LINCARE HOLDINGS INC – 10-Q – Management’s Discussion and Analysis of Results of Operations and Financial Condition
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This "Management's Discussion and Analysis of Results of Operations and Financial Condition" 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 indicate future performance. As used in this "Management's Discussion and Analysis of Results of Operations and Financial Condition," the words "we," "our," "us," "Lincare" and the "Company" refer toLincare Holdings Inc. and its consolidated subsidiaries.
Medicare Reimbursement
As a provider of home oxygen, respiratory and other chronic therapy services to the home health care market, we participate in Medicare Part B, the Supplementary Medical Insurance Program, which was established by the Social Security Act of 1965. Providers of home oxygen and other respiratory therapy services have historically been heavily dependent onMedicare reimbursement due to the high proportion of elderly persons suffering from respiratory disease. Durable medical equipment ("DME"), including oxygen equipment, is traditionally reimbursed byMedicare based on fixed fee schedules. Recent legislation, including the Patient Protection and Affordable Care Act ("PPACA"), the Medicare Improvements for Patients and Providers Act of 2008 ("MIPPA"), theMedicare ,Medicaid and SCHIP Extension Act of 2007 ("SCHIP Extension Act"), the Deficit Reduction Act of 2005 ("DRA") and theMedicare Prescription Drug, Improvement, and Modernization Act of 2003 ("MMA"), contain provisions that directly impact reimbursement for the primary respiratory and other DME products provided byLincare . PPACA, as amended, is a comprehensive health care reform law that contains a large number of health-related provisions to take effect over the next several years, including various cost containment and program integrity changes that will apply to the home medical equipment industry. MIPPA delayed the implementation of aMedicare competitive bidding program for oxygen equipment and certain other DME items that was scheduled to begin onJuly 1, 2008 and instituted a 9.5% price reduction nationwide for these items as ofJanuary 1, 2009 . The SCHIP Extension Act reducedMedicare reimbursement amounts for covered Part B drugs, including inhalation drugs that we provide, beginningApril 1, 2008 . DRA provisions negatively impacted reimbursement for oxygen equipment beginning in 2009 through the implementation of a capped rental arrangement. MMA changed the pricing formulas used to establish payment rates for inhalation drug therapies resulting in significantly reduced reimbursement beginning in 2005, established a competitive acquisition program for DME, established a Recovery Audit Contractors ("RAC") program, which implemented a new method for recovery ofMedicare overpayments by utilizing private companies operating on a contingent fee basis to identify and recoupMedicare overpayments, and implemented quality standards and accreditation requirements for DME suppliers. These legislative provisions, as currently in effect and when fully implemented, have had and will continue to have a material adverse effect on our business, financial condition, operating results and cash flows. PPACA was signed into law onMarch 23, 2010 . Together with the Health Care and Education Reconciliation Act of 2010 (signed into law onMarch 30, 2010 ) which amended the statute, PPACA is a comprehensive health care law that is intended to expand access to health insurance, reform the health insurance market to provide additional consumer protections, and improve the health care delivery system to reduce costs and produce better outcomes through a combination of cost controls, subsidies and mandates. Among other things, PPACA:
(1) Introduced a productivity adjustment factor that is applied to
updates (covered item updates) for 2011 and each subsequent year. Specifically,Medicare payment amounts are updated each year by the percentage increase in the consumer price index for all urban consumers (CPI-U) for the 12-month period ending with June of the previous year,
reduced by a productivity adjustment (as projected by the Secretary of Health
and Human Services). The application of the productivity adjustment may
result in the covered item update being negative for a year, and may result
in payment rates being less than such payment rates for the preceding year.
The covered item update for
furnished in 2012, net of the productivity adjustment has been established at
positive 2.4%.
(2) Made adjustments to the Medicare DME Competitive Acquisition Program
("competitive bidding"). PPACA expands the DME competitive bidding program to
100 markets from 79 markets under prior law. PPACA also added a requirement
to expand competitive bidding further to additional geographic markets
(certain markets may be excluded at the discretion of CMS) or use competitive
bid pricing information to adjust the payment amounts otherwise in effect for
areas that are not competitive acquisition areas byJanuary 1, 2016 . 24
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Table of Contents (3) Made important changes to key fraud and abuse statutes and increased funding
for fraud and abuse enforcement. PPACA increased funding for program
integrity initiatives, improved screening of providers and suppliers before
and after granting
enhanced penalties and procedures to deter fraud and abuse. PPACA also
specifically added a requirement that physician orders for covered items of
DME must be written by a physician and must document that a physician, a
physician assistant, a nurse practitioner, or a clinical nurse specialist had
a face-to-face encounter (including through the use of telehealth) with the
individual involved during the six-month period preceding such written order,
or other reasonable timeframe as determined by the Secretary of Health and
Human Services.
PPACA is a complex, sweeping health care reform law that will dramatically alter the structure of health insurance markets and the practice of medicine inthe United States . Due to the complex nature of the legislation and the extended time period over which various provisions of the new law will be implemented (pursuant to yet unwritten regulations), we can not predict at this time what effects PPACA and related regulations will have on our business in the future. The MIPPA legislation imposed a 9.5% reduction inMedicare payment rates for certain specified product categories, including oxygen, effectiveJanuary 1, 2009 . In addition to the 9.5% reduction, theCenters for Medicare and Medicaid Services ("CMS"), as required by statute, subjected the monthly payment amount for stationary oxygen equipment to additional cuts of 2.3%, thereby reducing the monthly payment rate from$199.28 in 2008 to$175.79 in 2009. The monthly payment amount was reduced by 1.5% in 2010, to$173.17 . We estimate that this reduction negatively impacted our annual net revenues in 2010 by approximately$8.4 million when compared to the prior year period. The stationary oxygen payment rate for 2011 was increased to$173.31 per month, an increase of 0.1%, and was not material to the Company's operating results in 2011. The stationary oxygen payment rate for 2012 has been established by CMS at$176.06 per month, an increase of 1.6%. We estimate that this increase will favorably impact our revenues in 2012 by approximately$10.0 million . The SCHIP Extension Act, which became law onDecember 29, 2007 , required CMS to adjust the methodology used to determineMedicare payment amounts for inhalation drugs by using volume-weighted average selling prices ("ASP") based on actual sales volumes rather than average sales prices. CMS publishes payment rates for inhalation drugs each calendar quarter, representing the unit reimbursement rates in effect for inhalation drugs dispensed within that quarter. These payment rates may be subject to volatility as a result of the underlying ASP data used to determine the rates in effect each quarter. The quarterly ASP data published by CMS for inhalation drugs provided in 2010 and 2011 resulted in reductions in theMedicare payment rates for inhalation drugs that negatively impacted the Company's annual net revenues by approximately$5.0 million and$14.8 million , respectively. Based upon the ASP payment rates published by CMS for the first three quarters of 2012, and assuming no changes in the volume or mix of drugs that we currently dispense, we estimate that our annual net revenues will be favorably impacted by approximately$11.7 million in 2012 when compared with 2011. We can not determine whether quarterly updates in ASP pricing data will result in future reductions in payment rates for inhalation drugs, or what impact such payment reductions could have on our business in the future. Additionally, since 2011, CMS is using 103% of Average Manufacturer Price ("AMP") rather than 106% of ASP for a drug when ASP exceeds AMP by 5% for either two straight quarters or three of the past four quarters. The policy limits substitution of the price formula in a given quarter to only those drugs where ASP and AMP can be compared using the same set of national drug codes. We can not determine at this time which, if any, inhalation drugs might meet the criteria established for substitution in a particular future quarter, nor the impact on payment rates for such drugs in the event that the AMP formula is utilized. OnFebruary 1, 2006 ,Congress passed the DRA legislation which changed the reimbursement methodology for oxygen equipment from continuous monthly payment for as long as the equipment is in use by aMedicare beneficiary, which includes payment for oxygen contents, related disposable supplies and accessories and maintenance of equipment, to a capped rental arrangement whereby payment for oxygen equipment may not extend over a period of continuous use of longer than 36 months. Separate payments for oxygen contents continue to be made for the period of medical need beyond the 36th month. Additionally, payment for routine maintenance and service of the oxygen equipment may be made following each six-month period after the 36-month rental period ends. The oxygen provisions contained in DRA became effective onJanuary 1, 2006 . In the case of beneficiaries receiving oxygen equipment prior to the effective date, the 36-month period of continuous use began onJanuary 1, 2006 . Accordingly, the first month in which the new payment methodology impacted our net revenues wasJanuary 2009 . We anticipate that these oxygen payment rules will continue 25
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to negatively affect our net revenues on an ongoing basis, as each month additional customers reach the 36-month capped service period, resulting in no further rental income from these customers. During 2011, we estimate that our sequential net revenues were reduced as a result of additional customers reaching the payment cap by approximately$20.2 million when compared to the prior year period. During the first half of 2012, we estimate that our net revenues were reduced by approximately$19.7 million compared to the first half of 2011, due to the oxygen rental payment cap.
