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Health Management Associates, Inc. (NYSE:HMA)

Q2 2012 Earnings Call

July 24, 2012 11:00 am ET

Executives

John Merriwether - VP, Financial Relations,

Gary Newsome - President and CEO

Kelly Curry - CFO

Bob Farnham - SVP - Finance

John Starcher - SVP and Group President

Analysts

A.J. Rice - UBS

Whit Mayo - Robert Baird

Darren Lehrich - Deutsche Bank

John Ransom - Raymond James

Gary Leiberman - Wells Fargo

Ralph Giacobbe - Credit Suisse

Kevin Fischbeck – Bank of America

Tom Gallucci – Lazard

Gary Taylor - Citi

Operator

Good morning, ladies and gentlemen. My name is Martina and I will be your conference operator today. At this time, I would like to welcome everyone to the Health Management Second Quarter 2012 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (Operator Instructions).

I would now like to turn the call over to Vice President of Financial Relations, John Merriwether. Mr. Merriwether, you may begin your conference.

John Merriwether

Thank you, Martina, and good morning everyone. I'd like to welcome you to Health Management's second quarter 2012 earnings conference call.

Before we get started with the call, I would like to read our disclosure statement. Statements made thought this presentation are based on current estimates of future events and the company has no obligation to update or correct these estimates. Listeners are cautioned that any such looking statements are not guarantees of future performance and involve risks and uncertainties that our actual results made different materially as a result of these various factors. Additional disclosure statements are included on the press release issued last night at 4:00 p.m. Eastern Time.

In addition, adjusted EBITDA, as mentioned on this call, is defined as consolidated net income before discontinued operations, net gains, losses on sales of the assets, net interest and other income, interest expense, income taxes and depreciation and amortization.

On the call with me this morning are President and Chief Executive Officer, Gary Newsome; Chief Financial Officer, Kelly Curry; Senior Vice President - Finance, Bob Farnham; and Senior Vice President and Group President, John Starcher.

Thank you for you attention. And I will turn the call over to Gary.

Gary Newsome

Thanks John, and good morning everyone. Thank you for joining us to discuss another strong quarter as we report our result for the second quarter ended June 30, 2012.

For the second quarter from continuing operations and compared to the same quarter a year ago, Health Management reported net revenue growth of 20.2% to $1.472 billion and adjusted EBIDTA growth of 14.5% to $233.3 million.

Excluding the impact of approximately $22.3 million or $0.05 per diluted share for interest rate swap accounting, as well as the significant mark-to-market adjustment on the swap due to interest rate conditions, diluted earnings per share from continuing operations increased 5% to $0.21 as compared to $0.20 per diluted share for the same quarter a year ago.

Contributing to these solid continuing operations financial results were an admissions increase of 7.1 %, adjusted admissions increase of 13.1%, emergency room increase of 20.1% and a surgery increase of 21.4%.

For continuing operations at hospitals we have owned and operated for one year or more, referred to as same-hospital continuing operations, compared to the prior year's second quarter, net revenue increased 6.1%, adjusted EBIDTA increased 7.4% to $255.4 million resulting in a 30 basis point improvement in EBIDTA margin to 19.7%. In addition, surgeries and emergency room visits were up 2.9% and 3.8% respectively.

Outpatient volume growth in the second quarter of 2012 continues to be a bright spot. While we still believe that a sluggish economic and anemic job growth is still weighing heavily on consumers utilization of in-patient services, the declines in uninsured volumes, which we have seen for several quarters, continued in the second quarter and while observation stays remain largely unchanged quarter over quarter, we have experienced an increase in observation stays in the greater than 24-hour category. This contributed to a same-hospital admission decline for the second quarter of 4% compared to the same period a year ago.

Outpatient services, however, continued their positive trend as outpatient surgeries grew and, as a result, same-hospital adjusted admissions were essentially flat for the quarter. Importantly, had uninsured and greater than 24-hour observation stays been the same as last year, second quarter same-hospital admissions would have declined 2.4% and same-hospital adjusted admissions would have increased 1.5%.

We are achieving strong operating results and high quality score despite the inpatient volume challenges by being effective stewards of our resources and continuing to seek efficiencies through process. We are focusing on our patient centered operating strategy while implementing our emergency room operations, physician recruitment and market service development initiatives. And we continue to believe that there are more opportunities for improvement in both the same-hospital and recently partnered or acquired facilities.

As evidence that our operational and patient centered focus is working our Santa Rosa Regional Medical Center located in Milton, Florida is number one in the entire country for three Medicare quality core measure categories heart-attack care, heart failure care and phenomena care.

In addition, as reported in Orthopedics this week and based on a study that reviewed a database of more than a billion patient records, our River Oakes Hospital in Flowood, Mississippi was recently named the number two hospital in America for back surgery. To quote the article, "River Oaks is the number two hospital in the country to give you the best bang for the buck for back surgery." We are very proud of the great workers of our associates and physicians that they are doing about Santa Rosa Regional Medical Center and River Oaks Hospital.

As you know a physician requirement is a key component of our operating strategy and just recently we announced strategic partnership with athenahealth to support our national physician and care delivery network.

Through this partnership athena's cloud base practice management, electronic health record or EHR and care coordination solutions and services will be introduced to 1200 plus providers who operate in 15 states at more than 300 locations. athena's suite of solutions will also be made available to the nearly 10,000 independent physicians affiliated with Health Management hospitals.

Our decision to partner with the athenahealth was co-driven by our clinical and business teams, but in large part was a physician-led mission. The signing of this partnership agreement culminates a 12-month review and due diligence process that involved more than 350 clinical experts and more than 200 physicians and we are excited to transition our physician associates to the athenahealth platform over the next 12 months.

As I mentioned on our first quarter earnings call, subsidiaries of Health Management completed the transaction to joint venture five INTEGRIS Oklahoma hospitals. Under the joint venture Health Management owns an 80% controlling interest in five hospitals and manages the day to day operations. The transaction with effective April 1, 2012, and combined these five hospitals represent 218 licensed bed and generates approximately $95 million of net revenue before the provision for doubtful accounts over 12 months. And this was all immediately prior to the joint venture. We're excited about the new partnership and the integration and the process is going very, very well as expected.

