Surgery Partners, Inc. (NASDAQ:SGRY) Q3 2019 Earnings Conference Call November 5, 2019 8:30 AM ET
Wayne DeVeydt - Chief Executive Officer
Tom Cowhey - Chief Financial Officer
Eric Evans - Chief Operating Officer
Conference Call Participants
Kevin Fischbeck - Bank of America Merrill Lynch
Ralph Giacobbe - Citigroup
Chad Vanacore - Stifel
Brian Tanquilut - Jefferies
Frank Morgan - RBC
Whit Mayo - UBS
Greetings, and welcome to the Surgery Partners, Third Quarter 2019 Earnings Conference Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions].
It is now my pleasure to introduce your host, Tom Cowhey, Chief Financial Officer. Thank you. Sir, you may begin.
Good morning, and welcome to Surgery Partners, third quarter 2019 earnings call. This is Tom Cowhey, Chief Financial Officer. Joining me today is Wayne DeVeydt, our Chief Executive Officer; and Eric Evans, our Chief Operating Officer.
As a reminder, during this call we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in this morning's press release and the reports we file with the SEC. The company does not undertake any duty to update such forward-looking statements.
Additionally, during today's call the company will discuss certain non-GAAP measures which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation of these measures can be found in our earnings release, which is posted on our website at surgerypartners.com, and in our most recent interim report on Form 10-Q when filed.
With that, I'll turn the call over to Wayne. Wayne?
Good morning. Thank you, Tom, and thank you all for joining us today. For our call this morning I’ll review some highlights from our third quarter results and then provide an update on several of our strategic initiatives that support our organic growth and margin expansion, and briefly discuss how those initiatives impact our sustainable double-digit adjusted EBITDA growth goals. Finally, I'll turn the call over to Tom to provide further details on the quarter.
Starting with the quarter, I'm pleased to report third quarter 2019 adjusted revenues of $458.3 million and adjusted EBITDA of $62.2 million. As we look deeper into the quarter, adjusted EBITDA grew by 5.4% over the third quarter of 2018, consistent with our previous guidance and our targeted double-digit full year growth.
Days adjusted same-facility revenue increased by 7.9% from the prior year quarter, driven by strong net revenue per case and volume growth. We are pleased with the significant growth over the prior year, representing our fifth consecutive quarter of same-facility revenue and case volume growth, which we believe is a testament to our efforts.
Finally, adjusted EBITDA margins were 13.6%, an improvement of 30 basis points over the prior year quarter. As Tom will discuss later, adjusting for the impact of closed or divested facilities, revenue growth would have been over 9% and EBITDA growth would have been approximately 13% over the prior quarter.
Our strong third quarter performance does not incorporate any add-back or adjustment for the impact of Hurricane Dorian in early September, which we estimate reduced our reported results by over $3 million in revenue, and approximately $1.2 million to $1.5 million in adjusted EBITDA.
While our facilities fared well in the storm, to ensure the safety of our employees and patients 14 of our facilities along the southeastern coast closed for anywhere from one to four days, representing over 750 previously scheduled surgical cases, many of which were higher acuity. It is our hope that we can recapture some of this lost volume by the end of the calendar year.
As we prepare for the fourth quarter, we continue to be pleased with our year-to-date progress on a variety of fronts. Same facility revenues continue to exceed the high end of our targeted long term range of 4% to 6%. These results are driven by both our physician recruiting efforts, as well as solid improvements in our commercial rates.
More importantly, as we discussed on our previous call, there is a compounding impact on our business as new surgeons continue to ramp up in our facilities, but we are concurrently improving our commercial rates, a compounding that we expect to meaningfully impact our fourth quarter 2019 and longer-term results.
A few data points to anchor on: On a year-to-date basis, same facility revenues were up 7.6%, an improvement of 300 basis points over the comparable period in 2018. During this period, the contribution margin from our physicians recruited since the beginning of 2018 are already more than double their contribution from all of 2018, and we expect to see further strength in the fourth quarter consistent with typical industry trends for our sector.
Our 2019 physician recruitment cohort is also driving strong results. To date, we've recruited an equivalent number of doctors at this point last year, and those doctors are performing cases at a 25% higher direct contribution margin per case versus last year.
And finally, our data-driven focus to growing our targeted specialties, including our total joints programs has yielded meaningful improvements in higher acuity cases. Year-to-date, we've done approximately 800 total joints in our ambulatory surgery centers, which is double our total at this point last year.
As you can see by our results, we continue to be pleased with our team's efforts in making our surgical facilities a destination of choice for both physicians and patients. We are equally pleased with the positive momentum we continue to make with payers and sharing with them the experience their members can enjoy at a much more affordable and efficient facility.
A testament to our efforts relates to our recently completed off-cycle rate negotiations in a few pilot markets where we achieved double digit commercial increases that commenced early in the fourth quarter of 2019. These negotiations were successful due the demonstrable value proposition we provide state, regional and national health plans.
Our health plan partners increasingly understand and value the benefits that a vibrant independent short-stay surgical facility operator can provide to them and their members. We look forward to continuing and are already actively engaged in this dialog with other payers across the country.
As we start to look to next year, we are confident we can continue to build on the strong foundation we’ve constructed over the last seven quarters. Our motto remains the same. We believe that our base business can grow at 2% to 3% on volume, and 2% to 3% on rate, yielding 4% to 6% same facility revenue growth with a bias toward the higher end of the range.
