MedCath Corporation F3Q08 (Qtr End 06/30/08) Earnings Call Transcript

MedCath Corporation (MDTH)

F3Q08 (Qtr End 06/30/08) Earnings Call Transcript

August 7, 2008 10:00 am ET

Executives

Ed French – President and CEO

Jeff Hinton – CFO and EVP

Phil Mazzuca – COO

Analysts

Darren Lehrich – Deutsche Bank

Erik Chiprich – BMO Capital Markets

Rob Hawkins – Stifel Nicolaus

David Bachman – Longbow Research

Miles Highsmith – Credit Suisse

David Nierenberg – Nierenberg Investment

Whit Mayo – Robert W. Baird

Presentation

Operator

Welcome to the MedCath Corporation conference call. Today, management will discuss the company's operating results for its third fiscal quarter ended June 30th, 2008. Parts of this announcement contain forward-looking statements that involve risks and uncertainties. Although management believes that these forward-looking statements are based on reasonable assumptions, these assumptions are inherently subject to significant economic, regulatory, and competitive uncertainties and contingencies that are difficult or impossible to predict accurately and are beyond its control, including but not limited to legislative changes, which would affect the healthcare industry as a whole. Actual results could differ materially from those projected in these forward-looking statements. MedCath does not assume any obligation to update these statements in a news release or otherwise should material facts or circumstances change in ways that will affect their accuracy. These various risks and uncertainties are described in detail in risk factors in the company's Annual Report on Form 10-K for the year ended September 30th, 2007 filed with the Securities and Exchange Commission on December 14th, 2007.

A copy of this form including exhibits is available on the Internet site of the Commission at www.sec.gov. These risks and uncertainties include among others the impact of healthcare reform initiatives, possible reductions or changes in reimbursements from government or third-party payers that would decrease revenue, a negative finding by a regulatory organization with oversight of one of the facilities, and changes in medical or other technology and reimbursement rates for new technologies.

In management's review of the quarter they will make reference to adjusted EBITDA, which is a measure used by management to measure operating performance and to allocate capital. Adjusted EBITDA and similar metrics are commonly used in the healthcare industry as an indicator of performance, and are also used as a measure of debt capacity and ability to service debt. Adjusted EBITDA should not be used as a measure of financial performance as defined under Generally Accepted Accounting Principles. The calculation of adjusted EBITDA excludes many items in its calculation, and as a non-GAAP measure, is susceptible to varying calculations. Adjusted EBITDA, as presented by MedCath, may not be similar to other companies' definition and calculations. MedCath's press release issued and posted on its Web site prior to this call provides a reconciliation from income from continuing operations, a GAAP financial measure to adjusted EBITDA, which you might find helpful in your review of MedCath's quarterly results.

After Management's prepared remarks, there will be a question-and-answer session. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you have already done so, please press the pound sign now then press star one again to ensure your question is registered.

I would now like to turn the call over to Ed French, President and CEO. Please go ahead sir.

Ed French

Julianne, thank you and good morning everyone. We have several employees, physicians, investors, analysts, and other friends of the company joining us this morning for this third quarter earnings conference call. We're glad to have you online.

With me today here are Phil Mazzuca, our Chief Operating Officer; and Jeff Hinton, our new Chief Financial Officer. Jeff is new to the company and this is his first quarter being with us, and he's a name familiar to many of you I know. I'll begin this call by affirming our continuing transformation and success in building long-term value for this company and our shareholders. The strategy for building long term value relies upon several pieces that we've announced and we've consistently discussed since we embarked upon our plan, One, taking advantage of our highly leveraged smaller hospitals for incremental cost gains; number two, diversifying the procedure base for new admissions and market expansion because we already enjoy number one or number two market positions in heart care in our markets; number three, we're actualizing assets to build a stronger balance sheet permitting growth through acquisition as we take on a look and feel of a high acuity acute care hospital company; and number four, capitalizing upon our venture experience with doctors and community hospitals to add value in all of our markets.

We're developing larger hospitals to leverage existing capital investments and operating costs as we diversify our service lines. This is being done while leaving significant capacity on the balance sheet for acquisition and growth. Long-term growth and transformation thesis at MedCath is a sound one. To underscore our transformation consider the following using the beginning point of our strategic redirection in early '06 and the completion of projects that we've already announced, but excluding acquisitions or other unannounced expansion potentials. Two years ago, we had three hospitals under 50 beds. Two years from now we'll have one. And when we finish our expansion of Bakersfield Heart Hospital that's already been announced, we'll have none under 50 beds. Two years ago, we had eight hospitals between 51 beds and 100 beds. Two years from now we'll have four. Two years ago we had over 100 beds at only one hospital. Two years from now we'll have five. When we complete Bakersfield, we'll have six. Our bed count from same stores of 727 for existing hospitals in ’06 was 727. Two years from now we'll be 902 beds from same stores without acquisitions, after Bakersfield, 976. Our average hospital size will increase in capacity by 36% two years from now from where it was when we embarked upon our transformation. After Bakersfield, we'll be 49%. Our total bed complement will grow by 24% two years from now and 34% after Bakersfield, again excluding completion of new shelf space and excluding any acquisitions. The preponderance of new capacity comes online in '09 while we had just completed 60 bed addition in the TexSAn and 28 beds in Arkansas that we finished earlier this year. The next major project to be completed will be the 120 bed tower [ph] in Louisiana at the end of the second quarter '09, and then Hualapai Mountain Medical Center in Kingman, Arizona will be completed early fiscal year '10. The latest now planned is Bakersfield's 72 bed addition that I am expecting will come online around fiscal year '11.