I'm pleased to report that our acquisition pipeline remains as active as ever, as potential partners are seeking us out for operational expertise, systems, capital resources, and even more importantly our patient centered approach and cultural fit.

We have several projects at various stages and while we have completed one transaction thus far in 2012, we continue to believe we will do an additional one to two transactions during the remainder of the year.

Switching gears a little here for a minute. We also recently announced a new addition to our leadership team. So we are very about welcoming to our team, Steve Clifton. Steve will be joining us in mid-August as our Senior Vice President and General Counsel. He has been serving as the Vice President of Legal Operations of HCA since 1997 where he was supervising 45 attorneys in all aspects of law and operations. He brings with him more than 25 years of legal experience and is a proven leader in the areas of healthcare law, compliance, and physician relationships. We're looking forward to Steve's arrival in August.

Also I want to recognize Linda Epstein for the work she has done in her role as the Interim General Counsel. She will be continuing to play a critical role in our legal department. Her initiative, leadership and dedication to Health Management has been greatly appreciated.

Thank you again for your attention. At this point, I'll turn the call over Kelly for a review of our second quarter results in a little further detail.

Kelly Curry

Thanks, Gary. Good morning to each of you. I'm sure you've all seen the press release that we issued last night. So as usual my comments will be brief.

Again our second quarter net revenue grew 20.2%, adjusted EBIDTA grew 14.5%, and excluding interest rates swap accounting and mark-to-market adjustments, our diluted earnings per share from continuing operations increased 5% to $0.21.

Same-hospital operations continued to perform well. Compared to our prior year's second quarter our net revenue increased 6.1% and net revenue per adjusted admission was strong at 6.3%.

For the eighth quarter in a row, two years now, we have seen a decline in uninsured patients seeking care at our same-hospital facility. Our markets own unemployment rates have improved compared to last year, but we are still running 60 to70 basis points above the national average. As we have said previously, we believe the unemployment rate will have to significantly improve before we experience sustainable meaningful in-patient line of growth.

Our continuing same-hospital uninsured admissions for the second quarter totaled 7% of total admission, which is a 40 basis point decline from the same quarter a year ago, and twice what it was in the first quarter at 20 basis points.

As you know, there are three components that comprise our accounts for uninsured and under-insured patients: bad debt expense, uninsured discounts, and charity indigent write-offs. These figures are consolidated and include our acquisitions.

Bad debt expense for the second quarter was $214.6 million or 12.7% of net revenue compared to $170.8 million or 12.2% of net revenue for the same period a year ago. This is within our objective range.

Uninsured self-pay discounts for the second quarter were $311.9 million, compared to $232.5 million a year ago. Health Management's charity and indigent care write-offs for the second quarter were $24.3 million, compared to $23.4 million for the prior year.

The sum of bad debt expense, uninsured discounts, and charity/indigent write-offs, as a percent of the sum of net revenue, uninsured discount, and charity/indigent write-offs, which Health Management refers to as our Uncompensated Patient Care Percentage was 27.2% for the second quarter compared to 25.8% for the same quarter a year ago, and 26.1% for the first quarter ended March 31.

Our adjusted EBITDA from continuing operations for the second quarter was $233.3 million or 15.8% of net revenues, an increase of $29.5 million or 14.5% over the prior year's $203.8 million.

On a same-hospital basis, our adjusted EBITDA from continuing operations for the second quarter was $255.4 million or a 19.7% margin compared to $237.8 million or a 19.4% margin for the same period a year ago. This represents the 30 basis points $17.6 million or 7.4% increase for the second quarter this year.

As with consolidated adjusted EBITDA, same-hospital EBITDA includes approximately $2.9 million of Medicare and Medicaid HIT incentive reimbursements, which was offset by approximately $5.5 million of government program payment deductions.

Moving over to the balance sheet and cash flow statement, total assets as of June 30 were nearly $6.2 billion. The balance in our accounts receivable account net, as of June 30, was $974 million, and the balance in the allowance for doubtful accounts was $621.6 million.

Health Management's days sales outstanding as of June 30, were 48, are one day less than the 49 reported at June 30, 2011. We received a Medicare tie-in notices for the Tennova hospitals during the second quarter and build up of AR has now been billed and received.

As a result, our cash collections continued strongly and we're achieving our internal targets. For the second quarter, cash flow from continuing operating activities was $228.9 million, after cash interest and tax payments aggregating $79 million. Again, cash flow from operations was positively affected by the collection of the AR associated with the Tennova Health Medicare tie-in notices.

Our capital expenditures for the second quarter were $113 million and with regard to our debt covenants as of June 30, Health Management’s total leverage ratio was 3.9 and the interest coverage ratio was 4.1. These ratios compared to a total leverage ratio maximum of 5.5 and an interest coverage ratio of minimum of 3.25. We are well within those requirements.

As with the last quarter, I want to take a minute here and mention the accounting for the interest rate swap. When we provided our 2012 objectives earlier in the year, we expected to incur $20 million or $0.05 per share per quarter of additional interest expense related to the swap.

Once again we required to mark the swap to market and because the yield curve continue to change with short-term rates falling, and longer term rate steepening, we incurred an additional $2 million of interest expense. We will continue to mark the securities to market each quarter and expect that if interest rates rise, our interest rate expense could be mitigated in the future.

So in summary, and a review of the second quarter results, excluding the impact of approximately $22.3 million or $0.05 per diluted share for the interest rate swap accounting, diluted earnings per share from continuing operations increased 5% to $0.21 as compared to $0.20 per diluted share for the same quarter in the prior year.

Same-hospital adjusted admissions were flat and would have grown 1.5% had uninsured volumes in greater than 24-hour observation stays been same as the prior year. Same-hospital surgeries were up 2.9% and ER visits were up 3.8%. Same-hospital net revenue increased 6.1% and same-hospital net revenue for adjusted admission increased 6.3%. Same-hospital adjusted EBITDA increased 7.4% to $255.4 million and same-hospital adjusted EBITDA margins were up 30 basis points to 19.7%. And cash flow from operations totaled $229 million.

