Tenet Healthcare Corp
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Tenet Healthcare Corp
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Good day. And welcome to the Tenet 3Q 2018 Earnings Call. As a reminder, today's call is being recorded.
At this time, I would like to turn the call over to Brendan Strong, Vice President of Investor Relations. Please go ahead.
Good morning. The slides referred to in today's call are posted on the company's website. Please note the cautionary statement on forward-looking information included in the slides.
In addition, please note that certain statements made during our discussion today constitute forward-looking statements. These statements relate to future events including, but not limited to, statements with respect to our business outlook and forecasts, our future earnings and financial position. These forward-looking statements represent management's current expectations, based on currently available information, as to the outcome and timing of future events but, by their nature, address matters that are uncertain. Actual results and plans could differ materially from those expressed in any forward-looking statement.
For more information, please refer to our Risk Factors discussed in Tenet's most recent Form 10-K and subsequent SEC filings. Tenet assumes no obligation to update any forward-looking statements or other information that speak as of their respective dates, and you are cautioned not to put undue reliance on these forward-looking statements.
I'll now turn the call over to Ron Rittenmeyer, Tenet's Executive Chairman and Chief Executive Officer. Ron?
Thanks, Brendan, and good morning and thanks for joining us. Before Dan dives into the details, I thought I'd take a few minutes and put the quarter into context from my perspective.
As you saw in the materials we posted yesterday afternoon, adjusted EBITDA came in within the range we projected but at the lower end of the range, while EPS was $0.29, which was above the higher end of our range and above consensus of $0.13. My view as CEO is that we had a solid quarter in Conifer and USPI, and we fell short in hospital operations. There are several puts and takes that impacted the overall number, and we've added some detail this time in our presentation materials on slides 5 and 6 to summarize the larger items impacting year-over-year comparability and Dan will spend some time on that.
First, allow me to take a few minutes so I want to add some color to those comments and statistics. On a normalized basis, adjusted EBITDA grew 2.8% this quarter. Ambulatory grew adjusted EBITDA less facility-level NCI by 11.5%.
Conifer improved its margins over 200 basis points this quarter. The hospital segment while up for the year declined 2.9% in the third quarter. Make no mistake, growth and operational excellence are my top priorities as it relates to hospital operations. While we had some headwinds in all the malpractice settlements this quarter, as well as an impact from prior hospital divestitures, our growth is not acceptable.
When we look at the quarter, 14 to 21 markets had positive adjusted admissions which we believe follows the trends we see in outpatient services. And we also noted that we had a shift into a greater number of observation cases, from inpatient cases which has a negative impact on admissions and suggests we're not really losing share, we're rather having a shift in share and we're looking into that deeper.
Detroit, which has been a topic discussed in the past remains a headwind but we have noted improvements and we expect these trends to continue. Detroit remains a very important market and we do see improvements in admissions and are noting that the environment has begun to stabilize.
We remain confident that Detroit is a very good market for Tenet and while our expectations is that volume challenges will persist in Detroit as we rebuild this market for the next several quarters, we believe we're on a path to restore organic growth in Detroit.
As I said, I and my team are not satisfied with our growth. And while we have noted, we have seen a shift to observation in outpatients from inpatients and some headwinds in a few markets, we are not stating excuses versus what we see as opportunities to make appropriate corrections.
We have increased marketing efforts at the local level with the marketing programs tailored to the specific market and community. In Detroit, for example, it is built on a theme of a community built on care. This campaign uses our employees, physicians, nurses, et cetera, to drive this message at the grassroots level using radio, billboards, bus wraps, speaking at community events, speaking in local churches. Each hospital has a tailored program directed to its community and the services needed. This is a clear departure from our past and we are expanding in selected markets to position us as a much stronger part of the community.
We have focused our resources on a hospital-by-hospital basis, on service lines, growth strategies, quality, weekly performance reviews, among other items. We're going to support this with appropriate amounts of capital and further build-out of our outpatient offerings with new micro hospitals, off-campus EDs and urgent care centers, as I've stated in the past.
In our Ambulatory segment, USPI's financial performance was strong in this quarter with adjusted EBITDA less facility-level NCI up 11.5%. This was driven by solid performance both in the surgical and non-surgical areas of the business. Overall, a great quarter and we feel very good about our position in the market and as part of our overall portfolio.
Conifer has improved its margins over 200 basis points this quarter and this should continue. The team has done a tremendous job improving their structure and the dramatic improvement in Conifer's margin underscores the value we created in a very short period of time. I continue to be pleased with the improvements in Conifer's performance and we continue to develop a stronger commercial engine to develop additional revenue opportunities in the future.
In terms of portfolio activities since we last spoke, we completed the sale of Aspen Healthcare in UK in August. We continue to target the Chicago closing and the remaining health plan for the fourth quarter. Last week, USPI formed a new joint venture with INTEGRIS and the HPI Community Hospital Group in Oklahoma City. As part of this transaction, USPI now has an ownership position in two additional surgical hospitals bringing our total number of surgical hospitals to 23.
USPI also announced a joint venture with a new healthcare partner Tower Health to expand access to care for patients in Southeastern Pennsylvania. We have deployed roughly $130 million on the Ambulatory acquisitions to the third quarter and will be between $225 million and $250 million by the end of the year. This will provide a nice tailwind to USPI's growth in 2019.