We don't have to look far to get confirmation that we've embarked upon the right path. The past couple of years we've seen our core business change in many ways. We've been through Medicare changing value weight for cardiac DRGs then we saw severity adjustments. Last year, we went through the procedure mix changes, the drug-eluting stents to bare metal stents and we've seen a decline in open heart surgeries. We've also seen some shift in inpatient to outpatient procedures for certain non-complex stent interventions, and we've not seen the last of those. I'll have more discussion about that in just a minute.

Our company's done a very good job of adapting to all these changes. With these headwinds, we have still accreted operating margins from 14.2% when we embarked upon our transformation to 15.3%. We de-levered from about 2.4 ex net debt to 0.4 ex net debt. We repurchased roughly 9% of our outstanding stock and we continue to provide excellent quality care and improve upon quality care. We de-leveraged the balance sheet through divesting of three hospitals. We sold the smallest of these hospitals and those with the least earnings growth potential. With the strongest balance sheet among the investor-owned hospital company, you can be sure we're dynamically engaged in exploring how best to deploy capital to improve the earnings and thus shareholder value. Related to this, our Board this week has directed us to actively review our capital alternatives in the context of our larger capital plans to meet our immediate and long-term objectives. We have the benefit of significant flexibility as it relates to our balance sheet, and we're looking at ways to put this to use to add value for our shareholders.

The procedure mix changes or industry change is largely attributable to increased use of statin drugs and introduction of drug-eluting stents. We believe we will continue to see material growth in heart business due to the population growth, aging, and lifestyle choices affecting health status and thus higher cardiac cases. Though the procedure mix and delivery mix have changed, we like our core business. It's changing, but it's still good business. You heard me say that we'll see periodic bumpiness in our results until we get our capacity online given our footprint size. This quarter underscores that. We saw fewer admissions primarily due to episodic doctor group disruptions in two markets, and a continuation of the trend of business moving from inpatient to outpatient for some cath, one-day stay procedures. These two events resulted in fewer admissions that caused much of our disappointment for the quarter. But the intra-quarter story is one that further speaks to the unevenness of volumes. Because the doctor disruptions resulted in groups realigning their interests in two markets during the month of May and not getting engaged again till June, and because we saw a material move of inpatient stents to outpatient in another market beginning in May, that month created the delta for the quarter. The good news about uncompensated care for the quarter is that it is sequentially lower this quarter as a percent of net revenue.

June saw business return to more normal level for admissions and procedure volumes, except for some continued inpatient to outpatient volume improvement. For July, we saw continued growth in admissions and adjusted admissions. New doctors in place, new services including hospitalists, and positive changes in procedure mix the past couple of months encourage us. However, we want to be more definitive in addressing the inpatient to outpatient moves. We don't want to go through the same process we did last year with drug-eluting stents to bare metal stent conversions by chasing the numbers every quarter and having you remind us that we are. Now, the good news about that is we're seeing an uptick in drug-eluting stent usage. Materially, in some hospitals, given the latest reports of drug-eluting stent efficacy, we believe we've seen the bottom of drug-eluting stent to bare metal stent conversions as we reported last quarter.

As to the inpatient to outpatient matter, we will now project what we think the inpatient to outpatient is headed and get it behind us. We've seen a migration from Q1 to Q2 being 17.3% to 22.4%, for much of our one-day stent business as it moved to outpatient. For this quarter, we've seen it migrate another approximate 5% to 27.8%. Over the past two years, we've had three hospitals go through what we believe is the total migration that is likely to be the potential for one-day stay conversions.

This quarter we saw an approximate $1.3 million EBITDA impact compared to the same quarter last year. We're thus projecting that over the next two years, we'll see $4.0 million change in reimbursement as we migrate a segment of our one-day stent business and we assume that the experience of the remaining hospitals mirrors that of the three that have already seen the transition. Another trend in our stent business that will potentially offset the financial impact of the stent migration though is the current upswing in drug-eluting stent cases as a percentage of our total stent cases. For various clinical reasons, some of our physician partners have previously been methodical in their adoption of the drug-eluting stent technology. However, with the recent advances in this technology and new product introductions, we've seen these physicians begin to increase their use of these stents. If these trends continue, the increased utilization of drug-eluting stents could potentially offset the financial impact related to the migration of certain stents to outpatient that I just spoke of.

Through all these changes and evolution of the company model, we're honored by the recognition for our quality. In the June edition of the Joint Commission Journal on Quality, two reports commented on high performance hospital systems. These reports list all the systems in the United States that have six operating units or more, some cases actually included some that had fewer. The list of the top 98 highest performing hospital systems in the United States show MedCath Hospitals as a group at number 11 overall and number 3 throughout the United States in patient satisfaction. We're included among some of the most well known tertiary and teaching hospitals in the world. The next closest investor-owned hospital company ranks number 47, and the preponderance of investor-owned companies is between the 90th and 98th ranking. We take great pride in this accomplishment, particularly in the context of the headwinds that we have dealt with or adapted to over the last few years. I thank opposition partners and team members for their continuous and tremendous focus on what's right about quality care and how we support our customers.

A few of the challenges that we have moving forward are these, deploying capital so that we are appropriately leveraged though without hamstringing our growth; maintaining the systems and improving upon them to fine-tune our operation as to the length of stay management and labor resources due to the procedure mix change; implementing growth plans for our legacy business while we fill new capacity; and currently getting a specialty hospital target off our backs since we'll look and feel like the high acuity acute care hospital company we are becoming. And we welcome these challenges as they portend opportunities. We like our path, we like our story. We're enthusiastic about having what we've begun, and we're enthusiastic about continuing our capacity expansions we've spoken about over the last couple years and we continue to speak of today.

During this quarter, as Jeff joined us as our new CFO, I want to tell you that in a short time, he's shown that he can make a difference and I'm delighted he's on our team. I'm also delighted that Art Parker did a yeoman's job as interim CFO continues as our Capital Markets and Investor Relations Exec providing other financial management support and while assuming more responsibility to assist me with our more ambitious and ongoing development efforts. Let me now call upon Jeff for his report.

