FORM 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

September 30, 2011 For the quarterly period ended September 30, 2011

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             .

Commission file number 333-168159

 

 

APRIA HEALTHCARE GROUP INC.

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   33-0488566
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
26220 Enterprise Court
Lake Forest, CA
  92630
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (949) 639-2000

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨    No  x

Note: As a voluntary filer not subject to the filing requirements of Section 13 or 15(d) of the Exchange Act, the registrant has filed all reports pursuant to Section 13 or 15(d) as if the registrant was subject to such filing requirements.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   x (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of October 31, 2011, there were 100 shares of the issuer’s common stock, par value $0.01 per share, issued and outstanding.

 

 

 


Table of Contents

APRIA HEALTHCARE GROUP INC.

FORM 10-Q

TABLE OF CONTENTS

 

         Page
No.
 
  PART I—Financial Information   
Item 1.  

Condensed Consolidated Balance Sheets as of September 30, 2011 (Unaudited) and December 31, 2010

     3   
 

Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended
September 30, 2011 and September 30, 2010

     4   
 

Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and September 30, 2010

     5   
 

Notes to Unaudited Condensed Consolidated Financial Statements

     6   
Item 2.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     29   
Item 3.  

Quantitative and Qualitative Disclosures About Market Risk

     55   
Item 4.  

Controls and Procedures

     55   
  PART II—Other Information   
Item 1.  

Legal Proceedings

     56   
Item 1A.  

Risk Factors

     56   
Item 2.  

Unregistered Sale of Equity Securities and Use of Proceeds

     68   
Item 3.  

Defaults Upon Senior Securities

     68   
Item 4.  

[Removed and Reserved]

     68   
Item 5.  

Other Information

     68   
Item 6.  

Exhibits

     69   
SIGNATURES      70   

 

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Table of Contents

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This quarterly report on Form 10-Q includes forward-looking statements regarding, among other things, our plans, strategies and prospects, both business and financial. These statements are based on the beliefs and assumptions of our management. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Generally, statements that are not historical facts, including statements concerning our possible or assumed future actions, business strategies, events or results of operations, are forward-looking statements. These statements may be preceded by, followed by or include the words “believes”, “expects”, “anticipates”, “intends”, “plans”, “estimates” or similar expressions.

Forward-looking statements are not guarantees of performance. You should not put undue reliance on these statements. You should understand that various important factors, in addition to those discussed elsewhere in this quarterly report on Form 10-Q, could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in our forward-looking statements:

 

   

trends and developments affecting the collectability of accounts receivable;

 

   

government legislative and budget developments that could continue to affect reimbursement levels;

 

   

potential reductions in reimbursement rates by government and third-party payors;

 

   

the effectiveness of our operating systems and controls;

 

   

healthcare reform and the effect of federal and state healthcare regulations;

 

   

economic and political events, international conflicts and natural disasters;

 

   

acquisition-related risks; and

 

   

the items discussed under “Risk Factors” in this quarterly report on Form 10-Q.

All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing cautionary statements. We undertake no obligations to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

As used in this report, unless otherwise noted or the context otherwise requires, references to “Company,” “we,” “us,” and “our” are to Apria Healthcare Group Inc., a Delaware corporation, and its subsidiaries; references to “Apria” and the “Issuer” are to Apria Healthcare Group Inc., exclusive of its subsidiaries; references to “Merger Sub” are to Sky Merger Sub Corporation, a Delaware corporation; references to “Holdings” are to Apria Holdings LLC, a Delaware limited liability company, exclusive of its subsidiaries; references to “Sky Acquisition” are to “Sky Acquisition LLC”, a Delaware limited liability company, exclusive of its subsidiaries; references to “Blackstone” and the “Sponsor” are to Blackstone Capital Partners V L.P.; references to the “Investor Group” are, collectively, to Blackstone and certain funds affiliated with Blackstone, Dr. Norman C. Payson and certain other members of our management; and references to “home medical equipment,” “durable medical equipment” and “DME” are used synonymously. On October 28, 2008, the Company was acquired by private investment funds affiliated with the Sponsor via a merger of the Merger Sub with and into Apria (the “Merger”), with Apria being the surviving corporation following the Merger. As a result of the Merger, the Investment Group beneficially owns all of Apria’s issued and outstanding common stock. The Merger and the related financing and refinancing transactions, including, but not limited to, the equity investment by the Sponsor, the borrowings under the Company’s senior secured bridge credit agreement dated October 28, 2008 (the “senior secured bridge credit agreement”) and the use of proceeds therefrom, the offerings of $700.0 million of the Company’s 11.25% Senior Secured Notes due 2014 (Series A-1) (the “Series A-1 Notes”) and $317.5 million of the Company’s 12.375% Senior Secured Notes due 2014 (Series A-2) (the “Series A-2 Notes”), the repayment of all outstanding borrowings under the Company’s senior secured bridge credit agreement, and the payment of related fees and expenses, are collectively referred to in this Quarterly Report as the “Transactions.”

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     September 30, 2011     December 31, 2010  
     (in thousands, except share data)  
ASSETS   

CURRENT ASSETS

    

Cash and cash equivalents

   $ 57,927      $ 109,137   

Accounts receivable, less allowance for doubtful accounts of $56,155 and $56,559 at September 30, 2011 and December 31, 2010, respectively

     325,876        282,798   

Inventories

     61,725        73,894   

Deferred income taxes

     68,764        58,028   

Deferred expenses

     3,209        3,061   

Prepaid expenses and other current assets

     21,103        20,221   
  

 

 

   

 

 

 

TOTAL CURRENT ASSETS

     538,604        547,139   

PATIENT SERVICE EQUIPMENT, less accumulated depreciation of $168,733 and $144,074 at September 30, 2011 and December 31, 2010, respectively

     201,902        169,878   

PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET

     93,266        83,893   

GOODWILL

     765,245        760,088   

INTANGIBLE ASSETS, NET

     576,874        578,957   

DEFERRED DEBT ISSUANCE COSTS, NET

     47,916        53,659   

OTHER ASSETS

     8,783        7,523   
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 2,232,590      $ 2,201,137   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

CURRENT LIABILITIES

    

Accounts payable

   $ 110,952      $ 86,637   

Accrued payroll and related taxes and benefits

     77,842        59,073   

Other accrued liabilities

     120,625        90,447   

Deferred revenue

     29,589        26,504   

Current portion of long-term debt

     382        1,323   
  

 

 

   

 

 

 

TOTAL CURRENT LIABILITIES

     339,390        263,984   

LONG-TERM DEBT, net of current portion

     1,017,838        1,018,098   

DEFERRED INCOME TAXES

     221,177        222,743   

INCOME TAXES PAYABLE AND OTHER NON-CURRENT LIABILITIES

     22,743        31,000   
  

 

 

   

 

 

 

TOTAL LIABILITIES

     1,601,148        1,535,825   

COMMITMENTS AND CONTINGENCIES

    

STOCKHOLDERS’ EQUITY

    

Common stock, $0.01 par value: 1,000 shares authorized; 100 shares issued at September 30, 2011 and December 31, 2010

     —          —     

Additional paid-in capital

     689,736        688,458   

Accumulated deficit

     (58,294     (23,146
  

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ EQUITY

     631,442        665,312   
  

 

 

   

 

 

 
   $ 2,232,590      $ 2,201,137   
  

 

 

   

 

 

 

See notes to unaudited condensed consolidated financial statements.

 

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APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2011     2010     2011     2010  
     (in thousands)  

Net revenues:

        

Fee for service arrangements

   $ 542,391      $ 486,027      $ 1,572,304      $ 1,433,562   

Capitation

     42,483        39,987        125,661        119,506   
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL NET REVENUES

     584,874        526,014        1,697,965        1,553,068   
  

 

 

   

 

 

   

 

 

   

 

 

 

Costs and expenses:

        

Cost of net revenues:

        

Product and supply costs

     190,241        167,198        558,563        488,265   

Patient service equipment depreciation

     27,588        23,094        73,470        71,843   

Home respiratory therapy services

     6,726        5,456        18,829        21,671   

Nursing services

     10,677        9,258        31,204        27,258   

Other

     4,322        2,978        10,796        9,871   
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL COST OF NET REVENUES

     239,554        207,984        692,862        618,908   

Provision for doubtful accounts

     14,511        10,981        51,353        39,801   

Selling, distribution and administrative

     307,810        271,157        907,508        787,738   

Amortization of intangible assets

     1,172        1,035        3,370        3,777   
  

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     563,047        491,157        1,655,093        1,450,224   
  

 

 

   

 

 

   

 

 

   

 

 

 

OPERATING INCOME

     21,827        34,857        42,872        102,844   

Interest expense

     33,228        32,736        99,158        97,971   

Interest income and other

     176        (250     (114     (555
  

 

 

   

 

 

   

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (11,577     2,371        (56,172     5,428   

Income tax (benefit) expense

     (6,890     2,476        (21,024     2,970   
  

 

 

   

 

 

   

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (4,687   $ (105   $ (35,148   $ 2,458   
  

 

 

   

 

 

   

 

 

   

 

 

 

See notes to unaudited condensed consolidated financial statements.

 

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APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Nine Months Ended
September 30,
 
     2011     2010  
     (in thousands)  

OPERATING ACTIVITIES

    

Net (loss) income

   $ (35,148   $ 2,458   

Items included in net (loss) income not requiring cash:

    

Provision for doubtful accounts

     51,353        39,801   

Depreciation

     100,095        93,722   

Amortization of intangible assets

     3,370        3,777   

Amortization of deferred debt issuance costs

     9,130        7,919   

Deferred income taxes

     (12,302     4,686   

Profit interest compensation

     2,278        3,194   

Loss on disposition of assets and other

     12,906        12,472   

Changes in operating assets and liabilities, exclusive of effects of acquisitions:

    

Accounts receivable

     (94,432     (96,060

Inventories

     1,356        (1,223

Prepaid expenses and other assets

     (1,929     (270

Accounts payable, exclusive of book-cash overdraft

     11,668        2,730   

Accrued payroll and related taxes and benefits

     18,578        (4,152

Income taxes payable

     (11,290     (2,126

Deferred revenue, net of related expenses

     2,938        (247

Accrued expenses

     33,211        27,357   
  

 

 

   

 

 

 

NET CASH PROVIDED BY OPERATING ACTIVITIES

     91,782        94,038   
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Purchases of patient service equipment and property, equipment and improvements, exclusive of effects of acquisitions

     (114,089     (84,682

Purchases of short-term investments

     —          (8,087

Maturities of short-term investments

     —          31,507   

Proceeds from disposition of assets

     162        634   

Cash paid for acquisitions

     (23,478     (2,260
  

 

 

   

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (137,405     (62,888
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Payments on other long-term debt

     (1,200     (1,314

Change in book-cash overdraft included in accounts payable

     —          (32,533

Debt issuance costs

     (3,387     (3,590

Cash paid on profit interest units

     (1,000     (78
  

 

 

   

 

 

 

NET CASH USED IN FINANCING ACTIVITIES

     (5,587     (37,515
  

 

 

   

 

 

 

NET DECREASE IN CASH AND CASH EQUIVALENTS

     (51,210     (6,365

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     109,137        158,163   
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 57,927      $ 151,798   
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURES — See Note 5 and Note 8 for a discussion of cash paid for interest and income taxes, respectively.

Purchases of patient service equipment and property, equipment and improvements exclude purchases that remain unpaid at the end of the respective quarter. Such amounts are then included in the following period’s purchases when paid. Unpaid purchases were $12.0 million and $7.6 million at September 30, 2011 and December 31, 2010, respectively.

See notes to unaudited condensed consolidated financial statements.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation: The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These statements include the accounts of Apria Healthcare Group Inc. (“Apria” or “the Company”) and its subsidiaries. Intercompany transactions and accounts have been eliminated in consolidation.

In the opinion of management, all adjustments, consisting of normal recurring accruals necessary for a fair presentation of the results of operations for the interim periods presented, have been reflected herein. The unaudited results of operations for interim periods are not necessarily indicative of the results to be expected for the entire year. For further information, refer to the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2010.

On October 28, 2008, the Company completed a merger (the “Merger”) with Sky Merger Sub Corporation (“Merger Sub”), a Delaware corporation and wholly-owned subsidiary of Sky Acquisition LLC, a Delaware limited liability company (“Buyer” or “Sky LLC”). Buyer is controlled by private investment funds affiliated with The Blackstone Group (“Sponsor”).

Company Background: Apria operates in the home healthcare segment of the healthcare industry, providing a variety of high-quality clinical patient care management programs, related products and supplies as prescribed by a physician and/or authorized by a case manager as part of a care plan. Essentially all products and services offered by the Company are provided through the Company’s network of approximately 550 locations, which are located throughout the United States. We provide services and products in two operating segments and within these two operating segments there are three core service lines: home respiratory therapy, home medical equipment and home infusion therapy. Both segments provide products and services in the home setting to patients and are primarily paid for by a third-party payor, such as Medicare, Medicaid, managed care or other third-party insurer. Sales for both segments are primarily derived from referral sources such as hospital discharge planners, medical groups or independent physicians.

Use of Accounting Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Among the significant estimates affecting the consolidated financial statements are those related to revenue recognition and the resulting accounts receivable, share-based compensation, income taxes, goodwill and long-lived assets.

Revenue Recognition and Concentration of Credit Risk: Revenues are recognized under fee for service/product arrangements for equipment the Company rents to patients, sales of equipment, supplies, pharmaceuticals and other items the Company sells to patients and under capitation arrangements with third party payors for services and equipment the Company provides to the patients of these payors. Revenue generated from equipment that the Company rents to patients is recognized over the rental period, typically one month, and commences on delivery of the equipment to the patients. Revenue related to sales of equipment, supplies and pharmaceuticals is recognized on the date of delivery to the patients. Revenues derived from capitation arrangements were approximately 7% of total net revenues for the three and nine months ended September 30, 2011 and 8% of total net revenues for the three and nine months ended September 30, 2010. Capitation revenue is earned as a result of entering into a contract with a third party to provide its members certain services without regard to the actual services provided, therefore revenue is recognized in the period that the beneficiaries are entitled to health care services. All revenues are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors, including private insurers, prepaid health plans, Medicare and Medicaid. Revenues reimbursed under arrangements with Medicare and Medicaid were approximately 30% of total net revenues for each of the three and nine months ended September 30, 2011 and September 30, 2010, respectively. In the nine months ended September 30, 2011 and September 30, 2010, no other third-party payor group represented more than 8% of the Company’s revenues.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Rental and sale revenues in the fee for service/product arrangement revenue line item were:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 

(dollars in millions)

   2011            2010            2011            2010         

Rental

   $ 166.3         30.7   $ 154.3         31.8   $ 482.7         30.7   $ 466.7         32.6

Sale

     376.1         69.3        331.7         68.2        1,089.6         69.3        966.9         67.4   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total fee for service

   $ 542.4         100.0   $ 486.0         100.0   $ 1,572.3         100.0   $ 1,433.6         100.0
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

In the Company’s business, there are multiple services and products delivered to patients. These arrangements involve equipment that is rented and related supplies that may be sold that cannot be returned. In arrangements with multiple deliverables, revenue is recognized when each deliverable is provided to the patient. For example, revenues from equipment rental supplies sales are recognized upon of delivery of the products, as the supplies sold are considered a separate unit of accounting.

Cash and Cash Equivalents: Cash is maintained with various financial institutions. These financial institutions are located throughout the United States and the Company’s cash management practices limit exposure to any one institution. Management considers all highly liquid instruments purchased with a maturity of less than three months to be cash equivalents.

Accounts Receivable: Included in accounts receivable are earned but unbilled receivables of $66.3 million and $55.2 million at September 30, 2011 and December 31, 2010, respectively. Delays ranging from a day up to several weeks between the date of service and billing can occur due to delays in obtaining certain required payor-specific documentation from internal and external sources. Unbilled receivables can also be impacted by the transition of patients during the integration of acquisitions and overall revenue growth. Earned but unbilled receivables are aged from date of service and are considered in the analysis of historical performance and collectability.

Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required to record total net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review.

Management performs periodic analyses to evaluate accounts receivable balances to ensure that recorded amounts reflect estimated net realizable value. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends, the extent of contracted business and business combinations. Also considered are relevant business conditions such as governmental and managed care payor claims processing procedures and system changes. Additionally, focused reviews of certain large and/or problematic payors are performed. Due to continuing changes in the healthcare industry and third-party reimbursement, it is possible that management’s estimates could change in the near term, which could have an impact on operations and cash flows.

Accounts receivable are reduced by an allowance for doubtful accounts which provides for those accounts from which payment is not expected to be received, although services were provided and revenue was earned. Upon determination that an account is uncollectible, it is written-off and charged to the allowance.

Deferred Revenue and Deferred Expense: A lessor is required to recognize rental income over the lease term. Rental of patient equipment is billed on a monthly basis beginning on the date the equipment is delivered. Since deliveries can occur on any day during a month, the amount of billings that apply to the next month are deferred. Only the direct costs associated with the initial rental period are deferred.

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market and consist primarily of pharmaceuticals and items used in conjunction with patient service equipment. Inventories are reduced by a reserve for slow moving or obsolete inventory.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Patient Service Equipment: Patient service equipment is stated at cost less depreciation and consists of medical equipment rented to patients on a month-to-month basis. Depreciation is provided using the straight-line method over the estimated useful lives of the equipment, which range from one to ten years.

Property, Equipment and Improvements: Property, equipment and improvements are stated at cost less depreciation. Depreciation is provided using the straight-line method over the estimated useful lives of the assets.

Capitalized Software: Included in property, equipment and improvements are costs related to internally developed and purchased software that are capitalized and amortized over periods that the assets are expected to provide benefit. Capitalized costs include direct costs of materials and services incurred in developing or obtaining internal-use software and payroll and benefit costs for employees directly involved in the development of internal-use software. Additions to capitalized internally developed software totaled $2.6 million for each of the three months ended September 30, 2011 and 2010, respectively, and $7.1 million and $8.7 million for the nine months ended September 30, 2011 and 2010, respectively.

Goodwill and long-lived assets: Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization.

Goodwill and indefinite-lived intangible assets are not amortized but instead tested at least annually for impairment, or more frequently when events or changes in circumstances indicate that the assets might be impaired. Goodwill is tested for impairment by comparing the carrying value to the fair value of the reporting unit to which the goodwill is assigned. A two-step test is used to identify the potential impairment and to measure the amount of impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired; otherwise, goodwill is impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit with the carrying amount of goodwill. Management has determined that our two operating segments are reporting units. As such, the Company has two reporting units: home respiratory therapy/home medical equipment and home infusion therapy. The Company performs the annual test for impairment as of the first day of its fourth quarter and determines fair value based on a combination of the income approach and the market approach. The income approach is based on discounted cash flows. The market approach uses a selection of comparable companies in determining market value. During the annual goodwill impairment test in 2010, the Company completed step one and determined that there was no impairment of goodwill since the fair value of the reporting units substantially exceeded the carrying value. Our annual indefinite-lived intangible assets impairment test in 2010 also resulted in no impairment as the fair value of the assets exceeded the carrying value. The goodwill amounts for the March 4, 2011 acquisition of Praxair assets (see Note 3 – Business Combinations for details of the Praxair acquisition), are based upon preliminary estimates that are subject to change in 2011 upon completion of the final valuation analysis. Final determination of these estimates could result in an adjustment to the purchase price allocation with an offsetting adjustment to goodwill. There were no indicators of impairment as of September 30, 2011. Our 2011 annual testing of goodwill and indefinite-lived intangible asset impairment is scheduled to occur in the fourth quarter of 2011.