Now, I'd like take a second and talk about the Conifer process. Over the last year we have made significant progress at Conifer. We made a number of changes within the business that it has enabled us to substantially improve performance including driving adjusted EBITDA growth of 32% year-to-date. At the same time, we have invested time and energy into the exploration of a potential sale of the business. We are now down to a very few viable participants. And while I realize many believe we should have accomplished this faster, our commitment to the shareholders is to do it right. This process has been very deliberate and has raised other opportunities that we are now actively evaluating for Conifer that could deliver more value to our shareholders than an outright sale. That includes strategic alternatives such as a merger, a tax efficient spin-off, or even a combination of alternative transactions.
And by the way, while this is taking some time, the improvement in Conifer's performance from when this started to today has been worth the investment as we did not allow this time to go to waste. We need to close out this process and I believe we are now in the late stages.
By taking the time to construct the new contract for Tenet and Conifer and explore in detail the options I mentioned, the final decision will be the right one for Conifer and our shareholders.
Before I conclude, I'd like to also provide a few thoughts on 2018, some early perspective on 2019 for the enterprise. We are going to lower our EBITDA outlook for 2018 to reflect the challenges that we faced in the hospital segment this quarter and which we expect will continue somewhat into the fourth quarter.
Even with this, based on where we are with our business planning process, we expect to grow adjusted EBITDA in the 3% to 5% range in 2019, which positions us to deliver results in 2019 that are consistent with consensus expectations.
And we expect to deliver 46% EBITDA growth to Conifer. We have more work to do over the next months to finalize our business planning process for 2019 and we'll provide our full outlook when we release our fourth quarter results in February.
With that, I'm going to turn it over to Dan and I'll have some closing comments. Dan?
Thank you, Ron, and good morning, everyone. We generated $577 million of adjusted EBITDA in the quarter, below the level that we wanted to achieve but within our range of expectations.
As outlined on slide 5, on a normalized basis, we grew EBITDA 2.8% this quarter, and we anticipate delivering 8% to 10% normalized EBITDA growth this year. Adjusted EPS was $0.29 and was above the high-end of our range for the quarter with lower NCI offsetting the lower EBITDA. Our hospital segment delivered $312 million of EBITDA, which was up $43 million year-over-year but down 2.9% after you normalize for the items listed on slide 6.
Ambulatory EBITDA was $184 million, a year-over-year increase of 15.7% and EBITDA less facility-level NCI was $116 million, up 11.5%. Conifer's EBITDA rose to $81 million with margins up 210 basis points. And adjusted free cash flow was $512 million in the first nine months of this year, a $200 million improvement over last year.
Turning to hospital volumes, which are summarized on slide 7, adjusted admissions were up 0.3% and admissions were down 2.1%. As we discussed on our earnings call last quarter, we have closed various subscale margin dilutive services at a number of hospitals, this lowered adjusted admissions 30 basis points and admissions by 40 basis points. Continued softness in Detroit also lowered our admissions and adjusted admissions by 70 basis points. After normalizing for Detroit and service line closures, adjusted admissions were up 1.3% and admissions were down 1.0% this quarter.
Revenue per adjusted admission increased 5.7%, or 3.6% if you adjust for the California Provider Fee revenue. Overall, cost per adjusted admission increased 3.9% this quarter.
SW&B only increased 0.9%, and supply expense was up 4.6%. Similar to recent quarters, supply costs were up due to acuity growth, including strong growth in high-intensity cardiovascular procedures.
Other operating expenses were up 9.5% per adjusted admission, primarily due to increased malpractice expense and about $20 million of losses on the risk-based contracts in California. These items were partially offset by a $16 million gain from the sale of an asset.
As shown on slide 6, we anticipate our losses on these risk-based contracts will be smaller going forward with about a $5 million loss in the fourth quarter and even lower on a quarterly basis in 2019. As you think about these three items impacting other operating expenses, we did not forecast the $20 million of losses on risk-based contracts, or the $16 million gain on asset sale. Also, malpractice expense was about $30 million more than we had anticipated in our Q3 forecast, which was a key reason why our results were lower than we had anticipated this quarter.
Moving to our Ambulatory business on slide 8, USPI's growth remains strong with surgical revenue up 6.6% this quarter. Cases were up 4% and revenue per case increased 2.5%. Starting in the third quarter, these growth rates now exclude Aspen which we sold in August.
In the non-surgical business, which consists of USPI's urgent care and imaging centers, revenue growth was strong again this quarter, up 9.4%.
As shown on slide 9, adjusted EBITDA less facility-level NCI increased 11.5%, consistent with the 11% growth that we anticipate for the full year. As Ron mentioned, we expect USPI to deploy $225 million to $250 million on acquisitions this year, providing a strong foundation for USPI's continued growth next year.
Moving to Conifer on slide 10, as a result of divestitures by Tenet and other customers, Conifer's revenue was down 7.5% this quarter. Despite this, margins improved 210 basis points, resulting in EBITDA of $81 million which was in line with our expectations. And margin should be up by more than 300 basis points in the fourth quarter compared to last year. We remain confident in Conifer's value proposition and long-term growth prospects. We expect additional margin improvement at Conifer next year, leading to EBITDA growth of 4% to 6% in 2019.