Thanks again for your attention. I will turn the call back over to Gary.

Gary Newsome

Thanks Kelly. We are very pleased with the results of our second quarter ended June 30th. We are reaffirming our 2012 annual diluted EPS objective of between $0.80 and $0.90 for the year excluding Medicare and Medicaid HIT payments, interest rate swap accounting and mark-to-market adjustments.

With a happy year ahead of us we are updating our 2012 annual same-hospital admissions objective range. We now expect same-hospital admissions for 2012 to decline between 1% and 3%. In addition, the company is adding a 2012 annual same-hospital adjusted admission objective range. The company expects same-hospital adjusted admission growth for 2012 to be in the positive 1% and negative 1%.

Changing topics here just for a second. A few of you called last week to about several articles written by two local Pennsylvania papers, the Carlisle Sentinel and Carlisle Pennsylvania and the Patriot-News in Harrisburg, Pennsylvania. In fact, an analyst report published this week referenced the news coverage.

Since we were enable to comment lastly if you wanted to give you more color and what was reported and some additional information concerning the story out of Pennsylvania. To do so I will break a little from form here and introduce John Starcher, our Group President for the Eastern Division that includes Pennsylvania market.

As many of you know, John joined us from Catholic Health Partners earlier this year. He will provide information on the call on news article, but he also give you some inside into what we think is happening in Pennsylvania. John has got great unique perspective and experience here as he spent more than five years leading CHP's fight against the SEIU, a healthcare labor union. I am excited for many of you to meet John in the upcoming analysts conferences and next year’s investor day. John?

John Starcher

Thank you, Gary. In the interest of time I'll try to be brief. Last week, the Carlisle Sentinel and subsequently the Patriot-News reported on (indiscernible) that out hospital, Carlisle Regional Medical Center (inaudible) 60 Minutes segment this fall purportedly in September. One paper exclusively remains at former Carlisle Emergency Room physician and another quoted an anonymous doctor as the source of the information.

It is our understanding from various sources that producer from 60 Minutes has been contacting and attempting to contact former physicians for a story. We are unclear as to whether the alleged project is focused solely on Carlisle Regional or something more broadly that would include other HMA Hospital or others in the industry.

We do know, however, that the producer has solicited contact from physicians who have worked with either Community Health Systems or us. His very public request is posted on the American Academy of Emergency Medicine websites. While I was surprised to see the spate of news story about this based on my previous experience with SEIU unfortunately, I was not surprised to see the stories originate our Pennsylvania.

For several months now, we have seen increasing levels of what we believe to be SEIU labor union tactics aimed that our company in general and very specifically the Pennsylvanian market.

You might be aware that the union was present at our recent annual stockholders meeting. It has also put up a website. It has run newspaper ads. It has passed our fliers at various physician seminars and physician career fairs. It is distributed whether inflammatory highly misleading and grossly taken out of context messages to various news outlets.

The majority of all this Union propaganda seems to be originating out of Oakland, California. The SEIU has not formally contacted us with any requests or demands at this time.

I have to admit there is a déjà vu in all this for me. These are the very same tactics that the SEIU used during their campaign against CHP and incidentally the very same highly aggressive tactics used in previous corporate labor campaigns with other large healthcare systems including Kaiser, ACA, Tenet, Community Health Systems, Sutter, Catholic Health West, Abiquiu Health, and Resurrection to name just a few.

In summary, we are aware that a possible story is out there, it is now very public. It is obvious we are seeing and should expect to continue to see increasing SEIU driven activity. Whether the two related is anyone's guest. Based upon my personal experience and having closely watched SEIU's campaigns against other large health systems, it now simply appears to be our turn.

I hope this gives you some context and more information. I look forward to meeting many of you soon.

At this point, Gary, I'll turn it back to you.

Gary Newsome

Thanks, John. We believe our objectives remain achievable by focusing on the blocking and tackling of hospital operations. And by that I mean maintaining the patient-centered focus, creating a desirable workplace environment for both associates and physicians, seeking efficiencies through process and controls and sticking to our proven operating initiatives. Our successes whether yesterday's, today's, or tomorrow's are attributable to the dedicated efforts of our clinical and ancillary associates and physicians.

Our associates care for millions of patients, somewhere around 4 million patient in counters each year and delivering high quality care as a team effort from our nursing and clinical associates and physicians who provide direct patient care to our ancillary and home office based associates to support to our caregivers. We are committed to doing the right thing, being servant leaders and never settling.

I'm very proud of the clinical results we are achieving. I'm grateful and appreciative of the tremendous efforts of our associates and physicians who make everyday, to comfort and heal those who need. Our mission is to provide the people, processes, capital, and expertise necessary for our hospital and physician partners to fulfill their local missions of delivering superior healthcare services. Health Management enables America's best local health care.

Thank you again for your attention this morning. We will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of A.J. Rice from UBS. Your line is open.

A.J. Rice - UBS

Thanks. Hello everybody. Probably two questions if I could ask. First of all, just one expense item, other operating expense is up sequentially as a percent of revenue it's about 100 basis points and 200 basis points year-over-year. I know legal is one thing that you tend to run through there, but there is other stuff. Can you just comment on what's going on there and how if there is any unusual items?

Kelly Curry

Well, what you are seeing is really with legal expense, A.J., just running a little higher in this quarter.

A.J. Rice - UBS

Okay. Any way to -- I mean that's a fairly big jump. Is that all legal you think?

Kelly Curry

It is a bump, it just has a function of process of how we were accruing relative to how the invoices came in which is -- which we have now resolved for the balance of the year, which is why we reaffirmed our guidance.

A.J. Rice - UBS

So this isn't a new level of normal, it is just a bump at this quarter that will go away?

Kelly Curry

Yeah, and of course we have got acquisitions in there.