Long-lived assets, including property and equipment and purchased intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment tests. Recoverability of assets to be held and used is measured by the comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such an asset is considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. There were no indicators of impairment as of September 30, 2011.

Purchased intangible assets consist primarily of trade names, patient backlog, capitated relationships and payor relationships resulting from the Merger. Purchased intangible assets that have definite lives are amortized over the estimated useful lives of the related assets, generally ranging from one to twenty years. The intangible assets resulting from the March 4, 2011 acquisition of Praxair assets are based upon preliminary estimates that are subject to change in 2011 upon completion of the final valuation analysis.

Deferred Debt Issuance Costs: Capitalized debt issuance costs include those associated with the Company’s Series A-1 Notes, Series A-2 Notes and Asset Based Revolving Credit Facility (“ABL Facility”). Such costs are classified as non-current assets. Costs relating to the ABL Facility are being amortized through the maturity date of August 2014. Costs relating to the Series A-1 Notes and Series A-2 Notes are amortized from the issuance date through October 2014. See Note 5— Long-term Debt.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Fair Value of Financial Instruments: The carrying value of debt approximates fair value because the underlying instruments are variable notes that reprice frequently. The fair values of cash and cash equivalents, short-term investments and the Series A-1 Notes and Series A-2 Notes are determined based upon “Level 1” inputs, consisting of quoted prices in active markets for identical items. The fair value of the Series A-1 Notes and Series A-2 Notes was $675.5 million and $292.1 million at September 30, 2011, respectively. The carrying amounts of cash and cash equivalents, accounts receivable, trade payables and accrued expenses approximate fair value due to their short maturity.

Product and Supply Costs: Product and supply costs presented within cost of total net revenues are comprised primarily of the cost of supplies and equipment provided to patients, infusion drug costs and enteral product costs.

Home Respiratory Therapy Expenses: Home respiratory therapy expenses presented within cost of total net revenues are comprised primarily of employee salary and benefit costs or contract fees paid to respiratory therapists and other related professionals who are deployed to service a patient. Home respiratory therapy personnel are also engaged in a number of administrative and marketing tasks, and accordingly, these costs are classified within selling, distribution and administrative expenses and amounted to $10.8 million and $9.5 million in the three months ended September 30, 2011 and September 30, 2010, respectively, and $32.1 million and $22.6 million in the nine months ended September 30, 2011 and September 30, 2010, respectively.

Distribution Expenses: Distribution expenses are included in selling, distribution and administrative expenses and totaled $48.8 million and $41.1 million in the three months ended September 30, 2011 and September 30, 2010, respectively, and $142.9 million and $120.0 million in the nine months ended September 30, 2011 and September 30, 2010, respectively. Such expense represents the cost incurred to coordinate and deliver products and services to the patients. Included in distribution expenses are leasing, maintenance, licensing and fuel costs for the vehicle fleet; salaries and other costs related to drivers and dispatch personnel; and amounts paid to courier and other outside shipping vendors. Such expenses fall within the definition of “shipping and handling” costs and are classified within selling and administrative expenses and may not be comparable to other companies.

Self-Insurance: Coverage for certain employee medical claims and benefits, as well as workers’ compensation, professional and general liability, and vehicle liability are self-insured. Amounts accrued for costs of workers’ compensation, medical, professional and general liability, and vehicle are classified in other accrued liabilities as follows:

 

(in thousands)

   September 30,
2011
     December 31,
2010
 

Workers’ compensation

   $ 23,408       $ 21,694   

Professional and general liability/vehicle

     11,115         10,552   

Medical insurance

     6,461         6,477   
  

 

 

    

 

 

 

Total

   $ 40,984       $ 38,723   
  

 

 

    

 

 

 

Income Taxes: The Company’s provision for income taxes is based on expected income, permanent book/tax differences and statutory tax rates in the various jurisdictions in which the Company operates. Significant management estimates and judgments are required in determining the provision for income taxes.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax assets will not be realized.

Profit Interest Units: We measure and recognize compensation expense for all profit interest unit awards made to employees based on estimated fair values on the date of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in our consolidated financial statements. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Profit interest unit expense is recognized on a straight-line basis over the requisite service period. The estimate of fair value of profit interest unit awards on the date of grant is determined through the allocation of all outstanding securities to a business enterprise valuation. The enterprise valuation is based upon a combination of the income approach and the market approach. The income approach is based on discounted cash flows. The market approach uses a selection of comparable companies in determining value. This determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. Changes in the subjective assumptions can materially affect the estimate of their fair value.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Recent Accounting Pronouncements: In June 2011, the Emerging Issues Task Force (“EITF”) issued EITF 09-H, “Health Care Entities: Presentation of the Provision for Bad Debts and Disclosures of Net Revenues and the Allowance for Doubtful Accounts” (“EITF 09-H”). EITF 09-H requires certain entities to present bad debt as an offset to revenue in the statement of operations. This issue will be effective for fiscal years beginning after December 15, 2011 and interim periods within those fiscal years. We are currently evaluating the impact of EITF 09-H on our financial position, results of operations, cash flows and disclosures.

NOTE 2 — RECENT DEVELOPMENTS

Amended and Restated ABL Facility: On August 8, 2011, we entered into a senior secured asset-based revolving credit facility, or ABL Facility, with Bank of America, N.A., as administrative agent and collateral agent and a syndicate of financial institutions and institutional lenders. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Barclays Capital, the investment banking division of Barclays Bank PLC joint bookrunners. The ABL Facility amended and restated our prior senior secured asset-based revolving credit facility dated October 28, 2008, which provided for a revolving credit financing of up to $150.0 million. The amended and restated ABL Facility provides for revolving credit financing of up to $250 million. See Note 5–Long-Term Debt.

Realignment of Management: On July 11, 2011, we announced the realignment of management responsibility for certain functions, including those related to revenue management and information technology. In connection with these changes, James G. Gallas, who has served as the Company’s Executive Vice President and Chief Administrative Officer, will cease to oversee revenue management, information technology and certain related functions. Management of those functions will be assumed by other members of our senior management team, and Mr. Gallas will assume a special projects role during a transitional period, which is presently expected to conclude on or prior to February 28, 2012. At the conclusion of this transitional period, Mr. Gallas’ employment is expected to terminate in accordance with the terms of his Amended and Restated Executive Severance Agreement dated as of March 10, 2009.

NOTE 3 — BUSINESS COMBINATIONS

The Company periodically acquires complementary businesses in specific geographic markets. The results of operations of the acquired companies are included in the accompanying condensed consolidated statements of operations from the dates of acquisition. On March 4, 2011, the Company completed its previously announced asset acquisition of Praxair, Inc.’s (NYSE: PX) and Praxair Healthcare Services, Inc.’s (collectively, “Praxair”) United States homecare business. The Company expects this business to contribute approximately $80 million to its revenue in 2011. This estimate and the acquired business’s contribution in future periods will be subject to decreases as a result of the impact of Medicare competitive bidding and other factors.

During the nine months ended September 30, 2011 and 2010, the Company purchased certain assets and businesses for total consideration of $23.4 million and $2.6 million, respectively. The 2011 total is comprised primarily of the asset acquisition of Praxair, Inc.’s U.S. homecare business.

NOTE 4 — GOODWILL AND INTANGIBLE ASSETS

Changes in goodwill by segment are as follows:

 

(in thousands)

   Home Infusion
Therapy
     Home Respiratory
Therapy and Home
Medical Equipment
     Total  

Balance, December 31, 2010

   $ 257,823       $ 502,265       $ 760,088   

Acquisition

     547         4,610         5,157   
  

 

 

    

 

 

    

 

 

 

Balance, September 30, 2011

   $ 258,370       $ 506,875       $ 765,245   
  

 

 

    

 

 

    

 

 

 

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Intangible assets consist of the following:

 

(dollars in thousands)

   September 30, 2011      December 31, 2010  
   Average
Life in
Years
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net Book
Value
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net Book
Value
 

Intangible assets subject to amortization:

                  

Capitated relationships

     20.0       $ 40,000       $ (5,834   $ 34,166       $ 40,000       $ (4,333   $ 35,667   

Payor relationships

     20.0         11,000         (1,604     9,396         11,000         (1,192     9,808   

Net favorable leasehold interest

     3.5         3,210         (2,675     535         3,553         (2,325     1,228   

Customer list

     1.2         1,123         (346     777         710         (456     254   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Subtotal

        55,333         (10,459     44,874         55,263         (8,306     46,957   

Intangible assets not subject to amortization:

                  

Trade names

        525,000         —          525,000         525,000         —          525,000   

Accreditations with commissions

        7,000         —          7,000         7,000         —          7,000   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Subtotal

        532,000         —          532,000         532,000         —          532,000   

Total

      $ 587,333       $ (10,459   $ 576,874       $ 587,263       $ (8,306   $ 578,957   
     

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

For the nine months ended September 30, 2011, the net increase in the carrying amount of goodwill of $5.2 million is the result of the acquisition of Praxair assets on March 4, 2011. Most of the goodwill recorded in conjunction with business combinations for the periods presented is expected to be deductible for tax purposes. Goodwill and intangible assets from our Praxair acquisition are based upon preliminary estimates that are subject to change in 2011 upon completion of the final valuation analysis.

Amortization expense amounted to $3.4 million and $3.8 million for the nine months ended September 30, 2011 and 2010, respectively. Estimated amortization expense for each of the fiscal years ending December 31 is presented below:

 

Year Ending

December 31,

   (in thousands)  

2011

   $ 4,478   

2012

     3,391   

2013

     2,550   

2014

     2,550   

2015

     2,550   

thereafter

     32,725   

NOTE 5 — LONG-TERM DEBT

Series A-1 Notes and Series A-2 Notes. Series A-1 Notes and Series A-2 Notes were issued by the Company in May 2009 and August 2009, respectively. The Series A-1 Notes and the Series A-2 Notes bear interest at a rate equal to 11.25% per annum and 12.375% per annum, respectively. The indenture governing the Series A-1 Notes and the Series A-2 Notes, among other restrictions, limits the Company’s ability and the ability of its restricted subsidiaries to:

 

   

incur additional debt;

 

   

pay dividends and make other distributions;

 

   

make certain investments;

 

   

repurchase our stock;

 

   

incur certain liens;

 

   

enter into transactions with affiliates;

 

   

merge or consolidate;

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

   

enter into agreements that restrict the ability of our subsidiaries to make dividends or other payments to us; and

 

   

transfer or sell assets.

Subject to certain exceptions, the indenture governing the Series A-1 Notes and the Series A-2 Notes permits Apria and its restricted subsidiaries to incur additional indebtedness, including senior indebtedness and secured indebtedness. The Series A-1 Notes are entitled to a priority of payment over the Series A-2 Notes in certain circumstances, including upon any acceleration of the obligations under the Series A-1 Notes, the Series A-2 Notes or any bankruptcy or insolvency event or default with respect to Apria or any guarantor of the Series A-1 Notes and the Series A-2 Notes.

The Series A-1 Notes and Series A-2 Notes will mature on November 1, 2014. On and after November 1, 2011, we may redeem the Series A-1 Notes and Series A-2 Notes, in whole or in part, at the redemption prices described below:

 

Series A-1 Notes

   Percentage  

November 1, 2011

     105.625

November 1, 2012

     102.813

November 1, 2013 and thereafter

     100.000

Series A-2 Notes

   Percentage  

November 1, 2011

     106.188

November 1, 2012

     103.094

November 1, 2013 and thereafter

     100.000

Amended and Restated ABL Facility: On August 8, 2011, we entered into a senior secured asset-based revolving credit facility, or ABL Facility, with Bank of America, N.A., as administrative agent and collateral agent and a syndicate of financial institutions and institutional lenders. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Barclays Capital, the investment banking division of Barclays Bank PLC joint bookrunners. The ABL Facility amended and restated our prior senior secured asset-based revolving credit facility dated October 28, 2008, which provided for a revolving credit financing of up to $150.0 million.

The ABL Facility provides for revolving credit financing of up to $250.0 million, subject to borrowing base availability, with a maturity of the earlier of (a) five years and (b) 90 days prior to the earliest maturity of our outstanding Series A-1 Notes and Series A-2 Notes, and includes both a letter of credit and swingline loan sub-facility. The borrowing base at any time is equal to the sum (subject to certain reserves and other adjustments) of (i) 85% of eligible receivables, (ii) the least of (a) 85% of eligible self-pay accounts, (b) 10% of the borrowing base, (c) $25,000,000 and (d) the aggregate amount of self-pay accounts collected within the previous 90 days, (iii) the lesser of (a) 85% of eligible accounts invoiced but unpaid for more than 180 days but less than 360 days and (b) 10% of eligible accounts invoiced but unpaid for 180 days or less and (iv) the lesser of (a) 85% of the net orderly liquidation value of eligible inventory and (b) $35.0 million.

Borrowings under our ABL Facility bear interest at a rate per annum equal to, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Bank of America, N.A. and (2) the federal funds effective rate plus 1/2 of 1% (“Base Rate”), plus an applicable margin (currently 1.25%) or (b) a LIBOR rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin (currently 2.25%). The applicable margin for borrowings under our ABL Facility is subject to (a) 25 basis points step ups and step downs based on average excess availability under the ABL Facility and (b) a step down of 25 basis points based on achieving a consolidated fixed charge coverage ratio greater than 1.75 to 1.00. In addition to paying interest on outstanding amounts under our ABL Facility, we are required to pay a commitment fee, in respect of the unutilized commitments thereunder, ranging from 0.375% to 0.50% per annum, which fee will be determined based on utilization of our ABL Facility (increasing when utilization is low and decreasing when utilization is high). We also pay customary letter of credit fees equal to the applicable margin on LIBOR loans and other customary letter of credit and agency fees.

From time to time, we issue letters of credit in connection with our business, including commercial contracts, leases, insurance and workers’ compensation arrangements. If the holders of our letters of credit draw funds under such letters of credit, it would increase our outstanding senior secured indebtedness.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

As of September 30, 2011, there were no outstanding borrowings under the ABL Facility, outstanding letters of credit totaled $21.1 million and additional availability under the ABL Facility, subject to the borrowing base, was $228.9 million. As of September 30, 2011, the available borrowing base did not constrain our ability to borrow the entire $228.9 million available borrowing capacity under our ABL Facility. At September 30, 2011, we were in compliance with all of the financial covenants required by the credit agreement governing the ABL Facility.

Interest paid on debt totaled $0.4 million and $0.2 million for the three months ended September 30, 2011 and 2010, and $60.4 million and $60.3 million for the nine months ended September 30, 2011 and 2010. Interest expense for the three months ended September 30, 2011 and 2010 was $33.2 million and $32.7 million, respectively, and $99.2 million and $98.0 million for the nine months ended September 30, 2011 and 2010, respectively.

As market conditions warrant, we and our major equity holders, including the Sponsor and its affiliates, may from time to time, depending upon market conditions, seek to repurchase our debt securities or loans in privately negotiated or open market transactions, by tender offer or otherwise.

NOTE 6 — STOCKHOLDERS’ EQUITY

For the nine months ended September 30, 2011, changes to stockholders’ equity were comprised of the following amounts (in thousands):

 

Net loss

   $ (35,148

Cash paid on profit interest units

     (1,000

Profit interest compensation

     2,278   
  

 

 

 
   $ (33,870
  

 

 

 

NOTE 7 — PROFIT INTEREST UNITS

In November and December of 2008, BP Healthcare Holdings LLC (“BP Holdings”) and Sky LLC, parent entities of the Company affiliated with the Sponsor, granted equity units to the Company’s Chief Executive Officer and the Company’s Chief Financial Officer for purposes of retaining them and enabling such individuals to participate in the long-term growth and financial success of the Company. In addition, in 2009 and 2010, Sky LLC (and following our reorganization in March 2010, Apria Holdings LLC) granted equity units to certain management employees for purposes of retaining them and enabling such individuals to participate in the long-term growth and financial success of the Company. Profit interest units are measured at the grant date, based on the calculated fair value of the award, and are recognized as an expense over the employee’s requisite service period. These equity awards were issued in exchange for services to be performed.

BP Holdings granted the Company’s Chief Executive Officer 38,697,318 Class B units, all of which are subject to vesting terms based on either (i) continued service to BP Holdings or its subsidiaries and/or (ii) performance/market conditions.

 

   

Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 80% of the total Class B units. These units vest over four years starting on October 28, 2008 based on continued service, but will become fully vested on an accelerated basis either (x) upon a change in control while the Company’s Chief Executive Officer continues to provide services to BP Holdings or its subsidiaries or (y) if affiliates of the Sponsor receive cash proceeds in respect to 50% of their units in BP Holdings equal to at least 200% of their aggregate capital contributions in respect of such units while the Company’s Chief Executive Officer continues to provide services to BP Holdings or its subsidiaries. In addition, if the Company’s Chief Executive Officer’s services are terminated (a) by the Company without “cause” or (b) by the Chief Executive Officer as a result of “constructive termination,” an additional number of these time-vesting Class B units will vest equal to the number that would have vested over the 24-month period following the applicable termination date. Any of these time-vested Class B units that are unvested on termination of the executive’s services will be forfeited.

 

   

Performance-Vesting Units. The remaining portion of the Class B units that vest based on performance/market conditions represent 20% of the total Class B units. One-half of these units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of all of their units in BP Holdings, with the other half eligible to vest if they receive cash proceeds equal to at least 300% of their aggregate capital contributions in respect of all of their units in BP Holdings. Any of these performance-vesting units that are unvested upon a termination of the Company’s Chief Executive Officer’s services (x) by the Company without “cause,” (y) by the executive as a result of “constructive termination” or (z) by the executive

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

 

for any reason on or following October 28, 2012, will remain outstanding until the second anniversary of the applicable termination date (unless they vest prior to that date). If the units do not vest by such anniversary, then any unvested performance-vesting units shall be immediately forfeited.

Assumptions used were as follows:

 

Expected Asset Volatility (1)

     23.0

Risk Free Interest Rate (2)

     2.24

Expected Life (3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the constant maturity treasury rate (“CMT Rate”) as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

The following table summarizes activity for profit interest units for the period December 31, 2010 to September 30, 2011:

 

     Class B Units  

Balance at December 31, 2010

     38,697,318   

Granted

     —     

Forfeited

     —     

Exercised

     —     
  

 

 

 

Balance at September 30, 2011

     38,697,318   
  

 

 

 

Vested units at September 30, 2011

     21,283,525   

There is no stated contractual life for the B units.

Sky LLC granted the Company’s Chief Financial Officer 500,000 Class A-2 units, 6,675,287 Class B units and 2,225,096 Class C units, all of which are subject to vesting terms based on either (i) continued service to Sky LLC or its subsidiaries or (ii) performance/market conditions.

