue to remind the teams that we don't manage to the quarter. We manage to the long-term growth algorithm. And so we're not necessarily going to accelerate a close to achieve a near-term goal. But I would tell you, no concerns at all on the kind of run rate of $200-plus million. And if anything, I would argue we're probably going to jump out of the gate even stronger next year.

Great. Thank you.

Our next question comes from Whit Mayo of Leerink Partners. Please go ahead.

Thanks, good morning. Dave, can you go back and maybe just unpack the comments on the managed care actions that you undertook in the quarter? And I guess the corollary to this question is really just maybe an update on the revenue cycle initiatives, the focus on revenue conversion, now that you're, I think, on one clearing house. My sense is these numbers aren't small. So maybe just any update around those would be helpful. Thanks.

Hey, good morning. I'm going to jump in on the managed care question; I'll turn it to David for revenue cycle. There was no specific managed care actions in the quarter. I mean, other than our normal contracting, we clearly continue to develop strong relationships with payers, explaining and using math to show them our value proposition. I think we're getting increased traction with that over time, as they see the benefit of what's primarily an independent model as we capture the benefit, the savings of it, we see that shifting in a positive direction around this area. So I really feel good what we did here is, on the core, we see the right opportunity as we head into 2024 and beyond to continue that momentum. So I don't want you guys to think about it as something that we will get on the radar tomorrow, but we do see a positive trend continuing to build there. Again speaking in broad strokes, that the team is doing a great job here. As we add new service lines and procedures, we will have a chance to go back and say, hey, we are going to create a bunch of more value for you, how do we work together for a win-win. So I'm really, really proud of our managed care team; they've made a lot of gains. But I also think some of the gains they've made are being proactive in getting us set up to take on those higher acuity cases. And so some of this is just access to the right payers with the right incentives for physicians and some of it is ongoing rate negotiation. But there was nothing particularly different in this quarter. With that, maybe talk about revenue cycle.

Yeah. Maybe just one additional point or context as to why I said what I said, 90% and they're like we're in the middle of doing our budget process. And so Eric and I had the pleasure of talking to our Board about kind of progress and our confidence that we have going into 2024. And some of what you see, as Eric was mentioning, managed care is an ongoing effort that we do, right, day in and day out, our dedicated team kind of focuses on this. And what gives us some degree of confidence when you look at the contributions on the top line side is how much work that team has done and contracted going into next year. So when we give guidance and as we give the visibility into 2024, our confidence is driven by the fact that we've already got 90% of our contracting baked in this space. So that's why it's there. And it is, again, when you go back to what we have built over the past several years, it is a consistent plan that allows us to have some degree of predictability to it. And I'm glad you asked on the revenue cycle front. We had talked about this in the past. Revenue cycle represents two opportunities for us. One is cash flow generation on a faster basis. It also allows us to get greater yield through our results. And in rev cycle, the it's a difficult job, as you know, in the healthcare services sector for us. We deal with payers that are constantly trying to find the right way to move business into our facilities. And so we're always dealing with the managed care providers, making sure that we're following their protocols appropriately and making sure that we do the right things on the front end to make sure that we decrease denials on the back end. And then when we do have denials on the back end, that we're actively managing those in accordance with our contracts with the payers. When you do that properly, you get increased yield opportunities. We've done a pretty good job of that, in the build that we have done over the years. We get to apply that logic every time we do an acquisition. So this is one of the values that we provide when we do M&A. So when we often talk about buying companies and then taking a turn off of those effective multiples in the second year and half years of ownership, part of that is applying our rev cycle approach, getting better yield and accelerating cash.

That's helpful. One follow-up question: can you give an update on how the seven divestitures you've made this year are tracking against the $100 million target? Thanks, guys.

Yeah. So in the quarter, we estimate roughly $35 million, plus or minus, of revenue that we're jumping over this year from revenue that we incurred last year in the third quarter that we don't have this year from the seven acquisitions. So we don't spike that out separately. We do that intentionally because I think we're proud of the growth that we have. But that's the business that we would have disposed of earlier this year.

Thank you. Ladies and gentlemen, that concludes today's event. Thank you for attending, and you may now disconnect your lines.