Jeff Hinton

Thank you Ed and let me start off by saying that I'm delighted to be a part of this management team and participating in what I believe is going to be a very exciting growth story.

Our press release distributed yesterday afternoon outlined similar complexities in reviewing our year-over-year performance. As such, unless stated otherwise, I will restrict my comments to same-facility results adjusted to exclude those items articulated in the release. In my view the three most important items to focus on this quarter are number one, the reduction in revenue both versus prior year and versus our internal projections; number two, the change from inpatient cases to outpatient for our stent business and how that change is expected to impact us going forward; and number three, uncompensated care defined as charity care plus bad debt expense. I'll also review our free cash flow during the quarter which is very strong, and provide an update on our development capital spending.

Overall, the third quarter was strikingly similar to the second quarter this year. Net revenue and adjusted EBITDA were basically equal. Our pretax income was down on a GAAP basis however, excluding share-based compensation expense, it was up 11.5% sequentially on lower minority interest expense and higher earnings from our unconsolidated affiliates. This quarter we had net revenue of $157.1 million versus $160.2 million in the prior year, 2% reduction. This reduction was primarily due to lower revenue in our hospital division which fell 2% year over year, and was flat, sequentially. In a moment, Phil will discuss more details around this reduction.

As Ed mentioned, we continued to be impacted this quarter by the migration of certain stent procedures from inpatient to outpatient. For the quarter we performed 27.8% of our drug-eluting stents as outpatient compared to 16.1% in year earlier period. We also performed 20.3% of our bare metal stents as outpatient compared to 9.7% in the third quarter of fiscal 2007. Both of these reflect further movement compared to the second quarter of 2008 when we performed 23% of our drug-eluting stents outpatient and 14% of our bare metal stents outpatient. We were especially impacted at two hospitals this quarter that began experiencing similar pressures by certain payers to migrate certain stents to outpatient. We believe that this migration is likely to continue, but only for a subset of our stent cases. And it already quantified the further impact we would expect from our history of that migration to be approximately $4 million on a fully developed annual basis. We are not certain how much time will be required to reach those levels. As Ed has also said if more recent trends continue that number will be at least partially offset by a higher utilization of drug-eluting stents.

Uncompensated care for hospital division improved this quarter versus the second quarter totaling $13.9 million, a reduction of $1.9 million sequentially. This improvement happened in part due to improved collection activity and a spotted increase in gross self-pay revenue of $2.4 million over the second quarter. Most of the increase in self-pay revenue was experienced at one of our hospitals. Free cash flow, defined as cash flow from continuing operations less maintenance capital expenditures and adjusted for a semi-annual bond interest payment, was $16.5 million this quarter or $0.84 per fully diluted share more than three times our GAAP EPS. DSO fell 4 days sequentially, further evidence of our solid collections in the quarter. We ended the quarter with net debt of $29.9 million, an improvement from $65.2 million in the prior quarter, reflecting the disposition of Dayton and our improved cash flow. Cash was $120.8 million of which $50.9 million resides at our hospital subsidiaries. We also extended $9.5 million on development capital expenditures. Our adjusted EBITDA was lower for the quarter than we had anticipated, primarily due to volume reductions in the two markets, as Ed has spoken of. That cause has appeared to stabilize, and Phil will have more comment on that in just a moment.

As we look to the fourth quarter, we have experienced a solid month both in terms of volumes and initial operating results for July. Based on this, we believe that our fourth quarter results will be in line with our results this quarter in regards to both net revenue and adjusted EBITDA. I will now turn the call over to Phil.

Phil Mazzuca

Thank you, Jeff. As in past quarters, I'll spend a few minutes providing you with an update on where we are related to achieving our primary operating objectives and the current and future benefits of these objectives.

From a volume perspective, adjusted admissions in the quarter were up 1% although admissions were down 4.8% versus prior year quarter. The decline in admissions was impacted by the increased inpatient to outpatient conversion of stent and cath cases in some of our markets, as well as an 8.2% decline in open heart surgery cases. Additionally during the quarter, there were unanticipated disruptions in two of our larger markets related to our major physician groups in those markets. The majority of this impact was felt in the latter part of May and has stabilized since then as evidenced by the following. During the month of May, the hospital division consolidated facilities experienced a material decline in admissions versus prior year May, as well as a large decline in adjusted admissions. In June, these facilities experienced a rebound in admissions and adjusted admissions versus prior year June. We believe that we are back on track with the start of the fourth quarter, tracking like June with admissions up approximately 3% in July and adjusted admissions which will be much higher than the admission rate. Our overall stent volume was flat for the quarter, although total drug-eluting stent volumes were up 5.4% versus prior year quarter.

I would note that we've seen a dramatic increase in drug-eluting stent utilization as a percent of total stents in July versus prior year July, due to the recent launch of the new generation drug-eluting stents. This is consistent with an article that was published in the Wall Street Journal that indicated that drug-eluting stents appear to be on the rise. It's still early to determine what the percentage utilization of drug-eluting stents will be for our facilities going forward, however on preliminary discussions with our physicians, there's a belief that drug-eluting stents usage will increase as the improved new generation drug-eluting stents become available. As Jeff mentioned, our facilities have historically trended below the national average of drug-eluting stents utilization as our physicians continue to review the efficacy of drug-eluting stents versus the use of bare metal stents.