 

   

Class A-2 Units. The Class A-2 units vest if an initial public offering (“IPO”) or change of control occurs and the valuation of Class A-1 units of Sky LLC implied by the transaction exceeds 110% of the aggregate capital contributions of affiliates of the Sponsor for the Class A-1 units. The Company’s Chief Financial Officer does not need to be employed at the time of the IPO or change in control to vest. The Class A-2 Units will be forfeited if an IPO or change of control occurs at a valuation that does not result in vesting.

 

   

Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 66 2/3% of the total Class B units. These units vest over 57 months starting on October 28, 2008 based on continued service, but will become fully vested on an accelerated basis upon a change in control while the Company’s Chief Financial Officer continues to provide services to Sky LLC or its subsidiaries. Any of these time-vested Class B units that are unvested on termination of the executive’s services will be forfeited.

 

   

Performance-Vesting Units. The remaining portion of the Class B units and all of the Class C units vest based on performance/market conditions. These units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of 25% of their units in Sky LLC while the Company’s Chief Financial Officer continues to provide services to Sky LLC or its subsidiaries.

Assumptions used were as follows:

 

Expected Asset Volatility (1)

     23.0

Risk Free Interest Rate (2)

     1.35

Expected Life (3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimates.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

The following table summarizes activity for profit interest units for the period December 31, 2010 to September 30, 2011:

 

     Class A-2
Units
     Class B
Units
     Class C
Units
 

Balance at December 31, 2010

     500,000         6,675,287         2,225,096   

Granted

     —           —           —     

Forfeited

     —           —           —     

Exercised

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Balance at September 30, 2011

     500,000         6,675,287         2,225,096   
  

 

 

    

 

 

    

 

 

 

Vested units at September 30, 2011

        2,669,848      

There are no stated contractual lives for the A-2, B or C units.

Sky LLC (and following our reorganization in March 2010, Apria Holdings LLC) granted certain management employees 45,436,994 Class B units and 15,629,380 Class C units, all of which are subject to vesting terms based on either (i) continued service to Sky LLC or its subsidiaries or (ii) performance/market conditions.

 

   

Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 66 2/3% of the total Class B units. These units vest over five years starting on the later of (x) October 28, 2008 and (y) the date the employee commenced employment based on continued service, but will become fully vested on an accelerated basis upon a change in control while the employee continues to provide services to Sky LLC or its subsidiaries. Any of these time-vested Class B units that are unvested on termination of the employee’s services will be forfeited.

 

   

Performance-Vesting Units. The remaining portion of the Class B units and all of the Class C units vest based on performance/market conditions. These units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of 25% of their units in Sky LLC while the employee continues to provide services to Sky LLC or its subsidiaries.

Notwithstanding the vesting terms described above, if the employee voluntarily resigns (in the absence of “constructive termination”) then Sky LLC may require the forfeiture of any vested Class B or C units.

Assumptions used were as follows for the 2011 grants:

 

Expected Asset Volatility (1)

     25.0

Risk Free Interest Rate (2)

     2.01

Expected Life (3)

     5.0 years   

Assumptions used were as follows for the 2010 grants:

 

Expected Asset Volatility (1)

     25.0

Risk Free Interest Rate (2)

     2.39

Expected Life (3)

     5.0 years   

 

(1) The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.
(2) The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the expected life.
(3) The expected life is based on management’s estimate.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

The following table summarizes activity for profit interest units for the period December 31, 2010 to September 30, 2011:

 

     Class A-2
Units
    Class B
Units
    Class C
Units
 

Balance at December 31, 2010

     2,075,000        35,341,831        12,635,175   

Granted

     —          —          —     

Forfeited

     (1,000,000     (2,118,678     (706,226

Exercised

     —          —          —     
  

 

 

   

 

 

   

 

 

 

Balance at March 31, 2011

     1,075,000        33,223,153        11,928,949   

Granted

     —          1,189,943        396,648   

Forfeited

     —          (435,345     (145,115

Exercised

     —          —          —     
  

 

 

   

 

 

   

 

 

 

Balance at June 30, 2011

     1,075,000        33,977,751        12,180,482   

Granted

     —          1,320,546        440,182   

Forfeited

     —          (667,529     (222,509

Exercised

     —          —          —     
  

 

 

   

 

 

   

 

 

 

Balance at September 30, 2011

     1,075,000        34,630,768        12,398,155   
  

 

 

   

 

 

   

 

 

 

Vested units at September 30, 2011

       10,468,836     

There are no stated contractual lives for the A-2, B or C units.

Pursuant to a reorganization we conducted in March 2010, units of Sky LLC were converted or exchanged into units of Apria Holdings LLC, its parent entity.

Expense recorded related to profit interest units was $0.7 million and $1.0 million in the three months ended September 30, 2011 and 2010, respectively, and $2.3 million and $3.2 million in the nine months ended September 30, 2011 and 2010, respectively. As of September 30, 2011, total unrecognized profit interest compensation cost related to unvested profit interest units was $3.1 million, which is expected to be expensed over a weighted average period of 3.3 years.

NOTE 8 — INCOME TAXES

The Company’s effective tax rate was 59.5% for the three months ended September 30, 2011, compared to 104.4% for the three months ended September 30, 2010. The Company’s effective tax rate was 37.4% for the nine months ended September 30, 2011, compared to 54.7% for the nine months ended September 30, 2010.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized.

In determining the necessity and amount of a valuation allowance, all available information (both positive and negative) is considered and analysis is performed to determine the appropriate weight that should be afforded to available objective and subjective evidence. Cumulative losses in recent years are considered significant negative evidence which could result in the accrual of a valuation allowance against deferred tax assets.

The Company has not sustained a cumulative book loss over the three-year period ended September 30, 2011 (after adjusting for the impact of certain non-recurring historical items which are not indicative of the Company’s ability to generate future income).

Based on available information, the Company concluded that a valuation allowance against federal deferred tax assets was not required at September 30, 2011. The Company will continue to assess the need for a valuation allowance as additional information becomes available.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

The Company accounts for its tax uncertainties under generally accepted accounting principles. A reconciliation of the beginning and ending balances of the gross liability for unrecognized tax benefits at September 30, 2011 is as follows (in millions):

 

Total gross unrecognized tax benefits at January 1, 2011

   $ 99.0   

Additions for tax positions related to the current year

     0.3   

Additions for tax positions related to prior years

     0.6   

Reductions for tax positions related to prior years

     (2.6

Reductions due to lapse in statute of limitations

     (9.1
  

 

 

 

Total gross unrecognized tax benefits at September 30, 2011

   $ 88.2   
  

 

 

 

Total gross unrecognized tax benefits of $88.2 million is reflected on the Company’s September 30, 2011 balance sheet as follows: (a) $8.0 million included in income taxes payable and other non-current liabilities and (b) $80.2 million included in deferred income taxes.

The amount of unrecognized tax benefits which, if ultimately recognized, could affect the effective tax rate in a future period is $83.8 million and $87.4 million as of September 30, 2011 and December 31, 2010, respectively. These amounts are net of related tax benefits and are inclusive of $1.7 million and $2.4 million of penalties and interest (net of tax benefit) as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011, the Company does not expect any material increases or decreases to its unrecognized tax benefits for the 12-month rolling period ending September 30, 2012.

Interest expense and penalties related to unrecognized tax benefits are recognized as part of the provision for income taxes. Gross interest and penalties of $2.4 million and $3.5 million are provided for within the liability for unrecognized tax benefits as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011, federal net operating loss (“NOLs”) carryforwards of approximately $332.9 million were available to offset future federal taxable income. Such NOLs will expire at various times and in varying amounts during the Company’s calendar 2015 through 2031 tax years. A significant portion of these NOLS are subject to an annual utilization limitation as required by Section 382 of the Internal Revenue Code of 1986, as amended.

The Company files federal and state income tax returns in jurisdictions with varying statutes of limitations expiration dates. The calendar 2008 through 2010 tax years generally remain subject to examination by tax authorities. The Company was recently notified that its calendar 2009 Federal income tax return will be audited by the Internal Revenue Service. Additionally, certain state tax agencies are currently examining the tax years 2005 and forward.

Net income tax refunds received (and tax payments made) for the nine-month period ended September 30, 2011 and 2010 amounted to $0.2 million and $(0.1 million), respectively.

NOTE 9 — COMMITMENTS AND CONTINGENCIES

Litigation: The Company is engaged in the defense of certain claims and lawsuits arising out of the ordinary course and conduct of its business, the outcomes of which are not determinable at this time. Insurance policies covering such potential losses, where such coverages are practicable and cost effective, are maintained. In the opinion of management, any liability that might be incurred upon the resolution of these claims and lawsuits will not, in the aggregate, have a material effect on the Company’s financial condition or results of operations, cash flows and liquidity.

Medicare and Medicaid Reimbursement: There are a number of provisions contained within recent, proposed or contemplated legislation that affect or may affect Medicare and Medicaid reimbursement policies for items and services provided. The Company cannot be certain of the ultimate impact of all legislated and contemplated changes, and therefore cannot provide assurance that these changes will not have a material adverse effect on the Company’s financial condition or results of operations.

Supplier Concentration: Currently, approximately 60.0% of purchases for patient service equipment and supplies are from five vendors. Although there are a limited number of suppliers, management believes that other vendors could provide similar products on comparable terms. However, a change in suppliers could cause delays in service delivery and possible losses in revenue, which could adversely affect the Company’s financial condition or operating results.

Guarantees and Indemnities: From time to time, certain types of contracts are entered into that contingently require indemnification of parties against third party claims. These contracts primarily relate to (i) certain asset purchase agreements,

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

under which indemnification may be provided to the seller of the business being acquired; (ii) certain real estate leases, which may require indemnification to property owners for environmental or other liabilities and other claims arising from use of the applicable premises; and (iii) certain agreements with officers, directors and employees, which may require indemnification of such persons for liabilities arising out of their relationship with the Company.

The terms of such obligations vary by contract and in most instances a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, no liabilities have been recorded for these obligations on the balance sheets for any of the periods presented.

NOTE 10 — SEGMENTS

The Company has two reportable operating segments: (1) home respiratory therapy and home medical equipment and (2) home infusion therapy. Within these two operating segments there are three core service lines: home respiratory therapy, home medical equipment and home infusion therapy. The home respiratory therapy and home medical equipment segment provides services and equipment to assist patients with oxygen systems, sleep apnea, ambulation and general care around the home, as well as to provide respiratory medications and related services. The home infusion therapy segment primarily provides patients with pharmaceuticals and services prescribed in conjunction with the administration of nutrients or medication intravenously or through a gastrointestinal tube.

 

    Net Revenues  
    Three Months Ended September 30,     Nine Months Ended September 30,  

(in thousands)

  2011     2010     2011     2010  

Operating Segment

       

Home Respiratory Therapy and Home Medical Equipment

  $ 293,370      $ 270,223      $ 862,040      $ 821,666   

Home Infusion Therapy

    291,504        255,791        835,925        731,402   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 584,874      $ 526,014      $ 1,697,965      $ 1,553,068   
 

 

 

   

 

 

   

 

 

   

 

 

 
    EBIT  
    Three Months Ended September 30,     Nine Months Ended September 30,  

(in thousands)

  2011     2010     2011     2010  

Operating Segment

       

Home Respiratory Therapy and Home Medical Equipment

  $ (11,415   $ 3,129      $ (43,627   $ 21,687   

Home Infusion Therapy

    33,379        31,611        86,483        81,118   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 21,964      $ 34,740      $ 42,856      $ 102,805   
 

 

 

   

 

 

   

 

 

   

 

 

 
    Depreciation and Amortization  
    Three Months Ended September 30,     Nine Months Ended September 30,  

(in thousands)

  2011     2010     2011     2010  

Operating Segment

       

Home Respiratory Therapy and Home Medical Equipment

  $ 33,183      $ 28,420      $ 90,818      $ 86,375   

Home Infusion Therapy

    4,459        3,899        12,647        11,124   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 37,642      $ 32,319      $ 103,465      $ 97,499   
 

 

 

   

 

 

   

 

 

   

 

 

 

Our Chief Operating Decision Maker (“CODM”) does not review assets assigned to segments. Therefore, such items are not reflected in the table above.

Earnings before interest and taxes (“EBIT”). EBIT is a measure used by our management to measure operating performance. EBIT is defined as net income (loss) plus interest expense and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles (“GAAP”) and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

The following table provides a reconciliation from net (loss) income to EBIT:

 

     Three Months Ended September 30, 2011     Three Months Ended September 30, 2010  

(in thousands)

   Home Respiratory
Therapy
and
Home Medical
Equipment
    Home
Infusion
Therapy
     Total     Home Respiratory
Therapy
and
Home Medical
Equipment
     Home
Infusion
Therapy
     Total  

Net (loss) income

        $ (4,687         $ (105

Interest expense, net (a)

          33,541              32,369   

Income tax (benefit) expense

          (6,890           2,476   
       

 

 

         

 

 

 

EBIT

   $ (11,415   $ 33,379       $ 21,964      $ 3,129       $ 31,611       $ 34,740   
       

 

 

         

 

 

 
     Nine Months Ended September 30, 2011     Nine Months Ended September 30, 2010  

(in thousands)

   Home Respiratory
Therapy
and
Home Medical
Equipment
    Home
Infusion
Therapy
     Total     Home Respiratory
Therapy
and
Home Medical
Equipment
     Home
Infusion
Therapy
     Total  

Net (loss) income

        $ (35,148         $ 2,458   

Interest expense, net (b)

          99,028              97,377   

Income tax (benefit) expense

          (21,024           2,970   
       

 

 

         

 

 

 

EBIT

   $ (43,627   $ 86,483       $ 42,856      $ 21,687       $ 81,118       $ 102,805   
       

 

 

         

 

 

 

 

(a) Reflects $33.2 million of interest expense, net of $(0.3) million of interest income for the three months ended September 30, 2011. Reflects $32.7 million of interest expense, net of $0.3 million of interest income for the three months ended September 30, 2010.
(b) Reflects $99.2 million of interest expense, net of $0.2 million of interest income for the nine months ended September 30, 2011. Reflects $98.0 million of interest expense, net of $0.6 million of interest income for the nine months ended September 30, 2010.

The Company allocates certain expenses that are not directly attributable to a product line based upon segment headcount.

NOTE 11 — CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Transaction and Management Fee Agreement: In connection with the Merger, Merger Sub entered into a transaction and management fee agreement with Blackstone Management Partners V L.L.C. (“BMP”). The Company succeeded to and assumed the rights and obligations of Merger Sub pursuant to the transaction and management fee agreement upon the closing of the Merger. Under the transaction and management fee agreement, Merger Sub agreed to pay BMP, at the closing of the Merger, an $18.7 million transaction fee in consideration for BMP undertaking financial and structural analysis, due diligence and other assistance in connection with the Merger. In addition the Company agreed to reimburse BMP for any out-of-pocket expenses incurred by BMP and its affiliates in connection with the Merger and the provision of services under the transaction and management fee agreement.

In addition, under this agreement, BMP (including through its affiliates) agreed to provide services, including without limitation, (a) advice regarding the structure, distribution and timing of debt and equity offerings and advice regarding relationships with the Company’s lenders and bankers, (b) advice regarding the business and strategy of the Company, including compensation arrangements, (c) advice regarding dispositions and/or acquisitions and (d) such advice directly related or ancillary to the above financial advisory services as may be reasonably requested by the Company. In consideration for the services, the Company pays BMP at the beginning of each fiscal year a management fee equal to the greater of $7.0 million or 2.0% of the Company’s consolidated EBITDA, as defined in the agreement, for the immediately preceding fiscal year. BMP shall have no obligation to provide any other services to the Company absent express agreement. In addition, in the absence of an express agreement to provide investment banking or other financial advisory services to the Company, and without regard to whether such services were provided, BMP is entitled to receive a fee equal to 1.0% of the aggregate transaction value upon the consummation of any acquisition, divestiture, disposition, merger, consolidation, restructuring, refinancing, recapitalization, issuance of private or public debt of equity securities (including an initial public offering of equity securities), financing or similar transaction by the Company.

 

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APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

At any time in connection with or in anticipation of a change of control of the Company, a sale of all or substantially all of the Company’s assets or an initial public offering of common equity of the Company or its successor, BMP may elect to receive, in consideration of BMP’s role in facilitating such transaction and in settlement of the termination of the services, a single lump sum cash payment equal to the then-present value of all then-current and future annual management fees payable under the transaction and management fee agreement, assuming a hypothetical termination date of the agreement to be the twelfth anniversary of such election. The transaction and management fee agreement will continue until the earlier of the twelfth anniversary of the date of the agreement or such date as the Company and BMP may mutually determine. The Company has agreed to indemnify BMP and its affiliates, directors, officers, employees, agents and representatives from and against all liabilities relating to the services contemplated by the transaction and management fee agreement and the engagement of BMP pursuant to, and the performance of BMP and its affiliates of the services contemplated by, the transaction and management fee agreement.

Intelenet Agreement: In May 2009, the Company entered into the Master Service Agreement (“Intelenet Agreement”) with Intelenet Global Services Private Limited (“Intelenet”), an Indian company affiliated with the Sponsor, regarding the outsourcing of certain functions relating to billing, collections and other administrative and clerical services. On May 31, 2011, it was announced that an affiliate of the Sponsor, along with other shareholders of Intelenet, agreed to sell Intelenet to Serco Group PLC, an international services company. The transaction closed in July 2011. During the seven months ended July 31, 2011, the Company paid approximately $13.8 million to Intelenet.

Equity Healthcare Agreement: Effective as of January 1, 2010, the Company entered into an employer health program agreement with Equity Healthcare LLC (“Equity Healthcare”), an affiliate of the Sponsor, pursuant to which Equity Healthcare will provide to the Company certain negotiating, monitoring and other services in connection with our health benefit plans. In consideration for Equity Healthcare’s services, the Company pays Equity Healthcare a fee of $2 per participating employee per month. As of September 30, 2011, the Company had approximately 8,300 employees enrolled in Equity Healthcare health benefit plans.

NOTE 12 — FINANCIAL GUARANTEES

The Company conducts substantially all of its business through its subsidiaries. Substantially all of the Company’s wholly-owned domestic subsidiaries (the “Guarantors”) fully and unconditionally guarantee the Series A-1 Notes and Series A-2 Notes on a senior secured basis. The Guarantors also guarantee our ABL Facility. See also Note 5—Long-Term Debt.

The following unaudited condensed consolidated financial statements quantify the financial position as of September 30, 2011 and December 31, 2010, the operations for the three and nine months ended September 30, 2011 and 2010, and the cash flows for the nine months ended September 30, 2011 and 2010. These condensed consolidated financial statements present financial information for the parent issuer, the guarantor subsidiaries, the non-guarantor subsidiaries and consolidating adjustments, consisting of the entries that eliminate the investment in subsidiaries and intercompany balances and transactions.