Turning to slides 11 through 13, you will note that we lowered the midpoint of our full-year adjusted EBITDA outlook by $50 million. This is due to a $60 million reduction for the hospital segment, primarily due to the risk-based contract losses and additional malpractice expense, partially offset by $10 million increase in the Ambulatory segment. Our outlook on Conifer's EBITDA has not changed.
Turning to cash flows, we lowered our range for adjusted free cash flow to $600 million to $800 million reflecting the reduction in EBITDA and a change in the timing of anticipated payments from the Provider Fee Programs in California and Michigan.
In the fourth quarter, we expect to realize approximately $100 million of proceeds from divestitures, and we anticipate investing about $100 million to $125 million for Ambulatory acquisitions. We paid off another $38 million of debt this quarter and expect to retire another $30 million through open market repurchases in the fourth quarter. And our leverage ratio at the end of the quarter was 5.70.
In summary, our hospital results did not meet our expectations. However, USPI and Conifer delivered strong results. Company-wide, we anticipate normalized EBITDA growth of 8% to 10% this year. And finally for 2019, we expect to grow EBITDA in the 3% to 5% range from our 2018 outlook range.
Let me now turn the call back to Ron.
Thanks, Dan. In closing, I'd like to make a few comments that I believe are relevant to where we are as a company. This year, we made some noteworthy strides, most of which were outlined on slide 14. First, we lowered our rates of hospital-acquired infections by evaluating and implementing standardized, proven, and effective methods for preventing infections. Since January, we've seen an 18% decline in this area and we've improved our patient experience score by 70 basis points with 7 of our 9 groups delivering improved levels of patient experience.
In expense management, we obviously have instituted a much sharper approach and we are operating with more discipline and rigor. If you recall, we started with $150 million reduction, then we later identified an additional $100 million. We are on track to deliver the full annualized run rate of $250 million by the end of the year.
Our portfolio is also improving. Since last November, we've exited non-core operations, including divesting eight hospitals and related outpatient centers, nine facilities in the UK, additional home, health and hospice assets, and other non-core businesses. We've also closed four OB programs, five behavioral health programs, all of which were subscale and margin dilutive.
At the same time, we built or bought 30 outpatient centers, including urgent care centers, off-campus EDs and surgery centers in prime locations. And we completed our buy-up of USPI to 95%, still lowering our leverage ratio.
Governance of the company has improved. 50% of our board is new since around this time last year and we've added important experience and fresh perspective, as well as improving diversity. We amended our by-laws to include a special meeting right, adding an important shareholder-friendly provision to our policies and practices. And we will have and will continue to engage frequently with shareholders and solicit their feedback on a wide range of topics, including strategy, performance and governance.
We've enhanced our leadership team. Since last November in the top corporate leadership ranks across the enterprise, we've transitioned or realigned roles and responsibilities. We eliminated roles that were duplicative and we've eliminated entire management layers. We changed our positions due to performance and we've taken our best people and promoted them. This is happening in our corporate functions and throughout our operation.
To provide a little context, we've transitioned approximately 20% of our corporate leaders and one-third of our hospital leaders. These may not be the names and faces you know, but they are the people that, I and the members of my team, count on to deliver results.
And today, we announced a very important promotion at USPI, Brett Brodnax has been named CEO of USPI, succeeding Bill Wilcox, who will continue his role as Chairman of USPI and the Vice Chairman of Tenet.
Brett was part of the original USPI team joining the company from Baylor in 1999. He's earned deep respect from physicians in health systems and also, internally, from his colleagues given his work to shape the company's culture of top notch service and quality. I'm confident the USPI will continue to thrive under Brett's leadership.
And Bill has done a terrific job at USPI. He drove incredible performance and built its legacy. We're very grateful to him for his many years of service, and I look forward to his guidance and contribution in his role as Vice Chairman of Tenet, as we work to integrate our operations and instill a stronger culture of performance.
As we look into the balance of the year and moving to 2019, we are prioritizing growth initiatives with each area of the business. As summarized on slide 15, we're going market-by-market in our hospital business. We're leveraging what works well and addressing areas for improvement and making changes that are needed.
At USPI, we are positioned to serve the seasonal increase in demand for surgical services in the last two months of this year, and we're adding to our portfolio through acquisitions and joint ventures.
And at Conifer, we have delivered tremendous value. Right now, we are focused on top line growth, expanding our client base and improving client services.
So net, I expect us to continue improving and addressing admissions, quality, service and to provide the returns we should be expected to achieve. It is not without headwinds but they are not an excuse but rather an opportunity. Not easily overcome in many cases, but they are also not going to stop the improvements we're making.
So with that, I'll close this section and operator, we can turn it over for questions now. Thank you.
Thank you. We will take our next question from Ralph Giacobbe of Citi. Please go ahead. Your line is now open.
Thanks. Good morning. Hoping we could start with some of the – with some investment (22:37) factors in the quarter. The risk based contracts first. Can you give us a sense of maybe the revenue contribution from these arrangements, how long the contracts run, your ability to exit and then sort of what happened I guess in the quarter for you to take the losses?