As we've discussed in past quarters, we continue to identify opportunities in our markets to increase inpatient and outpatient non-MDC5 volumes under our diversification strategy in some of our markets. We are pursuing new sources of high acuity inpatient and outpatient revenue through non-MDC5 product line such as bariatric surgery, general surgery, orthopedics, urology, and neurosurgery, which are coming online in a few of our markets. On a consolidated basis, our total inpatient surgical volume was up 1.3% versus prior year quarter, although open heart cases were down 8.2% and outpatient surgical volumes were up 54.4%. During the fiscal year, we have recruited 72 physicians as part of our diversification strategy, many of which are procedure based although part of the recruitment has been focused on the development of primary care networks in some of our markets to support the referral base of these programs as well as hospitals programs. We have added capacity in several of our hospitals to better handle more emergency patients, a good source of additional admissions that support diversified hospital assets. We are finalizing marketing plans to better use the new and existing outpatient ER capacity. Through the recruitment of non-MDC5 specialists and primary care physicians, we have broadened our ER backup panels to support our ER initiative and diversification strategy. I'll provide more information as to the diversification strategy as these programs continue to develop and provide incremental volumes in our facilities. We have also begun to recruit and place positions to our Kingman market where we plan to open our facility next fall. Early recruitment efforts have been positive and we have hired a physician recruiter specifically for that market.

In addition to the expansion of the non-MDC5 product line, we continue to focus on the expansion of our primary service line through the development of specialized and focused cardiac and cardiovascular programs including our initiative related to achieving chest pain center accreditation whereby all of our consolidating facilities should be accredited by the end of the calendar year. Currently, we have achieved the highest status of accreditation in each of our facilities that have been surveyed. We have also had success in the recruitment of cardiologists and cardiovascular surgeons to our markets, especially during the third quarter and into the fourth quarter of this fiscal year. We have recruited six cardiologists to join our facility during the third quarter and have recruited two cardiologists and two cardiovascular surgeons to start during our fourth quarter. This has been a result of the in-house recruitment initiative that we initiated over a year ago as well as the recruitment efforts of some of our physician groups. We expect our recruitment efforts to continue to provide for a good pipeline of new physicians to our markets.

From an efficiency standpoint, one of our objectives for fiscal year 2008 focuses on continuing to lower supply costs through a combination of contract negotiations for certain high cost medical devices and continuing to pursue the opportunities identified through our GPO arrangement with Broadlane. During the quarter, on a same facilities basis, supplies expense was down 6.2% per adjusted patient day versus prior year quarter. We continue to make good progress related to medical device contracts and we continue to achieve incremental savings related to our GPO contract, which was effective July 1, 2007. We have entered into new major CRM contracts during the fourth quarter which will save us approximately $1 million per year. We are also seeing favorable stent pricing, and are in the process of finalizing those negotiations this quarter. I'll have more to report related to these negotiations next quarter however we anticipate significant savings next year. This is extremely important as we continue to experience inpatient to outpatient shifts in our less complicated stent cases.

We continue to show good progress on the implementation of our management and engineering initiatives that we discussed in previous quarters. The impact from the salaries, wages, benefits, and contract labor basis for the quarter equated to a 3.4% reduction in salaries, wages, benefits, and contract labor per adjusted patient day on a same facilities basis. With the continued shift from inpatient to outpatient for some of our stent and cath cases, we have initiated a process whereby we have enlisted a small group of physicians, hospital clinical staff and management staff, as well as our management engineer to review alternative staffing models to manage our increased outpatient volumes under a new model to maintain quality while reducing costs. Our goal is to continue with our plan to improve staffing efficiencies. I will report on this initiative in future quarters as we implement the changes identified by this multi-disciplinary process improvement group. I'd like to note that our contract labor expense during the quarter declined 16.1% versus prior year quarter or 23.3% on a per adjusted patient day basis due to our efforts in replacing contract labor with permanent full-time and part-time staff. We will continue to execute on opportunities from a contract labor standpoint as we continue to believe that movement from contract labor will continue to increase quality and lower labor costs. The results of our continued efforts will be discussed in future quarters.

Our managed care initiatives have continued to result in gaining access to additional covered lines. We continue to focus on new relationships with managed care providers in our markets, and I'm pleased to announce that we executed a Humana contract in our Louisiana market during the quarter. Our diversification strategy, including the development of primary care networks, has helped us in accessing some of these new contracts. We continue to experience improved pricing on certain legacy contracts, and our average increase during the quarter ran into the mid-to-high single digits. For the quarter, our renegotiated contracts averaged an increase of 9%. For the year, we continued to expect to see managed care pricing increases of 5% to 7% on the average.

I'll now turn the call back to Ed.

Ed French

Thanks Phil and thanks Jeff. Julianne, we're ready for questions now, please.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question is from the line of Darren Lehrich with Deutsche Bank.

Darren Lehrich – Deutsche Bank

Thanks. Good morning everyone. I have, I guess, three things that I wanted to tackle. The first is, Ed, you discussed in your prepared remarks something about the board asking you to review I guess your capital objectives. Maybe if you could just shed a little bit more light on what exactly you mean there and maybe be a little more specific for us about that, that's my first question.

Ed French

Thanks Darren. I guess we call it "test for dummies" in that I've been hearing for a long time that we have an underleveraged balance sheet and our investors and analysts and we are as eager as a group as anyone else could be to properly deploy that to prove the valuation for our shareholders. There are a lot of ways to go about doing that specifics of which you would not expect me to discuss today obviously, but let me just tell you that we're actively engaged and we're looking at to how we want to position debt, how we want to deploy debt, and what that all means in terms of improving the valuation. I hope that, if nothing else, you have the comfort of knowing that we're not sitting on our hands about this topic, but we know there are opportunities at hand now. Because we know that our bond repurchase is within sight, we show as a current obligation now. So that would suggest that we would expect at some point in the future to be able to take advantage of that repurchase. So there are other opportunities that we see out there that we are exploring vigorously.