A.J. Rice - UBS

Okay. My other question is as you guys have talked about in your, in your prepared remarks you have made, you have updated your guidance, you have reflected the soft report on inpatient admissions in the second quarter, but effectively you must be assuming a nice rebound at least to sort of apply this volumes for the back after a year to hit that new updated guidance. Can you give us was it something about the way the quarter laid out in admissions, which you have seen in early July or there other factors that that make you think the volume should pick up somewhat trend relative to what we have seen in the first two quarters of this year and the back half the year?

Gary Newsome

A.J., its Gary. We really believe we have hit the bottom of the curve or thereabouts on the admissions decline. In fact we do feel -- we are not going to comment on July but we feel the way things have progressed throughout the quarter of the second quarter and the way things we look, we feel good about this objective range. And of course we will update it again as we get more clarity on that so.

Operator

Your next question comes from the line of Whit Mayo from Robert Baird. Your line is open.

Whit Mayo - Robert Baird

Hey thanks, good morning. I got this question a couple of times last night, I think I sort of know the answer, but with your uninsured volumes going down in the quarter your uncompensated gear did go up 140 basis points, I mean there were acquisitions maybe skewing that number, can you give us maybe a sense for sort of how we should be looking at the same-store uncompensated trend line, just any color, Kelly, to help force that out forth.

Kelly Curry

Sure, Whit. Well essentially man, I mean it is your right it is acquisition. Also there is an element in their from our rate increases, which would be attributable to the discount that are in there that we're writing off would have an impact on increasing those as we raise rate.

Whit Mayo - Robert Baird

Okay, but I mean, was there any underlying change in your collection trends?

Kelly Curry

No, no, actually as our numbers have indicated our cash collection as our AR days are showing we are doing a very, very good job in our collection areas. We are very happy with it.

Whit Mayo - Robert Baird

How much of your commercial book is still tight at charges at this point?

Kelly Curry

Tiny.

Whit Mayo - Robert Baird

Tiny bit, okay. One other questions that I had is the CapEx in the quarter did jump up, I think you have really been running historically in count of $80 million to $85 million number range and a $114 million were higher than what we were used to. Was there any accelerated spending, timing, just how should we look at that number and kind of think about the back half?

Bob Farnham

Yeah, hey, Whit, this is Bob. Yeah, we have one hospital that's a replacement hospital that is under construction right now in Poplar Bluff, Missouri. And so that contributed about $47 million of expenditure in the quarter. That project is going to continue through probably the first quarter of next year. So originally, we had thought that that facility was financed through REIT. Originally we thought that REIT would pay for the construction and then it would continue on through the REIT, but it doesn't -- that didn’t happen for us. So, we are financing that project internally. And then probably after it's done we will look for some long range financing for that facility.

Whit Mayo - Robert Baird

Okay, that's helpful, and may just to get back the AJ's question about the legal accrual let me just ask it more directly. I mean, Kelly, will you disclose with the actual dollar amount that was trued up in the quarter with what that was?

Kelly Curry

Well, no because we indicated at the beginning of the year that we'd include our legal cost in our estimates for the year and we have done that, and that's why we have reaffirmed our objectives. And this is just a matter of as the invoices come in, if we got through this process as we said before there is various places that you go through it is going to be a two year process and we are just working with it.

Operator

Your next question comes from the line of Darren Lehrich from Deutsche Bank. Your line is open.

Darren Lehrich - Deutsche Bank

Okay. Thanks everybody, good morning. Just back to Whit's question actually on CapEx, so I hear you Bob, we'll have a little bit more expenditure related to this replacement project, but relative to the 4.5% to 5.5% revenue range where does CapEx look like it is going to fall now for calendar year '12?

Bob Farnham

Yeah, the guidance as I think 4.5% to 5.5% that is probably been a bit at the higher end of that, probably 5.5% may be a little bit higher. So it will come in the higher end of the guidance now because we are financing that project internally.

Darren Lehrich - Deutsche Bank

Okay. Are there any other replacement hospitals that you'll be getting to this year that's that's really yet to know we've got a taste for kind of the run rate of CapEx?

Kelly Curry

Now, no, no, no, it's just the one. It's just the one that in the -- as our cash flows are stronger. But what we didn't want to do is we didn't like the financing terms that we were looking at. So we just decided we would do this internally till we got a better deal, which is what we should do. So now it's just being reflected at the CapEx, whereas before it was being externally financed.

Darren Lehrich - Deutsche Bank

Got it. And then as far as IT goes, how much will you be deploying about towards this, athena EHR project and is there any way to size how much investment you'll be making in your own systems internally just to I guess to comply with a meaningful use?

Kelly Curry

Yeah, minimal dollars on the athena thing. Certainly all included in our range reference for our CapEx and that also includes our meaningful use update. As you know because we're internal, we have our own systems. We do this in-house and it's -- since we did the work on the first phase the meaningful use, we've got the people, and we've actually got a plan laid out on how we're going to do it et cetera, and it's progressing. And it's just not going to be a major cost to us.

John Starcher

Well, athenahealth is cloud based. So we're not going to have the investment in hardware, software, and software maintenance that we would with another system.

Darren Lehrich - Deutsche Bank

Right, okay, and then if I could just I wanted to go back to Gary's comments on with regard to the impact you're seeing from the shift in observations. And if I heard you correctly there's little bit of a newer element in terms of the impact that we're seeing this quarter. I just want to flush out a little bit more. The shift that I guess we've seen overall has been pretty prolonged but there sounds -- it sounds like there's a newer element in terms of greater than 24 hours stays. So what are you seeing there, and can you give us a sense of where you think you're in the overall process of reclassifying patients in observation?

Gary Newsome

Well, first of all, observation days overall has been fairly flat. What we've seen is the shift from one day to two days stay and by definition of observation patient is a 23 hour stay. But what we're seeing now is a phenomenon with payors of all classes that are really, in some cases, have financial arrangements with physicians that incentivize the physicians to not admit the patients to put them in observation. I mean, we've had a extreme case where quite frankly and we were obviously able to reverse this because it was extreme. But just to give you a flavor for it, we had a patient that was admitted to our ICU on a ventilator as an observation patient. And of course, we had that reversed, and that was really a function of the financial relationship between the payor and a physician. And we're seeing some phenomenon.