 

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Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED BALANCE SHEETS

September 30, 2011

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  
ASSETS            

CURRENT ASSETS

           

Cash and cash equivalents

   $ 75,279      $ —        $ 467       $ (17,819   $ 57,927   

Accounts receivable less allowance for doubtful accounts

     —          324,926        950         —          325,876   

Inventories, net

     —          61,397        328         —          61,725   

Deferred income taxes

     6,127        62,637        —           —          68,764   

Deferred expenses

     —          3,209        —           —          3,209   

Intercompany

     262,240        510,644        —           (772,884     —     

Prepaid expenses and other current assets

     41        21,050        12         —          21,103   

Intercompany loan

     710,000        —          —           (710,000     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT ASSETS

     1,053,687        983,863        1,757         (1,500,703     538,604   

PATIENT SERVICE EQUIPMENT, less accumulated depreciation

     —          201,896        6         —          201,902   

PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET

     44,429        48,579        258         —          93,266   

GOODWILL

     —          765,245        —           —          765,245   

INTANGIBLE ASSETS, NET

     460,000        116,874        —           —          576,874   

DEFERRED DEBT ISSUANCE COSTS, NET

     47,916        —          —           —          47,916   

INVESTMENT IN SUBSIDIARIES

     402,227        732        —           (402,959     —     

OTHER ASSETS

     3,847        4,936        —           —          8,783   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL ASSETS

   $ 2,012,106      $ 2,122,125      $ 2,021       $ (1,903,662   $ 2,232,590   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY            

CURRENT LIABILITIES

           

Accounts payable

   $ —        $ 128,599      $ 172       $ (17,819   $ 110,952   

Accrued payroll and related taxes and benefits

     14,243        63,405        194         —          77,842   

Other accrued liabilities

     49,651        70,051        923         —          120,625   

Deferred revenue

     —          29,589        —           —          29,589   

Intercompany

     128,470        644,414        —           (772,884     —     

Current portion of long-term debt

     —          710,382        —           (710,000     382   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT LIABILITIES

     192,364        1,646,440        1,289         (1,500,703     339,390   

LONG-TERM DEBT, net of current portion

     1,017,500        338        —           —          1,017,838   

DEFERRED INCOME TAXES

     163,119        58,058        —           —          221,177   

INCOME TAXES PAYABLE & OTHER NON-CURRENT LIABILITIES

     7,681        15,062        —           —          22,743   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES

     1,380,664        1,719,898        1,289         (1,500,703     1,601,148   

COMMITMENTS AND CONTINGENCIES

           

STOCKHOLDERS’ EQUITY

           

Additional paid-in capital

     689,736        505,529        —           (505,529     689,736   

(Accumulated deficit) retained earnings

     (58,294     (103,302     732         102,570        (58,294
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ EQUITY

     631,442        402,227        732         (402,959     631,442   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 
   $ 2,012,106      $ 2,122,125      $ 2,021       $ (1,903,662   $ 2,232,590   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

21


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED BALANCE SHEETS

December 31, 2010

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  
ASSETS            

CURRENT ASSETS

           

Cash and cash equivalents

   $ 125,137      $ —        $ 407       $ (16,407   $ 109,137   

Accounts receivable less allowance for doubtful accounts

     —          281,917        881         —          282,798   

Inventories, net

     —          73,547        347         —          73,894   

Deferred income taxes

     5,012        53,016        —           —          58,028   

Deferred expenses

     —          3,061        —           —          3,061   

Intercompany

     344,992        256,742        —           (601,734     —     

Prepaid expenses and other current assets

     2,757        17,313        151         —          20,221   

Intercompany loan

     360,000        —          —           (360,000     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT ASSETS

     837,898        685,596        1,786         (978,141     547,139   

PATIENT SERVICE EQUIPMENT, less accumulated depreciation

     —          169,858        20         —          169,878   

PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET

     38,818        44,887        188         —          83,893   

GOODWILL

     —          760,088        —           —          760,088   

INTANGIBLE ASSETS, NET

     460,000        118,957        —           —          578,957   

DEFERRED DEBT ISSUANCE COSTS, NET

     53,659        —          —           —          53,659   

INTERCOMPANY RECEIVABLE

     —          —          —           —          —     

INVESTMENT IN SUBSIDIARIES

     362,248        702        —           (362,950     —     

INTERCOMPANY LOAN

     350,000        —          —           (350,000     —     

OTHER ASSETS

     3,340        4,183        —           —          7,523   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL ASSETS

   $ 2,105,963      $ 1,784,271      $ 1,994       $ (1,691,091   $ 2,201,137   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY            

CURRENT LIABILITIES

           

Accounts payable

   $ —        $ 102,858      $ 186       $ (16,407   $ 86,637   

Accrued payroll and related taxes and benefits

     12,173        46,771        129         —          59,073   

Other accrued liabilities

     20,049        69,421        977         —          90,447   

Deferred revenue

     —          26,504        —           —          26,504   

Intercompany

     202,901        398,833        —           (601,734     —     

Current portion of long-term debt

     —          361,323        —           (360,000     1,323   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL CURRENT LIABILITIES

     235,123        1,005,710        1,292         (978,141     263,984   

LONG-TERM DEBT, net of current portion

     1,017,500        350,598        —           (350,000     1,018,098   

DEFERRED INCOME TAXES

     178,603        44,140        —           —          222,743   

INCOME TAXES PAYABLE & OTHER NON-CURRENT LIABILITIES

     9,425        21,575        —           —          31,000   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES

     1,440,651        1,422,023        1,292         (1,328,141     1,535,825   

COMMITMENTS AND CONTINGENCIES

           

STOCKHOLDERS’ EQUITY

           

Additional paid-in capital

     688,458        447,926        —           (447,926     688,458   

(Accumulated deficit) retained earnings

     (23,146     (85,678     702         84,976        (23,146
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ EQUITY

     665,312        362,248        702         (362,950     665,312   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 
   $ 2,105,963      $ 1,784,271      $ 1,994       $ (1,691,091   $ 2,201,137   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

22


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2011

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 582,572      $ 2,302       $ —        $ 584,874   

Income from subsidiaries

     54,367        —          —           (54,367     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL NET REVENUES

     54,367        582,572        2,302         (54,367     584,874   

TOTAL COST OF NET REVENUES

     —          238,296        1,258         —          239,554   

Provision for doubtful accounts

     —          14,482        29         —          14,511   

Selling, distribution and administrative

     53,721        307,744        712         (54,367     307,810   

Amortization of intangible assets

     229        943        —           —          1,172   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     53,950        561,465        1,999         (54,367     563,047   

OPERATING INCOME

     417        21,107        303         —          21,827   

Interest expense

     33,643        (415     —           —          33,228   

Interest income and other

     (15,856     15,883        149         —          176   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (17,370     5,639        154         —          (11,577

Income tax (benefit) expense

     (7,235     345        —           —          (6,890
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

     (10,135     5,294        154         —          (4,687

Equity in income of subsidiaries, net of tax

     5,448        154        —           (5,602     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (4,687   $ 5,448      $ 154       $ (5,602   $ (4,687
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

23


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2011

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 1,690,836      $ 7,129       $ —        $ 1,697,965   

Income from subsidiaries

     126,132        —          —           (126,132     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL NET REVENUES

     126,132        1,690,836        7,129         (126,132     1,697,965   

TOTAL COST OF NET REVENUES

     —          689,133        3,729         —          692,862   

Provision for doubtful accounts

     —          51,090        263         —          51,353   

Selling, distribution and administrative

     162,857        868,656        2,127         (126,132     907,508   

Amortization of intangible assets

     688        2,682        —           —          3,370   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     163,545        1,611,561        6,119         (126,132     1,655,093   

OPERATING (LOSS) INCOME

     (37,413     79,275        1,010         —          42,872   

Interest expense

     99,344        (186     —           —          99,158   

Interest income and other

     (47,569     46,960        495         —          (114
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (89,188     32,501        515         —          (56,172

Income tax (benefit) expense

     (30,733     9,709        —           —          (21,024
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

     (58,455     22,792        515         —          (35,148

Equity in income of subsidiaries, net of tax

     23,307        515        —           (23,822     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (35,148   $ 23,307      $ 515       $ (23,822   $ (35,148
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

24


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2010

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 523,707      $ 2,307       $ —        $ 526,014   

Income from subsidiaries

     55,774        —          —           (55,774     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL NET REVENUES

     55,774        523,707        2,307         (55,774     526,014   

TOTAL COST OF NET REVENUES

     —          206,824        1,160         —          207,984   

Provision for doubtful accounts

     —          10,943        38         —          10,981   

Selling, distribution and administrative

     59,658        266,611        662         (55,774     271,157   

Amortization of intangible assets

     230        805        —           —          1,035   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     59,888        485,183        1,860         (55,774     491,157   

OPERATING (LOSS) INCOME

     (4,114     38,524        447         —          34,857   

Interest expense

     32,445        291        —           —          32,736   

Interest income and other

     (15,857     15,389        218         —          (250
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (20,702     22,844        229         —          2,371   

Income tax (benefit) expense

     (32,496     34,972        —           —          2,476   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET INCOME (LOSS)

     11,794        (12,128     229         —          (105

Equity in income of subsidiaries, net of tax

     (11,899     229        —           11,670        —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET (LOSS) INCOME

   $ (105   $ (11,899   $ 229       $ 11,670      $ (105
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

25


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2010

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Consolidating
Adjustments
    Consolidated  
     (in thousands)  

Operating net revenue

   $ —        $ 1,547,124      $ 5,944       $ —        $ 1,553,068   

Income from subsidiaries

     170,889        —          —           (170,889     —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL NET REVENUES

     170,889        1,547,124        5,944         (170,889     1,553,068   

TOTAL COST OF NET REVENUES

     —          615,807        3,101         —          618,908   

Provision for doubtful accounts

     —          39,511        290         —          39,801   

Selling, distribution and administrative

     161,363        795,394        1,870         (170,889     787,738   

Amortization of intangible assets

     688        3,089        —           —          3,777   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

TOTAL COSTS AND EXPENSES

     162,051        1,453,801        5,261         (170,889     1,450,224   

OPERATING INCOME

     8,838        93,323        683         —          102,844   

Interest expense

     97,640        331        —           —          97,971   

Interest income and other

     (50,352     49,463        334         —          (555
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

(LOSS) INCOME BEFORE TAXES

     (38,450     43,529        349         —          5,428   

Income tax (benefit) expense

     (42,747     45,717        —           —          2,970   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET INCOME (LOSS)

     4,297        (2,188     349         —          2,458   

Equity in income of subsidiaries, net of tax

     (1,839     349        —           1,490        —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

NET INCOME (LOSS)

   $ 2,458      $ (1,839   $ 349       $ 1,490      $ 2,458   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

26


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2011

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Consolidating
Adjustments
    Consolidated  
     (in thousands)  

OPERATING ACTIVITIES

          

NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES

   $ (28,569   $ 121,584      $ 179      $ (1,412   $ 91,782   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

INVESTING ACTIVITIES

          

Purchases of patient service equipment and property, equipment and improvements

     (16,673     (97,297     (119     —          (114,089

Proceeds from disposition of assets

     —          162        —          —          162   

Cash paid for acquisitions

     (229     (23,249     —          —          (23,478
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (16,902     (120,384     (119     —          (137,405
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

FINANCING ACTIVITIES

          

Payments on other long-term debt

     —          (1,200     —          —          (1,200

Debt issuance costs related to ABL Facility

     (3,387     —          —          —          (3,387

Cash paid on profit interest units

     (1,000     —          —          —          (1,000
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET CASH USED IN FINANCING ACTIVITIES

     (4,387     (1,200     —          —          (5,587
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

     (49,858     —          60        (1,412     (51,210

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     125,137        —          407        (16,407     109,137   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 75,279      $ —        $ 467      $ (17,819   $ 57,927   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

27


Table of Contents

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2010

(Unaudited)

 

     Issuer     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Consolidating
Adjustments
    Consolidated  
     (in thousands)  

OPERATING ACTIVITIES

          

NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES

   $ 10,053      $ 97,545      $ (59   $ (13,501   $ 94,038   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

INVESTING ACTIVITIES

          

Purchases of patient service equipment and property, equipment and improvements

     (15,416     (69,253     (13     —          (84,682

Purchases of short term investments

     (8,087     —          —          —          (8,087

Maturities of short term investments

     31,507        —          —          —          31,507   

Proceeds from disposition of assets

     27        607        —          —          634   

Cash paid for acquisitions

     —          (2,260     —          —          (2,260
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES

     8,031        (70,906     (13     —          (62,888
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

FINANCING ACTIVITIES

          

Payments on other long-term debt

     —          (1,314     —          —          (1,314

Change in book-cash overdraft included in accounts payable

     —          (32,533     —          —          (32,533

Debt issuance costs

     (3,590     —          —          —          (3,590

Cash paid on profit interest units

     (78     —          —          —          (78
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET CASH USED IN FINANCING ACTIVITIES

     (3,668     (33,847     —          —          (37,515
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

     14,416        (7,208     (72     (13,501     (6,365

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     150,364        7,208        591        —          158,163   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 164,780      $ —        $ 519      $ (13,501   $ 151,798   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

28


Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not be indicative of future performance. Our forward-looking statements reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties such as the current global economic uncertainty, including the tightening of the credit markets and the recent significant declines and volatility in our global financial markets, that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in the “Risk Factors” and “Forward-Looking Statements” sections of this quarterly report on Form 10-Q. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and the related notes and other information included in this quarterly report on Form 10-Q. References in this report to the “Company,” “we,” “us” and “our” refer to Apria Healthcare Group Inc. and its subsidiaries, unless otherwise noted or the context requires otherwise.

Overview. We have three core service lines: home respiratory therapy, home medical equipment and home infusion therapy. In these core service lines, we offer a variety of patient care management programs, including clinical and administrative support services, products and supplies, most of which are prescribed by a physician as part of a care plan. We provide these services to patients through approximately 550 locations throughout the United States. We have two reportable operating segments:

 

   

home respiratory therapy and home medical equipment; and

 

   

home infusion therapy.

Strategy

Our strategy is to position ourselves in the marketplace as a high-quality provider of a broad range of healthcare services and patient care management programs to our customers. The specific elements of our strategy are to:

 

   

Grow profitable revenue and market share. We are focused on growing profitable revenues and increasing market share in our core home infusion therapy and home respiratory therapy service lines. We have undertaken a series of steps towards this end. Since our acquisition of Coram in December 2007, we have grown our revenue and patient census in the home infusion therapy segment and expanded our platform for further cross-selling opportunities. Our acquisition of Praxair’s homecare business in the United States in March 2011 expanded our geographic footprint and market share in several key markets in the southeastern, south central and western areas of the country. Since January 1, 2010, we have expanded our home respiratory therapy and home medical equipment sales force by 43%, of which 11% relates to the acquisition of Praxair assets. This expansion has allowed us to more efficiently cover each market served by promoting our products and services to physicians, hospital discharge planners and managed care organizations. On an ongoing basis, we continually evaluate the size of our sales force.

 

   

Continue to participate in the managed care market. We participate in the managed care market as a long-term strategic customer group because we believe that our scale, expertise, nationwide presence and array of home healthcare products and services enables us to sign preferred provider agreements and participating Health Maintenance Organization (“HMO”) agreements with managed care organizations. Managed care represented approximately 70% of our total net revenues for the nine months ended September 30, 2011.

 

   

Leverage our national distribution infrastructure. With approximately 550 locations and a robust platform supporting shared national services, we believe that we can efficiently add products, services and patients to our systems to grow our revenues and leverage our cost structure. For example, we have successfully leveraged this distribution platform across a number of product and service offerings, including a continuous positive airway pressure (“CPAP”)/ bi-level supply replenishment program, enteral nutrition and negative pressure wound therapy (“NPWT”) services, and we are using our nursing capacity to provide infusion services through our growing network of ambulatory infusion suites. We seek to achieve margin improvements through operational initiatives focused on the continual reduction of costs and delivery of incremental efficiencies. At the same time, we believe that it is essential to consistently deliver superior customer service in order to increase referrals and retain existing patients. Performance improvement initiatives are underway in all aspects of our operations including customer service, patient satisfaction, logistics, supply chain, clinical services and billing/collections. We believe that by being responsive to the needs of our patients and payors we can provide ourselves with opportunities to take market share from our competitors.

 

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Continue to lead the industry in accreditation. The Medicare Improvement for Patients Act of 2008 (“MIPPA”) made accreditation mandatory for Medicare providers of durable medical equipment, prosthetics, orthotics and supplies (“DMEPOS”), effective October 1, 2009, per Centers for Medicare and Medicaid Services (“CMS”) regulation. We were the first durable medical equipment provider to seek and obtain voluntary accreditation from The Joint Commission. In June 2010, we completed a nationwide independent triennial accreditation renewal process conducted by The Joint Commission and the Commission renewed our accreditation for another three years. The Joint Commission accreditation encompasses our full complement of services including home health, home medical equipment, clinical respiratory, ambulatory infusion services, pharmacy dispensing, and clinical consultant pharmacist services. We have more than 19 years of continuous accreditation by The Joint Commission—longer than any other homecare provider.

 

   

Execute our strategic initiatives to drive profitability. For the past several years, we have successfully engaged in a range of cost savings initiatives to ease pressure on our revenue that has been and continues to be caused by Medicare, Medicaid and managed care reimbursement changes. These initiatives are designed to improve customer service, delivery and vehicle routing services, streamline the billing and payment process, effectively manage purchasing costs and improve the overall experience of the patients we serve. We launched a substantial multi-year cost reduction plan in late 2007. To date, we have made significant progress across a number of the identified initiatives targeting expected annual savings of approximately $181 million, of which we realized approximately $171 million through September 30, 2011.

We review our business on an ongoing basis in the light of current and anticipated market conditions and other factors and, from time to time, may undertake restructuring efforts and/or engage in dispositions of our existing assets or businesses in order to optimize our overall business, performance or competitive position. From time to time, we may also engage in acquisitions of new assets and/or businesses, some of which may be significant. In addition, significant dispositions or restructuring transactions could result in material reductions of our assets, revenues or profitability or otherwise have a material adverse effect on our results of operations, cash flow and capital resources. To the extent any such decisions are made, we would likely incur costs, expenses, impairment and/or restructuring charges associated with such transactions, which could be material.

Recent Developments

Amended and Restated ABL Facility. On August 8, 2011, we amended and restated our existing senior secured asset-based revolving credit facility. See “Liquidity and Capital Resources—Long Term Debt—ABL Facility.”

Realignment of Management. On July 11, 2011, we announced the realignment of management responsibility for certain functions, including those related to revenue management and information technology. In connection with these changes, James G. Gallas, who has served as the Company’s Executive Vice President and Chief Administrative Officer, will cease to oversee revenue management, information technology and certain related functions. Management of those functions will be assumed by other members of our senior management team, and Mr. Gallas will assume a special projects role during a transitional period, which is presently expected to conclude on or prior to February 28, 2012. At the conclusion of this transitional period, Mr. Gallas’ employment is expected to terminate in accordance with the terms of his Amended and Restated Executive Severance Agreement dated as of March 10, 2009.