Darren Lehrich – Deutsche Bank

Okay. But just so I'm clear this isn't any broader strategic review it's really specific to how you want to deploy capital, is that a fair observation?

Ed French

Yes. How we want to access the debt markets and how we want to deploy capital, how we want to strengthen the use of the balance sheet opportunities so that we can do two things, improve the valuation on current basis, but also have capacity for long-term growth.

Darren Lehrich – Deutsche Bank

Okay, thanks Ed. My second question is, obviously this shift that we've been hearing about and frankly have been anticipating it to be probably a longer shift over the next couple of years, maybe if you could just kind of key into the three hospitals that you referenced, what their conversion rate is approximately, and where you think all this might be going. And I guess just as far as the opportunities that you're evaluating to get your costs in line with the reality of this reimbursement change, maybe just talk a little bit more about what you see there, either from a labor or from stent renegotiation standpoint, how you might offset that $4 million?

Ed French

I'll call on Phil to comment on some specifics to extend. He has stats that I don't have on top of the mind. But going back about two years ago, one of our markets we saw some movement – it was then called the PRO, now it's called the QIO, took the initiative to focus on one-day stays for certain cath procedures. About a year, maybe five quarters ago, we saw it in a second market and then about two quarters ago we saw it evolving in the third market. The movement of those has varied because they have different practice patterns to begin with, different procedure mix and patient mix and payer mix expectations that'll have an impact on the ultimate number of conversions. But we've seen them from, I would suggest, as high as 50% of the total business being converted to outpatient one market, to perhaps 40%, 45% in other, or if not, a little bit less than that. So I would suggest that somewhere between a third and a half of the business might be the ultimate. We've already shown where we were this year, this quarter 27.8%. So that would suggest we have some opportunity to go yet, we're not up to the third yet and I hope that helps answer your question. As regards the adjustment of labor, Phil's commented on using management engineering approach and our working with physicians and staff to recognize that the delivery system is different. What's interesting about all of this of course is when we convert somebody from inpatient to outpatient for a procedure that doesn't mean that our cost is going to go down proportionately because they're admitted as a 23 hour observation patient. So we're still going to provide the intensity of services during that period of time, pre and post-cath procedure that the patients need. And so we would expect that to have contributed to some of the margin erosion that we've seen already. But I think that as we continue to now know where this thing is headed as we've quantified it, and as we continue to build our capacity hospitals to accommodate the outpatients in a way that we haven't been able to in the past because we've added several day beds in several of our hospitals, I think now we're in a position to go ahead and do the engineering and the process of proving pieces that are fine-tuned. Phil, do you have anything you want to add to that or Jeff would you like to –?

Phil Mazzuca

I think, Darren, just to follow up on that statement, when this conversion first started and we didn't have that many patients converting from inpatient to outpatient these patients, as Ed said, were continued to be treated like inpatients; they were ultimately just put into outpatient status but still stayed at the hospital in a bed with the same type of services. As we saw this dramatic increase this last quarter, I really started discussions with our physicians at our hospitals, and because the volume per hospital where this has happened is higher, we're able to take specific units and put these patients on those units in an observation status and we're looking at ways that we can become more efficient from a staffing standpoint to treat these patients. So, I would imagine by next quarter we'll have better color for you as far as what that really means, but we're also seeing this increase, significant increase in drug-eluting stent utilization. I think as Jeff and Ed have talked in the past, I think part of the margin erosion, because of the move from inpatient to outpatient, if not all of it, may be compensated by this significant uptick in drug eluting stent utilization.

Darren Lehrich – Deutsche Bank

What was that in July, if you could just contrast what the month of July was related to your DES mix versus in the last quarter or two?

Phil Mazzuca

It was north of 40% increase. It was huge.

Darren Lehrich – Deutsche Bank

And so that would put you now in the 80s?

Phil Mazzuca

Oh, no. We're not even, as far as drug-eluting stent utilization as a percent of total, that probably puts us in the 50s or mid 50s because we were at 41% as a total, the rest of the country is at 72%. In conversations I had with some of our key physicians, especially those that had used the higher level of bare metal stents in the past, every single one of them told me that with the new stent releases, that's going to increase. And one particular physician whose hospital was in the 30s told me that he believes his hospital probably will be in the low 70s as they ramp up. So we're are going to –.

Darren Lehrich – Deutsche Bank

Okay. So it was 40% not 40 percentage points, okay.

Phil Mazzuca

That's right, that's right.

Darren Lehrich – Deutsche Bank

All right. And then I guess my last question, I'll jump off here, is where are you now with your non-MDC5 mix, and maybe just give us kind of a spot percentage where you are in the third quarter. Thanks.

Phil Mazzuca

Looking for the number here.

Ed French

While Phil's looking for that, Darren, let me leave you with two points regarding the conversation we just had about the inpatient to outpatient mix. The analogy I want to draw is on the discussion last year on the conversion of drug eluting to bare metal stent what's different about this is two things. One, we're quantifying and getting it behind us, we know now what to expect based upon what we've seen. With the other transformation of drug eluting to bare metal, we just didn't know what to expect. We think we've quantified this. But secondly, the advantage that we have now is we can identify ways to engineer the processes so we can adapt to this. Unlike the drug eluting/bare metal, we had a disadvantage because there was little way to adapt to that kind of a transformation rather than do new product negotiation. I think this will not have the same kind of a long-term overhang for us in terms of not being able to respond to it.