Now, what we're doing and what we've been doing and we have all the tools and the people involved in this is really enhancing our documentation, our processes, everything necessary so that we, and then also additionally with our new Vice President of Payor Relations, we have opportunity to go back and as we negotiate and renegotiate with payors to really get this clarified so we don't have that as a problem going forward in the future.

Kelly Curry

In addition we're rolling out from enhancements through our clean doc systems, and assist our feet on the ground, if you will, and in our ER operations to deal with this. But it's just it's principally, as you might imagine managed care payors and we're -- it's just a part of their continuing game. But the reason why we let you guys know is that we felt that it was important for you to understand what we were seeing relative through our admissions as a tie to the greater than 24 hour observation stays.

Darren Lehrich - Deutsche Bank

Okay, last thing here just, any updates from your investigation, any new developments there? I just want to make sure we're aware of any kind of disclosures that we will get in the 10-Q on that?

Kelly Curry

Really there is nothing new to report at this time. I think that what you'll find in any of the filings going forward is we will be very consistent with what you've seen in the past.

Operator

Your next question comes from the line of John Ransom from Raymond James. Your line is open.

John Ransom - Raymond James

Could you give us any more clarity on the mix of hi-tech payments third and fourth quarter? Will third quarter looked like second quarter or is it a different number and any idea there?

Kelly Curry

Well, that -- my thought is if you owe the government money it's due today, if they owe you it can wait. And, so I think that's what we're seeing. We're pulling pretty much, expecting most of it to show up in the fourth quarter.

John Ransom - Raymond James

Do you think third quarter looks like second quarter just from modeling purposes?

Kelly Curry

Probably now.

John Ransom - Raymond James

Okay, but your annual number, you still think any anticipated. What would cause you not to book your annual number? Would it just be the government dragging the feet and your account is not being comfortable that you can book a revenue?

Kelly Curry

Oh, no, we -- well, we've to, again now the -- I think you and I discussed this in the past that the requirements for booking that or has to do specifically with when the cost reports are filed unrelated to the cash payments and for the cost reporting period that the payments are received in, okay. So that will depend on and our cost reporting periods varies for our various hospitals. So -- but we were -- are expecting the cash to come in and it will be $90 million to $120 million.

John Ransom - Raymond James

Okay. And secondly, you guys have talked about the pipeline in the past. Any -- I know you mentioned it, but did you think may be you might be a little further along this year in terms of an out feel anything that's flipping in terms of timing or are you still on track?

Gary Newsome

I think we're still on track. In fact the pipeline is probably or not probably is the most attractive group of hospitals that we've seen probably historically. And that being said, we've had opportunities to do transactions and we decided not to do them for various reasons either strategically didn't fit or in markets where we did not want to venture into. But we feel very good about our pipeline is excellent facility and I think it's just a matter of timing, John.

John Ransom - Raymond James

Okay. And this is more of a philosophical question but it strikes us at least that may be markets that were attractive a decade ago just demographically don't look that attractive today. In light of the fact that, I know you're changing what you're looking to buy to more cities that have faster growth and are larger, but any thoughts about your existing portfolio and maybe some assets that may come out of that over time that where the demographics are never going to get you any kind of growth?

Kelly Curry

Well, in terms of our acquisitions criteria that's which we've shared with you, we're very focused on that. And we're not opposed facilities, I mean, for instance we did the five INTEGRIS hospitals, which would be smaller, and probably more typical of what we did 10 or 15 years ago. But we've also, we've also picked up some larger facilities and for instance physicians with Regional in Nashville Tennessee, as a part of the Tennova transaction.

So we're opportunistic. We, it's more about the demographics and the out migration and the location and being non-urban that drive our decision making. But any facility that and what Gary is referring to is is that various facilities that's come our way that might be a part of that strategy but upon closer inspection they fail. And if they fail our screens then we're just not interested because we're very disciplined.

Gary Newsome

John, I think that you may be happy with part two of your question, it's about our current portfolio and looking at where we have hospitals versus we're constantly evaluating our portfolio of hospitals. We've had hospitals in our systems from day one that we organized as a company back in the '70s and it's interesting hospitals continue to perform very well. With that being said, it's just -- it's prudent for us as stewards of this company to continue to look at our portfolio and appropriately adjust it as we go forward.

Operator

Your next question comes from the line of Gary Leiberman from Wells Fargo. Your line is open.

Gary Leiberman - Wells Fargo

Just wondering if you talked about your depreciation expense went up fairly substantially, sequentially in year-over-year much more than so than your PP&E, is there some dynamic going on there?

Bob Farnham

Yeah, Gary, its Bob. This quarter as well as the first quarter the biggest reason for the increase was the Tennova acquisition that we closed October 1st. But you're right in your observation, depreciation expense is up about $7.5 million, I guess, in the second quarter over the first quarter. And there are a couple of reasons for that, and number one is INTEGRIS transaction we closed April 1st. That probably added about $2.1 million of depreciation for the quarter. The Monroe, Georgia facility, replacement facility that we finished in the first quarter, that came online on April 1st, that added about a $1.5 million, $2 million of depreciation for the quarter.

Additionally, I mentioned the replacement hospital it's under construction out in Poplar Bluff. We had to increase the depreciation there so that we were fully depreciated on the book value there by the time we opened the new facility and that's about $3.5 million to $4 million this quarter and that will probably continue through the first quarter of next year. So those are really the reasons that contributed to the increase in the second quarter over the first quarter.

Gary Leiberman - Wells Fargo

Okay, and then rents came down a little bit, is there anything going out with any of your leases or anything?

Bob Farnham

Yeah, we over the last six months or so we really wanted to take advantage of the lower interest rates and so as some of our equipment leases have termed out, we've replaced those with some longer-term capitalized leases. And right, you're actually sequentially rent expense down a little bit and so there is a little bit of flip there between rent expense and depreciation from increased capitalized lease.