In
(1) Established a competitive acquisition program for DME that was expected to
commence in 2008, but was subsequently delayed by further legislation. MMA
instructed CMS to establish and implement programs under which competitive
acquisition areas would be established throughout
purposes of awarding contracts for the furnishing of competitively priced
items of DME, including oxygen equipment. The program was initially intended
to be implemented in phases such that competition under the program would
occur in nine of the largest metropolitan statistical areas ("MSAs") in the
first year and an additional 70 of the largest MSAs in a second, subsequent
round of bidding.
For each competitive acquisition area, CMS is required to conduct a competition under which providers submit bids to supply certain covered items of DME. Successful bidders are expected to meet certain program quality standards in order to be awarded a contract and only successful bidders can supply the covered items toMedicare beneficiaries in the acquisition area (there are, however, regulations in place that allow non-contracted providers to continue to provide equipment and services to their existing customers at the new prices determined through the bidding process). The contracts are expected to be re-bid at least every three years. CMS is required to award contracts to multiple entities submitting bids in each area for an item or service, but has the authority to limit the number of contractors in a competitive acquisition area to the number it determines to be necessary to meet projected demand. CMS concluded the bidding process for the first round of MSAs inSeptember 2007 , however, inJuly 2008 ,Congress enacted the MIPPA legislation which retroactively delayed the implementation of competitive bidding and reducedMedicare prices nationwide by 9.5% beginning in 2009 for the product categories, including oxygen, that were initially included in competitive bidding. In 2009, CMS reinstituted the bidding process in the nine largest MSA markets. Reimbursement rates from the re-bidding process were publicly released by CMS onJune 30, 2010 . CMS announced average savings of approximately 32% off the payment rates then in effect for the product categories included in competitive bidding. As ofJanuary 1, 2011 , these payment rates were in effect in the nine markets only.Lincare was offered contracts to provide oxygen equipment in just two of the nine markets,Charlotte andMiami , and we accepted and signed those contracts. The Company's annualMedicare revenues from the product categories in the nine markets affected by competitive bidding were approximately$48.0 million at the time the program commenced. During 2011, we completed acquisitions of companies that were contracted to provide home oxygen equipment and positive airway pressure devices in all nine competitive bidding markets. CMS is currently undertaking a second round of competitive bidding in 91 additional markets, with contracts expected to be effective inJuly 2013 . The bid submission period closed onMarch 30, 2012 , and CMS is expected to announce final pricing results inNovember 2012 . The Company'sMedicare revenues from the product categories in the 91 additional markets to be included in the second round of competitive bidding were approximately$267.0 million in 2011. The PPACA legislation requires CMS to expand competitive bidding further to additional geographic markets (certain markets may be excluded at the discretion of CMS) or to use competitive bid pricing information to adjust the payment amounts otherwise in effect for areas that are not competitive acquisition areas byJanuary 1, 2016 . We will continue to monitor developments regarding the implementation of the competitive bidding program. While we can not predict the outcome of the competitive bidding program on our business when fully implemented nor theMedicare payment rates that will be in effect in future years for the items subjected to competitive bidding, it is likely that the program will materially adversely effect our financial position and operating results.
(2) Established a Recovery Audit Contractors ("RAC") program to identify and
recoup
demonstration project by CMS, the RAC program was designed to test a new
method for recovery of
operating on a contingent fee basis to identify and recoup
overpayments from providers. Section 302 of the Tax Relief and Health Care
Act of 2006 made the program permanent and requires the
and Human Services to expand the program to 26
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all states. The RAC contractors are empowered to audit claims submitted by
health care providers and to withhold future payments, including in cases
where the reimbursement rules are unclear or subject to differing
interpretations. This activity, as well as the activity of intermediaries and
others involved in government reimbursement, may include changes in
long-standing interpretations of reimbursement rules, which could have a
material adverse effect on our future financial position and operating
results.
InOctober 2008 , CMS announced the establishment of new Zone Program Integrity Contractors ("ZPICs"), who are responsible for ensuring the integrity of allMedicare -related claims. The ZPICs assumed the responsibilities previously held byMedicare's Program Safeguard Contractors ("PSCs"). Industry-wide, ZPIC audit activity increased substantially throughout 2010 and 2011 and that activity 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 DME industry. In order to ensure thatMedicare beneficiaries only receive medically necessary and appropriate items and services, theMedicare program has adopted a number of documentation requirements. For example, the Durable Medical Equipment Medicare Administrative Contractor ("DME MAC") 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 DME MACs, 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, health care 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 health care providers. Moreover, auditors' interpretations of these policies are inconsistent and subject to individual interpretation, leading to significant increases in individual supplier and industry-wide perceived error rates. High error rates lead to further audit activity and regulatory burdens. If these or other burdensome positions are generally adopted by auditors, DME MACs, other contractors or CMS in administering theMedicare 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 toMedicare and our future revenues and cash flows fromMedicare may be reduced. We can not currently predict the adverse impact these interpretations of theMedicare documentation requirements might have on our operations, cash flow and capital resources, but such impact could be material. Federal and state budgetary and other cost-containment pressures will continue to impact the home respiratory care industry. We can not predict whether new federal and state budgetary proposals will be adopted or the effect, if any, such proposals would have on our business.
Government Regulation
The federal governments ofthe United States andCanada and all states and provinces in which we currently operate regulate various aspects of our business. In particular, our operating centers are subject to federal laws that regulate the repackaging of drugs (including oxygen) and interstate motor-carrier transportation. Our operations also are subject to state and provincial laws, where applicable, governing, among other things, pharmacies, nursing services, distribution of medical equipment and certain types of home health activities. Certain of our employees are subject to state laws and regulations governing the ethics and professional practice of respiratory therapy, pharmacy and nursing. As a health care provider inthe United States , we are subject to extensive government regulation, including numerous laws directed at preventing fraud and abuse and laws regulating reimbursement under various government programs. InCanada , we are subject to numerous similar and other laws and regulations including anti-corruptions laws and regulations. The marketing, billing, documenting and other practices of health care companies are all subject to government scrutiny. To ensure compliance withMedicare ,Medicaid and other regulations, regional health insurance carriers and state agencies often conduct audits and request customer records and other documents to support our claims submitted for payment of services rendered to customers. Similarly, government agencies periodically open investigations and obtain information from health care providers pursuant to the legal process. Violations of federal and state regulations can result in severe criminal, civil and administrative penalties and sanctions, including disqualification fromMedicare and other reimbursement programs, which could have a material adverse effect on our business.