Phil Mazzuca

As far as the MDC5, we're 78% MDC5 for this quarter versus 79.4% for prior year from a discharge basis, but a lot of our non-MDC5 business at this point is outpatient business. With several of our hospitals at capacity, our focus really has been outpatient surgery and we saw that 50 some percent increase in outpatient surgery quarter over quarter. As we continued to increase our capacity with day patient beds or inpatient beds, we're going to see the increase in the inpatient capacity of the non-MDC5 go up. But we've only been able to really focus so far on the outpatient side of it because of capacity issues in some of our markets. When you look at a hospital like TexSAn that just was licensed for an additional 60 beds, we will increase in cardiology business there because we were bumping on capacity issues from a cardiology standpoint. But at the same time, we have significant non-MDC5 opportunities there in our new bariatric program, spine surgery, and those types of things. I think you're going to start to see the discharge number increase from a non-MDC5 basis as capacity comes online.

Darren Lehrich – Deutsche Bank

Okay, great. Thanks a lot.

Ed French

Thanks, Darren.

Operator

Your next question is from the line of Erik Chiprich with BMO Capital Markets.

Erik Chiprich – BMO Capital Markets

Good morning. Thanks for taking the question. Just a follow-up on some of the questions Darren had. You mentioned the one third to 50% of total stenting done outpatient, is that of all stenting or is that the percentage of one day stenting that's being outpatient right now?

Ed French

Well that's percentage of all because it's really certain one day stents that have been targeted. Complex, co-morbid patients who are still quite sick have to be admitted not only for observation but for care, those will continue to be treated at inpatients, Erik.

Erik Chiprich – BMO Capital Markets

Okay. Thank you. And then could you provide a little more granularity on the breakout in the quarter of where you came up short, the changes from the practices at the physician offices versus what the impact was from the migration of the stenting?

Ed French

Well, yes we can quantify in those two markets, we call it doctor disruption for lack of a better term, which really is a matter of doctors realigning some of the practices within the market. In large measure, it's about a little better than $3 million in net revenue impact.

Erik Chiprich – BMO Capital Markets

Okay.

Ed French

And I would suggest, as you've heard us say in the past, if we look at our marginal cost uptick on marginal cost business being 35% to 40%, so you can presume in the neighborhood of $1.2 to $1.5 million probably relates to EBITDA expense from the admissions.

Erik Chiprich – BMO Capital Markets

Okay. And then taking a step back again, on the $4 million impact that you expected to shift to outpatient stenting, is that going forward or is some of what happened in the third quarter included in that $4 million that you're talking about?

Jeff Hinton

That's going forward on a fully developed basis. As I said, there's some time that will be required to get there; we're not sure how long that will be. But obviously the things that Phil spoken to is an improved pricing on our stents that diagnostic to whether it's inpatient or outpatient, that should help us across the board. And I might also note that the difference between inpatient and outpatient on drug eluting is smaller than it is on bare metal. So the shift to more drug eluting helps us in that respect as well.

Erik Chiprich – BMO Capital Markets

Okay, that's helpful. And then one more question, if I may. Just curious to get an update on the expansion at Arkansas Heart, how that's ramping and if you expect that to get to the target of $8 million in EBITDA by 2010? Thanks.

Phil Mazzuca

I can tell you clearly that our volume is above our budgeted number for Arkansas' expansion and we do believe that we will get to the targeted $8 million number that you have just addressed.

Erik Chiprich – BMO Capital Markets

Thank you.

Ed French

You're welcome, Erik. Thank you.

Operator

Your next question is from the line of Rob Hawkins with Stifel Nicolaus.

Rob Hawkins – Stifel Nicolaus

Good morning. I'm sorry to belabor this too, I'm still a little confused over the $4 million numbers, if you don't mind, just a couple of questions to drill into that. That $4 million number is that just the three hospitals or is that say, is that an assumption that it expands to the remaining four as well? And then two, is that an EBITDA $4 million number or a revenue $4 million that'll get a margin applied to it or is that a net income number?

Jeff Hinton

First of all, that is applied to all facilities, so it is taking what we have experienced in a hind sight basis and applying it to every place it has not yet been experienced.

Rob Hawkins – Stifel Nicolaus

Fair enough.

Jeff Hinton

It is also an EBITDA number.

Rob Hawkins – Stifel Nicolaus

It's an EBITDA number. Okay.

Phil Mazzuca

Also, Rob, so you don't lose the thought though, you heard us speak to the uptick in drug-eluting stents, so we believe that that $4 million relates only to the inpatient/outpatient version is going to be offset to some extent or potentially fully by the uptick of drug-eluting stents.

Jeff Hinton

We applied no EBITDA benefit to the change or expected uptick to drug-eluting stents to that number.

Rob Hawkins – Stifel Nicolaus

That sets me up for kind of a loaded question that is what's the difference between drug eluting and bare metal in terms of the margin impact and say if you're 50 now and it takes a year or two to get up to say 70, how can we think about that in terms of what value that will bring to the company?

Jeff Hinton

I think generally, we've put all those factors in our statement that they could be at least partially offset, or as Ed said, they could completely wipe out the impact of the shift. The issue in the near term, as we've experienced last two quarters, is we've been ahead of the curve, moving it to outpatient and the drug eluting percent increase in utilization is a more recent phenomenon. But certainly we'd say, collectively, those factors would have the impact potentially of offsetting the shift.

Ed French

We'd rather have you model on that figure than give you the specifics margin for each procedure, Rob.

Rob Hawkins – Stifel Nicolaus

That's quite clear. I just hate to do something incorrect that causes some sort of negative value impact.

Ed French

Well, we appreciate that.

Rob Hawkins – Stifel Nicolaus

Then finally, your cash flow numbers were pretty phenomenal for the quarter. There's no detail, I know you'll have a queue out, what's behind that, and how sustainable – looks like maybe the maintenance CapEx number is a little bit down, and should I be still thinking kind of the normal hospital maintenance CapEx numbers of somewhere between 4.5% and 6% percent of revenues typically on that?