Gary Leiberman - Wells Fargo

Okay. Do you think we'll see more of that throughout the year or do you think you're pretty much done after?

Bob Farnham

Not probably, I think that the quarterly depreciation, that's a pretty good run rate for the rest of the year and may be even up a little bit. But yes, I think you'll continue to see us take advantage of low interest rates and execute leases for equipment acquisition.

Operator

Your next question comes from the line of Ralph Giacobbe from Credit Suisse. Your line is open.

Ralph Giacobbe - Credit Suisse

Last quarter, I think you guys talked about working with HPG on ortho pricing and renegotiating some of your contracts and starting to roll that out. I guess did you see that benefit in the second quarter, is that back half benefit, and if at all can you size it for us?

Bob Farnham

Yeah, it's Bob. We did wrap up, I think, our largest fixed hip and knee vendors we renegotiated with. I think the last we finished in April, early May, but we're beginning to see the benefit about a mid single digit price benefit there. So we're beginning to see that and should continue to see that through the balance of the year.

Ralph Giacobbe - Credit Suisse

Okay. And then just on the pricing side, pretty strong pricing now for what looks like two years. So, I guess, one, can you help us parse out what you see from a peer pricing perspective as opposed to a kind of an equity or payor mix benefit and may be talk about that in the context of your strategy whether it's focused on the ED or investment, new technologies to sort of help us understand the sustainability beyond where we're now and how big acquisitions are as part of sort of helping that pricing stat?

Kelly Curry

Well, in terms of what we've done, as a part of our general strategy, we are continuing to expand services and our marketing. In particular, we're paying a lot of focus on the outpatient side. As you heard us say, we've been increasing access in many of our services. We've been deploying technology where we can encourage that. An example that has been the make out where we've done these on an outpatient basis and continue to do so. And we will look for additional ways to continue to grow that business.

And what that's doing is that's driving some higher acuity to the outpatient side. Now, we all know that it's a higher acuity, but we don't know how high because we don't have any index to measure it against. But we know that it's taking place because we know we're doing stuff that previously we were not doing on an outpatient basis its more complex.

Bob Farnham

Just some comments relative to the quarter with regard the net revenue per adjusted admission, I mean, the business that we did get was very good business in terms of mix and acuity. On the inpatient side, even though admits were down 4%, inpatient surgeries were down less than 0.5% and case mix index was up was 1.41 in the quarter versus 1.40 for the prior year so, good mix of business and acuity on the inpatient side.

As Kelly said on the outpatient side, although acuity is hard to measure, we saw good results on surgery -- the outpatient surgeries were up almost 5% and really good performance. Orthopedics were up overall about 9%, spinal implants were up about 6%, cardiac business was actually pretty much flat overall and which is a better result than we’ve seen over the last six to eight quarters.

So, all those factors that would contribute to a higher net revenue for inpatients for adjusted admission were there this quarter for us. And I think it’s important to note, I mean, in terms of the fact that our outpatient business was essentially our adjusted admission for the past two quarters have been flat on the same-store basis because of the outpatient business that we are driving. It's still through and continues to be true that people that are insured in the markets that we are in unless carried into a hospital, they don’t want inpatient stays. And what’s being demonstrated here is that we are prosecuting our strategy of developing further business because they will seek outpatient services because they want take care of their health issues. So that continues to be a great opportunity for growth force.

So with the headwind of the increase in the observation patients over 24 hours, we still managed to replace that business, manage our cost real effectively, I mean, the flexible cost management that we’ve reflected enabled to shift between this in and outpatient business that we’ve seen as we continue to pursue our outpatient strategy really shows what kind of systems we have, what kind of people we have in the field they can execute on it.

So, I think it’s -- it really shows you what we are capable of this company. And in light of the ACA and what’s coming, it shows that one of the reasons why we are leader in cost management is that we know how to do it and it’s going to benefit us tremendously as we look forward to the full implementation of the ACA.

Ralph Giacobbe - Credit Suisse

Okay, that’s helpful. And then just my last one, I just want to go back to the observation calendar just to make sure I'm clear on exactly what’s going on, is there -- did you suggest there is something from a physician perspective that is a benefit to them to shift it that way I guess I just was a little bit unclear with that? And then just a second piece of that. I think you'd volume would be down 2.4 and adjusted admission up 1.5. So, I guess help us reconcile because that would be a benefit to both when you would think a shift would sort of help one and potentially hurt the other. So, if you would help us understand the numbers as well that will be great?

Bob Farnham

You mean the shift from for the doctor relative to the increase in observations?

Ralph Giacobbe - Credit Suisse

I think you said that if you sort of kept the numbers flat or made adjustments that volume would have been down 2.4 and the adjusted admissions would have been up 1.5. And I would think that it would help the volume, the potentially sort of heard the adjusted admission just sort of optics shifting one to the other so you can help us reconcile that?

Bob Farnham

Right. Well, I guess the numbers are what they are and calculated out. So, if you change -- the increase if you take out those observations it had on the inpatient is inpatients to our hospital they're not included in either side of the equation when we are doing it for calculations based on what the actual data was, but when we adjust what they become admission, you see what I mean? In other words has two point -- those 1.6 observations marked that’s not an inpatient or an outpatient, that’s an observation. So, when you add that statistic in if changes the numbers.

Ralph Giacobbe - Credit Suisse

So right now that’s not being included in an inpatient or adjusted admission staff.

Bob Farnham

No, no, observations are not.

Ralph Giacobbe - Credit Suisse

Okay.

Bob Farnham

Talking about the see because the statistic for outpatient is derived off of -- of a driven off of revenue and observation revenue is very low. So, it’s in there, but is insignificant, let's put in that way.

Unidentified Company Speaker

It’s not material.

Bob Farnham

You has question about physicians patient -- inpatient business is by design, a lot of the cases that historically been inpatient are moving to outpatient. Technology events everything associated were doing that. But in some cases physicians are incentivized through their relationship with payors to not in that. And to avoid doing so they like to use the observation process and in some cases those observations extent greater than 23 hours, which is not what observation was designed to do. So, from that standpoint we are working on that internally and as I mentioned before in our processes, in our documentation as well as our relationship with payors.