Numerous federal, state and provincial laws and regulations, including the Federal Health Insurance Portability And Accountability Act of 1996 ("HIPAA") and the Health Information Technology For Economic And Clinical Health Act ("HITECH Act"), govern the collection, dissemination, security, use and confidentiality of patient-identifiable health
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information. As part of our provision of, and billing for, health care equipment and services, we are required to collect and maintain patient-identifiable health information. New health information standards, whether implemented pursuant to HIPAA, the HITECH Act, congressional action or otherwise, could have a significant effect on the manner in which we handle health care related data and communicate with payors, and the cost of complying with these standards could be significant. If we do not comply with existing or new laws and regulations related to patient health information, we could be subject to criminal or civil sanctions. Health care is an area of rapid regulatory change. Changes in the laws and regulations and new interpretations of existing laws and regulations may affect permissible activities, the relative costs associated with doing business, and reimbursement amounts paid by federal, state, provincial and other third-party payors. We can not predict the future of federal, state and local regulation or legislation, includingMedicare andMedicaid statutes and regulations, or possible changes in national health care policies. Future legislative and regulatory changes could have a material adverse effect on our business.
Operating Results
The following table sets forth, for the periods indicated, a summary of the Company's net revenues by product category:
For The Three Months Ended For The Six Months Ended June 30, June 30, 2012 2011 2012 2011 (In thousands) (In thousands) Respiratory and other chronic therapies $ 445,054 $ 403,022 $ 894,598 $ 789,042 DME, infusion and enteral therapies 51,109 46,011 102,443 91,558 Total $ 496,163 $ 449,033 $ 997,041 $ 880,600 Net revenues for the three months endedJune 30, 2012 , increased by$47.1 million (or 10.5%), compared with the three months endedJune 30, 2011 and for the six months endedJune 30, 2012 , increased by$116.4 million (or 13.2%) compared with the six months endedJune 30, 2011 . The Company estimates that the 10.5% increase in net revenues in the three-month period of 2012 was comprised of approximately 11.0% internal and acquisition growth offset by approximately 0.5% negative impact from$2.1 million ofMedicare payment changes (see "Medicare Reimbursement" above). The Company estimates that the 13.2% increase in net revenues in the six-month period of 2012 was comprised of approximately 13.7% internal and acquisition growth offset by approximately 0.5% negative impact from$4.3 million ofMedicare payment changes in 2012. The internal growth in net revenues is attributable to underlying demographic growth in the markets for our products and gains in customer counts resulting primarily from our sales and marketing efforts that emphasize high-quality equipment and customer service. Growth in net revenues from acquisitions is attributable to the effects of acquisitions of local and regional companies and is based on the estimated contribution to net revenues for the four quarters following such acquisitions. The contribution of respiratory and other chronic therapy products to our net revenues was 89.7% during the three and six months endedJune 30, 2012 and during the three and six months endedJune 30, 2011 was 89.8% and 89.6%, respectively. Our strategy is to focus on the provision of oxygen, respiratory and other chronic therapy services to patients in the home and to provide home medical equipment, infusion and enteral nutrition products and services where we believe such services will enhance our core respiratory business. Cost of goods and services, as a percentage of net revenues, was 32.3% and 32.5%, respectively, for the three and six months endedJune 30, 2012 , compared with 31.7% and 30.3%, respectively, for the comparable prior year periods. Cost of goods and services for the three months endedJune 30, 2012 , increased$17.9 million , or 12.6%, when compared with the prior year period. Cost of goods and services for the six months endedJune 30, 2012 , increased$57.3 million , or 21.5%, when compared with the prior year period. The increase in cost of goods and services in 2012 is primarily attributable to the Company's acquisition of a specialty pharmacy business with gross margins that are substantially lower than other products and services provided by the Company and higher sale volumes of CPAP supplies and inhalation drugs. 28
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Cost of goods and services for the three and six-month periods includes the cost of medical equipment (excluding depreciation of$30.4 million and$59.5 million in 2012 and$28.1 million and$54.9 million in 2011, respectively), drugs and supplies sold to patients and certain costs related to the Company's respiratory drug product line. These costs include an allocation of customer service, distribution and administrative costs relating to the respiratory drug product line of approximately$14.2 million and$28.1 million for the three and six-month periods of 2012, respectively, and approximately$13.6 million and$27.5 million for the three and six-month periods of 2011, respectively. Included in cost of goods and services in the three and six months endedJune 30, 2012 are salary and related expenses of pharmacists and other service professionals of$2.6 million and$5.4 million , respectively. Such salary and related expenses for the three and six months endedJune 30, 2011 , were$3.0 million and$5.8 million , respectively. Operating expenses, as a percentage of net revenues, were 22.5% and 22.8%, respectively, for the three and six months endedJune 30, 2012 , compared with 22.8% and 23.2%, respectively, for the comparable prior year periods. Operating expenses for the three and six months endedJune 30, 2012 , increased by$9.7 million , or 9.5%, and$22.8 million , or 11.2%, respectively, over the prior year periods. The Company has been successful in achieving productivity gains that have contributed to containment of the growth in wage expenses and in managing the growth of its employee health benefit costs. These positive developments were partially offset by increases in vehicle related expenses during the first six months of 2012, most significantly fuel costs. The Company manages 1,058 operating centers from which customers are provided equipment, supplies and services. An operating center averages approximately seven to eight employees and is typically comprised of a center manager, two customer service representatives (referred to as "CSRs" - telephone intake, scheduling, documentation), two or three service representatives (referred to as "Service Reps" - delivery, maintenance and retrieval of equipment and delivery of disposables), a respiratory therapist (non-reimbursable clinical follow-up with the customer and communication to the prescribing physician) and a sales representative (marketing calls to local physicians and other referral sources). The Company includes in operating expenses the costs incurred at the Company's operating centers for certain service personnel (center manager, CSRs and Service Reps), facilities (rent, utilities, communications, property taxes, etc.), vehicles (vehicle leases, gasoline, repair and maintenance), and general business supplies and miscellaneous expenses. Operating expenses for the interim periods of 2012 and 2011 within these major categories were as follows:
Operating Expenses (in thousands)
For The Three Months Ended For The Six Months Ended June 30, June 30, 2012 2011 2012 2011 Salary and related $ 72,640 $ 67,826 $ 147,357 $ 134,256 Facilities 15,612 12,796 32,022 28,561 Vehicles 14,533 13,756 29,553 26,420 General supplies/miscellaneous 9,092 7,811 17,927 14,859 Total $ 111,877 $ 102,189 $ 226,859 $ 204,096 Included in operating expenses during the three and six months endedJune 30, 2012 are salary and related expenses for Service Reps in the amount of$28.9 million and$57.8 million , respectively. Such salary and related expenses for the three and six months endedJune 30, 2011 were$28.3 million and$55.9 million , respectively. Selling, general and administrative ("SG&A") expenses, as a percentage of net revenues, were 18.1% and 18.4%, respectively, for the three and six months endedJune 30, 2012 , compared with 19.0% and 19.1% for the comparable prior year periods. SG&A expenses for the three and six months endedJune 30, 2012 increased by$4.1 million , or 4.8%, and$14.6 million , or 8.7% when compared to the prior year periods. SG&A expenses include costs related to sales and marketing activities, corporate overhead and other business support functions. Included in SG&A during the three and six months endedJune 30, 2012 are salary and related expenses of$68.6 million and$138.0 million , respectively. These salary and related expenses include the cost of the Company's respiratory therapists for the three and six months endedJune 30, 2012 of$18.0 million and$35.7 million , respectively. Included in SG&A during the three and six months endedJune 30, 2011 are salary and related expenses of$62.9 million and$125.1 million , respectively. These salary and related 29
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expenses include the cost of the Company's respiratory therapists for the three and six months endedJune 30, 2011 of$17.9 million and$34.5 million , respectively. The Company's respiratory therapists generally provide non-reimbursable clinical follow-up with the customer and communication, as appropriate, to the prescribing physician with respect to the customer's prescribed plan of care. The Company includes the salaries and related expenses of its respiratory therapist personnel (licensed respiratory therapists or, in some cases, registered nurses) in SG&A because it believes that these personnel enhance the Company's business relative to its competitors who do not employ respiratory therapists. Bad debt expense as a percentage of net revenues was 2.6% and 2.3% for the three and six months endedJune 30, 2012 , respectively, and 2.0% for the three and six months endedJune 30, 2011 . Bad debt expense for the three and six months endedJune 30, 2012 increased by$3.9 million and$5.3 million , respectively, over the comparable prior year period. Included in depreciation and amortization expense in the three and six months endedJune 30, 2012 is depreciation of medical equipment of$30.4 million and$59.5 million , respectively, and depreciation of other property and equipment of$1.8 million and$4.3 million , respectively. Included in depreciation and amortization expense in the three and six months endedJune 30, 2011 is depreciation of medical equipment of$28.1 million and$54.9 million , respectively, and depreciation of other property and equipment of$1.5 million and$3.7 million , respectively. Operating income for the three and six months endedJune 30, 2012 , was$88.5 million (17.8% of net revenues) and$174.9 million (17.5% of net revenues), respectively, compared with$80.1 million (17.8% of net revenues) and$164.7 million (18.7% of net revenues), respectively, for the comparable prior year periods. Operating income for the three and six months endedJune 30, 2012 , increased by$8.4 million , or 10.5%, and$10.2 million , or 6.2% when compared to the prior year periods. The increase in operating income in 2012 over 2011 is attributed primarily to the growth in net revenues and containment of costs and expenses during the period.