Ed French

Rob, actually, we're a little less than that on maintenance CapEx, because we think we're probably between 3% and 4%. We have the benefit of still having new houses out here for the most part. So we're at the point where some maturity in terms of technological views that we're having replacement cath labs and some other diagnostic imaging and lab equipment, but that's just normal wear and tear. But facilities themselves require very little maintenance CapEx. Typical hospital would be as you described 4% to 6% and 5%'s figure, is sort of less than that.

Rob Hawkins – Stifel Nicolaus

But I mean, should I be thinking about cash flow normaling out over the next year, kind of typical kind of one times what your GAAP EPS number is, or do you guys think you guys have the ability to kind of push – the cash EPS here might be stronger than the GAAP EPS?

Jeff Hinton

Well, certainly with free cash flow, as I defined it at three times our GAAP EPS, I don't think I'd be satisfied with period there. I think we've got some very strong cash EPS relative to GAAP. Now a part of that again is share-based comp, there's no cash associated with that. That is further reason for us to have more cash earnings to GAAP earnings.

Rob Hawkins – Stifel Nicolaus

You do think it's sustainable at a larger than GAAP basis?

Jeff Hinton

I'd stop short of projecting three times GAAP EPS every quarter, but –.

Rob Hawkins – Stifel Nicolaus

Well no –.

Jeff Hinton

But sure I expect it to be – continue to be stronger.

Rob Hawkins – Stifel Nicolaus

Can you give me a little metrics, sorry, 1, 1.5 or something like that?

Jeff Hinton

I think I'd stop short of doing that.

Rob Hawkins – Stifel Nicolaus

Okay. Alright, thank you, guys. I'll jump back into queue.

Ed French

Thanks, Rob.

Operator

Your next question is from the line of David Bachman with Longbow Research.

David Bachman – Longbow Research

Hi. Good morning, guys. A couple of housekeeping questions on lines that I never seem to get quite right is on the earnings from unconsolidated affiliates and minority interests, can you just give us a little bit more color on this quarter on that and maybe how to look at that in the next quarter?

Ed French

The material change from our unconsolidating entities [ph] this quarter comes from Yuma, Arizona. It’s a prior quarter transaction where we bought a little over 27% of an ongoing cath lab that has two units – by the way, we're expanding it to add a third cath lab as we speak, so we'll be opening this season with 50% more capacity. And we've had material uptick in our earnings as a results of that unit. That would be the primary change. We've had also other MedCath partners units that have an impact on that. As the hospitals we have see there is some variability with regard to stent usage, we've seen it also in some of the facilities that we manage for others that are minority owned, non-consolidating. So what you see there though is a composite of all those, it's a pretty good story actually.

David Bachman – Longbow Research

Okay. Good, that's helpful. And then on, I think Phil mentioned, favorable stent pricing. We've had some contacts that have been surprised at the stent pricing looking better than they had anticipated. Can you give us, maybe Phil give us a little bit more color on what's going on with the stent pricing. Is it the new competition out there, or what's happening on that front?

Phil Mazzuca

Yes, that's what I believe is going on. It's the new competition coming in lowering everybody's stent pricing. And at the same time, the new competition wants to get their stents into the market, so they're also pricing very favorably too.

David Bachman – Longbow Research

Okay, so it's really a competition story. And then just one last question, strategic question for Ed, I guess. As you look out over the choppiness that's going to come and some of the pushback that you're obviously going to get from investors during this transition albeit I think you guys are certainly on the right track here, what are the advantages of undergoing this transition as a public company at this point?

Ed French

Well, that's a good question and a fair one, and we've been asked that. But one of the advantages is we get to enjoy all this quality time with our friends on these phone calls. That aside, and that being seriously and I don't take that lightly because we're challenged; it is a public company, we're challenged by our investors, by our analysts, and it keeps us on our toes because we know we have some accountability for what we have to do. Now, we could be as accountable as a private company, but we like being a publicly traded company. We are undervalued by our estimation, tremendously undervalued, and I think as a couple of things happen, One, the overhang regarding legislation becomes either accepted or goes away as we continue to develop our footprint, we continue to increase margins, and as we can do some development that we're very much interested in, over time, this plays out. It's a long-term play. We enjoy where we are David. I could tell you, I have no intentions of doing anything differently from what I said right now, we're sticking to our plan and what I feel good about is we've been on this path now for over a couple of years, we've done what we said we're going to do. The only thing we haven't done is an acquisition, and we said we intended to do one in '08. We're not going to do one in fiscal '08 not that we haven't had opportunities, but we've chosen to not do them in '08 because we didn't like what we saw, the prices that we saw or the other circumstances. We're fine. Long answer to a simple question, but we think there are advantages to being what we are. And another thing too is important. Going back a couple or three years ago, you remember that I said that one of our ambitions was to develop this company so that we improve our currency so that we can play in the ways that help us with strategic and exponential growth at the right time. I don't know when that time is, but we're very happy that notwithstanding share price as a market multiple, we're very happy with our currency, meaning that we've got some stability, we're growing, better margins, quality reputation is there, and all those indicators that will point to other than share price market multiples gives us a lot of encouragement. And I think the market multiple will take care of itself in time as our investors are appropriately aligned with us for a long-term perspective.

David Bachman – Longbow Research

Okay, great. I appreciate your taking time to answer that question.

Ed French

Pleasure, thank you.

David Bachman – Longbow Research

Thanks.

Ed French

Thanks, David.

Operator

Your next question is from the line of Miles Highsmith with Credit Suisse.

Mile Highsmith – Credit Suisse

Hey, good morning, guys. Can you just remind me, first of all, what the percent of the cases where there were outpatients back before the QIO started to come in, whatever six to eight quarters ago and then as follow up is in the two markets where you had some dark [ph] issues on the realignment, can you maybe just give a little more color around what was that realignment, how normal is that, and then recurring, and any additional details would be very helpful. Thank you.