Our results to date are proof that if we focus on bringing the right doctors, doing the right procedures in our targeted specialties and focus on getting appropriate payment for the value we bring to the system, we can achieve at least this level of growth.
On top of this baseline for growth, we've been focused on three additional areas to expand margins that we expect will contribute an additional 3% to 5% of growth in support of our double digit adjusted EBITDA growth goals. These areas include procurement, revenue cycle and G&A leverage. We continue to plant seeds in each of these areas and we are confident they will bear further fruit in 2020 and beyond.
We have built new leadership teams in these functions over the past 18 months that continue to scale these initiatives and we see broad opportunities. In procurement, as we continue to optimize our GPO contract, we are also making progress in negotiating purchase discounts on implants and other supplies, as well as being more creative in how we purchase to take advantage of rebate opportunities.
On revenue cycle, our centralized operations are starting to exceed our collection targets and we're using new data from consolidation of electronic claims submissions to begin to optimize denials management across wide portions of our business. And as many of you know from your previous experience with several members of this management team, we have a maniacal focus on G&A management. We have just recently implemented new tools and policies to further monitor and manage our costs. These distinct initiatives on top of our base growth give us confidence in our double digit trajectory.
Finally, as we look beyond the tactical, our Idaho Falls Community Hospital is slated to open stores just days from now. This multi-year investment in a new acute care hospital will complement our existing surgical hospital and expand our capabilities in this very important market for our company. We are excited to be able to better serve this community with a brand new facility and we expect this to be a material contributed to our adjusted EBITDA in years to come.
More broadly, our Idaho Falls effort demonstrates our willingness to make strategic investments across our portfolio to achieve long term sustainable accelerated growth. We are building Surgery Partners every day to be positioned consistently and predictably achieve near term, medium term and long term growth goals.
Before I turn the call over to Tom, I'd like to spend a moment on Friday's announcement from CMS regarding the calendar year 2020 Medicare hospital outpatient prospective payment system and ambulatory surgical center payment system final rule. We were pleased with the announcement across a variety of fronts, as we felt CMS demonstrated their commitment to ASCs.
With respect to overall rates, CMS has finalized an aggregate rate increase in 2020 of 2.6%, which is 50 basis points higher than the 2019 aggregate rate increase. While the specific rate cells will impact individual ASCs in different ways, we are pleased by CMS continuing commitment to the ASC industry.
Another exciting development for 2020 is that total knees and six additional coronary intervention procedures were added to the Medicare ASC cover procedures list for the first time, opening up vast new markets for our facilities. And finally, total hip replacements, six spinal surgical procedures and third anesthesia services were removed from the Medicare inpatient only list, making these procedures eligible to be paid by Medicare in the hospital outpatient setting in addition to the hospital inpatient setting in 2020.
As with total knees which was first removed from the inpatient only list in 2018, we believe this move could signal additional near term and long term opportunities for our facilities to better serve the Medicare population.
The continued favorable actions undertaken by CMS to benefit ASCs demonstrate what we know to be true. Our industry in general and Surgery Partners in particular is on the right side of quality and cost effective healthcare delivery. Government regulation continues to reflect this.
With that, let me hand the call back over to Tom for an overview of our third quarter financial results and 2019 outlook. Tom?
Thank you, Wayne. Today I'll spend a few minutes on our third quarter 2019 financial performance, starting with some of our key revenue drivers, then moving on to adjusted EBITDA, cash flows and our 2019 outlook.
Starting with the top line, surgical cases were just shy of 130,000 in the quarter, up 2.1% from the prior year period, despite the loss of cases from closed or divested facilities that contributed nearly 3,300 cases in the prior year quarter, and the impact of Hurricane Dorian which we estimate impacted us by just over 750 cases in the current year quarter.
We ended the third quarter with approximately $458.3 million in adjusted revenue, up 3.2% as compared to the prior year quarter, despite overcoming $25 million of revenue in the prior year quarter from closed or divested facilities and over $3 million of estimated lost revenue from Hurricane Dorian in the current period.
On a same-facility basis, days adjusted total company surgical revenues were up 7.9% from the prior year quarter, driven primarily by net revenue per case, but also by higher same facility volumes.
Turning to operating earnings, our third quarter 2019 adjusted EBITDA was $62.2 million, a 5.4% increase over the comparable period in 2018. Of note, closed or divested facilities contributed just under $4 million of adjusted EBITDA in the prior year quarter, and we estimate that the marginal adjusted EBITDA impact from Hurricane Dorian in the current period is between $1.2 million and $1.5 million.
Our third quarter result is consistent with our expected quarterly cadence, despite the hurricane impact, and continues to position us well to achieve full year, double digit adjusted EBITDA growth.
During the quarter we recorded approximately $5.3 million of transaction, integration and acquisition costs, bringing our year-to-date total to $16.8 million, less than half of our year-to-date 2018 costs and consistent with our guidance that integration-related costs would subside. Of note, third quarter 2019 transaction, integration and acquisition costs included approximately $1.4 million of costs associated with our de novo hospital in Idaho Falls. We expect to continue to record these costs outside of adjusted EBITDA for the remainder of 2019 and throughout 2020.
While net revenues and our ancillary and optical segments were down slightly on a combined basis versus the prior year period, combined adjusted EBITDA from these two segments was relatively stable versus the prior year quarter and consistent with our previous comments about our outlook for these businesses.