Good morning, Ralph. This is Dan. Let me address that. The risk based business that we're referring to where these losses emanated from is in Southern California. And we've had that business for a number of years and it's been a solid business.
Just a little bit of background on it. Generally speaking, the business, it's an IPA related type business, negotiates and enters into contracts with plans and then manages the population a lot, whether they're cared for at a hospital, including some of our hospitals or physician offices or other care settings. Based on the claims, the experience that we've seen this year, there's been a deterioration in the claims trends, and it could be attributable to a number of different things as you can imagine. These are risk-based capitation-related contracts where you're paid a fixed amount for each life per member per month. And between some of the higher acuity, that's been incurred, specialty mix and other items such as ESRD type of patients, they tend to drive incremental claim dollars, and that's what we've seen.
And so, based on where we're at with our experience this year, we had to address this in the quarter and that was the driver of the – about the $20 million of losses. We are fully evaluating the business on a going-forward basis; we're evaluating all the contracts, where we can if it makes sense we will terminate contracts if necessary. But we're evaluating the business if it makes sense going forward, and if it doesn't we will exit that business and sell it.
Okay. Can you give us a sense of the revenue base?
It's about $100 million or so.
Okay. That's helpful. And then you attributed some of the lower outlook to, I guess, your payer mix expectations. I just wanted to get a little more details there. The pricing is steady (25:23) even ex the California Provider Fee looked pretty healthy. So, I just want a little more context on sort of payer mix and what's driving those pressures, so if you can help flesh out what you're seeing there?
Yeah. So, let me – let me – I'll address the payer mix, but let me provide a little context. So, in terms of the reduction in the hospital segment outlook, it's largely attributable to, as we mentioned in our release, to these losses related to these contracts, that risk-based plan, as well as incremental malpractice expenses we've encountered. As well as some – there is a portion related to payer mix, the trends there. You may have noticed uninsured volumes are up higher than we obviously would prefer and just some of the mix between commercial book of business as well.
So, we're on it. We have a number of different growth strategies at each and every hospital and all the markets. Where we need to make leadership changes, we're doing that. But based on where we're at right now with some of the trends that we felt it was prudent to adjust the guidance at this point.
Okay. All right. Thank you.
We will now take our next question from Ann Hynes of Mizuho Securities. Please go ahead. Your line is open.
Hi. Thanks. Ron, you mentioned that part of the Conifer sale, you reworked your contract with Conifer and Tenet. Can you go into a little bit of detail about what was changed to try to get that process, the sale process or strategic process moving forward?
Well, the contract between Tenet and Conifer doesn't really move the process forward. I mean, we have to have a new contract, this one expires. The one we've got, we could renew the current one on a month-over-month basis. But the reality is we've spent a lot of time on that contract, developing that during the process. And so, we're going forward with that contract. At this point, I'm not comfortable talking about that publicly given where we are. So, I would just say that the contract clearly has the things that you expect. We've looked at pricing and adjusted pricing appropriately and we consider all that as we look forward on Conifer's performance. We've also put in a series of standards that they have to achieve, a heavy focus on cash and some other areas that we expect them to perform to.
I think we have also, in the last year, really done a much better job of closing the gap between Conifer's performance and the things that we measure. You know we have really begun the shift from Conifer measuring what they think is good performance versus we expect the measurement to be done by the clients.
So, good performance needs to be defined by the customer, not by Conifer. And there was, I think, a little mix there that we needed to fix and we've done that in this process. So, all I would say is the contract is very balanced, it's arm's length like it's supposed to be. And I think it provides Conifer with upside and it provides Tenet with the appropriate protections to get its cash collected and for them to execute the mission that they are supposed to be doing. I think that's probably the best way I could describe it at this point.
All right. Thanks. And any update on potential divestiture program? It's something that you've highlighted a lot in past presentations.
Other than – I mentioned in the thing that we're getting close to finalizing the ones that we publicly have talked about, we're not going to publicly announce divestitures going forward. I would tell you that there is a divestiture program always in play. We're always looking at our operations. We're always looking at whether or not they still strategically fit. I know that sounds like a lot of words but it is the kiss of death to start telling you, we're going to divest hospital A, B, or C or this type of business because then we – as we've proven in the past, performance is very difficult obviously to maintain when you've made those statements. It's hard to retain staff, doctors, et cetera and unless you have a deal signed, it's almost a impossible ball to catch.
So, I don't want to create more turmoil to that. I think we've done that in the past. I don't think that's a good business posture for us going forward. But I would tell you that there is an active view where we continually go look at profitability. Just take a look at the service lines we've closed. We've been reasonably aggressive this year taking out service lines that are margin dilutive. We are going to continue to look at our assets, whether it's at USPI or at Tenet on the basis of whether or not they're still providing the type of return we want or is it better to move some of those assets, bring cash in, pay down debt and or redeploy to other assets.
So, that's a process that, I guess, the only way, I'd say is a reasonably active and ongoing effort that we continually work at and we evaluate every call we get when people call in asking us if expressing an interest to see if that interest makes better sense than what we're actually doing. So, it's kind of a glib comment that everything is for sale to some degree. I mean, you do what you need to go do and I think the only concern I've got here is just mentioning locations that we're actively looking at just because I think it is a – it's a bite – you get a big bite later, if you're not careful with that.