Liquidity and Capital Resources
Our primary sources of liquidity have been internally generated funds from operations and proceeds from equity and debt transactions. We have used these funds to meet our capital requirements, which consist primarily of operating costs, capital expenditures, acquisitions, debt service and share repurchases. The Company also has access to borrowings under its credit facilities. Net cash provided by operating activities was$130.1 million for the six months endedJune 30, 2012 , compared with$131.8 million for the six months endedJune 30, 2011 . Net cash used in investing activities was$57.7 million for the six months endedJune 30, 2012 . Investing activities during the six-month period endedJune 30, 2012 included our net investment in property and equipment of$62.2 million ,$2.7 million of purchases of short-term investments and$15.9 million of business acquisition expenditures offset by the sale and maturity of investments of$23.1 million . Net cash provided by financing activities was$59.0 million for the six months endedJune 30, 2012 . Financing activities during the six-month period endedJune 30, 2012 included advances under our revolving credit agreement of$220.0 million , proceeds from the issuance of a$250.0 million single draw term loan facility and proceeds of$4.4 million from the exercise of stock options and issuance of common shares offset by repayments under the revolving credit agreement of$320.0 million , payment of$34.7 million of dividends, payments on debt and long-term obligations of$9.1 million and$50.0 million of repurchases of our common shares. As ofJune 30, 2012 , our principal sources of liquidity consisted of approximately$146.3 million of cash and cash equivalents,$19.6 million of short-term investments and$413.2 million available under our revolving credit agreement. The revolving credit agreement, datedSeptember 15, 2011 , makes available to us up to$450.0 million over a five-year period, subject to certain terms and conditions set forth in the agreement. As ofJune 30, 2012 , there were no borrowings outstanding and$36.8 million of standby letters of credit issued under the credit facility. OnJuly 2, 2012 , the Company announced that its Board of Directors had declared a quarterly cash dividend of$0.20 per share which was paid onJuly 30, 2012 , to stockholders of record as ofJuly 16, 2012 . The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board of Directors. Our Board of Directors has authorized a share repurchase plan whereby the Company may repurchase from time to time, on the open market or in privately negotiated transactions, shares of the Company's common stock in amounts determined pursuant to a formula (the "share repurchase formula") that takes into account both the ratio of the Company's 30
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net debt to cash flow and its available cash resources and borrowing availability. During the first quarter of 2012, the Company repurchased and retired 1,877,670 shares for$50.0 million pursuant to the repurchase plan. The Company did not repurchase any shares in the second quarter of 2012. As ofJune 30, 2012 ,$273.7 million of the Company's common stock was eligible for repurchase in accordance with the plan's formula. OnOctober 31, 2007 , we completed the sale of$275.0 million principal amount of convertible senior debentures, due 2037 - Series A (the "Series A Debentures") and$275.0 million principal amount of convertible senior debentures due 2037 - Series B (the "Series B Debentures" and together with the Series A Debentures, the "Series Debentures") in a private placement. The Series Debentures pay interest semi-annually at a rate of 2.75% per annum. The Series Debentures are unsecured and unsubordinated obligations and are convertible under specified circumstances based upon a base conversion rate, which, under certain circumstances, will be increased pursuant to a formula that is subject to a maximum conversion rate. Upon conversion, holders of the Series Debentures will receive cash up to the principal amount, and any excess conversion value will be delivered in shares of our common stock or in a combination of cash and shares of common stock, at our option. The base conversion rate for the Debentures as ofJune 30, 2012 is 31.0828 shares of common stock per$1,000 principal amount of Series Debentures, equivalent to a base conversion price of approximately$32.17 per share. In addition, if at the time of conversion the applicable price of our common stock exceeds the base conversion price, holders of the Series Debentures will receive an additional number of shares of common stock per$1,000 principal amount as determined pursuant to a specified formula. We have the right to redeem the Series A Debentures and the Series B Debentures at any time afterNovember 1, 2012 andNovember 1, 2014 , respectively. Holders of the Series Debentures will have the right to require us to repurchase for cash all or some of their Series Debentures upon the occurrence of certain fundamental change transactions or onNovember 1, 2012 , 2017, 2022, 2027 and 2032 in the case of the Series A Debentures andNovember 1, 2014 , 2017, 2022, 2027 and 2032 in the case of the Series B Debentures. Our future liquidity will continue to be dependent upon our operating cash flow and management of accounts receivable. We anticipate that funds generated from operations, together with our current cash on hand and funds available under our revolving credit facility, will be sufficient to finance our working capital requirements, fund anticipated acquisitions and capital expenditures, and meet our contractual obligations for at least the next 12 months. Accounts Receivable: The Company maintains payor-specific price tables in its billing system that reflect the fee schedule amounts statutorily in effect or contractually agreed upon by various government and commercial payors for each item of equipment or supply provided to a customer. Due to the nature of the health care industry and the reimbursement environment in whichLincare operates, situations can occur where expected payment amounts are not established by fee schedules or contracted rates, and estimates are required to record revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that revenues and accounts receivable will have to be revised or updated as additional information becomes available. Contractual adjustments to revenues and accounts receivable can result from price differences between allowed charges and amounts initially recognized as revenue due to incorrect price tables or subsequently negotiated payment rates. Actual adjustments that result from differences between the payment amount received and the expected realizable amount are recorded against the allowance for sales adjustments and are typically identified and ultimately recorded at the point of cash application or account review. We report revenues in our financial statements net of such sales adjustments. Accounts receivable are reported net of allowances for sales adjustments and uncollectible accounts. Bad debt is recorded as an operating expense and consists of billed charges that are ultimately deemed uncollectible due to the customer's or third-party payor's inability or refusal to pay. The Company's payor mix is highly concentrated amongMedicare ,Medicaid and other government third-party payors and contracted private insurance or commercial payors. Government payment rates are determined according to published fee schedules established pursuant to statute, law or other regulatory processes and commercial payment rates are based on contractual line item pricing as reflected in the respective contracts. Fee schedule updates have historically occurred on a prospective basis and have been made available to the Company in advance of the effective date of a change in reimbursement rates. The Company's proprietary billing system has features that allow the Company to timely update payor price tables within the system as changes occur in order to accurately record revenues and accounts receivable at their expected realizable values. Additional systems and manual controls and processes are used by management to evaluate the accuracy of these recorded amounts. Based on the Company's experience, it is unlikely that a change in estimate of unsettled amounts from third-party payors would have a material adverse impact on its financial position or results of operations. 31
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Accounts receivable balance concentrations by major payor category as of
Percentage of Accounts Receivable Outstanding:
June 30, December 31, 2012 2011 Medicare 43.3 % 37.2 % Medicaid/Other Government 13.6 % 14.7 % Private Insurance 32.9 % 38.4 % Customer Pay 10.2 % 9.7 % Total 100.0 % 100.0 %
Aged accounts receivable balances by major payor category as of
Percentage of Accounts Aged in Days:
June 30, 2012 0-60 61-120 Over 120 Medicare 48.3 % 16.5 % 35.2 % Medicaid/Other Government 44.2 % 18.6 % 37.2 % Private Insurance 50.6 % 15.2 % 34.2 % Customer Pay 32.6 % 19.9 % 47.5 % All Payors 46.9 % 16.7 % 36.4 %
Percentage of Accounts Aged in Days:
December 31, 2011 0-60 61-120 Over 120 Medicare 67.5 % 12.9 % 19.6 % Medicaid/Other Government 55.1 % 18.0 % 26.9 % Private Insurance 60.1 % 13.7 % 26.2 % Customer Pay 30.5 % 15.0 % 54.5 % All Payors 59.2 % 14.2 % 26.6 % We operate 39 regional billing and collection offices ("RBCOs") that are responsible for the billing and collection of accounts receivable. The RBCOs are aligned geographically to support the accounts receivable activity of the operating centers within their assigned territories. As ofJune 30, 2012 , there were 1,533 full-time employees in the RBCOs. Accounts receivable collections are performed by designated collectors within each of the RBCOs. The collectors use various reporting tools available within our proprietary billing system to identify claims that have been denied or partially paid by the responsible party and claims that have not been processed by the third-party payor in a timely manner. Collections of accounts receivable are typically pursued using direct phone contact to determine the reason for non-payment and, if necessary, corrected claims are prepared for resubmission and further follow-up with the responsible party. In some cases, third-party payors have developed electronic inquiry methods that we can access to determine the status of individual claims. We have benefited from the increasing availability of electronic funds transfers from payors, which now account for approximately 77.4% of all payments received. Our accounts receivable days sales outstanding ("DSO") increased to 60 days atJune 30, 2012 compared with 47 days atDecember 31, 2011 . Our bad debt expense, as a percentage of net revenues, was 2.3% during the six-month period endedJune 30, 2012 and 2.0% during the six-month period endedJune 30, 2011 . Contributing to the increase in our 32
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accounts receivable is a significant increase in the number ofMedicare claims subject to prepayment review, primarily by the DME MACs. These reviews are substantially delaying the collection of ourMedicare accounts receivable as well as related secondary amounts due under supplemental insurance plans. We estimate that accounts receivable subject toMedicare pre-payment review were approximately$59.9 million as ofJune 30, 2012 . Also contributing to the increase in accounts receivable and bad debt expense are copayments and deductibles due from customers who are finding it difficult to pay their out-of-pocket charges due to loss of insurance coverage or reductions in their investment or employment income. The ultimate collection of accounts receivable may not be known for several months. We record bad debt expense based on a percentage of revenue using historical Company-specific data. The percentage and amounts used to record bad debt expense and the allowance for doubtful accounts are supported by various methods and analyses including current and historical cash collections, bad debt write-offs, aged accounts receivable and consideration of any payor-specific concerns. The ultimate write-off of an accounts receivable occurs once collection procedures are determined to have been exhausted by the collector and after appropriate review of the specific account and approval by supervisory and/or management employees within the RBCOs. Management and RBCO supervisory and management employees also review accounts receivable write-off reports, correspondence from payors and individual account information to evaluate and correct processes that might have contributed to an unsuccessful collection effort. We do not use an aging threshold for account receivable write-offs. However, the age of an account balance may provide an indication that collection procedures have been exhausted, and would be considered in the review and approval of an account balance write-off. Income Taxes Our effective income tax rate was 38.67% and 38.88%, respectively, for the three and six month periods endedJune 30, 2012 compared with 39.71% and 39.15%, respectively, for the three and six month periods endedJune 30, 2011 . The income tax rate decreased from the three and six month periods endedJune 30, 2011 primarily due to an increase in favorable adjustments associated with the filing of amended state returns. We have elected to treat our portion of all foreign subsidiary earnings throughJune 30, 2012 as permanently reinvested under the relevant accounting guidance and accordingly have not provided for any U.S. federal or state tax thereon. Our intention is to reinvest the earnings permanently or to repatriate the earnings when it is tax effective to do so. It is not practicable to determine the amount of incremental taxes that might arise were these earnings to be remitted. However, the amount of cash for all foreign subsidiaries permanently reinvested, and the amount of incremental taxes that might arise were these earnings to be remitted, are not material. Future Minimum Obligations In the normal course of business, we enter into obligations and commitments that require future contractual payments. The commitments primarily result from repayment obligations for borrowings under our revolving credit facility and Series Debentures as well as contractual lease payments for facility, vehicle, and equipment leases, deferred taxes and acquisition obligations.
New Accounting Standards
InMay 2011 , theFinancial Accounting Standards Board ("FASB") issued Accounting Standards Update 2011-04, "Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS," to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. The guidance expands the disclosure requirements around fair value measurements categorized in Level 3 of the fair value hierarchy and requires disclosure of the level in the fair value hierarchy of items that are not measured at fair value but whose fair value must be disclosed. It also clarifies and expands upon existing requirements for fair value measurements of financial assets and liabilities as well as instruments classified in shareholders' equity. The guidance is effective for interim and annual financial periods beginning afterDecember 15, 2011 with early adoption not permitted. The adoption of ASU 2011-04 did not have an impact on our financial condition, results of operations or cash flows. 33
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InJune 2011 , the FASB issued Accounting Standards Update 2011-05, "Presentation of Comprehensive Income," to eliminate the current option to present the components of other comprehensive income in the statement of changes in equity and to require presentation of net income and other comprehensive income (and their respective components) either in a single continuous statement or in two separate but consecutive statements. The amendments do not alter any current recognition or measurement requirements in respect of items of other comprehensive income. The guidance is to be applied retrospectively and is effective for interim and annual periods beginning afterDecember 15, 2011 , with early adoption permitted. The adoption of ASU 2011-05 did not have an impact on our financial condition, results of operations or cash flows. InSeptember 2011 , the FASB issued Accounting Standards Update 2011-08, "Testing Goodwill for Impairment," which allows an initial assessment of qualitative factors to determine whether it is more likely than not (i.e., there is more than a 50% likelihood) that the fair value of a reporting unit is less than its carrying amount for purposes of determining whether it is necessary to perform the first step of the two-step goodwill impairment test. Accordingly, the calculation of a reporting unit's fair value is not required unless, as a result of the qualitative assessment, it is more likely than not that fair value of the reporting unit is less than its carrying amount. The amendments do not affect the manner in which the first and second steps of the impairment test are performed. The guidance is to be applied prospectively and is effective for annual and interim goodwill impairment tests performed for fiscal years beginning afterDecember 15, 2011 with early adoption permitted. The adoption of ASU 2011-08 did not have an impact on our financial condition, results of operations or cash flows. InDecember 2011 , the FASB issued Accounting Standards Update 2011-11, "Disclosures about Offsetting Assets and Liabilities," which requires disclosures to provide information to help reconcile differences in the offsetting requirements under U.S. GAAP and IFRS. The guidance applies to disclosures concerning financial instruments and derivative instruments that are either (1) offset in the balance sheet, or (2) subject to an enforceable master netting arrangement. The guidance is to be applied retrospectively and is effective for interim and annual financial periods beginning on or afterJanuary 1, 2013 . We will adopt the new guidance effectiveJanuary 1, 2013 . The Company does not expect the adoption of this guidance to have an impact on its financial condition, results of operations or cash flows. InDecember 2011 , the FASB issued Accounting Standards Update 2011-12, "Deferral of the Effective Date for the Presentation of Reclassification Adjustments Out of Accumulated Other Comprehensive Income," which indefinitely defers the effective date of the provision in ASU No. 2011-05, "Presentation of Comprehensive Income", pertaining only to the presentation of reclassification adjustments out of accumulated other comprehensive income ("OCI"), and reinstates the previous requirements to present reclassification adjustments either on the face of the statement in which OCI is reported or to disclose them in a note to the financial statements. The other requirements in ASU No. 2011-05 are not affected by ASU No. 2011-12, including the requirement to report comprehensive income either in a single continuous statement or in two separate but consecutive statements. The guidance is to be applied retrospectively and is effective for interim and annual periods beginning afterDecember 15, 2011 , with early adoption permitted. The adoption of ASU 2011-12 did not have an impact on our financial condition, results of operations or cash flows.