Moving on to cash flow and liquidity; an important part of our strategy is to optimize our cash flow to be able to deploy available capital and generate returns for our shareholders. We continue to evaluate our portfolio to ensure that we are the best owner for our assets as we scour the landscape for organic and inorganic investment opportunities to drive future growth. I'm particularly pleased with the efforts of our treasury and development teams, whose efforts have once again been a highlight this quarter.
At the end of the third quarter, the company had cash balances of approximately $111 million, and our revolving credit facility remains undrawn with approximately $115 million of availability. Of note, during the third quarter Surgery Partners had net operating cash inflows defined as operating cash flow less distributions to non-controlling interests of $28.3 million. We deployed approximately $8 million in cash that is accounted for in various sections of the cash flow statement related to a buy-up and related investment in an existing facility in Montana, and we used approximately $13.3 million for payments on our long-term debt.
The ratio of total net debt to EBITDA at the end of the third quarter of 2019 as calculated under the company's credit agreement decreased to approximately 7.6x as a result of higher trailing 12 month adjusted EBITDA and greater visibility into the value of some of our managed care initiatives.
As we have noted before, the company has an appropriately flexible capital structure with no financial covenant on the term loan or our senior unsecured notes. We continue to project that the company's total net debt to EBITDA ratio should naturally decline over time as our business continues to grow, but may fluctuate on a quarterly basis based on timing of cash flows.
With respect to our capital structure and leverage calculation, we expected financing leases will increase by approximately $105 million in the fourth quarter as we take possession of our new facility in Idaho Falls, and we project that our new community hospital will also incur nearly $30 million of new local debt to finance equipment needs.
Consistent with the terms of our credit agreement, we expect to begin to incorporate the long term EBITDA contribution from this facility in our credit agreement EBITDA in the fourth quarter, which we believe could be between $20 million and $30 million annually, when run rate is achieved over the next few years. Given the magnitude of this adjustment, we wanted to start to socialize the deleveraging impact of this adjustment with investors now.
Before we move on, I'd like to take a moment to discuss the investment we made this quarter in our surgical hospital in Montana, including purchasing the remaining interest in an associated ASC and the local clinic. This non-traditional opportunity first identified by our local teams allows us to fully deploy some of the strategic resources we have built in revenue cycle and managed care, unlocking a myriad of revenue and cost synergies over time. This unique investment in an existing market will better position Surgery Partners to grow in this geography and better serve the local community, and we are truly excited by the long-term potential of this market.
Moving on to our 2019 outlook, we are excited by our progress this quarter on a variety of fronts and remain committed to double digit adjusted EBITDA growth this year and our full year revenue guidance of low single digit growth or high single digit growth excluding divested revenues from the 2018 baseline.
As we look forward to the fourth quarter, which is seasonally our largest earnings quarter, we would ask investors to keep in mind the following trends: Higher deductibles that continue to push commercial procedures to later points in the year. To date, our government business mix is approximately 140 basis points higher than the same period last year. We continue to expect commercial business mix to improve in the fourth quarter, which should drive higher net revenue and profit per case.
The values of some of our strategic initiatives, including the savings from our health plan consolidation are back-end weighted. The two surgical hospitals we closed late in 2018 were negative contributors to adjusted EBITDA in the fourth quarter of 2018. Those losses will not recur this year. And we have newly negotiated rates that are currently in effect in several key markets. While the seasonal nature of our business always introduces late year risk, we believe we are well positioned to achieve our full year guidance.
In summary, we believe our year-to-date 2019 results continue to demonstrate our ability to achieve our targets. We are pleased to see strong same-facility revenue growth with continued margin expansion as our initiatives take hold. We continue to invest to expand existing facilities and enter new markets that will support organic growth as we finalize preparations for new Medicare procedures in our facilities starting in 2020.
With that, we will open the call for Q&A. Operator?
Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Kevin Fischbeck with Bank of America Merrill Lynch. Please proceed with your question.
Great, thanks. Wayne, I guess I heard the comment, but I guess I wasn't sure exactly what the context was. You said that you guys are reiterating your 46% kind of same store revenue growth expectation. I mean you could have given the bias to the high end of that. Was that just really for 2019 or are you saying that for the next couple of years you think it can be toward the higher end of that range?
Hey Kevin, good morning. The short answer is not just for the current year, but we think really for the next several years that we should be at the high end of that range. I think as we continue to go deeper and see the volume kind of compounding effect of our recruiting efforts, coupled with the fact that I think our opportunities on rates are probably much more meaningful than the typical 2% to 3% on rate that you should get. So I would say the bias is toward the high end of that range.
And when you think about that rate dynamic part of it, how much of it is on the kind of commercially recontracted versus some of the acute mix shift as you kind of talked about as well?
So I will say first and foremost that just a substantial part of it is just getting the rates that we're entitled to in the markets. We've started several markets that are well below you know what our appropriate level – what we would say even being at the average of average rates. Since we've been able to bring on the full time managed care team, and as I mentioned in the prepared remarks we've had several programs, we've done off cycle increases that have been in the double-digit range, and so I think we're getting more and more momentum there.
That being said, mix does play a factor in that, but I would say mix could be the factors that could put us above that high end of that range, you know above 6%. But I would say just purely on the typical rate negotiation of 2% to 3% that you should get on rate, we should be able to exceed or at least be at the high end of that and then let mix be the delta.
Yes, and this isn’t a compound – hey Kevin, it's Tom. Good morning. You know it's a compounding effect as well, especially as you think about how our physician partners are able to share in the economics of the facility through their ownership, as we achieve more attractive rates that actually incents them to bring more procedures to our facilities.