Yeah. Okay.
So, that's the best I can give you.
Thanks.
Sure.
We will now take our next question from Josh Raskin of Nephron. Please go ahead. Your line is open.
Hi. This is Rachana on for Josh. And thanks for the question. Ron, you highlighted a number of ongoing initiatives to improve hospital operations. So, how should we think about CapEx spend for 2019? Also, could you give us a timeframe to fully stabilize the Detroit assets?
Good morning. This is Dan. Let me – I'll address the capital expenditures, certainly when we're talking about this year, for 2018 on a consolidated basis, estimated capital expenditures of $650 million. In terms of next year, we haven't obviously gone out with that level of detail yet. But now, I would say that capital will probably be in that neighborhood next year. We're obviously focusing our capital from the hospital perspective on high-acuity service lines, increasing patient access sites, freestanding EDs, micro hospitals, urgent care business, all again to drive additional access points to improve our hospitals' patient care in our markets, and drive growth in the hospital business.
Certainly, we'll continue to invest capital in the USPI business. I mentioned in our remarks, we'll probably invest about $225 million to $250 million this year. The pipeline is very, very strong in the surgical business. And so, we'll come out with exactly where we think we'll be next year in USPI when we – on our February call. But certainly, the levels that we've been investing over the past several years of $125 million, $150 million certainly we'll be at least at those levels. And depending on the opportunities that arise, I mean, we could be a little north of that.
At Conifer, certainly it's a low capital type of business. And so, I wouldn't expect any material change in the type of capital that we've been investing in Conifer over the past several years.
Yeah, the only thing I'd add to that is that, the capital is not free, and we are going to be very diligent going forward on spending money where we get a return. There are some things you always – there's some amount of capital for maintenance and things you have to do, which we will always do, and make sure we're putting the type of the focus on our preventive maintenance that means we're spending those dollars appropriately. But beyond that, this is really going to be a focus on greater return, certainly in the hospital business, better returns, and then the stuff Dan talked about. So, I think, that's the only other color I'd add.
Yeah. This is Eric Evans, Josh (sic) [Rachana] (34:54). Your Detroit question, a couple of things to follow up on there. Clearly, Ron mentioned earlier, we've seen stabilization there. You guys know we finalized our Wayne State agreement and our focus there is really – a lot of the basics you just heard about from a business planning perspective. We are investing heavily and increasing our access points in our connection with the community. That's everything from meeting the physician community need that there is there to bring in the right physicians, specialists, primary care to meet the community need, as well as urgent care center access points, we just actually approved our 16th for the city of Detroit.
We've got a big marketing plan, as Ron mentioned, in Detroit that we're also doing in other markets. And look, we have some of the premier assets in the state of Michigan in our Detroit Medical Center, the Children's Hospital of Michigan is the premier children's hospital in the state. The Rehab Institute of Michigan is a really renowned asset. And so, our job is to take the investments we've made in our acute assets and make sure that we are using those to attract the best docs and the best staff, and we're very, very focused on that. And as Ron mentioned, we expect to return to an organic growth number in Detroit in the second half of 2019.
Okay, great. Thank you.
We will now take our next question from A.J. Rice of Credit Suisse. Please go ahead. Your line is open.
Thanks. Hi, everybody. First, maybe to just get you to talk a little more about your 2019 outlook, obviously 3% to 5% growth for this business would seem on the surface to be pretty straightforward and a reasonable range, but you've got a lot of moving parts. Obviously, we've been talking about Detroit. You got your annualized savings of the $250 million that you're exiting the year at, you've got divestitures in Chicago and health plan out in the west, and then you've got – annualizing the acquisitions that you already mentioned USPI among other things that are headwinds and tailwinds. When you think about some of those, maybe if there's some big ones to highlight, is the 3% to 5% growth, what is really the assumption about the core businesses, the assumption of growth there versus the 3% to 5% headline number?
Good morning, A.J. This is Dan. Let me address that. When we think about next year, we feel good about what we think we can deliver. Let me get through some pieces and just to give you a sense of how we're thinking about the math. In terms of – let's start with the Ambulatory business, obviously, performing very well, a number of transactions are coming online recently, we felt very, very good about USPI's ability to continue to grow at the levels that we've seen recently. We'll obviously get into more minutia when we put out the specific guidance, but we feel very, very good about the USPI assets and the continued growth there.
In terms of Conifer, as we've mentioned in our prepared remarks, we think growth there should be 4% to 6% next year. So, you can do the math on that and see where – in Conifer where at least with our initial thinking is, at least for Conifer next year. And you're right about the cost reduction initiatives. We're on track for our $250 million realizing that as we've pointed out. We're going to realize about $195 million or $200 million this year. So there's another $50 million rolling into next year as well.
And so, when you just look at those pieces, you get to that 3% to 5% growth. But listen, on the hospital business, we are optimistic that we have good opportunities to grow our hospital business next year. We obviously have had some issues this year that we've been addressing, but there's a lot of opportunities where you have those type of issues or that creates opportunities as well and that's obviously – that's what we're targeting. We think certainly with continued strong cost management as well as we feel very good in terms of from a pricing next year, we have – next year is already about 80% contracted from a commercial book of business, so we feel real good about our pricing there.