Forward Looking Statements
Statements in this report concerning future results, performance or expectations are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. All forward-looking statements included in this document are based upon information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statements. In some cases, forward-looking statements that involve risks and uncertainties contain terminology such as "may," "will," "should," "could," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue" or variations of these terms or other comparable terminology. Key factors that have an impact on our ability to attain these estimates include potential reductions in reimbursement rates by government and other third-party payors, changes in reimbursement policies, the demand for our products and services, the availability of appropriate acquisition candidates and our ability to successfully complete and integrate acquisitions, efficient operations of our existing and future operating facilities, regulation and/or regulatory action affecting us or our business, economic and competitive conditions, access to borrowed and/or equity capital on favorable terms and other risks described below. 34
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In developing our forward-looking statements, we have made certain assumptions relating to reimbursement rates and policies, internal growth and acquisitions and the outcome of various legal and regulatory proceedings. If the assumptions we use differ materially from what actually occurs, then actual results could vary significantly from the performance projected in the forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this report.
Risks Related to Our Pending Merger with Parent and Purchaser and the Related Tender Offer
COMPLETION OF THE OFFER AND THE MERGER ARE SUBJECT TO VARIOUS CONDITIONS, AND NEITHER THE OFFER NOR THE MERGER MAY OCCUR EVEN IF WE OBTAIN STOCKHOLDER APPROVAL.
Consummation of the Offer and Merger is subject to customary conditions, including, in the case of the Merger, adoption of the Merger Agreement by our stockholders in certain circumstances, the absence of legal restraints and the receipt of requisite antitrust approval. Each party's obligation to consummate the Merger is also subject to the accuracy of the representations and warranties of the other party (subject to certain qualifications and exceptions) and the performance in all material respects of the other party's covenants under the Merger Agreement, including, with respect to us, customary covenants regarding operation of our and our subsidiaries' respective business prior to closing. As a result of these conditions, we cannot assure you that either the Offer or the Merger will be completed, even if stockholder approval of the Merger is required and obtained. If the Merger is not completed for any reason, we expect that we would continue to be managed by our current management, under the direction of our board of directors.
THE MERGER PROCESS COULD ADVERSELY AFFECT OUR BUSINESS, SHARE PRICE, REPUTATION AND RESULTS OF OPERATIONS.
Our efforts to complete the Merger could cause substantial disruptions in our business, which could have an adverse effect on our financial results. Among other things, uncertainty as to whether a transaction will be completed with Parent and Purchaser may affect our ability to recruit prospective employees or to retain and motivate existing employees. Employee retention may be particularly challenging while the merger is pending, because employees may experience uncertainty about their future roles with Parent and Purchaser. Uncertainty as to our future could adversely affect our business, reputation and our relationship with customers and potential customers. For example, vendors, customers and others that deal with us could defer decisions concerning working with us, or seek to change existing business relationships with us. Further, a substantial amount of the attention of management and employees is being directed toward the completion of the Merger and thus is being diverted from our day-to-day operations because matters related to the Merger (including integration planning) require substantial commitments of time and resources. If the proposed Offer and/or Merger is not completed, the share price of our common stock will likely fall to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, under circumstances described in the Merger Agreement, we may be required to pay a termination fee of up to$155,000,000 or Parent's out-of-pocket expenses related to the Merger (up to a cap of$10,000,000 ) if the Merger Agreement is terminated. Further, the failure of the proposed Merger to be completed may result in negative publicity and/or a negative impression of us in the investment community and may affect our relationship with employees, vendors and other partners in the business community.
WHILE THE MERGER AGREEMENT IS IN EFFECT, WE ARE SUBJECT TO RESTRICTIONS ON OUR BUSINESS ACTIVITIES.
While the Merger Agreement is in effect, we are subject to restrictions on our business activities and must generally operate our business in the ordinary course consistent with past practice (subject to certain exceptions). These restrictions could prevent us from pursuing attractive business opportunities that arise prior to the completion of the Merger and are generally outside the ordinary course of business, and otherwise have a material adverse effect on our future results of operations or financial condition. 35
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Certain Risk Factors Relating to the Company's Business
We operate in a rapidly changing environment that involves a number of risks. The following discussion highlights some of these risks and others are discussed elsewhere in this report. These and other risks could materially and adversely affect our business, financial condition, operating results and cash flows. A MAJORITY OF OUR CUSTOMERS HAVE PRIMARY HEALTH COVERAGE UNDER MEDICARE PART B, AND RECENTLY ENACTED AND FUTURE CHANGES IN THE REIMBURSEMENT RATES OR PAYMENT METHODOLOGIES UNDER THE MEDICARE PROGRAM COULD MATERIALLY AND ADVERSELY AFFECT OUR BUSINESS. As a provider of oxygen, respiratory and other chronic therapy services for the home health care market, we have historically depended heavily onMedicare reimbursement as a result of the high proportion of elderly persons suffering from respiratory disease. Medicare Part B, theSupplementary Medical Insurance Program, provides coverage to eligible beneficiaries for DME, such as oxygen equipment, respiratory assistance devices, continuous positive airway pressure devices, nebulizers and associated inhalation medications, hospital beds and wheelchairs for the home setting. Approximately 63% of our customers have primary coverage under Medicare Part B. There are increasing pressures onMedicare to control health care costs and to reduce or limit reimbursement rates for home medical equipment and services.Medicare reimbursement is subject to statutory and regulatory changes, retroactive rate adjustments, administrative and executive orders and governmental funding restrictions, all of which could materially decrease payments to us for the services and equipment we provide. Recent legislation, including the Patient Protection and Affordable Care Act ("PPACA"), the Medicare Improvements for Patients and Providers Act of 2008 ("MIPPA"), theMedicare ,Medicaid and SCHIP Extension Act of 2007 ("SCHIP Extension Act"), the Deficit Reduction Act of 2005 ("DRA") and theMedicare Prescription Drug, Improvement, and Modernization Act of 2003 ("MMA"), contain provisions that directly impact reimbursement for the primary respiratory and other DME products provided byLincare . PPACA, as amended, is a comprehensive health care reform law that contains a large number of health-related provisions to take effect over the next several years, including various cost containment and program integrity changes that will apply to the home medical equipment industry. MIPPA delayed the implementation of aMedicare competitive bidding program for oxygen equipment and certain other DME items that was scheduled to