Yes, and I guess maybe just to build on that, this ramp that you've been able to do over the last couple of years as far as physician recruiting and then their ramp up as they come onboard, I mean how much more do we have to go before you kind of anniversary all of that and get to a point where it's now kind of steady state versus this kind of big ramp. Do we have about a year on this this next year or is next year going to kind of normalize into the long term sustainable growth trajectory?
Let me first start by saying, as we've done our own internal five year projections and shared them with our board, there is no reason to believe that we should not be able to achieve the higher end of that range for both the near and the longer term, and so I don't think that we're going to hit an inflection point for at least two years to three years out at best if not longer, simply because I think the opportunity is meaningful.
But I would add to that with, the shifts we're seeing with CMS, the new procedures that will come in our procedures, it's going to open up a whole new avenue for us to leverage our fixed costs that we have there today. So if I look at peer – ignore even the transition and the new opportunity that's afforded to us with CMS rules that were finalized on Friday, I would say Kevin, I think we've got you know three to five years of positive runway at the high end of that range or better.
Alright, great. Thanks.
Our next question comes from the line of Ralph Giacobbe with Citigroup. Please proceed with your question.
Thanks, good morning. You know just wanted to understand the improvement of the commercial rates beginning kind of in the fourth quarter. Can you give us any sense at all of what percentage of the commercial book will see the boost? And I certainly understand the value you guys bring, but just help us on the premise of the payers’ kind of giving you the off-cycle bumps. You know where are you kind of in that process? And then I guess for those that don't give you those off-cycle increases, how long to kind of get through the book to get to that higher baseline?
Yes, so let me first start with just strategically, why would a payer give us an off-cycle increase; I think that's the most logical question. One of the things that I would tell you Ralph is that we've been meeting with the payers. We've gone to them with them understanding that it is our preference and it is our playbook to be the value play in a market, to have the quality that we offer at our facilities, coupled with the value play. And so what we do now is share with them the data that shows where we think the value play should be at versus what we're being compensated at, and what alternatives are available to us in the market if the payer chooses not to want to participate in that value play.
And so sort of differently, you know it's always our preference as we've said to first partner with the payer on the right market structure. But if that's not available to us, we know there's many providers out there and health systems that would like to partner with us as well and we continue to try to partner with those that look at being a value play in the market.
But under any scenario our rates go up, I will tell you, pretty much across the board as we look at our book and as we’re going through these negotiations, we can either partner with the health system and have meaningful rate increases or we can partner with the payer and have meaningful rate increases.
And as I said, it is our goal, it is our mission to be the value play in a market, and so we're not necessarily looking for what just drives the greatest EBITDA, we're looking for what accomplishes a longer sustainable business model goal. That being said, if a player, in this case a payer would not want to participate, then we are going to partner with the health system to get the rates we believe we are entitled to in a market.
The other thing, I would tell you is, while we won't size that necessarily for you, what percentage it is of commercial just now, but I will tell you as it was nine of our facilities, reasonable contributors to our EBITDA in Q4, all getting a double digit increase across the board. This initiative just so you know started though early in the year. These were things we thought would happen when they would happen, so we're very pleased with that.
We have inflationary kickers over the next several years that are meaningful and so I feel like this was the starting point of starting to leverage our value prop and leverage the idea of providers being in the market.
The other thing though is I'm going to let Eric just comment on since he's been here. He really brings as you know a lot of surgical facility and surgical hospital experience, and one of the things that he has been doing in the managed care sector is really looking at just even basic things available to us. For example, under the charge master and whether or not we've been taking advantage of those opportunities that have afforded us in our facilities.
So Eric, maybe comment on some of your work there as well and how that will start benefiting us in Q4 as well and beyond.
Sure. Good morning, Ralph. And just to build on Wayne's points, one thing I would also say just on the payer side is we do take a very much collaborative approach. So as we think about any rate increase, the reality of it is most of the time that's going to be in a situation that makes our facilities more attractive and actually draw patients potentially from higher cost settings, right.
So the goal here is in total, another reason a payer would do something off-cycle with us is the opportunity to make us more sustainable in the market to actually draw procedures over to what our higher value settings, even with their rate increases, and so we look for win-win’s there clearly.
To Wayne point you know, from a facility standpoint, as we've grown the company, we have not been as probably as this one as we could be around, just thinking about annual rate increases, how we should think about managing our book based on where we sit in a given market and so we've got some opportunities there as well that we're looking at, to be more consistent and to make sure that we are appropriately adjusting our charges to reflect market realities and win where we sit.
But all of that said, I think what's great is even in these conversations where we are having discussions with payers that maybe a bit out of cycle, the reality of it is for these payers, we present enough value creation that they want to make investments in us, right. They want to make investments in us as an alternative in some markets, and they want to make investments in us because of our quality and services, and so we feel good about you know we're part of the solution, and we want to make sure that while we offer a discount, we don't offer a deep discount that is unwarranted.
Okay, that's very helpful. I wanted to sort of switch topics, but this is somewhat related. You guys noted the CMS announcement of knee replacement and certain cardiac procedures moving to ASCs. Is there any way to sort of frame the opportunity or give us some guardrails around what you think the opportunities are? And then you know we certainly had payers, namely United and Anthem, sort of pushed changes to benefit design around site of service and prior auth. Can you give us a sense of either maybe what your overlap with those payers are in your markets and how meaningful or not of a driver do you see it specifically for 2020? Thanks.