In terms of Medicare, you've obviously seen the recent updates there. It's about 2% next year, so we have good sense of where Medicare is obviously at. Outpatient just came in, and about 1% for us next year. So, cost management, pricing, we feel real good about. We obviously have work to do to grow volumes in the hospital business and that's what we're targeting. And that will be incremental to those other items that I mentioned. The USPI growth, the Conifer growth, as well as the growth that would come from additional cost actions.
Okay, great. Let me just – for the follow up, go back to the commentary around Conifer. I guess as you guys have broadened the discussion about what you might consider, I think my focus maybe – and I think maybe some of the investment community has been more on, okay, what kind of dollars can you realize upfront from this transaction? And I think it's made me think about there is this aspect if you're going to probably have an ongoing relationship with whatever happens here, they're going to be collecting your dollars in your revenue cycle management.
I wonder if you could flesh out a little bit, you talked about the contract, is that contract in stone or could a new buyer or new entity, if it's a spin-off, whatever, rework the contract, is there potential – some of the people that you're talking to might actually be able to do things that Conifer can't do for you on their own, and that that could get potentially incorporated in the contract? And I'm sure there's a trade-off between upfront and ongoing fee payments, and is that on the table? How do you think about that?
This is Ron. You kind of answered most of those questions, but I'll throw it out this way. The contract is never in stone, right? The contract is written, it's fundamentally in stone. Would we consider, as Tenet, extending the contracts longer? Sure. I mean, it depends on what the deal is when we finally cut it and where we plan to go with that deal and how that plays out. So, yeah, we would consider certain things. I mean, clearly, we're not going to start over and because we have an agreement with Conifer, it's a commercial agreement, it's a good agreement for both sides.
So, it's based on the premise they got to deliver and if they deliver, they get paid. If they deliver above expectations, they get a higher return. If they deliver – and miss expectations, they get a penalty that hurts. There's a reason for that, right, because collecting our cash is very important. I mean, we're married to them. We're going to get a divorce, but we still got to live with them. So, they are a major part of our life going forward. It's not optional at this stage.
So, part of the sale anticipates that a long-term contract will go with it, and that's the value in the deal. So, I think, though you've got to be flexible, we're far enough along that I don't think the things you're bringing up are truly major concerns at this stage that I would worry about because most of that stuff has been discussed and has been talked about. There are nuances to it, but I don't think that that is a strong point, so those concerns (42:55).
Yeah. I was thinking more in terms of an opportunity maybe, is there or are there entities that would look at this or ways you could structure where maybe they can do even more than Conifer can do on their own?
Yeah. Well, sure, I mean that's part of – theoretically, that's part of the deal. I mean, listen, when you're in a negotiation, everybody – the guy you're negotiating with always feels he can give you more and that's why his price should be lower And we just want him to stand against that and support it. So, you kind of get into negotiating tactics here of where we've been, but look at the end of the day, we know the value of the company. This is something I spent a lot of time in my life doing. And both sides have to stand behind what they're saying. So, you can't promise something that doesn't have some skin in it. Otherwise, there's no reason to promise it, right? So...
Right.
...but I think we've made very good progress here and I feel confident that we have those things bracketed at this stage, so.
Okay. Thanks a lot.
We will now take our next question from Sarah James of Piper Jaffray. Please go ahead. Your line is open.
Thank you. You mentioned that you're looking deeper into this shift in share from inpatient to outpatient. So, I wanted to understand how you're tracking that. Is there a way that you can identify the shift to outpatient for specific patients or surgical categories? And then, once you're able to track it, can you talk about how you could utilize that information to benefit growth?
Good morning. This is Eric. So, the shift from inpatient to outpatient, there's a couple of things we mentioned, so I'll break it into a couple of buckets. The first bucket is this, this quarter we saw an increase in our observation patients, which is a patient that is basically, it's a head in a bed in a hospital that is not classified as an inpatient. And so, that is something that's moved around. We see it move from time to time. We had more of an expansion of those types of observation patients this quarter than we've seen and we're looking at that very closely to make sure that we classify the patients in the right level of acuity. And we're confident we have them there. We're just trying to make sure we understand whether this is just a shift for the quarter.
Typically, we see markets that are up and down, and they pretty much cancel each other out. We have a normal trend. So, it's a little different this quarter. So, that is one that we look at very closely.
The second part of that question is just in general, the shift from in-patient to out-patient. And one of the great things about having USPI is that we can work very closely together on making sure that we manage that shift with our medical staff, with our communities, so that when a patient wants to go to a different setting or we have a technology opportunity, that we do that in lockstep with each other and have an opportunity to earn that business.
And so, we do see that as an opportunity. And every year, as you know, the ASC list gets updated with procedures that were used to be only done in hospitals that are now done in the ASC setting. And Brett and I will coordinate very closely on that to ensure that we're well-positioned as that business leaves the hospitals to number one, earn the business in the out-patient setting; and then number two, that we're planning thoughtfully about how we bring in high acuity business in the hospitals that backfills that.
So, it's a movement that's been happening for a long time, and it's one that we have to work very closely with USPI in our markets to make sure that we deal with appropriately.