begin onJuly 1, 2008 and instituted a 9.5% price reduction nationwide for these items as ofJanuary 1, 2009 . The SCHIP Extension Act reducedMedicare reimbursement amounts for covered Part B drugs, including inhalation drugs that we provide, beginningApril 1, 2008 . DRA provisions negatively impacted reimbursement for oxygen equipment beginning in 2009 through the implementation of a capped rental arrangement. MMA changed the pricing formulas used to establish payment rates for inhalation drug therapies resulting in significantly reduced reimbursement beginning in 2005, established a competitive acquisition program for DME, established a Recovery Audit Contractors ("RAC") program, which implemented a new method for recovery ofMedicare overpayments by utilizing private companies operating on a contingent fee basis to identify and recoupMedicare overpayments, and implemented quality standards and accreditation requirements for DME suppliers. These legislative provisions, as currently in effect and when fully implemented, have had and will continue to have a material adverse effect on our business, financial condition, operating results and cash flows. See "MEDICARE REIMBURSEMENT" for a full discussion of the PPACA, MIPPA, SCHIP Extension Act, DRA and MMA provisions. A SIGNIFICANT PERCENTAGE OF OUR BUSINESS IS DERIVED FROM THE SALE AND RENTAL OF MEDICARE-COVERED OXYGEN AND DME ITEMS, AND RECENT LEGISLATIVE ACTS IMPOSE SUBSTANTIAL CHANGES IN THE MEDICARE PAYMENT METHODOLOGIES AND REDUCTIONS IN THE MEDICARE PAYMENT AMOUNTS FOR THESE ITEMS. DRA changed the reimbursement methodology for oxygen equipment from continuous monthly payment for as long as the equipment is in use by aMedicare beneficiary, which includes payment for oxygen contents, related disposable supplies and accessories and maintenance of equipment, to a capped rental arrangement whereby payment for oxygen equipment may not extend over a period of continuous use of longer than 36 months. Separate payments for oxygen contents continue to be made for the period of medical need beyond the 36th month. Additionally, payment for routine 36
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maintenance and service of the oxygen equipment may be made following each six-month period after the 36-month rental period ends. The oxygen provisions contained in DRA became effective onJanuary 1, 2006 . In the case of beneficiaries receiving oxygen equipment prior to the effective date, the 36-month period of continuous use began onJanuary 1, 2006 . Accordingly, the first month in which the new payment methodology impacted our net revenues wasJanuary 2009 . We anticipate that the new oxygen payment rules will continue to negatively affect our net revenues on an ongoing basis, as each month additional customers reach the 36-month capped service period, resulting in up to two or more years without rental income from these customers. During 2011, we estimate that our sequential net revenues were reduced as a result of additional customers reaching the payment cap by approximately$20.2 million when compared to the prior year period. During the first half of 2012, we estimate that our net revenues were reduced by approximately$19.7 million compared to the first half of 2011, attributed to the oxygen rental payment cap. OnJuly 15, 2008 ,Congress enacted the MIPPA legislation which reducedMedicare payment rates nationwide for certain DME items, including oxygen equipment, by 9.5% beginning in 2009. In addition to the 9.5% reduction, CMS subjected the monthly payment amount for stationary oxygen equipment to additional cuts of 2.3% in 2009, thereby reducing the monthly payment rate from$199.28 in 2008 to$175.79 in 2009. The monthly payment amount was reduced by 1.5% in 2010, to$173.17 . We estimate that this reduction negatively impacted our annual net revenues in 2010 by approximately$8.4 million when compared to the prior year period. The stationary oxygen payment rate for 2011 was increased to$173.31 per month, an increase of 0.1%, and was not material to the Company's operating results in 2011. The stationary oxygen payment rate for 2012 has been established by CMS at$176.06 per month, an increase of 1.6%. We estimate that this increase will favorably impact our revenues in 2012 by approximately$10.0 million . A SIGNIFICANT PERCENTAGE OF OUR BUSINESS IS DERIVED FROM THE SALE OF MEDICARE-COVERED RESPIRATORY MEDICATIONS, AND RECENT LEGISLATION AND MEDICARE POLICY REVISIONS IMPOSED SIGNIFICANT REDUCTIONS IN MEDICARE REIMBURSEMENT FOR SUCH INHALATION DRUGS. Recently enacted legislation negatively affectedMedicare reimbursement amounts for covered Part B drugs, including inhalation drugs that we provide, beginningApril 1, 2008 (See "MEDICARE REIMBURSEMENT"). The SCHIP Extension Act required CMS to adjust the average sales price ("ASP") calculation methodology used to determineMedicare payment amounts for inhalation drugs by using volume-weighted ASPs based on actual sales volume rather than average sales price. CMS publishes payment rates for inhalation drugs each calendar quarter, representing the unit reimbursement rates in effect for inhalation drugs dispensed within that quarter. These payment rates may be subject to volatility as a result of the underlying ASP data used to determine the rates in effect each quarter. The quarterly ASP data published by CMS for inhalation drugs provided in 2010 and 2011 resulted in reductions in theMedicare payment rates for inhalation drugs that negatively impacted the Company's annual net revenues by approximately$5.0 million and$14.8 million , respectively. Based upon the ASP payment rates published by CMS for the first three quarters of 2012, and assuming no changes in the volume or mix of drugs that we currently dispense, we estimate that our annual net revenues will be favorably impacted by approximately$11.7 million in 2012 when compared with 2011. We can not determine whether quarterly updates in ASP pricing data will result in future reductions in payment rates for inhalation drugs, or what impact such payment reductions could have on our business in the future. Additionally, since 2011, CMS is using 103% of Average Manufacturer Price ("AMP") rather than 106% of ASP for a drug when ASP exceeds AMP by 5% for either two straight quarters or three of the past four quarters. The policy limits substitution of the price formula in a given quarter to only those drugs where ASP and AMP can be compared using the same set of national drug codes. We can not determine at this time which, if any, inhalation drugs might meet the criteria established for substitution in a particular future quarter, nor the impact on payment rates for such drugs in the event that the AMP formula is utilized.
FEDERAL REGULATORY CHANGES SUBJECT THE MEDICARE REIMBURSEMENT RATES FOR OUR EQUIPMENT AND SERVICES TO ADDITIONAL REDUCTIONS AND TO POTENTIAL DISCRETIONARY ADJUSTMENT BY CMS, WHICH COULD REDUCE OUR REVENUES, NET INCOME AND CASH FLOWS.
InFebruary 2006 , a final rule governing CMS' Inherent Reasonableness, or IR, authority became effective. The IR rule establishes a process for adjusting fee schedule amounts for Medicare Part B services when existing payment amounts are determined to be either grossly excessive or deficient. The rule describes the factors that CMS or its contractors will consider in making such determinations and the procedures that will be followed in establishing new payment amounts. To date, no payment adjustments have occurred or have been proposed as a result of the IR rule. 37
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The effectiveness of the IR rule itself did not trigger payment adjustments for any items or services. Nevertheless, the IR rule puts in place a process that could eventually have a significant impact onMedicare payments for our equipment and services. We can not predict whether or when CMS will exercise its IR authority with respect to payment for our equipment and services, or the effect that such payment adjustments would have on our financial position or operating results.
FUTURE IMPLEMENTATION OF A COMPETITIVE BIDDING PROCESS UNDER MEDICARE COULD REDUCE OUR REVENUES, NET INCOME AND CASH FLOWS.