So Ralph, I appreciate the question. Let me start by saying, I think both are very meaningful trends for our industry and our business model specifically. Look, I think – let me start with the payers, this is well overdue.
I think enough quality data has been supported now that shows that the quality is actually in many cases equal or better than what you get in acute care hospital settings and I would also add that nobody will debate or dispute that there is generally a 45% lower cost structure for it and so I would say that the payers and the moves they are making, and I would tell you there is meaningful overlap in our markets with those two payers you mentioned, as well as other payers that are considering similar processes.
On top of that, you know relative to skating where the puck is going, we didn't spend much time this past year highlighting the idea that we were fairly bullish this would happen, but we knew that you know you never quite know if this gets delayed another year. So in terms of sizing it, I don't want to get ahead of our board, but we actually have board meeting this week and as part of it, we're going to be sharing with our board a little bit of our thoughts on this space.
But what I would tell you is we've spent the last year expanding multiple location ORs for exactly this opportunity, and as you know OR expansions are fairly inexpensive to do if you're simply adding on a room to an existing facility.
I would also tell you on our physician recruiting efforts, we've spent a fair amount of time this past year starting to build deeper relationships with those physicians in markets that we believe our facilities are not only capable of bringing on this new windfall that's coming our way, but more importantly with the quality physicians we want to do it with. And while I won't give specific names, I mean we have physicians that are doing anywhere from 500 to 1,000 total joint procedures a year, which gives you an idea, but mostly in Medicare and generally in high retirement communities, but areas that we are actually well positioned, and so we're going to continue to have those relationships and we're looking at syndicating.
So more to come, but what I would tell you is I just view these as additional tools in the toolbox, which should give us confidence in our long term to double digit growth.
Okay. Very helpful, thank you.
Hey Ralph, I'm going to pile on, even though I know you probably just dropped off. The only other thing that I just want to highlight for you is this is part of the reason that we've been trying to demonstrate for you the number of procedures that we're already doing of this type in our ASCs, right. So we're doing these types of procedures today for our commercial clients, and we have the capabilities and are actually doing this in about a third of our ASCs today and have capability to do it more than that. But we think we're really well positioned for this opportunity over the short-term and over the longer-term.
Okay, thank you.
Our next question comes from the line of Chad Vanacore with Stifel. Please proceed with your question.
Hey, good morning Wayne and Tom.
A - Tom Cowhey
I would like to continue with Ralph's question on the opportunity in knees and maybe even hips. So if you can't quantify initial impact in 2020, where do you think you can get to in five years or if you'd rather, how much of that business do you think migrates from inpatient to outpatient?
So a difficult question to answer, not because we don't want to answer it, but because I think ultimately some of these projections we are going to be sharing with our board. I will tell you it is our intention to share these early next year with you on a five year outlook and we will get more detail, but let me give some, maybe some anecdotal things that hopefully will be somewhat helpful in answering it.
For 2020 it's a little more challenging simply because we've been working with a number of physicians that we would like to start having move procedures into our facilities, but ultimately they couldn't until this rule went into effect. So what I would tell you is we've got a lot of physicians lined up. We have a lot of individuals that were running to commit, but the reality was until Friday we will now know for certain how strong that commitment is and whether we actually get those individuals to syndicate and move forward with us. So you know until I can really see how that enrollment comes along, we have to see where that's at.
The other thing to keep in mind is that some patients are of course as you know never really candidates. I mean they have to remain in an inpatient setting and so one of the things we have to look at too as we've been targeting certain surgeons and physicians, we're trying to target those that we believe have at least more of a bias to what they could do in an outpatient setting.
So again, a lot of moving parts, but I think 2020 is a slower ramp up to be honest, just because we're now late in the year, a lot of these docs we've been recruiting now. Now it's going to be full push to go back out and say look, the rules are there, can we get you to start scheduling time?
If you just take physician recruiting in general, and I don't think these patterns would be any different with our Medicare doctors. You know last year we added almost 500, this year we think we'll add about 500 new surgeons as the year progresses. But when you look at those numbers, generally the pattern is those physicians will do one or two procedures for the first two to three months in your facility, simply to see, can you deliver on your promise, right. And then if you do, they start to do three to five in next month, and four to five, and then eventually you're getting them to do 25 procedures a month.
But I want you to know that ramp-up time; it takes really a full digestive year from soup to nuts. So I think it will be slow out of the gate in 2020, but ramp up by the end of 2020. I think 2021 is when you really start to see more run rate sustainable movement of that. But remember we're going after a new physician base that a lot of them do purely Medicare that we're trying to get moved into this population.
So more to come, but in general I'm just very bullish that this just – to me, I just view it as another example of why we should have confidence in double digit growth. I wouldn't necessarily start adding to it, because as you know there's many levers you pull at different times, but we think the opportunity is very meaningful.
Alright, so I'm going to ask an even more granular question on the general topic, which is presumably most hip and knee replacements are Medicare covered. Have you thought about how that impacts government payments?
Yes. So this is Eric. I mean certainly yes, there is a fair amount of those that are Medicare covered and clearly we are very, very focused on looking at implant costs and making sure that we appropriately prepared for what that reimbursement looks like, because it will put pressure on margins. The good news is that acuity growth, when you think about just the revenue opportunity for us is pretty meaningful in the ASC setting, so we've got a lot of efforts under way.