Got it. And just to clarify, when you talk about backfilling the high acuity in in-patient, consumers are increasingly relying on ratings and reviews to select where they seek treatment for high acuity items. So, how is kind of evolving their investments to attract share gain in high acuity? So, specifically, I'm thinking across hiring decisions, CapEx and marketing spend. Thanks.
Yeah, it's a great question. I mean, clearly, consumerism is taking more hold in healthcare which is exactly why we have to work so closely with USPI and make sure we meet the patient where they want to be treated. This is a big part of our urgent care center strategy. It's a big part of our branding strategy in each local market, how we market high-end service lines. And then of course, as Ron touched on, our confident push for improvement in outcomes and in our patient experience which we are making progress on, we're very, very focused on that.
And we do believe that the increased transparency is driving – and the increased deductibles is driving a lot more power to the consumer. The good news for us is with the premier ambulatory provider in USPI and with our market positions in the markets we're left in, we feel very, very well-positioned to deliver on that going forward.
Thank you.
We will now take our next question from Ana Gupte of Leerink Partners. Please go ahead. Your line is open.
Hey. Thanks, good morning. Yeah. So, the first question I had was on the bridge that you have to get to the adjusted hospital EBITDA, it's like – it come up with $1.4 billion in your deck, but you don't account for the malpractice which is obviously clearly it feels like a one-timer, and then you haven't any adjustment for Detroit.
Can you give us a sense for what the magnitude of those two are? I would think that the adjusted EBITDA would be higher if you took those into account on baseline.
Ana, this is Dan. Let me address that. Yes. We did not include malpractice as a separate line on that schedule or slide six.
As I mentioned in my remarks though, the incremental malpractice costs in the third quarter were roughly about $30 million that were not in our guidance for the quarter. So you could do the math if you want to also add that into your analysis. Again, $30 million over and above what we had factored into our Q3 guidance when we last talked in August.
Okay. So, it'd be $1.43 billion, in which case roughly there – which would – then the EBITDA would, I guess, the headline story would have been more positive, U.S. doctors treating down pretty dramatically. I think, I mean, the feedback from investors is that there was a myth that if you take that out, it looks a lot better than the headline suggested. Is that fair?
As I mentioned, there was $30 million of incremental malpractice to settle various older claims, some of which were older than five years old. And we went through the various components that contributed to the adjustment to our guidance and malpractice was certainly part of it, as well as the risk-based contract losses of about $20 million.
Okay. Okay. That's helpful. Thanks. Then, on the pricing growth and the 2019 expectation that you have, you say the pricing growth sustainable because on a net basis in-patient is outweighing the out-patient. You're incorporating the bad debt issues in there.
When you look at after your portfolio rationalization, where is your capacity utilization at this point? And to what degree with the service line improvements, can you optimize your acuity and/or payer mix in the in-patient setting? And are you seeing any kind of improvement in commercial relative to the other segments?
And so, this is Eric. I'd answer a couple of those questions. So, first of all, when we look forward, capacity utilization still remains. We have, in our remaining markets we have plenty of capacity to support, obviously, our growth perspectives and our capacity utilization is a little higher in the markets that we're keeping obviously than the ones we're getting rid of.
But I would say that from a go forward's perspective, when you think about pricing, we're continuing to focus on high acuity items or high acuity service lines. And so, you're seeing that growth show up in the revenue.
It's the same thing we're seeing in our ERs. If you look at the level one and two visits, they're down slightly. The level four and five, they're up about 3%. So, we continue to expect that acuity is going to drive a fair part of that, along with the managed care agreement terms that we've already negotiated. So, we feel good about the pricing.
From a service line perspective, if you look at the markets we're in, that we have – that we remain in, because of the markets we divested, our market share is up approximately 6 points in those markets. We feel better positioned than ever. 80% of those markets, we're number one or two in, and we're working very closely with Brett to not just be looking at the in-patient market share, but really be thinking about kind of what does the healthcare system look like in the market and we think that positions us well to again grow the high acuity in our hospitals and also grow overall out-patient volume in the USPI assets.
Got it. Thanks for the color.
We will now take our next question from John Ransom of Raymond James. Please go ahead. Your line is open.
Hi. At the risk of having Ron get mad at me, I'm going to ask this question. So, please be gentle. The thing that I'm struggling with a little bit is, when you talk to potential buyers about Conifer, how do you also preserve your flexibility on divestitures without sacrificing too much value? I mean, I assume, it could be as simple as a payout of one price today and a price five years down the road, but how should we think about that?
Really good to hear from you, John. I appreciate the comment or question. It is a good question. That's an interesting – it is an interesting question. It's a negotiation point. We've had buyers that obviously want to approach it with – you've got to guarantee never to do a divestiture. So, we can't do that.
Right.
There's realism here. You've got to – you set – you try to set some floor, some reasonable numbers, some projection based on what you know today and what you believe will happen during – but the other argument is then how do you deal with acquisitions. If we have an acquisition of some business or USPI rolls into that portfolio and gets handled through Conifer, do they then pay us for that, right?
Right.