Critical Accounting Policies. We consider the accounting policies that govern revenue recognition and the determination of the net realizable value of accounts receivable to be the most critical in relation to our consolidated financial statements. These policies require the most complex and subjective judgments of management. Additionally, the accounting policies related to goodwill, long-lived assets, share-based compensation and income taxes require significant judgment. These policies are presented in detail in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section in our Annual Report for the year ended December 31, 2010.

Government Regulation

We are subject to extensive government regulation, including numerous laws directed at regulating reimbursement of our products and services under various government programs and preventing fraud and abuse, as more fully described below. We maintain certain safeguards intended to reduce the likelihood that we will engage in conduct or enter into arrangements in violation of these restrictions. Corporate contract services and legal department personnel review and approve written contracts, Company policies, procedures and programs subject to these laws. We also maintain various educational and internal audit programs designed to keep our managers updated and informed regarding developments on these topics and to reinforce to employees our policy of strict compliance in this area. Federal and state laws require that we obtain facility and other regulatory licenses and that we enroll as a supplier with federal and state health programs. Under various federal and state laws, we are required to make filings or submit notices in connection with transactions that might be defined as a change of control of the Company or of organizations we acquire. We are aware of these requirements and

 

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routinely make such filings with, and seek such approvals from, the applicable regulatory agencies. Notwithstanding these measures, due to changes in and new interpretations of such laws and regulations, and changes in our business, violations of these laws and regulations may still occur, which could subject us to civil and criminal enforcement actions; licensure revocation, suspension or non-renewal; severe fines and penalties; the repayment of amounts previously paid to us and even the termination of our ability to provide services, including those provided under certain government programs such as Medicare and Medicaid. See “Risk Factors—Risks Relating to Our Business—Continued Reductions in Medicare and Medicaid Reimbursement Rates and the Comprehensive Healthcare Reform Law Could Have a Material Adverse Effect on Our Results of Operations and Financial Condition“ and “Risk Factors—Risks Relating to Our Business—Our Failure To Maintain Required Licenses Could Impact Our Operations.”

Medicare and Medicaid Revenues. In the three and nine months ended September 30, 2011 and 2010, approximately 24% and 6% of our net revenues were reimbursed by the Medicare and state Medicaid programs, respectively. No other third-party payor represented more than 8% of our total net revenues for the three and nine months ended September 30, 2011. The majority of our revenues are derived from rental income on equipment rented and related services provided to patients, sales of equipment, supplies and pharmaceuticals and other items we sell to patients for patient care under fee-for-service arrangements. Revenues derived from capitation arrangements represented 7% of total net revenues for the three and nine months ended September 30, 2011.

Medicare Reimbursement. There are a number of legislative and regulatory initiatives in Congress and at CMS that affect or may affect Medicare reimbursement policies for products and services we provide. Specifically, a number of important legislative changes that affect our business were included in the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“MMA”), which was signed into law in December 2003; the Deficit Reduction Act of 2005 (“DRA”), which was signed into law in February 2006; MIPPA, which became law in July 2008 and the comprehensive healthcare reform law signed in March 2010 (“the Reform Package”). These Acts and their implementing regulations and guidelines contain numerous provisions that were significant to us and continue to have an impact on our operations today.

Budget Control Act of 2011. On August 2, 2011, the Budget Control Act of 2011 was signed into law. The Budget Control Act of 2011 authorized increases in the United State’s debt limit of at least $2.1 trillion, established caps on funding appropriations estimated to reduce federal spending by $917 billion over the next ten years, and created the Joint Select Committee on Deficit Reduction (“Joint Committee”), a bipartisan committee consisting of twelve Members of Congress instructed to develop legislation to reduce the federal deficit by at least another $1.5 trillion over the ten-year period of fiscal years 2012 – 2021. The Joint Committee is not limited in what it may propose to reduce the federal deficit and its proposal will likely include changes to federal healthcare programs, including reductions in provider reimbursement in the Medicare and Medicaid programs. The President, Medicare Payment Advisory Commission (MedPAC) and other parties have made recommendations for the Joint Committee to consider. Such recommendations have included limiting federal spending for what a state Medicaid program spends on certain DMEPOS items, increasing Medicare premiums for certain high-income beneficiaries, and increasing fraud and abuse oversight in the federal healthcare programs. The Joint Committee’s proposal is subject to special, expedited procedures in Congress if issued by November 23, 2011 and passed by both chambers of Congress by December 23, 2011. The failure of Congress and the President to enact legislation reducing the deficit by at least $1.2 trillion over the period of fiscal years 2012 – 2021 by January 15, 2012, will trigger automatic spending reductions in fiscal years 2013 – 2021 through sequestration, which is the required cancellation of budgetary resources. Under sequestration, certain federal programs are protected, including Medicaid. However, payments to Medicare providers and suppliers would be reduced by an amount not to exceed 2% beginning in 2013. At this time, we cannot predict whether the Joint Committee will recommend spending cuts to federal healthcare programs or whether they will enact any legislation. Any reduction in provider and supplier reimbursement rates under federal healthcare programs could have a material adverse effect on our financial condition and results of operations.

DMEPOS Competitive Bidding. The MMA required implementation of a competitive bidding program for certain DMEPOS items. By statute, CMS was required to implement the DMEPOS competitive bidding program over time, with Round 1 of competition occurring in portions of 10 of the largest Metropolitan Statistical Areas (“MSAs”) in 2007, launch of the program in 2008 and in 70 additional markets in 2009, and in additional markets after 2009.

In 2007 and 2008, CMS sought and reviewed bids and developed a plan to implement Round 1 on July 1, 2008. CMS offered us contracts in several CBAs in Round 1; we accepted the contracts for certain product categories and declined others due to unacceptably low single payment amounts (“SPAs”) in certain markets, which would not adequately cover the cost of providing quality service to our patients in those areas. We, along with other winning contract suppliers, began providing services under Round 1 on July 1, 2008.

The bidding process for Round 1 was controversial and complex, which resulted in deadline extensions. Moreover, CMS was subject to numerous lawsuits seeking a delay of Round 1. Then on July 15, 2008, MIPPA was enacted which,

 

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among other provisions, delayed the DMEPOS competitive bidding program by requiring that Round 1 competition commence in 2009, and required a number of program reforms prior to CMS’ re-launching the program. As a result, contracts that were awarded under Round 1 were terminated. In January 2009, CMS released an interim final rule on the DMEPOS competitive bidding program implementing certain MIPPA provisions requiring CMS to conduct the Round 1 Rebid in 2009 and mandating certain changes for both the Round 1 Rebid and subsequent rounds of the program. Changes mandated by MIPPA include requirements for the government to administer the program more transparently, exemption of certain DMEPOS products from the program and a new implementation schedule.

In July 2010, CMS published a proposed rule containing several provisions related to the competitive bidding program. The proposed rule included the proposed list of 21 additional MSAs to be included in Round 2, as well as provisions relating to the diabetic supply category. Those provisions include a proposed definition of “mail order” and “non-mail order” items and a proposal for providers to supply a minimum level of product choices to patients. The final rule was published in November 2010. CMS adjusted certain aspects of the geographic boundaries of three large MSAs, but otherwise the Round 2 markets are now final.

Under MIPPA, the initial CBAs and product categories subject to rebidding in the Round 1 Rebid are very similar to those of Round 1. However, MIPPA excludes Negative Pressure Wound Therapy Pumps and Related Supplies and Accessories as a competitive bidding product category in Round 1 and permanently excludes Group 3 Complex Rehabilitative Power Wheelchairs and Related Accessories as a competitive bidding product category. MIPPA also includes a new provision requiring bids for mail order diabetes testing supplies after Round 1 to include a certain percentage of all types of available diabetic testing strips.

The new rates took effect on January 1, 2011 for the Round 1 Rebid markets. The estimated annual total net revenues associated with the items that would have been subject to competitive bidding in Round 1 of what was to be the initial year of the program represented approximately 1.4% of our annual total net revenues. Based on 2008 data provided to bidders during the Round 1 Rebid process, we estimate that after the DRA and MIPPA reimbursement reductions of 2009 and a change in our business mix since 2007 are allocated for, the estimated annual total net revenues associated with items subject to competitive bidding in the Round 1 Rebid is approximately 1.0% of our annual total net revenues. In early July 2010, CMS announced the new Single Payment Amounts (“SPAs”) for each of the product categories and each of the CBAs included in the Round 1 Rebid. The average price reduction for all products in all CBAs was 32%. CMS then began the contracting process with suppliers by issuing contract offer letters to qualified providers. We received contract offers for a substantial majority of the bids we submitted. We did not receive contract offers for certain product categories in certain CBAs, and we filed a formal request for CMS to reconsider certain of those bids. As a result of that reconsideration, CMS awarded us an additional contract. Approximately $22 million of our net revenues for the fiscal year ended December 31, 2010 was generated by the products and CBAs included in the Round 1 Rebid.

Notwithstanding the changes MIPPA requires, competitive bidding imposes a significant risk to DMEPOS suppliers. Under the rules governing the program, if a DMEPOS supplier operating in a CBA is not awarded a contract for that CBA, the supplier generally will not be able to bill and be reimbursed by Medicare for DMEPOS items supplied in that CBA for the time period covered by the competitive bidding program unless the supplier meets certain exceptions or acquires a winning bidder. Because the applicable statutes mandate financial savings from the competitive bidding program, a winning contract supplier will receive lower Medicare payment rates under competitive bidding than the otherwise applicable DMEPOS fee schedule rates. As competitive bidding is phased in across the country under the revised MIPPA and Reform Package implementation schedule, we will likely experience a reduction in reimbursement, as will most if not all other DMEPOS suppliers in the impacted areas. In addition, there is an increasing risk that the new competitive bidding prices will become a benchmark for reimbursement from other payors, as evidenced by the Administration’s fiscal budget proposal which would cap state Medicaid reimbursement levels at competitive bid rates using an as-yet-undetermined methodology. Neither MIPPA nor the Reform Package prevents CMS from adjusting prices for DMEPOS items in non-bid areas; however, before using its authority to adjust prices in non-bid areas, MIPPA requires that CMS issue a regulation that specifies the methodology to be used and consider how prices through competitive bidding compare to costs for those items and services in the non-bid areas.

The Reform Package also includes changes to the Medicare DMEPOS competitive bidding program. Significantly, Round 2 of the competitive bidding program has been expanded from 70 to 91 of the largest MSAs. In August 2011, CMS announced the product categories that will be included in Round 2. Round 2 will include the majority of the same product categories, but CMS will expand the program by (i) combining standard power wheelchairs and manual wheelchairs into a single new product category, (ii) including Negative Pressure Wound Therapy as a category in all markets and (iii) expanding the Support Surfaces (Group 2 mattresses and overlays) category across all Round 2 markets. Assuming few changes to the Round 2 bidding rules and the markets currently being implemented and/or planned by CMS, we estimate that approximately

 

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$144 million of our net revenues for the fiscal year ending December 31, 2011 would be subject to competitive bidding. Although the bidding process for Round 2 is currently scheduled to commence in late 2011 with bidder registration, the new Round 2 rates and guidelines are currently scheduled to take effect in July of 2013. Therefore, we cannot estimate the impact of potential Round 2 rate reductions on our business until more specific information is published by CMS and its contractors. The Reform Package also gives the Secretary of Health and Human Services additional authority to apply competitive bid pricing to non-bid areas via a rulemaking process and that could occur by 2016. In addition, efforts to repeal the competitive bidding program altogether or mandate significant program changes continue. In March 2011, the Fairness in Medicare Bidding Act of 2011 (“FIMBA”) was introduced into the U.S. House of Representatives. FIMBA would repeal the program without specifying a reduction in the industry’s current reimbursement levels. Other efforts are underway by independent economists who seek to alter certain critical aspects of the program. Specifically, those efforts are designed to change the way in which CMS conducts the auction process itself, establishes the single payment rates, determines supplier capacity needed and related aspects which, if adopted by CMS in their entirety or in part, would change how Round 2 would be administered. We cannot predict whether these or other efforts to repeal or amend the program will be successful, or their potential impact on the Company.

With respect to the competitive bidding program generally, at an April 2011 Program Advisory and Oversight Committee (“PAOC”) meeting, CMS briefed the PAOC regarding the current status of the Round 1 Rebid of the DMEPOS competitive bidding program and also provided updated information regarding the timeline for Round 2 of the program. Round 2 registration is expected to commence in the fourth quarter of 2011 and the bidding window for Round 2 is expected to begin in the first quarter of 2012. CMS anticipates that the Round 2 bidding window would close in the spring of 2012 and also would begin the bid evaluation process. Currently, CMS plans for the bid evaluation process to end in the fall of 2012, at which time CMS would announce the SPAs and begin the contracting process. In the spring of 2013, CMS anticipates making announcements about the contract suppliers. The Round 2 rates are currently targeted to take effect on July 1, 2013. CMS emphasized that the timeline is tentative and potentially subject to further revision. At this time, we cannot quantify what negative impact, if any, the implementation of Round 2 will have upon our revenue or operations once Round 2 is in effect, but it could be material.

We believe that our geographic coverage, clinical marketing programs and purchasing strength provide competitive advantages to maintain and enhance market share under Medicare competitive bidding. However, the bidding rules are complex and it is possible for bidders to be disqualified for technical reasons other than pricing. There is no guarantee that we will be selected as a winning contract supplier in any future phases of the program and be awarded competitive bidding contracts by CMS or that we will garner additional market share. Under the current competitive bidding regulations, if we are not selected as a winning contract supplier for a particular CBA, we will generally not be allowed to supply Medicare beneficiaries in the CBA with products subject to competitive bidding for the contract term of program, unless we elect to continue to service existing patients under the “grandfathering provision” of the program’s final rule for certain products or we acquire a winning supplier. Also, CMS takes the position that it has the authority to determine if an acquired supplier is still needed to serve the CBA, and there is no guarantee that agency staff will approve such an acquisition or do so in a timely manner. Because of our combination of both managed care and traditional business, we believe we can nevertheless maintain a favorable overall market position in a particular CBA even if we are not selected as a contract supplier.

Medicare Fee Schedule for DMEPOS and Consumer Price Index-Urban (“CPI-U”) Adjustments. In addition to the adoption of the DMEPOS competitive bidding program, the MMA implemented a five-year freeze on annual Consumer Price Index (“CPI”) payment increases for most durable medical equipment from 2004 to 2008. In MIPPA, in order to offset the cost of delaying the implementation of the DMEPOS competitive bidding program, Congress approved a nationwide average payment reduction of 9.5% in the DMEPOS fee schedule payments for those product categories included in Round 1, effective January 1, 2009. Product categories subject to competitive bidding but furnished in non-competitive bid areas were eligible to receive mandatory annual CPI-U updates beginning in 2010. Competitively bid items and services in metropolitan areas with contracts in place are not eligible to receive a CPI-U payment update during a contract period, which is currently a three-year period.

The DMEPOS items and services that were not in a product category subject to competitive bidding in Round 1 received a 5.0% CPI-U payment update in 2009. For 2010, the CPI-U was -1.4%. However, annual DMEPOS payment updates were not permitted to be negative according to statute. Therefore, the CPI update in 2010 was 0%. The Reform Package makes changes to Medicare DMEPOS fee schedule payments for 2011 and subsequent years. The CPI-U payment update will now be adjusted annually by a new “multi-factor productivity adjustment” measurement which may result in negative DMEPOS payment updates. While CPI-U for 2011 is +1.1%, the “multi-factor productivity adjustment” is -1.2%, so the net result is a 0.1% decrease in DMEPOS fee schedule payments in 2011 for items and services not included in an area subject to competitive bidding. The CPI-U payment update for 2012 has not yet been published.

 

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Capped Rentals and Oxygen Equipment. Under the DRA, beginning with Medicare beneficiaries who received DMEPOS products and services as of January 2006, ownership of certain durable medical equipment categorized by CMS in the “capped rental” category (e.g., hospital beds, wheelchairs, nebulizers, patient lifts and CPAP devices) automatically transfers to the Medicare beneficiary at the end of a maximum rental period. As of January 1, 2006, the maximum rental period for this category became 13 months. Therefore, the first month in which the new policy had an impact on our revenue was February 2007. In addition, the service and maintenance fee, which had been paid to suppliers twice yearly after the rental period ended in order to cover various non-equipment service costs for patients who require use of the equipment, was eliminated for those patients who commenced service on or after January 1, 2006. However, the DRA provides for additional payments for maintenance and service of the item for repair parts and labor not covered by a supplier’s or manufacturer’s warranty. Implementing regulations also imposed other repair and replacement obligations on suppliers with respect to equipment that does not last the useful lifetime of the equipment, which CMS has generally defined as being five years.

With respect to oxygen equipment, the DRA converted Medicare reimbursement for oxygen equipment from an ongoing rental method to a capped rental and rent-to-purchase methodology and limited reimbursement for rental of oxygen equipment to the current 36-month maximum. The DRA mandated that, after the 36-month rental period, the ownership of the equipment would transfer to the Medicare beneficiary, who would assume primary responsibility for identifying when repairs or preventive maintenance are needed. However, MIPPA repealed the mandatory title transfer for oxygen equipment. The existing implementing regulations to the DRA and MIPPA provisions also limit supplier replacement of oxygen equipment during the rental period, and require suppliers to replace equipment that does not last the useful lifetime of the equipment, which CMS has generally defined as being five years. As a result, the equipment will continue to be owned by the home oxygen provider for as long as the patient’s medical need exists, after which time it will be returned to the home oxygen provider.

The 36-month rental period was retroactively applied to January 1, 2006 for all beneficiaries requiring oxygen as of December 31, 2005. Accordingly, Medicare services provided on or after January 1, 2009 were the first Medicare claims in which the rental cap impacted us. DRA regulations, which remain intact despite the repeal of mandatory title transfer, established new payment classes for oxygen equipment, including transfilling and portable equipment, new monthly rental reimbursement rates, and new reimbursement rates for the delivery of oxygen contents, if applicable. On November 19, 2008, CMS published revised regulations implementing DRA and MIPPA. Under the revised regulations, suppliers must continue furnishing oxygen equipment after the 36-month rental cap period during any period of medical need for the remainder of the reasonable useful lifetime of the equipment, with certain limited exceptions. CMS also specified that a new period of continuous use will not begin following the 36-month rental cap period until the end of the equipment’s reasonable useful lifetime, unless the equipment is replaced because it is lost, stolen, irreparably damaged, or is replaced after the reasonable useful life expires. CMS has provided that the reasonable useful lifetime of oxygen equipment is five years (60 months). Therefore, a new oxygen capped rental period (36 months) may begin after the five year (60 months) useful lifetime of the oxygen equipment. However, at least one Durable Medical Equipment Medicare Administrative Contractor (“DMEMAC”) has provided that a patient must request that the supplier provide the new oxygen equipment and the supplier may not arbitrarily issue new equipment. Among other provisions, CMS also stated that it would not reimburse suppliers for oxygen tubing, cannulas and supplies patients may need between the 37th and 60th months of oxygen therapy and requires that the initial supplier of oxygen therapy make arrangements with another supplier if a patient relocates temporarily or permanently outside of the initial supplier’s service area. In addition, CMS stated that it would not establish any reimbursement rates for non-routine services patients may require after the 36-month rental period.