We do feel confident we can make that an accretive business, but it's going to take some work, and clearly we have to earn some commercial mix with that. And so the idea here is that a lot of these surgeons, you know they have a fair mix and our job is to earn all that business and make it all make sense in total, and we believe through our efforts, particularly as we gain volume and as we really go deep on how we deal the physician preference items in the type of deals that we give with our vendors for implants, we see it as a tremendous opportunity. But you're right, it’s something you got to prepare for and be very, very precise on how you manage your cost.
You know a reminder, well lower margin business, you know it's a very strong return on invested capital and so from our perspective this is still very good business, very positive EBITDA cash flow growth. It will put some pressure on margins, but I would tell you even with that, we still expect margin expansion over the next five years and consistently every year.
Alright, and then I just want to get to on the rate renegotiations for the fourth quarter. Did I hear that right; you got double digit rates compared to say your target of 2% to 3% and then you know why such a large rate increase?
So, the first answer is, yes, that you did hear correctly. Two is, look it really came down to the value play in a market. I think as Eric said, the data has always been readily available and I think as a management team, hopefully we'll continue to prove to you and our investors that we're very data driven of our decision making.
And so as we went out with the data, we simply met with the payers to show them where we know the market was bearing relative to rates for procedures being done in an outpatient setting, and we have health system data that we can get, we can get other ASC – I mean, this data is available and as you go out and pull this data, even if it's sanitized, you can understand where you stand in the packing order.
And so part of it has been simply us going out saying we've been an underpaid facility for many years. We believe we had meaningful value. We show them our ability to create steerage over time through our programs and our quality programs, and we basically show than the alternative, which is if we can't get paid meaningful rates to maintain and grow a sustainable business model in certain markets, then we’ll partner with health systems that will also give us the sustainable rate.
So I think the key is we have health systems that see all the trends happening. Their procedures are moving into an outpatient setting, and many of them are not prepared for this, and we have payers who would prefer to see those costs go to where we're adding value play, then move to a health system cost structure. And so we just happen to be uniquely positioned in the right space at the right time to have two very leverageable points, and we're going to continue to use those in every market we're in.
One thing I might just add on to that, when you think about managed care side, we are taking a more of a state, regional and national approach, and one of the problems when you're just simply individual facility negotiations that we've missed, it’s kind of telling the broader story of the value we can create in a given market or state region.
That is a different approach for us and I do think that as payers realize our scale in certain markets and our ability to actually meaningfully help them more than just one location, but across the geography, that also changes the story, and changes the kind of the place we're negotiating on, right, not just about local unit cost, but about how in the course of a reach – how over a broad geography can we help drive costs down in the system and help them create value, and I think that's positioning us well as we move forward.
Alright, I'm going to sneak in one more question. So by maintaining double digit growth outlook for FY '19, this implied steep ramp above what would be typical seasonal strength in 4Q, how much of that ramp do you expect to be driven by revenue increase and how much is that from margin improvement?
So I appreciate the question. Just some high level things to keep in mind. Just as we benefited from some of those divested assets in Q3 in the sense that they had EBITDA last year and of course that's not here this year, those assets were very lumpy in their seasonality and so some of our divestitures actually lost money in Q4. So let me just start by saying that there is several million dollar pickup simply by not having losses recurred in Q4, which probably gives you a little more of a sense that the seasonality patterns are not as far off as what historically you've seen if you just adjust for that.
I would tell you that it's probably heavier on the revenue side, a pretty meaningful lift that we have coming, both through the rate negotiations, plus the ramp up of doctors that we've seen from not only '18, but all those hired in '19 and those patterns, you know historically as I mentioned earlier, the seasonality of how a doctor gets engaged with your facilities, usually gets pretty meaningful in Q4.
Q4 is typically heavy commercial and many physicians are generally somewhat intentional on how they schedule their procedures around Q4 and so I would say it's heavier weighted toward that. That being said, we have value benefits coming through we expect from our benefit design changes we made in our health plans and a more G&A leverage and the RCM benefits continue to look positive each day. So I think you'll see both margin improvement, but I think you'll see strong top line.
Alright, that's it for me. Thanks.
Our next question comes from the line of Brian Tanquilut with Jefferies. Please proceed with your question.
Hey, good morning guys. I guess my first question just to follow up on Chad's last question, as I think about Q4, is there anything qualitatively at least you can share with us in terms of what you're seeing, maybe with volume shifting from Q3 because of Dorian or how should we feel comfortable or confident with the revenue ramp that you're expecting, just like you alluded to?
Yes, so Brian let me start by saying that, again, I think due to the one-time items that were there last year coupled with many of our initiatives that were fourth quarter loaded for the benefits that we expected, obviously we have insights that you are trying to get comfortable with.
That being said, when Hurricane Dorian happened, as you know it's a day that you lose. You just don’t have to recover those days back to schedule procedures, but the hope is that you'll get some of those rescheduled into the fourth quarter. And what I would say is, you know October seems to be at least indicating that that has happened.
Now we're not done closing our books. We have a view on case volume, but I would say all those facilities that were affected appeared to be performing well in October and generally very strong versus our original expectations when we built our budget. So I think you know as of today we feel pretty good on the volume.
You know I think the biggest thing is it really comes down the mix, and does the mix shift like in commercial we've historically seen occur, especially because we know we had pretty meaningful rate lift across the board in our commercial book in the quarter. So I think it's going to be more to come, but I would say our commitment to double digit growth is still there, and we have many levers that we could pull if we felt there was any pressure in the quarter.