Jeff Hinton

I think if you're looking at the outpatient percentage on stents, first of all it was 17.6% a year ago, and it's moved up to the 23% level that we quoted for this quarter (inaudible) yes, 23.4% for the quarter. That's total bare metal and drug eluting.

Mile Highsmith – Credit Suisse

Oh, sorry. Okay, thanks.

Jeff Hinton

And then the physician – your other question, would you repeat your other question about the physician?

Mile Highsmith – Credit Suisse

Just maybe a little more color on the realignment in the two markets with the doctors.

Ed French

I'll be glad to do that Miles. It's not unusual to have doctors realign to partnerships now and then. In other words, some doctors leave, some doctors come, they separate into groups. And when we have, though, as we do in some of our markets, very large groups who are material to our alignment with them and they have disruptions, then that'll have much more of a direct impact on us than if we have a lot of small movements. We had two markets where the one market of several doctors broke off from the exciting group to reestablish among themselves and with others in the community, but not away from us but they took between 30 and 90 days off for either vacations during the time and/or to get new provider numbers from Medicare for their new practice. And so during that period of time, many of those doctors just out of pocket. And the other market – and by the way, they're back and they're on our staff, and they're going to practice with us, life's fine. And the other market, having nothing to do with us, again, the doctors have had just some realignment within their group as to coverage and affiliations and their practice patterns, referral patterns, and what not, that caused some disruption. Again, much of that mitigated since the month of May, and we're seeing more stability there as well. That's about as finite as I can get on those two instances.

Mile Highsmith – Credit Suisse

That's very helpful. I'm sorry, I guess in my first question, I was just thinking more specifically if we're whatever 28% this quarter on the DES percent outpatient, any just ballpark sense as to where we were, again, back a year and a half ago or something like that? Was it like 13% or something?

Jeff Hinton

Well, the 17% number was combined drug eluting and bare metal, and that was one year ago, not 18 months ago. If you'll hold on just a minute, I'll give you the drug eluting percentage a year ago. Yes, that was about 16% a year ago.

Mile Highsmith – Credit Suisse

Okay, thank you.

Operator

Your next question is from the line of David Nierenberg with Nierenberg Investment.

David Nierenberg – Nierenberg Investment Management

Good morning, guys.

Ed French

Good morning, David.

David Nierenberg – Nierenberg Investment Management

Ed, your largest shareholder is very happy to hear of the board's commitment to managing your balance sheet assets in a more shareholder-friendly way. As you and the other people on the call know well, this is something which we have sought for a long time. I'm not going to seek on this call any further specificity from you on it because I understand that diplomacy is best conducted outside of the context of a fishbowl. But I do want to acknowledge this good decision by management and board and express our strong support for it and build on the point by Longbow, which is to say if the public markets have not been affording this company the stock price valuation which it deserves, and I fully believe that the stock market is not appropriately valuing this company, then one of the wonderful potential benefits of the board's balance sheet decision is that we can take advantage, as continuing shareholders, of the fact that other shareholders don't seem to know what this company is worth. So we are very, very pleased by this decision. Thank you for implementing it.

Ed French

David, thank you for your support and your encouragement. You've been very, very vocal about that. We appreciate it as well, and I appreciate you joining in this morning. Thank you.

Operator

Your next question is from the line of Whit Mayo with Robert W. Baird.

Whit Mayo – Robert W. Baird

Thanks. Just one question really, I appreciate all the discussion this morning but when we look at the various bed expansion projects that you've announced over the course of the past year or so, you provided us with a general outlook as to what the anticipated financial impact from some of these would be. Do those numbers still hold now or would you be in a position to update those for us?

Ed French

Those numbers hold. I don't mind telling you that while we don't speak of budgets, we don't speak of guidance around them or individual markets, I'll make a general statement to which I'll attribute some accuracy. That is as we do our budgets, my expectation is the pro formas that we use to sell these projects are going to get reflected in the budgets.

Whit Mayo – Robert W. Baird

Okay. That's all I got, thanks.

Ed French

Yes, sir.

Operator

You have a follow up question from the line of Darren Lehrich with Deutsche Bank.

Darren Lehrich – Deutsche Bank

Thank you. Thanks for taking the follow up here. Just a question about your outpatient, can you give us what the outpatient revenue percentage is, and I guess maybe just something to consider given what you're describing as a fundamental shift in the business. Maybe in the future, you could parse out for us the difference between inpatient admissions and outpatient visits and your operating stats so we can model the two separately. It might be a useful exercise.

Jeff Hinton

Darren, if you're looking for the outpatient revenue percent of gross revenue, for the quarter, it was 29% versus prior year quarter of 24%.

Darren Lehrich – Deutsche Bank

And on a net basis?

Ed French

We don't have net. We use an outpatient conversion factor built around the gross figures, Darren.

Darren Lehrich – Deutsche Bank

Okay. Alright. And this is my last question. And I think know the answer, but what did trigger the move in the high yield notes from long term to current liabilities? Is that just an expression of your intent to take them out over the next 12 months?

Ed French

The answer is yes. And that's one of the errors that I quiver as we consider what our options are for using our balance sheet to strengthen value for shareholders. And so, it would be – frankly, I doubt there would be an expectation that we would be making some movement in that to acknowledge that. That would be again that test for dummies [ph] if we were sitting on our hands and not responding to that.

Darren Lehrich – Deutsche Bank

Yes. Very good. Thanks.

Ed French

Take care.

Operator

There are no further questions at this time. I will now turn the call back over to Mr. French for any closing remarks.

Ed French

Julianne, thank you. Again, thank you all for the discussion, for joining in and the stimulating questions; we appreciate your support in following us. We look forward to more dialogue and coming back next quarter to carry on this onward story. Thank you.

Operator

Thank you for participating in today's conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. U.S.ERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!