Regarding repairs and maintenance of oxygen equipment, CMS revised its regulations so that for services provided on or after January 1, 2009, the implementing regulations permitted payment in calendar year 2009 only to suppliers for general maintenance and servicing of certain oxygen equipment every six months, beginning after the first six-month period elapsed after the initial 36-month rental period. The final rule governing repairs and maintenance of oxygen equipment limits payment for general maintenance and servicing visits to 30 minutes of labor based on rates the Medicare contractors establish. With respect to equipment parts, CMS has stated that payments will not be made for equipment parts and that the supplier is responsible for replacing the parts on equipment from the supplier’s inventory in order to meet the patient’s medical need for oxygen. CMS issued guidance in November 2009 continuing the general maintenance and servicing payments for certain oxygen equipment.

In a proposed rule issued in June 2010, CMS proposed to change the threshold rental month from which the original oxygen supplier would continue to be responsible for serving a patient, regardless of his/her move outside of the supplier’s service area, from the 36th to the 18th month. The agency sought public comments, and in a final rule published in November 2010, the agency indicated that it would not change its current policy but would continue to study the issue. We cannot speculate on any future changes CMS may make to its repair, maintenance and service, supply or other fee schedules related to oxygen. We may or may not continue to provide repair and maintenance service on oxygen equipment that has met the cap. We routinely evaluate the impact of the changes caused by all applicable legislation and regulations and adjust our operating policies accordingly.

 

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In recent years, there have been several legislative and executive branch efforts to further reduce the maximum rental period for oxygen therapy, equipment and related services. Former President Bush’s 2007, 2008 and 2009 healthcare budget proposals sought to reduce the maximum rental period for oxygen equipment from the DRA-mandated 36 months to 13 months, which was recommended by the U.S. Department of Health and Human Services’ (“HHS”) Office of Inspector General (“OIG”) in a limited study of the oxygen benefit published in 2006 entitled “Medicare Home Oxygen: Equipment Cost and Servicing.” Neither President Obama’s 2010, 2011 or 2012 budget proposals nor the Reform Package included a reduction in the oxygen rental period. However, President Obama’s most recent budget proposal would further reduce the amount state Medicaid programs pay for oxygen therapy and other durable medical equipment services and products by mandating that state Medicaid rates be no higher than Medicare rates, including those impacted by the Medicare DMEPOS competitive bidding program. It is premature to know whether this or future budgets or proposals or the final recommendations of the Joint Committee charged with addressing the federal deficit will contain such a provision or any other provisions based on these or future studies released by one or more government agencies.

Over the course of 2008, CMS and the DMEMACs issued coverage determinations for positive airway pressure (“PAP”) devices, including CPAP and bi-level devices. Among other changes, the Medicare DMEMAC local coverage determinations (“LCDs”) require additional documentation of clinical benefit of the PAP devices for continued coverage of the device beyond the first three months of therapy. Specifically, for PAP devices with initial dates of service on or after November 1, 2008, documentation of clinical benefit must be demonstrated by: (1) a face-to-face clinical re-evaluation by the treating physician (between the 31st and 90th day) with documentation that symptoms of obstructive sleep apnea are improved; and (2) objective evidence of adherence to use of the PAP device, reviewed by the treating physician. The LCDs define adherence to therapy as the use of the PAP device greater than or equal to four (4) hours per night on 70% of nights during a consecutive 30-day period anytime during the first three months of initial usage. If the clinical benefit requirements are not met, then continued coverage of the PAP device and related accessories are denied by Medicare as not medically necessary. We believe these requirements effectively require suppliers to supply PAP devices that monitor patient compliance and record hours of use, which adds to our expense structure without a corresponding increase in payments from Medicare. We adjusted our operational model, patient care and payment policies to comply with these Medicare requirements. These requirements only apply to Medicare Part B fee-for-service patients, not to those patients enrolled in Medicare Advantage or commercial health plans, and Medicare Part B fee-for-service represents a smaller portion of the overall PAP patient market. However, some commercial payors are now implementing the same or similar rules as those adopted by Medicare. Despite our intensive efforts to educate patients about the importance of complying with their physician-prescribed therapy, some of our Medicare Part B and commercially insured patients do not meet the threshold for compliance. In order to reduce the impact of the LCDs, we are continuing to educate patients and referral sources concerning the importance of compliance with the patient’s prescribed therapy and the government’s need for documentation pertaining to initial and ongoing medical necessity. However, these and similar LCDs and trends are likely to continue to significantly impact the PAP industry.

Reimbursement for Inhalation and Infusion Therapy Drugs. As a result of the MMA, beginning January 2005, Medicare Part B reimbursement for most drugs, including inhalation drugs, became based upon the manufacturer-reported ASP (subject to adjustment each quarter), plus 6%, plus a separate dispensing fee per patient episode. CMS publishes the ASP plus 6% payment levels in the month that precedes the first day of each quarter, and we have no way of knowing if the quarterly average sales prices (“ASPs”) will increase or decrease since manufacturers report applicable ASP information directly to CMS. Since 2006, dispensing fees have remained at $57.00 for a 30-day supply for a new patient, $33.00 for each 30-day supply thereafter, and $66.00 for each 90-day supply.

The Medicare reimbursement methodology for non-compounded, infused drugs administered through durable medical equipment, such as infusion pumps, was not affected by this MMA change. It remains based upon either 95% of the October 1, 2003 Average Wholesale Price (“AWP”) or, for those drugs whose AWPs were not published in the applicable 2003 compendia, at 95% of the first published AWP. Also, coding and reimbursement changes pertaining to compounded medications, issued in 2007, did not have a material impact on us due to the extremely low volume of patient-specific, physician-prescribed compounding that was performed by our inhalation pharmacies.

In 2007 and 2008, there were other changes to the reimbursement methodology for the inhalation drugs Xopenex and albuterol. Beginning in the third quarter of 2007, CMS began reimbursing providers of Xopenex and albuterol a blended ASP for these two inhalation drugs. On December 29, 2007, the President signed into law the Medicare, Medicaid, and State Children’s Health Insurance Program Extension Act of 2007, which partially reversed the CMS regulatory decision regarding Xopenex and albuterol. Beginning on April 1, 2008, Medicare began to reimburse providers for Xopenex by blending the average sales prices of Xopenex and albuterol, but it no longer reimbursed providers for albuterol at the blended price. Rather, albuterol is reimbursed using an albuterol-only ASP.

 

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We estimate that the combined effect of these changes to inhalation drug reimbursement resulted in a $7.9 million decline in revenue for the year ended December 31, 2009 from the same period in 2008. However, we implemented strategies intended to partially mitigate these negative impacts in subsequent periods, including the discontinuation of the inhalation drug Xopenex from our inhalation pharmacies’ drug formulary and other formulary changes.

A limited number of infusion therapies, supplies and equipment are covered by Medicare Part B. The MMA, through the new Medicare Part D program, provided expanded coverage for certain home infusion therapy drugs, but excluded coverage for the corresponding supplies and clinical services needed to safely and effectively administer these drugs. We have contracted with a limited number of Medicare Part D prescription drug plans in order to provide continuity of care for certain patients.

Due to ongoing Part D and Part B coverage and payment issues associated with home infusion therapy, the industry is continuing to work with CMS, the Center for Medicare and Medicaid Innovation (“CMMI”) and Congress to rectify the Medicare coverage and payment limitations that restrict Medicare beneficiary and referral source access to quality home infusion therapy services. Bills were introduced in the 110th, 111th and 112th Congresses to consolidate home infusion therapy coverage under Part B. The currently proposed Medicare Home Infusion Therapy Coverage Act would provide for Medicare infusion benefit coverage in a more comprehensive manner that is analogous to how the therapy is covered by the managed care sector, including Medicare Advantage plans. Industry representatives continue to present the cost-saving and patient care advantages of home infusion therapy to CMS, members of Congress and the Obama Administration in an effort to, at a minimum, include a formal demonstration project in either CMS’ or the CMMI’s work plan or future legislation. In addition to a June 2010 report issued by the Government Accountability Office (GAO), entitled “Home Infusion Therapy: Differences Between Medicare and Private Insurers’ Coverage,” testimony before the Senate Finance Committee in September 2009 acknowledged the current gap in coverage and potential benefits of home infusion therapy to the Medicare program and beneficiaries. At this time, we cannot predict whether legislation will be passed or whether CMS and/or the CMMI will include a demonstration project in a future work plan.

Enrollment and Accreditation of Durable Medical Equipment Suppliers; Surety Bond Requirements. While we support the elimination of fraudulent suppliers and are working with CMS to support these initiatives, some of the CMS initiatives and developments with respect to the enrollment and accreditation of providers could impact our operations in the future. For example, all durable medical equipment providers who bill the Medicare program for DMEPOS services and products are required by MIPPA to be accredited. Although we and all of our branches currently are accredited, if we or any of our branches lose accreditation, or if any of our new branches are unable to become accredited, that could have a material adverse effect on our results of operations, cash flow and capital resources.

CMS also requires that all durable medical equipment providers who bill the Medicare program maintain a surety bond of $50,000 per NPI number which Medicare has approved for billing privileges. We obtained the required surety bonds for all of our applicable locations before the October 2009 deadline and, more recently, for a number of former Praxair locations we acquired, and received confirmation from the National Supplier Clearinghouse (“NSC”) that the NSC has recorded the bonds properly in its records. In addition, the NSC prescribes an elevated bond amount of $50,000 per occurrence of an adverse legal action within the 10 years preceding enrollment, reenrollment or revalidation. The rule is designed to ensure that Medicare can recover any erroneous payment amounts or civil money penalties up to $50,000 that result from fraudulent or abusive supplier billing practices.

In October 2008, CMS announced enhancements to its program integrity initiatives designed to identify and prevent waste, fraud and abuse. The initiatives include: (i) conducting more stringent reviews of DMEPOS suppliers’ applications, including background checks of new DMEPOS suppliers’ principals and owners to ensure they have not been suspended by Medicare; (ii) making unannounced site visits to suppliers and home health agencies to ensure they are active, legitimate businesses; (iii) implementing extensive pre- and post-payment claims review; (iv) verifying the relationship between physicians who order a large volume of DMEPOS equipment and the beneficiaries for whom they ordered these services; and (v) identifying and visiting beneficiaries to ensure appropriate receipt of Medicare-reimbursable items and services. We work cooperatively with CMS and its contractors in response to these initiatives but cannot predict whether CMS’ various program integrity efforts will or will not negatively impact our operations.

In February 2011, CMS released a final rule implementing certain provisions of the Reform Package intended to prevent fraud, waste and abuse. This final rule includes new requirements regarding enrollment screening, enrollment application fees, payment suspension, temporary moratoria on enrollment and supplier termination. Significantly, as part of the final rule, CMS classified providers and suppliers as limited, moderate and high risk according to their risk of fraud, waste and abuse. Currently enrolled DMEPOS suppliers are classified in the moderate risk category while newly enrolled

 

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DMEPOS suppliers are classified in the high risk category. As such, DMEPOS suppliers will be under greater scrutiny relative to many other health care providers and suppliers. We work cooperatively with CMS and its contractors in response to these initiatives to prevent fraud, waste and abuse but cannot predict whether CMS’ various program integrity efforts will or will not negatively impact our operations.

In August 2010, CMS released a final rule imposing more stringent standards for DMEPOS suppliers, which introduced several new enrollment standards and expanded some existing standards and participation requirements, all of which DMEPOS suppliers must meet to establish and maintain billing privileges in the Medicare program. These standards became effective on September 27, 2010.

Following the implementation of a three-year demonstration program using Recovery Audit Contractors (“RACs”) to detect and correct improper payments in the Medicare fee-for-service program, the Tax Relief and Health Care Act of 2006 required HHS to establish the RAC initiative as a permanent, nationwide program by January 1, 2010. CMS selected the four RAC contractors for the permanent RAC program and it is currently underway. Prior to initiating any audits, RACs are required to obtain CMS’ pre-approval of the issue that will be subject to audit, and then post the approved audit issue on their websites. All RACs have now posted CMS-approved audit issues on their websites. The currently posted approved audit issues include those which apply to durable medical equipment (“DME”) suppliers. States have also implemented similar state Medicaid audit programs, often know as Medicaid Integrity Contractors (“MICs. The Reform Package expands the RAC program to include Medicare Parts C and D in the program. In addition, the Reform Package requires states to establish contracts with RACs to identify underpayments and overpayments and to recoup overpayments made for services provided under State Medicaid programs. Absent an exception, States will be required to implement their RAC programs by January 1, 2012. In addition, in March of 2010, President Obama issued a presidential memorandum announcing a government-wide program expanding the use “payment recapture audits” in order to reclaim improper payments. We cannot at this time quantify any negative impact that the expansion of the RAC program or other similar programs may have on us.

Also in October 2008, CMS announced the establishment of new Zone Program Integrity Contractors (“ZPICs”), who are responsible for ensuring the integrity of all Medicare-related claims. The ZPICs assumed the responsibilities previously held by Medicare’s Program Safeguard Contractors (“PSCs”). Industry-wide, ZPIC audit activity increased significantly throughout 2010 and accelerated in 2011; it is expected to continue to increase for the foreseeable future as additional ZPICs become operational across the country. The industry trade associations are advocating for more standardized audit procedures, contractor transparency and consistency surrounding all government audit activity directed toward the DMEPOS industry.

Other Issues

 

   

Medical Necessity & Other Documentation Requirements. In order to ensure that Medicare beneficiaries only receive medically necessary and appropriate items and services, the Medicare program has adopted a number of documentation requirements. For example, the DMEMAC Supplier Manuals provide that clinical information from the “patient’s medical record” is required to justify the initial and ongoing medical necessity for the provision of DME. Some DMEMACs, CMS staff and government subcontractors have recently taken the position, among other things, that the “patient’s medical record” refers not to documentation maintained by the DME supplier but instead to documentation maintained by the patient’s physician, healthcare facility or other clinician, and that clinical information created by the DME supplier’s personnel and confirmed by the patient’s physician is not sufficient to establish medical necessity. It may be difficult, and sometimes impossible, for us to obtain documentation from other healthcare providers. Moreover, auditors’ interpretations of these policies are inconsistent and subject to individual interpretation. This is then translated to individual supplier significant error rates and aggregated into a DMEPOS industry error rate. High error rates lead to further audit activity and regulatory burdens. If these or other burdensome positions are generally adopted by auditors, DMEMACs, other contractors or CMS in administering the Medicare program, we would have the right to challenge these positions as being contrary to law. If these interpretations of the documentation requirements are ultimately upheld, however, it could result in our making significant refunds and other payments to Medicare and our future revenues from Medicare may be reduced. We cannot currently predict the adverse impact, if any, these interpretations of the Medicare documentation requirements might have on our operations, cash flow and capital resources, but such impact could be material.

 

   

Inherent Reasonableness. The Balanced Budget Act of 1997 granted authority to HHS to increase or reduce Medicare Part B reimbursement for home medical equipment, including oxygen, by up to 15% each year under an “inherent reasonableness” authority. Pursuant to that authority, CMS published a final rule that established a process by which such adjustments may be made. The rule applies to all Medicare Part B services except those paid under a physician fee schedule, a prospective payment system, or a competitive bidding program. Neither HHS nor CMS has issued any subsequent communication or information for several years and therefore, we cannot predict whether or when HHS would exercise its authority in this area or predict any negative impact of any such change.

 

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The impact of changes in Medicare reimbursement that have been enacted to date are reflected in our results of operations for the applicable periods through September 30, 2011. We cannot estimate the combined possible impact of all legislative, regulatory and contemplated reimbursement changes that could have a material adverse effect on our results of operations, cash flow, and capital resources. Moreover, our estimates of the impact of certain of these changes appearing in this “Government Regulation” section are based on a number of assumptions and are subject to uncertainties and there can be no assurance that the actual impact was not or will not be different from our estimates. However, given the unpredictability of the Joint Committee’s debt reduction efforts, the recent significant increases in industry audit volume and the increasing regulatory burdens associated with responding to those audits, it is likely that the negative pressures from legislative and regulatory changes will continue and accelerate.

Medicaid Reimbursement. State Medicaid programs implement reimbursement policies for the items and services we provide that may or may not be similar to those of the Medicare program. Budget pressures on these state programs often result in pricing and coverage changes that may have a detrimental impact on our operations and/or financial performance. States sometimes have interposed intermediaries to administer their Medicaid programs, or have adopted alternative pricing methodologies for certain drugs, biologicals, and home medical equipment under their Medicaid programs that reduce the level of reimbursement received by us without a corresponding offset or increase to compensate for the service costs incurred. For example, Medi-Cal adopted a regulation that limits the amounts a provider can bill for certain durable medical equipment and medical supplies. In March 2009, the California Association of Medical Product Suppliers (“CAMPS”) initiated a lawsuit to invalidate this regulation as having been adopted in violation of California’s Administrative Procedure Act. In August 2009, the trial court entered a decision denying CAMPS’ petition. CAMPS appealed the court’s decision but on September 16, 2011, the Court of Appeal upheld the trial court’s decision. CAMPS did not file a further appeal and the validity of the regulation was accordingly upheld. As a result, we may be making refunds and other payments to Medi-Cal, and our future revenues from Medi-Cal may be reduced. We periodically evaluate the possibility of stopping or reducing our Medicaid business in a number of states with reimbursement or administrative policies that make it difficult for us to safely care for patients or conduct operations profitably. Moreover, the Reform Package increases Medicaid enrollment over a number of years and imposes additional requirements on states which, combined with the current economic environment and state deficits, could further strain state budgets and therefore result in additional policy changes or rate reductions. The President’s most recent budget proposal, which was discussed by Congressional and Administration leaders as part of the debt ceiling negotiations leading up to passage of the Budget Control Act of 2011, discussed above, would limit the amount state Medicaid programs pay for DMEPOS to be no higher than Medicare payment levels, including those impacted by Medicare competitive bidding. We cannot currently predict the adverse impact, if any, that any such change to or reduction in our Medicaid business might have on our operations, cash flow and capital resources, but such impact could be material. In addition, we cannot predict whether states will consider similar or other reimbursement reductions, whether or how healthcare reform provisions pertaining to Medicaid will ultimately be implemented or whether any such changes would have a material adverse effect on our results of operations, cash flow and capital resources.

HIPAA. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) is comprised of a number of components pertaining to the privacy and security of certain protected health information (“PHI”), as well as the standard formatting of certain electronic health transactions. Many states have similar, but not identical, restrictions. Existing and any new laws or regulations have a significant effect on the manner in which we handle healthcare related data and communicate with payors. Among other provisions, the HITECH Act of the American Recovery and Reinvestment Act of 2009 (“ARRA”) includes additional requirements related to the privacy and security of PHI, clarifies and increases penalties of HIPAA and provides State Attorneys General with HIPAA enforcement authority. We have adopted a number of policies and procedures to conform to HIPAA requirements, as modified by the HITECH Act of ARRA, throughout our operations, and we have educated our workforce about these requirements. With such a large workforce that relies on mobile technology for operations, we cannot, however, guarantee that we will not have a HIPAA privacy or data security concern in the future. We face potential administrative, civil and possible criminal sanctions if we do not comply with these existing or new laws and regulations dealing with the privacy and security of PHI. Imposition of any such sanctions could have a material adverse effect on our operations.