I appreciate that comment. Wayne, as I think about shifting gears to the whole total knee replacement opportunity, obviously one of the key debates is what is the right reimbursement, right. I mean this is kind of a new area for a lot of the payers as well. So you mentioned 45% cheaper than hospitals is what you guys are averaging at as an ASC industry. Is that the starting point of the conversation as we think about the economics of total knee replacements?
So first of all, if you look at what they proposed, I think its $8,000.
North of $8,000.
Just north of $8,000 is what they proposed. You know we've looked at a number of our facilities and believed we can earn a reasonable return on that. Keep in mind, I think this is what typically happens with all government business, everybody cries fall-outs as they can't make money in this environment as we've heard for years on Medicaid and Medicare, and then somehow the industry becomes innovative and figures it out. And so I would just simply tell you that in a lot of ways we actually welcome the stake in the ground at these rates.
Would we like to be paid more? Of course, we would, but I would tell you our business model was built to be efficient like this, and because of our fixed cost leverage structure, we think we'll be just fine. The core issue is going to be how do we continue to manage our contracts around our implant costs, and what we're doing there, and that's where Eric and the procurement team have a pretty substantial effort that gives us confidence that we can do well in that environment.
And if we're not able to in a particular market or a particular facility, remember we lose nothing from this, this is only upside to us. So you know I feel like we're in the right spot at the right time and we've got a lot of optionality on how we want to play.
Eric, anything you want to add?
Yes. The other thing I would add there Brian is that I think what's interesting. So Medicare obviously is typically one of the lower payers. When we talk to commercial payers, you know what we really spend our time focusing on is the gap between what they pay today and what they could pay in our facilities and in the value creation, it's pretty large and so it's interesting. As payers are starting to look at this, they are realizing that ‘hey, they're probably making an investment on the ASC side to pay a better rate that helps cover, make sure we cover the implant and helps attract docs to the outpatient setting.’
Making those investments is still a huge win for them. And so we expect, yes, while there is some pressure on the Medicare side, and I think it will kind of play out over time, whether the rate they have is sustainable and it actually moves enough business, because what they really want to do is take advantage of that huge gap, right.
So whether they go to $8,600 or eventually $10,000 or whatever that number is, their savings is large, and so they are trying to find that spot. I will tell you on the payer side, they see that large opportunity as well and it's our job to make sure we get paid fairly and capture some of the value that we can create, so we see it as a huge win.
I would agree with Wayne that just having the stake in the ground, and saying you know what, outpatient is probably a place a lot of these procedures should be certainly changes the dialog.
Brian, I'm just going to add one thing on to that. You know as you think about the rates here, we believe that we can make money, but this has got to be an end and non-core [ph], right and that's the very simple way I am thinking about it. This has got to be a positive to volume and bringing procedures in and filling space that we might not otherwise utilize or where we are making more marginal dollars versus lower contribution procedures, right. And that's I think part of the reason why we're still also cautious about 2020 and the ramp is that we want to make sure that we are actively managing this to achieve that end result.
That makes a lot of sense. Tom, My last question, as I think about Idaho Falls, you mentioned that in your prepared remarks. How should I think about the ramp or the drag from that in 2020 on EBITDA?
So EBITDA drag in 2020 is going to be excluded from adjusted EBITDA as a start-up cost. And as we've done every quarter this year, we've highlighted what that is going to be for investors. You know it could be $10 million plus next year and I think that it will be in that same zip code as we hit a lot of – as the facility opens, and we look at what 2019 will be from an EBITDA drag with a lot of that obviously occurring just in the fourth quarter.
And the only thing I'll throw in there, having opened a number of new hospitals, I've never seen a hospital in year one go positive. It's always, it's going to be a drag for a while, but I will tell you that the turnaround here we expect in this market, given our context and given our strong position in the market already, our strong value position, even with this new hospital, for a new hospital we expect it to be a relatively quick ramp. But obviously every hospital has a period of time it goes through that has to build so.
And Brian, we want to see what the trajectory looks like. We want to see how quickly it gets – the facility get licensed and work with the team out there, whose done a yeoman's effort in getting it to this stage. But there's a lot of variables in play right now and I'm being consciously cautious in what I tell you right now, because we want to – you know we want to see what this looks like when it opens, and how quickly it looks like it's going to ramp before we give any real projections or baseline for what this could look like next year.
Alright, thanks guys.
Our next question comes from the line of Frank Morgan with RBC. Please proceed with your question.
Good morning. I'll stick with Idaho Falls for just a second. Would you remind me, I think that facility is going to be leased, but in terms of – is that correct? And the number two with regard to your leverage calculations in your covenants, does the start-up losses on those facilities, I'm assuming those get excluded from covenant calculations.
And then the second question, you mentioned the Montana opportunity. I'd just like a little bit more color there in terms of what you see as the EBITDA opportunity, the capital deployment required in that market and just any more color in detail on how much you think that could contribute in 2020? Thanks.
Yes, let me start with Idaho, and then I can answer Montana or Wayne can. But the Idaho, yes, Medical Properties Trust was kind enough to construct the building in the new parking garage for us and so when we take possession of that facility, we will have a lease payment that will essentially be accounted for as interest for the vast majority of that payment, but it will show up in the debt schedule as a financing lease, and our current estimate on that is that it will be about $105 million plus or minus. We obviously need to finalize the calculations once we take possession.
And then don't forget, we do have a very attractive facility that we have put in place in Idaho for the equipment, to help for that facility, and so that will be just shy of $30 million as well. I mean, we expect that you know in the fourth quarter that that facility will be pretty close to fully drawn as we outfit the new facility.