Operator

Your next question comes from the line of Kevin Fischbeck from Bank of America. Your line is open.

Kevin Fischbeck – Bank of America

Great, thank you. I was wondering if you just talk a little more about the same-store margins because obviously year-over-year the margins were down on a consolidated basis, but acquisition just viewing the analysis here. Can you talk about the line items and kind of what drove the 30 basis point increasing in margins on a same-store basis?

Bob Farnham

As we continue to – we continue to refine our cost management strategy. I think the work that we done on the – on our supply management, for instance, continues to get tremendous benefit for us. As you know, we actually negotiate our own orthopedic contracts and working with Bob and his team, they really, really make some inroads there, but with our orthopedic suppliers and that continue to benefit.

In addition, we are constantly looking at our processes. You heard Gary say for a very long time that we continue to improve your processes. What happens is is that as you simplify your processes your quality goes up. We know that’s true. We’ve demonstrated that with our core measure results.

And so, we continue to focus on that as well. And as you continue to do that you raise efficiencies with your associate staff. And I think you are seeing that, you can see that generally in the American economy. I think productivity gains are one of the things that have really been a driver of the economy as we gone through this economic period. So, we too are doing the same thing. And I think that one of the advantages that we get is it by having our own systems, where we find the need to enhance or provide additional information to our people who are on the ground, we have the flexibility to do that in a real hurry.

For instance, we were in a meeting – our normal financial operations meeting just a couple of weeks ago, and we were talking about looking at particular time to relate the patient accounts. And we are talking about looking in a particular patient account that we thought there might be some opportunity to drive better results from, and so our meeting is over at 11 o’clock, at 2 o’clock, I had a report in my hand.

So, that’s the kind of thing that just has a lot of value when you want to take advantage of opportunities and you keep adding those up and you continue to get it’s like picking up pennies, that’s a way you should describe it when I worked in a hospital. I don't have many problem with stopping and picking up pennies because you start picking up pennies, the people are thinking about the nickels and dimes and quarters, etcetera before you get a chance to get there. And so we keep our focus on managing our cost, on having the systems to give our people what they need in the field and frankly having the people that can take advantage of that which we have.

Kevin Fischbeck – Bank of America

Okay, so just to confirm that the other operating expense you mentioned earlier in the call that legal expense was a big increase in a year-over-year consolidated number. That number is getting your G&A that’s not in your same-store number, right?

Bob Farnham

Right. And that’s also how that’s – that also include the acquisitions as well, that part of an increase.

Kevin Fischbeck – Bank of America

Yeah, okay. And then just as far as your guidance appreciate the adjusted admission guidance, but so it looks like your adjusted admission outlook is kind of its pretty similar to what you did in the second half of this year -- I’m sorry, what you did the first half of this year into the second half of this year, but it looks like your admission number implies some improvement in the second half of the year. So, if you can just talk a little bit about the divergence between those two numbers?

Bob Farnham

As Gary said, we said after the first quarter we believe that we are moving into the U. Now, we don’t know where we are on it, but we believe we have moved into it. And we have had some the observation stays over two days, in the first quarter we dropped the items out we thought we are affecting our numbers and we would have seen a reduction in the amount of decline in our inpatient admission holding some things that we thought were variables that were new that we were holding those constant and continue to see that. And so, we do believe that as we look forward that we are moving into the year. Now, we don’t know where we are in U, but we believe we are in the U, and we do believe we are going to see a turn there.

For one thing and which you heard me say I’m sure, but if not others on the call I had and that is that in our markets we’ve seen a decline in unemployment. But that decline is not because people found jobs because they moved to Miami or wherever because the services in larger cities where folks that are in that situation are broader than they are in smaller communities and so we – that’s what happened.

Now we are seeing some, and it’s not throughout the company, I mean Florida is looking a little better to us as the state numbers indicate. Mississippi has been hard yet. We are looking – we are still looking for the State of Mississippi to better economic figures. But in general, we are seeing some flattening, we are in the U, we think it’s to going improve. That’s really what we’re trying to communicate.

And then in terms of the inpatient admissions, the adjusted -- excuse me, the adjusted admission figure that we gave, we talked about that for quite long back. We thought about given the guidance on that at the beginning of the year, I mean, we moved away with from because it’s been awfully tough to calculate that figure because there is a lot of numbers moving in and out of it. But we – as we continue to see like in the first quarter, we’ve had big adjustments for the amount of outpatient business that we’ve done in that figure. So, we do believe that as the proxy for our business it’s a very good number. So that’s where we provided it.

Kevin Fischbeck – Bank of America

So, you’re saying that you feel like the admission numbers have bottomed, but the outpatient numbers have been so strong, it just kind of conservatively assuming that number comes down a little bit and that – those two things coming even out?

Bob Farnham

That’s where – that’s what we are thinking and we are – I can’t, it’s a – we’re looking at the markets and we’re looking at these markets individually and that’s what our feeling is now.

Gary Newsome

This is Gary. I mean in the reality as we continue to deploy our strategy in our hospitals, same hospitals or the hospitals we currently own in terms of position recruitment and service development, all those things will continue to drive both inpatient and outpatient, I mean, that’s the strategy as we go forward as we get to expand our footprint, that message hasn’t changed now for several years. Fundamentally, it works.

And as we move into the various changes as we are seeing in the industry going forward as we develop our primary care networks in our marketplaces that’s the right thing to do. And by doing so as we expand these services in our footprint and marketplaces, we’re going to gain a bigger market share. And even in a lethargic economy, even in lethargic utilization trends, we can grow our market share.

Operator

Your next question comes from line Tom Gallucci from Lazard. Your line is open.