Enforcement of Healthcare Fraud and Abuse Laws. In recent years, the federal government has made a policy decision to significantly increase and accelerate the financial resources allocated to enforcing the healthcare fraud and abuse laws. Moreover, Congress adopted a number of additional provisions in the Reform Package that are designed to reduce healthcare fraud and abuse. In addition, private insurers and various state enforcement agencies have increased their level of scrutiny of healthcare claims in an effort to identify and prosecute fraudulent and abusive practices in the healthcare area. From time to time, we may be the subject of investigations or a party to additional litigation which alleges violations of law. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial position, results of operations or prospects.

 

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Anti-Kickback Statutes. As a provider of services under the Medicare and Medicaid programs, we must comply with a provision of the federal Social Security Act, commonly known as the “federal anti-kickback statute.” The federal anti-kickback statute prohibits the offer or receipt of any bribe, kickback or rebate in return for the referral or arranging for the referral of patients, products or services covered by federal healthcare programs. Federal healthcare programs have been defined to include plans and programs that provide health benefits funded by the United States Government, including Medicare, Medicaid and TRICARE (formerly known as the Civilian Health and Medical Program of the Uniformed Services or CHAMPUS), among others. Some courts and the OIG interpret the statute to cover any arrangement where even one purpose of the remuneration is to influence referrals. Violations of the federal anti-kickback statute may result in civil and criminal penalties and exclusion from participation in federal healthcare programs.

Due to the breadth of the federal anti-kickback statute’s broad prohibition, there are a few statutory exceptions that protect various common business transactions and arrangements from prosecution. In addition, the OIG has published safe harbor regulations that outline other arrangements that also are deemed protected from prosecution under the federal anti-kickback statute, provided all applicable criteria are met. The failure of an activity to meet all of the applicable safe harbor criteria does not necessarily mean that the particular arrangement violates the federal anti-kickback law, but these arrangements will be subject to greater scrutiny by enforcement agencies.

Some states have enacted statutes and regulations similar to the federal anti-kickback statute, but which apply not only to the federal healthcare programs, but also to any payor source of the patient. These state laws may contain exceptions and safe harbors that are different from those of the federal law and that may vary from state to state. A number of states in which we operate have laws that prohibit fee-splitting arrangements between healthcare providers, if such arrangements are designed to induce or encourage the referral of patients to a particular provider. Additionally, several states have passed laws further regulating interactions between healthcare providers and physician referral sources. In late 2009, the state of New York enacted a requirement for certain healthcare providers to file a formal annual statement in which they attest that they have adopted a formal corporate compliance program which meets the state’s specific requirements; we comply with that annual requirement. Possible sanctions for violations of these restrictions include exclusion from state-funded healthcare programs, loss of licensure, and civil and criminal penalties. Such statutes vary from state to state, are often vague and often have been subject to only limited court or regulatory agency interpretation.

Marketing Laws. Because of our drug compounding and oxygen services, we may be subject to new and increasingly common state laws and regulations regarding our marketing activities and the nature of our interactions with physicians and other healthcare entity customers. These laws may require us to comply with certain codes of conduct, limit or report certain marketing expenses, disclose certain physician and customer arrangements, and ensure the appropriate licensure of certain sales personnel. There have also been similar federal legislative and regulatory initiatives. Violations of these laws and regulations, to the extent applicable, could subject us to civil and criminal fines and penalties, as well as possible exclusion from participation in federal healthcare programs, such as Medicare and Medicaid. From time to time, we may be the subject of investigations or audits or be a party to litigation which alleges violations of these laws. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial position, results of operations or prospects.

Physician Self-Referral. Certain provisions of the Omnibus Budget Reconciliation Act of 1993 (the “Stark Law”) prohibit healthcare providers such as us, subject to certain exceptions, from submitting claims to the Medicare and Medicaid programs for designated health services if we have a financial relationship with the physician making the referral for such services or with a member of such physician’s immediate family. The term “designated health services” includes several services commonly performed or supplied by us, including durable medical equipment and home health services. In addition, “financial relationship” is broadly defined to include any ownership or investment interest or compensation arrangement pursuant to which a physician receives remuneration from the provider at issue. The Stark Law prohibition applies regardless of the reasons for the financial relationship and the referral; and therefore, unlike the federal anti-kickback statute, an intent to violate the law is not required. Like the federal anti-kickback statute, the Stark Law contains a number of statutory and regulatory exceptions intended to protect certain types of transactions and business arrangements from penalty.

In order to qualify an arrangement under a Stark Law exception, compliance with all of the exception’s requirements is necessary. Violations of the Stark Law may result in loss of Medicare and Medicaid reimbursement, civil penalties and exclusion from participation in the Medicare and Medicaid programs.

In addition, a number of the states in which we operate have similar prohibitions against physician self-referrals, which may not necessarily be limited to Medicare or Medicaid services and may not include the same statutory and regulatory exceptions found in the Stark Law.

 

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False Claims. The federal False Claims Acts impose civil and criminal liability on individuals or entities that submit false or fraudulent claims for payment to the government. Violations of the federal civil False Claims Act may result in treble damages, civil monetary penalties and exclusion from the Medicare, Medicaid and other federally funded healthcare programs. If certain criteria are satisfied, the federal civil False Claims Act allows a private individual to bring a qui tam suit on behalf of the government and, if the case is successful, to share in any recovery. Federal False Claims Act suits brought directly by the government or private individuals against healthcare providers, like us, are increasingly common and are expected to continue to increase.

The federal government has used the federal False Claims Act to prosecute a wide variety of alleged false claims and fraud allegedly perpetrated against Medicare and state healthcare programs. The government and a number of courts also have taken the position that claims presented in violation of certain other statutes, including the federal anti-kickback statute or the Stark Law, can be considered a violation of the federal False Claims Act, based on the theory that a provider impliedly certifies compliance with all applicable laws, regulations and other rules when submitting claims for reimbursement.

On May 20, 2009, President Obama signed into law the Fraud Enforcement and Recovery Act of 2009 (“FERA”). Among other things, FERA modifies the federal False Claims Act by expanding liability to contractors and subcontractors who do not directly present claims to the federal government. FERA also expanded the False Claims Act liability for what is referred to as a “reverse false claim” by explicitly making it unlawful to knowingly conceal or knowingly and improperly avoid or decrease an obligation owed to the federal government.

A number of states have enacted false claims acts that are similar to the federal False Claims Act. Even more states are expected to do so in the future because Section 6031 of the DRA amended the federal law to encourage these types of changes in law at the state level. In addition, there is a corresponding increase in state-initiated false claims enforcement efforts.

Other Fraud and Abuse Laws. HIPAA created, in part, two new federal crimes: “Healthcare Fraud” and “False Statements Relating to Healthcare Matters.” The Healthcare Fraud statute prohibits executing a knowing and willful scheme or artifice to defraud any healthcare benefit program. A violation of this statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.

The increased public focus on waste, fraud and abuse and their related cost to society will likely result in additional Congressional hearings, CMS regulatory changes or new laws. The Reform Package also provides for new regulatory authority, additional fines and penalties. More recently, additional legislation has been proposed in the U.S. Senate which would further expand the government’s oversight of the healthcare industry via new regulatory authority. In addition, a Senate bill released earlier this year (S. 1251) would require pre-payment review of all claims for durable medical equipment that are at high risk for fraud and abuse. At this time, we cannot predict whether these or other reforms will ultimately become law, or the impact of such reforms on our business operations and financial performance.

Facility and Clinician Licensure. Various federal and state authorities and clinical practice boards regulate the licensure of our facilities and clinical specialists working for us, either directly as employees or on a per diem or contractual basis. Regulations and requirements vary from state to state, and in some states, we are required to make filings in connection with transactions that may be defined as a change of control. Moreover, several states are currently contemplating the establishment or expansion of facility licensure related to the home healthcare industry. We are committed to complying with all applicable licensing requirements and maintain centralized functions to manage over 4,500 facility licenses and/or permits that are required to operate our business.

Healthcare Reform. Economic, political and regulatory influences are causing fundamental changes in the healthcare industry in the United States. Various healthcare reform proposals are formulated and proposed by the legislative and administrative branches of the federal government on a regular basis. In addition, some of the states in which we operate periodically consider various healthcare reform proposals. Even with the passage of the Reform Package, we anticipate that federal and state governments will continue to review and assess alternative healthcare delivery systems and payment methodologies and public debate of these issues will continue in the future.

The 2010 mid-term election changed the composition of Congress and affected certain priorities related to healthcare. Congress is debating the potential to repeal or amend the Reform Package altogether. A number of other parties, including some State governments, have begun to challenge the Reform Package, and we cannot predict the outcome of such challenges. Changes in the law or new interpretations of existing laws can have a substantial effect on permissible activities, the relative costs associated with doing business in the healthcare industry and the amount of reimbursement by

 

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governmental and other third-party payors. Also, the government has begun to promulgate the implementing rules and regulations of the Reform Package, including additional requirements related to our business and that of our customers. Until those rules are more clearly understood, and due to uncertainties regarding the ultimate features of additional reform initiatives and their enactment and implementation over the next few years, we cannot predict which, if any, of such reform proposals will be adopted, or when they may be adopted, or that any such reforms will not have a material adverse effect on our results of operations, cash flow, capital resources and liquidity.

Key Factors and Trends Impacting our Business in 2011

Although other factors and trends will likely impact us, including some we do not foresee at this time, our performance in 2011 has been impacted and will continue to be impacted by the following key factors and trends:

 

   

Changes in outsourcing strategy. As a part of our ongoing review of our outsourcing strategy, we determined in 2010 to return certain of the outsourced functions to our personnel and facilities in the United States. Consequently, we have experienced increased administrative costs because we no longer have the full benefit of the favorable offshore labor rates and we have increased our personnel related to these functions at higher than historical levels.

 

   

Increasing Costs Relating to Sales Personnel. Our selling, distribution and administrative costs increased in 2011 as a result of the full year impact of additional sales personnel added for a portion of 2010.

 

   

Medicare Competitive Bidding. While we do not expect a significant financial impact of Medicare competitive bidding on our business in 2011 it remains an important trend in our industry and we continue to monitor its potential impact.

 

   

Collectability of accounts receivable. The collection of accounts receivable remains one of our most significant challenges. We expect that our provision for doubtful accounts for the year ended December 31, 2011 as a percentage of net revenue will be at a rate comparable to that which we experienced for the year ended December 31, 2010.

 

   

Integration of Praxair. As previously announced, we completed our asset acquisition of Praxair, Inc.’s (NYSE: PX) and Praxair Healthcare Services, Inc.’s (collectively, “Praxair”) United States homecare business on March 4, 2011. We expect this business to contribute approximately $80 million to our revenue in 2011. This estimate and the acquired business’s contribution in future periods will be subject to decreases as a result of the impact of Medicare competitive bidding and other factors.

 

   

Increasing Audit Activity. We, along with others in the industry, have experienced a very significant increase in audits this year. We believe that such increased audit activity will continue to be the case for the foreseeable future. Such audits are designed to measure industry and provider claim error rates, primarily relating to medical necessity documentation in the treating physician’s records for various DMEPOS items. Such audits are labor-intensive to respond to and are likely to result in refunds to the government. Additionally, commercial insurers have increased their post-payment audit volume in 2011 as well.

Results of Operations

Three Months Ended September 30, 2011 and 2010

Net Revenues. Net revenues in the three months ended September 30, 2011 were $584.9 million, compared to $526.0 million in the three months ended September 30, 2010, an increase of $58.9 million or 11.2%. Revenue for the three months ended September 30, 2011 increased primarily due to an increase in home infusion therapy segment revenue and the previously announced acquisition of Praxair assets. The revenue increase was partially offset by the non-renewal or termination of, or changes to, certain payor contracts among other factors.

We expect to continue to face pricing pressures from Medicare and Medicaid as well as from our managed care customers as these payers seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See “Business—Government Regulation.”

Gross Profit. Gross profit margin is defined as total net revenues less total costs of total net revenues divided by total net revenues. The gross profit margin for the three months ended September 30, 2011 was 59.0%, compared to 60.5% for the three months ended September 30, 2010. The decline in gross profit margin percentage is primarily due to an increase in the

 

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revenue of the home infusion therapy segment as a percent of total net revenue, a decrease in the home infusion therapy segment margin percentage due to an increase in specialty revenue as a percent of infusion therapy segment net revenue and a decline in the home respiratory therapy and home medical equipment segment margin percentage. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenue than the home respiratory and home medical equipment segment. The decline in home respiratory therapy and home medical equipment segment margin percentage was partially due to an increase in respiratory therapist salaries expense.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on management’s estimate of the net realizable value of accounts receivable. Accounts receivable estimated to be uncollectible are provided for by computing a required reserve using estimated future cash receipts based on historical cash receipts collections as a percentage of revenue. In addition, management adjusts for changes in billing practices, cash collection protocols or practices, or changes in general economic conditions, contractual issues with specific payors, new markets or products. The provision for doubtful accounts, expressed as a percentage of total net revenues, was 2.5% and 2.1% in the three months ended September 30, 2011 and September 30, 2010, respectively. In late 2010, based upon a review of key outsourcing initiatives, we determined that certain outsourced billing and collections functions should instead be performed by us and we are currently transitioning such functions back to our operations in the United States. The increase in the provision for doubtful accounts in the quarter ended September 30, 2011 is the result of unfavorable collections experience occurring in the quarter ended September 30, 2011 primarily due to the transition of our previously outsourced billing and collections process back to Apria personnel and the impact of a major payor using an intermediary.

Selling, Distribution and Administrative Expenses. Selling, distribution and administrative expenses are comprised of expenses incurred in direct support of operations and those associated with administrative functions. Expenses incurred by the operating locations include salaries and other expenses in the following functional areas: selling, distribution, clinical services, warehousing and repair. Many of these operating costs are directly variable with revenue growth patterns. Some are also very sensitive to market-driven price fluctuations such as facility lease and fuel costs. The administrative expenses include overhead costs incurred by the operating locations and regional and corporate support functions. These expenses are generally less sensitive to fluctuations in revenue growth than operating costs.

Selling, distribution and administrative expenses were $307.8 million, or 52.6% of total net revenues, for the three months ended September 30, 2011, compared to $271.2 million, or 51.5% of total net revenues, for the three months ended September 30, 2010.

Selling, distribution and administrative expenses increased by $36.7 million for the three months ended September 30, 2011, compared to the three months ended September 30, 2010. The increase was comprised of a $31.8 million increase in labor and related expenses and a $4.8 million increase in other operating expense.

The increase in labor and related expenses of $31.8 million was primarily due to increases in headcount as a result of the acquisition of Praxair assets, an increase in salaries and related benefits resulting from headcount increases associated with our decision to return certain outsourced functions relating to documentation, billing and collections back to Apria personnel, growth in infusion headcount to support growth in our infusion revenue and growth in our respiratory therapy and home medical equipment sales force.

The increase in other operating expenses of $4.8 million was primarily due to increased operating costs as a result of the acquisition of Praxair assets and an increase in costs related to delivery, partially offset by a decrease in professional fees related to certain corporate initiative projects.

Amortization of Intangible Assets. Amortization of intangible assets was $1.2 million and $1.0 million in the three months ended September 30, 2011 and September 30, 2010, respectively.

Interest Expense. Interest expense increased $0.5 million, or 1.5%, to $33.2 million in the three months ended September 30, 2011 from $32.7 million in the three months ended September 30, 2010.

Interest Income and Other. Interest income and other decreased to $(0.2) million for the three months ended September 30, 2011 from $0.3 million in the three months ended September 30, 2010.

Income Tax Benefit. Our overall effective tax rate is the ratio of our tax expense (benefit) over our pre-tax income (loss) for the reporting period. Our tax expense (benefit) is comprised of two items: (1) the tax computed using an Estimated Annual Effective Tax Rate (“EAETR”) and (2) certain tax charges and benefits which are recognized on a discrete basis in the interim period in which they occur.

 

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Our EAETR is determined by taking into account estimated pre-tax income (loss) and permanent book/tax differences. Our EAETR is applied to year-to-date pre-tax income (loss) at the end of each interim period to compute a year-to-date tax expense (or benefit). Significant differences in our EAETR compared with statutory rates can arise from permanent book/tax differences as a percentage of our estimated pre-tax income (loss).

Our effective tax rate was a benefit of 59.5% for the three months ended September 30, 2011, compared to an expense of 104.4% for the three months ended September 30, 2010. Differences in our effective tax rate compared with federal and state statutory rates stem primarily from the tax rate impact of non-deductible equity compensation and certain discrete items.

During the three months ended September 30, 2011, net tax benefits totaling $3.7 million were recognized, on a discrete basis, which resulted in an increase to our effective tax rate above our EAETR. The $3.7 million primarily relates to the release of tax contingency accruals due to a change in tax rules regarding an uncertain tax position (“UTP”) and the expiration of the statute of limitations for other UTPs.

During the three months ended September 30, 2010, our actual effective tax rate of 104.4% was in line with our EAETR.

Our provision for income taxes is based on expected income, permanent book/tax differences and statutory tax rates in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining the provision for income taxes. We are routinely under audit by federal, state or local authorities regarding the timing and amount of deductions, allocation of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately reflect our potential obligations.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized.

In determining the necessity and amount of a valuation allowance, all available information (both positive and negative) is considered and analysis is performed to determine the appropriate weight that should be afforded to available objective and subjective evidence. Cumulative losses in recent years are considered significant negative evidence which could result in the accrual of a valuation allowance against deferred tax assets.

We have not sustained a cumulative book loss over the three-year period ended September 30, 2011 (after adjusting for the impact of certain non-recurring historical items which are not indicative of our ability to generate future income).

Based on available information, we have concluded that a valuation allowance against federal deferred tax assets was not required at September 30, 2011. We will continue to assess the need for a valuation allowance as information becomes available.

Segment Net Revenues and EBIT

The following table sets forth a summary of results of operations by segment:

 

(in thousands)

   Three Months Ended
September 30, 2011
     Percentage of
Net Revenues
    Three Months Ended
September 30, 2010
     Percentage of
Net Revenues
 

Net revenues:

          

Home respiratory therapy and home medical equipment

   $ 293,370         50.2   $ 270,223         51.4

Home infusion therapy

     291,504         49.8        255,791         48.6   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total net revenues

   $ 584,874         100.0   $ 526,014         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

($ in thousands)

   Three Months Ended September 30, 2011  
   Home Respiratory
Therapy
and Home Medical
Equipment
    Percentage of
Segment
Net Revenues
    Home Infusion
Therapy
     Percentage of
Segment
Net Revenues
    Total  

EBIT

   $ (11,415     (3.9 )%    $ 33,379         11.5   $ 21,964   

 

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($ in thousands)

   Three Months Ended September 30, 2010  
   Home Respiratory
Therapy
and Home Medical
Equipment
     Percentage of
Segment
Net Revenues
    Home Infusion
Therapy
     Percentage of
Segment
Net Revenues
    Total  

EBIT

   $ 3,129         1.2   $ 31,611         12.4   $ 34,740   

 

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We allocate certain expenses that are not directly attributable to a product line based upon segment headcount.