The losses, our current interpretation of the credit agreement is exactly how you put it; the losses are eligible to be excluded, but because we're taking the debt in, we're trying to – it's matching principle, essentially you're having the debt on your balance sheet, so you're trying to give a sense as to what the contribution from that is, and as we finalize those projections, we'll give you a better sense as to what that is when we report the fourth quarter. But we've given you at least some benchmarks as to the type of opportunity that we're expecting over the course of the next few years.
And it will be deleveraging.
Relative to Idaho Falls [Cross Talk] yes, just a little bit of background there. This is a market where we have a lot of experience already, so we were already a majority owner in the hospital system, we were an owner in the ASC and then there was also the clinic in the market. And if you have a little bit of history, it's a 100-year plus physician clinic. So it's a very well established market.
There were some opportunities that we thought that we could really deploy, especially where we saw a lot of the growth going in the market. And similar to what we did in Idaho Falls, you know we saw this as probably a unique opportunity to start building a broader ecosystem, and so step one for us was really to get more ownership in the hospitals, so that we could syndicate some more doctors that we would like to syndicate.
Also we took over full ownership then with the ASC, which allows us to get the HOPD rates since it is on campus. And so there is some, what I would call, low hanging synergies that will be able to start driving value.
Now, you'll start to see some of that value next year in EBITDA growth, but the real meaningful value will be in 2021. We get the kind of the full-year run rate of the ramp up, that will do, because obviously preparing the facility for HOPD requires different AC equipment – there's just different things we have to do.
That being said, the capital improvements that we had to do and the capital deploy too, we've already done this year, and so I think it's really just – and we've already committed and so I don't think you'll see much more cash flow outlay going into next year. It's just rather executing on our plans and where we're going.
Future cash flow outlay would be if we do something similar in Idaho Falls, but I think our first bet is, let's go get the low hanging fruit and the synergies that are available to us. We've got some good rates in that market. We've got some really strong physicians that we’d like to syndicate, and you know we think this will be a good ramp up, a good story starting both next year, plus we'll start to get the full value of owning more of the hospital for the pieces that we retain that we don't syndicate.
Okay, thank you.
Our final question comes from the line of Whit Mayo with UBS. Please proceed with your question.
Hey, thanks. I'll just stick with one question. I wanted to go back to the three strategic initiatives that Wayne discussed; procurement, revenue cycle, G&A. I think these are areas that have been called out for some time. I'm just wondering specifically maybe what's changed? Are you finding new cost opportunities? Are there opportunities within the opportunities? I just want to make sure that I'm processing these three initiatives appropriately?
Yes Whit, so let me first start with all three of the initiatives and the easiest analogy I can give you is a nine inning baseball game and I would say we're in the third inning right of opportunity. I mean we are far from what this company is capable of doing.
You know the first year, just as a reminder last year when this new management team joined, it's important to recognize that despite the 125 plus facilities, there was no centralized procurement function. And so just moving to a centralized procurement function, establishing a GPO, giving new contracted rates, all low hanging fruit, but things you would expect of a company of our size and scale. Rolling that out across the facilities took time, and so that's what's happened.
Now we're moving to just a very simplification of evolution, which is okay, now how do we get – you know we hadn't even moved to kind of preferred implants or preferred pricing. We were just simply getting better pricing due to the lack of leveraging scale. And so I would just say that on the procurement front, we have nothing short of 20 new initiatives that are constantly in front of us that are kind of the next round of low hanging fruit we're going after.
On the RCM front, as a reminder we had so many divergent systems, that we're submitting claims in so many different ways. The ability to actually go out and actually put in true RCM management best practices was completely hindered by the lack of consolidation of platforms.
Last year, through the end of last year, and then early this year, you know we got over 95% of our facilities, all on a single claims processing platform, consistently processing through the claims clearinghouse and warehouse, and then with that data now we can actually take actions on it. And so again, I would tell you very low hanging fruit that we've been going after. Last year was the investment year, this year was the execution year, but even on the execution, it just starts opening our eyes to more and more opportunities.
And then finally on the G&A front, if you can imagine what we read on the maturity curve on procurement in RCM, it was the same thing last year was. We had no centralized benefit plan. I mean, we had 24 different health plans for a company that was self-insured, right. Obviously we made that transition last year and those value creations come through this year. Now we can get more creative and benefit design.
And so there is always like this evolution that we're in, but I would say we're still in the very early innings. I'd say two years in and we're in the third inning now and we still got another six innings to go of opportunity, just in those three arenas.
Great, that was helpful.
Thanks for the question, and really thanks for everybody's time today. I know this has been an interesting journey, the last 18 months, almost 20 months now. So we've kind of been laying out where we were going to take the company.
I know as a management team we're very excited about the progress and where we're at. We're even more excited about hosting an IR Day, which will publish more information regarding next year. We plan to give a five year outlook and really share with you a lot of exciting things we've been doing in building this platform asset.
Before we conclude our call though, I do want to take a moment to thank our 10,000 plus associates and our 4,000 plus physicians for their contributions. I know I feel privileged to be able to participate in this journey of improving healthcare and making it more affordable for Americans.
As we execute against our goal to become the preferred partner for operating short stay surgical facilities across the U.S., it is really the daily efforts of each and every Surgery Partners employee and physician that gets us there.
Thanks for joining our call this morning and have a great day.
Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day!