Tom Gallucci – Lazard

Good morning. Thanks for all the color. I guess just a questioner to about your relationship with payors. You mentioned on the observation whether issue is sort of become part of negotiation we tend to get some clarity there. So, one, do you expect the impact of that issue to be a similar magnitude going forward or do you expected to sort of reverse itself? And then number two just more broadly with relationship with payors [Technical Difficulty]

Unidentified Company Speaker

…clinical physician staff everything in the process. The other part is dealing with payors. So, the reason I -- that's a long answer is it we can improve that the whole situation with a greater than 23 hours internally, but get the full solution we have had the payors on board as well. And so there would be improvement, we help to not see that trend continue in fact.

Gary Newsome

Yeah, and we’ve done, how we are dealing with that number one as you know we’ve, I think we brought on new person as our Senior Vice President of Payor Relations, Jack Towsley. We are looking at our as we go into negotiating our contracts to deal with this issue. And then in addition, we are sharpening as I think I mentioned earlier we are really sharpening our systems kind of assisted as well.

And then finally I would say it’s sort of like back in New York, I guess, before Giuliani was Mayor, I used to be this guy saying on the corner all the time with the shell game going on. And that sort of what is like a managed care providers, it's a moving target. And so you go to be aggressive, you go to be on top of that. So, but we see this is something that’s I mean when you have the kind of environment that we are operating in, it just we're all have been have to alert and we're all been have to continue to sharpen our pencils.

Tom Gallucci – Lazard

Just as we’re thinking about the relationships more broadly their between hospitals and payors there, are there any other shells that are sort of being moved around these days that we should be thinking about?

Gary Newsome

Well, the revenue is may be was a poor example, but it comes to mind when I think about it that the –but now not really we are focused and I think our numbers demonstrate that we can run our businesses, and that’s what we are doing.

Operator

We have time for one final question. Your last question comes from the line of Gary Taylor from Citi. Your line is open.

Gary Taylor - Citi

Hey, good morning guys or good afternoon, I guess, but few minutes, a few quick ones. I just want to go back to I know several people have asked about this other operating expense item or just the dollar amount this quarter. Typically that amount would be up or at least flat seasonally into the third quarter, I mean, given these legal invoices you expense this quarter, do you look for on a dollar basis, other operating expense to be down sequentially?

Kelly Curry

Well, I think probably that the – as we said a that beginning of the year, we included in our guidance our expenses associated legal and we continue to affirm that. And we've having some changes from time to time and in categories and this is an example of one. In addition, as we do acquisitions that number could change so, which we expect to do for the years out.

Gary Taylor - Citi

So, it could be down or it could be up?

Kelly Curry

That's right.

Gary Taylor - Citi

Okay. On, I wanted to understand a little bit better, obviously the surgical growth has been good and that's been a driver of the same-store revenue growth and I think kind of the metrics of the math behind how the adjusted admissions worked, etc, can be confusing. But clearly that good surgical growth is driving same-store revenue growth. When we look at the total surgeries that you report I guess based on what Bob had said about outpatient surgeries been up about 5, inpatient being a little worse than flat, it looks like of your total surgeries roughly 60% of those are outpatient. Is that about right?

Kelly Curry

I have to dig up --

Gary Taylor - Citi

I don't know.

Kelly Curry

I have to dig them out.

Gary Taylor - Citi

Okay. And then a follow on. I just want to think about this, maybe we can follow-up as well, but when we look at your total surgeries they're about 58% of your adjusted admissions. I guess, do you have kind of a ballpark for what amount of the company's total revenue is driven by inpatient, outpatient surgery?

Kelly Curry

No, I don't.

Gary Taylor - Citi

No?

Kelly Curry

I don't have that.

Gary Taylor - Citi

Okay. Well, I'll follow up if I can. On INTEGRIS, do you have an estimate for EPS dilution this quarter? Do you believe it was materially dilutive to EPS this quarter?

Kelly Curry

No, we do not. We do not believe it will be dilutive.

Gary Taylor - Citi

But for this quarter was it?

Kelly Curry

They had a single digit margin the product push --

Bob Farnham

That of course.

Gary Taylor - Citi

Okay, last question on the SEIU. I guess, if you been around long enough, I guess we should all expect that there's campaigns, ads and commercials and maybe 60 Minutes stories or whatever, but kind of aside from that is there a reason why your Pennsylvania hospitals in particular, the employees might be more attracted to being in an union than historically? I guess, what we would really care about is how much risk that SEIU is successfully in unionizing your Pennsylvania hospitals, and if so, is there a material gap in wages, benefits, such that eventually that's something that's material to earnings power?

John Starcher

This is John. I think, as you pointed out, even the casual observer would appreciate that the SEIU in particular has been very active in large healthcare systems. And they're nothing if not opportunistic. And frankly, they run their course through all the other large particularly publicly investor-owned healthcare systems. And so, we appear to be the last organization standing.

Specifically with regard to Pennsylvania I think I'd look at that not so much in terms of the competitiveness of wages and benefits as I would. Some states simply are more prone to being pro-union than others particularly those states that are not right to work states. Pennsylvania is a very highly organized state in and of itself, it has got a high concentration of SEIU employees in and out healthcare, 1199P is very active. And so, that's why we believe its sort of the epicenter of the recent activities.

Gary Taylor - Citi

So, I guess, just my last follow on that. I mean, is there a reason for obviously Pennsylvania has been highly organized for years and maybe this is just, as you said, your turn, but outside of it kind of being your turn in terms of SEIU's target, is there a reason to believe your own employees would be more or less receptive to unionization than they might have been a year ago or five years ago?

John Starcher

No, no reason whatsoever. Frankly, our Pennsylvania facilities are performing extraordinarily well. Satisfaction scores are good, our relationships with physicians are good. So, no reason that would suggest some ground up effort by the employees. I think again it's simply an organization that's concentrated in Pennsylvania that's looking at an ability to be opportunistic.

Operator

I will now turn the call back to Mr. Merriwether for closing remarks.

John Merriwether

Great. Thank you, Martina. Just wanted to say thanks everybody for being on the call today. Another good quarter for Health Management. And have a great day.

Operator

This concludes today's conference call. You may now disconnect.

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