See reconciliation of EBIT to net income included at the end of this section.

Home Respiratory Therapy and Home Medical Equipment Segment. For the home respiratory therapy and home medical equipment segment total net revenues increased $23.2 million, or 8.6%, to $293.4 million in the three months ended September 30, 2011 from $270.2 million in the three months ended September 30, 2010. Revenues for the home respiratory therapy and home medical equipment segment decreased to 50.2% of total revenue in the three months ended September 30, 2011 from 51.4% in the three months ended September 30, 2010.

Home respiratory therapy revenues are derived primarily from the provision of oxygen systems, obstructive sleep apnea equipment, home ventilators, nebulizers, respiratory medications and related services. Revenues from the home respiratory therapy service line increased by 8.5% in the three months ended September 30, 2011 compared to the three months ended September 30, 2010. The increase in revenue resulted primarily from increases in sleep apnea, oxygen, other respiratory revenue and respiratory drugs revenue. Revenue in this service line was positively impacted by the acquisition of Praxair assets and negatively impacted by the termination of or changes to certain payor contracts. In addition, we experienced an increase in sleep apnea volume.

Home medical equipment revenues are derived from the rental and sale of equipment to assist patients with ambulation, safety and general care in and around the home. Home medical equipment revenues increased by 9.1% in the three months ended September 30, 2011 compared to the three months ended September 30, 2010. The increase was primarily due to an increase in overall volume. The increase in overall volume was partially offset by a decrease in revenue due to the termination of or changes to certain payor contracts.

EBIT for the home respiratory therapy and home medical equipment segment in the three months ended September 30, 2011 was a negative $11.4 million, compared to a positive $3.1 million in the three months ended September 30, 2010. The negative EBIT was 3.9% of segment net revenues in the three months ended September 30, 2011, compared to positive 1.2% of segment net revenues in the three months ended September 30, 2010. The decrease in the EBIT as a percentage of segment net revenues from 1.2% for the three months ended September 30, 2010 to a negative 3.9% in the three months ended September 30, 2011 is primarily due to increases in the provision for doubtful accounts primarily due to the outsourcing of our billing and collections process and in the sales, distribution and administrative costs as a percentage of net revenues in the three months ended September 30, 2011 compared to the three months ended September 30, 2010.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $35.7 million, or 14.0% to $291.5 million for the three months ended September 30, 2011 from $255.8 million in the three months ended September 30, 2010. Revenues for the home infusion therapy segment increased to 49.8% of total revenue in the three months ended September 30, 2011 from 48.6% in the three months ended September 30, 2010.

The home infusion therapy segment involves the administration of drugs or nutrients directly into the body intravenously through a needle or catheter. Infusion therapy services also include administering enteral nutrients directly into the gastrointestinal tract through a feeding tube. The growth in home infusion therapy revenue resulted primarily from an increase in the overall volume of specialty drugs, enteral nutrients, and core drugs.

EBIT for the home infusion therapy segment in the three months ended September 30, 2011 was $33.4 million, compared to $31.6 million in the three months ended September 30, 2010. EBIT was 11.5% of segment net revenues in the three months ended September 30, 2011, compared to 12.4% of segment net revenues in the three months ended September 30, 2010. The decrease in EBIT as a percentage of net segment revenues from 12.4% for the three months ended September 30, 2010 to 11.5% for the three months ended September 30, 2011 is primarily due to a decrease in the gross profit as a percentage of segment net revenues due to an increase in specialty revenues as a percent of infusion therapy segment net revenues and an increase in the provision for doubtful accounts as a percentage of segment net revenues in the three months ended September 30, 2011 compared to the three months ended September 30, 2010.

 

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The following table provides a reconciliation from net income to EBIT:

 

(in thousands)

   Three Months Ended September 30, 2011     Three Months Ended September 30, 2010  
   Home Respiratory
Therapy
and
Home Medical
Equipment
    Home
Infusion
Therapy
     Total     Home Respiratory
Therapy
and
Home Medical
Equipment
     Home
Infusion
Therapy
     Total  

Net (loss) income

        $ (4,687         $ (105

Interest expense, net

          33,541              32,369   

Income tax (benefit) expense

          (6,890           2,476   
       

 

 

         

 

 

 

EBIT

   $ (11,415   $ 33,379       $ 21,964      $ 3,129       $ 31,611       $ 34,740   
       

 

 

         

 

 

 

Nine Months Ended September 30, 2011 and 2010

Net Revenues. Net revenues in the nine months ended September 30, 2011 were $1,698.0 million, compared to $1,553.1 million in the nine months ended September 30, 2010, an increase of $144.9 million or 9.3%. Revenue for the nine months ended September 30, 2011 increased primarily due to an increase in home infusion therapy segment revenue and the previously announced acquisition of Praxair assets. The revenue increase was partially offset by the non-renewal or termination of, or changes to, certain payor contracts among other factors.

We expect to continue to face pricing pressures from Medicare and Medicaid as well as from our managed care customers as these payers seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See “Business—Government Regulation.”

Gross Profit. Gross profit margin is defined as total net revenues less total costs of total net revenues divided by total net revenues. The gross profit margin for the nine months ended September 30, 2011 was 59.2%, compared to 60.1% for the nine months ended September 30, 2010. The decline in gross profit margin percentage is primarily due to an increase in the revenue of the home infusion therapy segment as a percent of total net revenue and a decrease in the home infusion therapy segment margin percentage due to an increase in specialty revenue as a percent of infusion therapy segment net revenue. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenue than the home respiratory and home medical equipment segment.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on management’s estimate of the net realizable value of accounts receivable. Accounts receivable estimated to be uncollectible are provided for by computing a required reserve using estimated future cash receipts based on historical cash receipts collections as a percentage of revenue. In addition, management adjusts for changes in billing practices, cash collection protocols or practices, or changes in general economic conditions, contractual issues with specific payors, new markets or products. The provision for doubtful accounts, expressed as a percentage of total net revenues, was 3.0% and 2.6% in the nine months ended September 30, 2011 and September 30, 2010, respectively. In late 2010, based upon a review of key outsourcing initiatives, we determined that certain outsourced billing and collections functions should instead be performed by us and we are currently transitioning such functions back to our operations in the United States. The increase in the provision for doubtful accounts in the nine months ended September 30, 2011 is the result of unfavorable collections experience occurring in the nine months ended September 30, 2011 primarily due to the transition of our previously outsourced billing and collections process back to Apria personnel and the impact of a major payor using an intermediary.

Selling, Distribution and Administrative Expenses. Selling, distribution and administrative expenses are comprised of expenses incurred in direct support of operations and those associated with administrative functions. Expenses incurred by the operating locations include salaries and other expenses in the following functional areas: selling, distribution, clinical services, warehousing and repair. Many of these operating costs are directly variable with revenue growth patterns. Some are also very sensitive to market-driven price fluctuations such as facility lease and fuel costs. The administrative expenses include overhead costs incurred by the operating locations and regional and corporate support functions. These expenses are generally less sensitive to fluctuations in revenue growth than operating costs.

Selling, distribution and administrative expenses were $907.5 million, or 53.4% of total net revenues, for the nine months ended September 30, 2011, compared to $787.7 million, or 50.7% of total net revenues, for the nine months ended September 30, 2010.

 

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Selling, distribution and administrative expenses increased by $119.8 million for the nine months ended September 30, 2011, compared to the nine months ended September 30, 2010. The increase was comprised of a $94.8 million increase in labor and related expenses and a $25.0 million increase in other operating expense.

The increase in labor and related expenses of $94.8 million was primarily due to an increase in salaries and related benefits resulting from headcount increases associated with our decision to return certain outsourced functions relating to documentation, billing and collections back to Apria personnel, increases in headcount as a result of the acquisition of Praxair assets, growth in infusion headcount to support growth in our infusion revenue, growth in our respiratory therapy and home medical equipment sales force and higher management incentive compensation expense as a result of meeting certain targets in 2011 that were not met in 2010.

The increase in other operating expenses was $25.0 million, of which $13.3 million related to the acquisition of Praxair assets. Of the $13.3 million, $6.2 million of costs related primarily to the closing of certain Praxair facilities and professional fees associated with the acquisition. The remaining $11.7 million increase was primarily due to an increase in costs related to delivery.

Amortization of Intangible Assets. Amortization of intangible assets was $3.4 million and $3.8 million in the nine months ended September 30, 2011 and September 30, 2010, respectively.

Interest Expense. Interest expense increased $1.1 million, or 1.1%, to $99.1 million in the nine months ended September 30, 2011 from $98.0 million in the nine months ended September 30, 2010.

Interest Income and Other. Interest income and other decreased to $0.1 million for the nine months ended September 30, 2011, from $0.6 million for the nine months ended September 30, 2010.

Income Tax Benefit. Our overall effective tax rate is the ratio of our tax expense (benefit) over our pre-tax income (loss) for the reporting period. Our tax expense (benefit) is comprised of two items: (1) the tax computed using an Estimated Annual Effective Tax Rate (“EAETR”) and (2) certain tax charges and benefits which are recognized on a discrete basis in the interim period in which they occur.

Our EAETR is determined by taking into account estimated pre-tax income (loss) and permanent book/tax differences. Our EAETR is applied to year-to-date pre-tax income (loss) at the end of each interim period to compute a year-to-date tax expense (or benefit). Significant differences in our EAETR compared with statutory rates can arise from permanent book/tax differences as a percentage of our estimated pre-tax income (loss).

Our effective tax rate was a benefit of 37.4% for the nine months ended September 30, 2011, compared with an expense of 54.7% for the nine months ended September 30, 2010. Differences in our effective tax rate compared with federal and state statutory rates stem primarily from the tax rate impact of non-deductible equity compensation and certain discrete items.

During the nine months ended September 30, 2011, net tax benefits totaling $3.0 million were recognized, on a discrete basis, which resulted in an increase to our effective tax rate above our EAETR. The $3.0 million primarily relates to the release of tax contingency accruals due to a change in tax rules regarding an uncertain tax position (“UTP”) and the expiration of the statute of limitations for other UTPs.

During the nine months ended September 30, 2010, net tax benefits totaling $2.8 million were recognized, on a discrete basis, which resulted in a reduction to our effective tax rate below our EAETR. The $2.8 million primarily relates to the release of tax contingency accruals due to the completion of certain state tax audits.

Our provision for income taxes is based on expected income, permanent book/tax differences and statutory tax rates in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining the provision for income taxes. We are routinely under audit by federal, state or local authorities regarding the timing and amount of deductions, allocation of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately reflect our potential obligations.

Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized.

 

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In determining the necessity and amount of a valuation allowance, all available information (both positive and negative) is considered and analysis is performed to determine the appropriate weight that should be afforded to available objective and subjective evidence. Cumulative losses in recent years are considered significant negative evidence which could result in the accrual of a valuation allowance against deferred tax assets.

We have not sustained a cumulative book loss over the three-year period ended September 30, 2011 (after adjusting for the impact of certain non-recurring historical items which are not indicative of our ability to generate future income).

Based on available information, we have concluded that a valuation allowance against federal deferred tax assets was not required at September 30, 2011. We will continue to assess the need for a valuation allowance as additional information becomes available.

Segment Net Revenues and EBIT

The following table sets forth a summary of results of operations by segment:

 

($ in thousands)

  Nine Months Ended
September 30, 2011
    Percentage of
Net Revenues
    Nine Months Ended
September 30, 2010
    Percentage of
Net Revenues
 

Net revenues:

       

Home respiratory therapy and home medical equipment

  $ 862,040        50.8   $ 821,666        52.9

Home infusion therapy

    835,925        49.2        731,402        47.1   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total net revenues

  $ 1,697,965        100.0   $ 1,553,068        100.0
 

 

 

   

 

 

   

 

 

   

 

 

 

 

($ in thousands)

   Nine Months Ended September 30, 2011  
   Home Respiratory
Therapy
and Home Medical
Equipment
    Percentage of
Segment
Net Revenues
    Home Infusion
Therapy
     Percentage of
Segment
Net Revenues
    Total  

EBIT

   $ (43,627     (5.1 )%    $ 86,483         10.3   $ 42,856   
      Nine Months Ended September 30, 2010  

($ in thousands)

   Home Respiratory
Therapy
and Home Medical
Equipment
    Percentage of
Segment
Net Revenues
    Home Infusion
Therapy
     Percentage of
Segment
Net Revenues
    Total  

EBIT

   $ 21,687        2.6   $ 81,118         11.1   $ 102,805   

We allocate certain expenses that are not directly attributable to a product line based upon segment headcount.

See reconciliation of EBIT to net income included at the end of this section.

Home Respiratory Therapy and Home Medical Equipment Segment. For the home respiratory therapy and home medical equipment segment total net revenues increased $40.3 million, or 4.9%, to $862.0 million in the nine months ended September 30, 2011 from $821.7 million in the nine months ended September 30, 2010. Revenues for the home respiratory therapy and home medical equipment segment decreased to 50.8% of total revenue in the nine months ended September 30, 2011 from 52.9% in the nine months ended September 30, 2010.

Home respiratory therapy revenues are derived primarily from the provision of oxygen systems, obstructive sleep apnea equipment, home ventilators, nebulizers, respiratory medications and related services. Revenues from the home respiratory therapy service line increased by 4.8% in the nine months ended September 30, 2011, compared to the nine months ended September 30, 2010. The increase in revenue resulted primarily from increases in sleep apnea and oxygen. Revenue in this service line was positively impacted by the acquisition of Praxair assets and negatively impacted by the termination of or changes to certain payor contracts. In addition, we experienced an increase in sleep apnea volume.

Home medical equipment revenues are derived from the rental and sale of equipment to assist patients with ambulation, safety and general care in and around the home. Home medical equipment revenues increased by 5.4% in the nine months ended September 30, 2011, compared to the nine months ended September 30, 2010. The increase was primarily due to an increase in overall volume. The increase in overall volume was partially offset by a decrease in revenue due to the termination of, or changes to, certain payor contracts.

 

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EBIT for the home respiratory therapy and home medical equipment segment in the nine months ended September 30, 2011 was a negative $43.6 million, compared to a positive $21.7 million in the nine months ended September 30, 2010. The negative EBIT was 5.1% of segment net revenues in the nine months ended September 30, 2011, compared to positive 2.6% of segment net revenues in the nine months ended September 30, 2010. The decrease in the EBIT as a percentage of segment net revenues from 2.6% for the nine months ended September 30, 2010 to a negative 5.1% in the nine months ended September 30, 2011 is primarily due to increases in the provision for doubtful accounts primarily due to the outsourcing of our billing and collections process and in the sales, distribution and administrative costs as a percentage of net revenues in the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $104.5 million, or 14.3% to $835.9 million for the nine months ended September 30, 2011 from $731.4 million in the nine months ended September 30, 2010. Revenues for the home infusion therapy segment increased to 49.2% of total revenue in the nine months ended September 30, 2011 from 47.1% in the nine months ended September 30, 2010.

The home infusion therapy segment involves the administration of drugs or nutrients directly into the body intravenously through a needle or catheter. Infusion therapy services also include administering enteral nutrients directly into the gastrointestinal tract through a feeding tube. The growth in home infusion therapy revenue resulted primarily from an increase in the overall volume of specialty drugs, enteral nutrients, and core drugs.

EBIT for the home infusion therapy segment in the nine months ended September 30, 2011 was $86.5 million, compared to $81.1 million in the nine months ended September 30, 2010. EBIT was 10.3% of segment net revenues in the nine months ended September 30, 2011, compared to 11.1% of segment net revenues in the nine months ended September 30, 2010. The decrease in EBIT as a percentage of net segment revenues from 11.1% for the nine months ended September 30, 2010 to 10.3% for the nine months ended September 30, 2011 is primarily due to a decrease in the gross profit as a percentage of segment net revenues due to an increase in specialty revenues as a percent of infusion therapy segment net revenues and an increase in the provision for doubtful accounts as a percentage of net revenues in the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010.

The following table provides a reconciliation from net income to EBIT:

 

(in thousands)

   Nine Months Ended September 30, 2011     Nine Months Ended September 30, 2010  
   Home Respiratory
Therapy
and
Home Medical
Equipment
    Home
Infusion
Therapy
     Total     Home Respiratory
Therapy
and
Home Medical
Equipment
     Home
Infusion
Therapy
     Total  

Net (loss) income

        $ (35,148         $ 2,458   

Interest expense, net

          99,028              97,377   

Income tax (benefit) expense

          (21,024           2,970   
       

 

 

         

 

 

 

EBIT

   $ (43,627   $ 86,483       $ 42,856      $ 21,687       $ 81,118       $ 102,805   
       

 

 

         

 

 

 

Liquidity and Capital Resources

Our principal source of liquidity is our operating cash flow, which is supplemented by our Amended ABL Facility (as defined below), which provides for revolving credit of up to $250.0 million, subject to borrowing base availability. In recent years, we have generated operating cash flows in excess of our operating needs, which has afforded us the ability to pursue acquisitions and fund patient service equipment purchases to support revenue growth. We believe that our operating cash flow, together with our existing cash and cash equivalents, and Amended ABL Facility, will continue to be sufficient to fund our operations and growth strategies for at least the next 12 months.

In the nine months ended September 30, 2011, our free cash flow was $(22.3) million. For the nine months ended September 30, 2010 our free cash flow was $9.4 million. See discussion below on changes in the components of free cash flow; net cash provided by operations and purchases of patient service equipment and property, equipment and improvements. Free cash flow is a financial measure which is not calculated in accordance with GAAP. Free cash flow is defined as cash provided by operating activities less purchases of patient service equipment and property, equipment and improvements, exclusive of effects of acquisitions. It is presented as a supplemental performance measure and is not intended as an alternative to any other cash flow measure calculated in accordance with GAAP. Further, free cash flow may not be comparable to similarly titled measures used by other companies.

 

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A table reconciling free cash flow to net cash provided by operating activities is presented below:

 

(in thousands)

   Nine Months Ended
September 30, 2011
    Nine Months Ended
September 30, 2010
 

Reconciliation — Free Cash Flow:

    

Net (loss) income

   $ (35,148   $ 2,458   

Non-cash items

     166,830        165,571   

Change in operating assets and liabilities

     (39,900     (73,991
  

 

 

   

 

 

 

Net cash provided by operating activities

     91,782        94,038   

Less: Purchases of patient service equipment and property, equipment and improvements

     (114,089     (84,682
  

 

 

   

 

 

 

Free cash flow

   $ (22,307   $ 9,356   
  

 

 

   

 

 

 

Cash Flow. The following table presents selected data from our consolidated statement of cash flows:

 

(in thousands)

   Nine Months Ended
September 30, 2011
    Nine Months Ended
September 30, 2010
 

Net cash provided by operating activities

   $ 91,782      $ 94,038   

Net cash used in investing activities

     (137,405     (62,888

Net cash used in financing activities

     (5,587     (37,515
  

 

 

   

 

 

 

Net decrease in cash and equivalents

     (51,210     (6,365

Cash and equivalents at beginning of period

     109,137        158,163   
  

 

 

   

 

 

 

Cash and equivalents at end of period

   $ 57,927      $