They probably wouldn't. They would just add it to their volume and et cetera and we'd negotiate a price. So, the ins and outs are, to me, just kind of part of what an outsourcing contract does. In my experience, and again, different industries to some degree, ins and outs are just part of the business, because Conifer's job is to take the base that it owns which is in terms of its customer base which is primarily us and CHI and some others, and then build on that.
And it's going to potentially lose clients over time if they divest a piece of their business, and it's going to benefit every time a client acquires a piece of business. So, I don't – we don't spend a lot of time on this because that's sort of the position we take that the ins and outs are part of a normal outsourcing process. And if you look at outsourcing as a industry, that's typically how it's thought of.
I have found on the hospital side, since I've been here, that it's viewed a little differently because people want security. And the problem in outsourcing is there is no security. Security is only in really performance execution and proving that you can handle more business, and going out looking for every bit of that. So, I don't see it as a major point of turning somebody on or off.
I think that we try to be frank about what's already in the pipeline to be divested, what we know and we make those adjustments. But short of that – because by the way, when we divest the hospitals, it's up to Conifer doing that business. And usually, there's some transitional period of a year, maybe two years in a divestiture. They give them two years to prove that they can do that business or not. Conifer has lost some of that in the past, but they've also retained some of it. So, again, I think that's just part of negotiation. I don't know if that answers your question, but the best way I can think of saying it, so...
No. It's interesting about the two-year transition, so that helps.
Well, some are a year. I mean, it could be less.
Yeah.
It depends on who's buying it, right? So...
Right. My other question would be not to beat the dead horse of Detroit too much, but you guys talked about turning the corner. How much of that, in your opinion, was getting the physician issue settled with the university, and how much of that is just kind of catching up on some deficiencies and just Management 101?
Again, a hard question. I think, the university thing, right or wrong, lots of doctors – the whole thing we went through feeds the base of the problem, right? Now, your question would be, okay, so when that's going on, what happened with Management 101? Did they do the right things at all times? The answer probably they didn't do the right thing at all times. What they did is – in some cases, I think they did a darn good job, but other cases they probably missed a few box. So, it's a combination. But having said that, we made some major changes. We're totally – I mean, we have a great guy leading it in Tony Tedeschi. He is a doctor. He does a great job. He has rallied the organization pretty very well up there. So, I'm comfortable with that.
But you've got to go back out in the community and rebuild your issue, and rebuild what you're doing. That's our whole change in how we're approaching marketing as a company. We were totally into just digital marketing and the problem is in Downtown Detroit, digital marketing is probably not as effective as putting things on buses and billboards and other kind. And so we've expanded our – we've brought in people now that look at marketing more as a consumer business. And I think that's really what's helped. So, it's really a combination of all of it. Eric, do you want to – do you have any other thoughts?
No, I mean, I think you covered it well. I mean, ultimately, Detroit Medical Center is a core foundational piece of the Detroit community. And while we had some struggles this year and certainly there were distractions, we feel very confident in our ability to make that a vibrant part of the company. And the investments we're making, we've announced a growth there in orthopedics downtown and in partnership with a lot of community leaders. We have continued to invest in our core strategic service lines including the last part of our Children's Hospital tower opening up this week. And so we have a lot of pieces in place to turn the story around. We see it stabilizing and we again see this becoming a growth (58:08).
And the marketing effort, just the theme of a community of care, I mean, has had – has really begun to resonate we believe in the community. And the fact that we're doing outreaches at every aspect. When you think of the inner-city community, I mean, it's important that we do that outreach where the inner-city community exists and not just in a digital environment where they may not even see it.
So we're doing a major drive on signing up Medicare/Medicaid and that's had a positive – a tremendously positive influence in the last couple of weeks. So, I think, all its good. Do you have something else you want to – okay.
Thanks. Thank you so much.
Okay.
Thank you.
Sure.
We will take our final question from Matthew Gillmor of Robert Baird. Please go ahead your line is open.
Hey. Thanks. I did want to ask about the Ambulatory business. The growth trends there were obviously very good. I know the comp got a little easier from a case perspective. Can you talk about the trend in that business? Were there any particular geography or specialty that was driving the stronger growth in the quarter?
And then, you talked about the confidence with the fourth quarter ramp. Is that based on just the normal seasonality? Are you seeing something from a volume perspective in October that's part of the confidence?
Hi. This is Bill Wilcox. Well, we continue to see positive trends both in the organic and the inorganic opportunities through de novos, and also through mergers and acquisitions. And as Dan mentioned that the pipeline is as strong as it's ever been. I think, the contributing factors to that are that many health system partners or many health systems and potential partners are really focused on developing Ambulatory strategies. And then, on the independent surgery centers, of which there's a large number, many of those owners are looking for some strategic stability that would come through affiliating with a company like ours.
In terms of the fourth quarter, we always – as we become more and more cyclical and more dependent on the – particularly the November, December volumes, it's always a time for us to make certain that we have expanded our surgical schedules, and operating days as much as possible. We're working very closely with our physicians and our nurses to be able to do that. And we're confident that we're going to end the year with strong volumes as we have in the last three to four years.
Got it. Thanks, Bill. I'll leave it there.
All right. Thanks very much, Matt. That's going to conclude our call today. And if anybody has any follow-up questions, please give me a call. Thanks.
That concludes today's call. You may now disconnect. Thank you.