CMS is required by law to establish and implement programs under which competitive acquisition areas will be established throughoutthe United States for purposes of awarding contracts for the furnishing of competitively priced items of DME, including oxygen equipment (See "MEDICARE REIMBURSEMENT"). The program was initially intended to be implemented in phases such that competition under the program would occur in nine of the largest MSAs in the first year, and an additional 70 of the largest MSAs in a second, subsequent round of bidding. The PPACA legislation expands the DME competitive bidding program from 79 markets under prior law to 100 markets. PPACA also adds a requirement to competitively bid all areas or use competitive bid information to set prices in all areas by 2016, effectively expanding the program to all geographic markets. For each competitive acquisition area, CMS is required to conduct a competition under which providers submit bids to supply certain covered items of DME. Successful bidders are expected to meet certain program quality standards in order to be awarded a contract and only successful bidders can supply the covered items toMedicare beneficiaries in the acquisition area (there are, however, regulations in place that allow non-contracted providers to continue to provide equipment and services to their existing customers at the new prices determined through the bidding process). The contracts are expected to be re-bid at least every three years. CMS is required to award contracts to multiple entities submitting bids in each area for an item or service, but has the authority to limit the number of contractors in a competitive acquisition area to the number it determines to be necessary to meet projected demand. CMS concluded the bidding process for the first round of MSAs inSeptember 2007 , however, inJuly 2008 ,Congress enacted the MIPPA legislation which retroactively delayed the implementation of competitive bidding and reducedMedicare prices nationwide by 9.5% beginning in 2009 for the product categories, including oxygen, that were initially included in competitive bidding. In 2009, CMS reinstituted the bidding process in the nine largest MSA markets. Reimbursement rates from the re-bidding process were publicly released by CMS onJune 30, 2010 . CMS announced average savings of approximately 32% off the current payment rates in effect for the product categories included in competitive bidding. As ofJanuary 1, 2011 , these payment rates were in effect in the nine markets only. We were offered contracts to provide oxygen equipment in just two of the nine markets,Charlotte andMiami , and we accepted and signed those contracts. The Company's annualMedicare revenues from the product categories in the nine markets affected by competitive bidding were approximately$48.0 million at the time the program commenced. During 2011, we completed acquisitions of companies that were contracted to provide home oxygen equipment and positive airway pressure devices in all nine competitive bidding markets. CMS is currently undertaking a second round of competitive bidding in up to 91 additional markets, with contracts expected to be effective inJuly 2013 . The bid submission period closed onMarch 30, 2012 , and CMS is expected to announce final pricing results inNovember 2012 . The Company'sMedicare revenues from the product categories in the 91 additional markets to be included in the second round of competitive bidding were approximately$267.0 million in 2011. The PPACA legislation requires CMS to expand competitive bidding further to additional geographic markets (certain markets may be excluded at the discretion of CMS) or to use competitive bid pricing information to adjust the payment amounts otherwise in effect for areas that are not competitive acquisition areas byJanuary 1, 2016 . We will continue to monitor developments regarding the implementation of the competitive bidding program. While we can not predict the outcome of the competitive bidding program on our business when fully implemented nor theMedicare payment rates that will be in effect in future years for the items subjected to competitive bidding it is likely that the program will materially adversely effect our future financial position and operating results.
FUTURE REDUCTIONS IN REIMBURSEMENT RATES UNDER MEDICAID COULD REDUCE OUR REVENUES, NET INCOME AND CASH FLOWS.
Due to budgetary shortfalls, many states are considering, or have enacted, cuts to theirMedicaid programs, including funding for our equipment and services. These cuts have included, or may include, elimination or reduction of 38
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coverage for some or all of our equipment and services, amounts eligible for payment under co-insurance arrangements, or payment rates for covered items. Approximately 7% of our customers are eligible for primaryMedicaid benefits, and State Medicaid programs fund approximately 12% of our payments from primary and secondary insurance benefits. Continued state budgetary pressures could lead to further reductions in funding for the reimbursement for our equipment and services which, in turn, could have a material adverse effect on our financial position and operating results.
FUTURE REDUCTIONS IN REIMBURSEMENT RATES FROM PRIVATE PAYORS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION AND OPERATING RESULTS.
Payors such as private insurance companies and employers are under pressure to increase profitability and reduce costs. In response, certain payors are limiting coverage or reducing reimbursement rates for the equipment and services we provide. Approximately 28% of our customers and approximately 32% of our primary and secondary payments are derived from private payors. Continued financial pressures on these entities could lead to further reimbursement reductions for our equipment and services that could have a material adverse effect on our financial condition and operating results. WE DEPEND UPON REIMBURSEMENT FROM THIRD-PARTY PAYORS FOR A SIGNIFICANT MAJORITY OF OUR REVENUES, AND IF WE FAIL TO MANAGE THE COMPLEX AND LENGTHY REIMBURSEMENT PROCESS, OUR BUSINESS AND OPERATING RESULTS COULD SUFFER. We derive a significant majority of our revenues from reimbursement by third-party payors. We accept assignment of insurance benefits from customers and, in most instances, invoice and collect payments directly fromMedicare ,Medicaid and private insurance carriers, as well as from customers under co-payment provisions. Approximately 49% of our revenues are derived fromMedicare , 32% from private insurance carriers, 12% fromMedicaid and the balance directly from individual customers and commercial entities. Our financial condition and results of operations may be affected by the reimbursement process, which in the health care industry is complex and can involve lengthy delays between the time that services are rendered and the time that the reimbursement amounts are settled. Depending on the payor, we may be required to obtain certain payor-specific documentation from physicians and other health care providers before submitting claims for reimbursement. Certain payors have filing deadlines and they will not pay claims submitted after such time. We are also subject to extensive pre-payment and post-payment audits by governmental and private payors that could result in material refunds of monies received or denials of claims submitted for payment under such third-party payor programs and contracts. We can not ensure that we will be able to continue to effectively manage the reimbursement process and collect payments for our equipment and services promptly. WE ARE SUBJECT TO EXTENSIVE FEDERAL, STATE AND CANADIAN REGULATION, AND IF WE FAIL TO COMPLY WITH APPLICABLE REGULATIONS, WE COULD SUFFER SEVERE CRIMINAL OR CIVIL SANCTIONS OR BE REQUIRED TO MAKE SIGNIFICANT CHANGES TO OUR OPERATIONS THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND RESULTS OF OPERATIONS. The federal governments ofthe United States andCanada and all states and provinces in which we currently operate regulate various aspects of our business. In particular, our operating centers are subject to federal laws that regulate the repackaging of drugs (including oxygen) and interstate motor-carrier transportation. Our operations also are subject to state and provincial laws, where applicable, governing, among other things, pharmacies, nursing services, distribution of medical equipment and certain types of home health activities. Certain of our employees are subject to state laws and regulations governing the ethics and professional practices of respiratory therapy, pharmacy and nursing. As a health care provider inthe United States , we are subject to extensive government regulation, including numerous laws directed at preventing fraud and abuse and laws regulating reimbursement under various government programs. InCanada , we are subject to numerous similar and other laws and regulations including anti-corruption laws and regulations. The marketing, billing, documenting and other practices of health care companies are all subject to government scrutiny. To ensure compliance withMedicare ,Medicaid and other regulations, regional health insurance carriers and state agencies often conduct audits and request customer records and other documents to support our claims submitted for payment of services rendered to customers. Similarly, government agencies periodically open investigations and obtain information from health care providers pursuant to the legal process. Violations of federal and state regulations can result in severe criminal, civil and administrative penalties and sanctions, including disqualification fromMedicare and other reimbursement programs, which could have a material adverse effect on our business.
Health care is an area of rapid regulatory change. Changes in the laws and regulations and new interpretations of existing laws and regulations may affect permissible activities, the relative costs associated with doing business, and
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reimbursement amounts paid by federal, state, provincial and other third-party payors. We can not predict the future of federal, state and local regulation or legislation, includingMedicare andMedicaid statutes and regulations, or possible changes in national health care policies. Future legislation and regulatory changes could have a material adverse effect on our business. WE ARE SUBJECT TO BURDENSOME AND COMPLEX BILLING AND RECORD-KEEPING REQUIREMENTS IN ORDER TO SUBSTANTIATE OUR CLAIMS FOR PAYMENT UNDER FEDERAL, STATE AND COMMERCIAL HEALTH CARE REIMBURSEMENT PROGRAMS, AND OUR FAILURE TO COMPLY WITH EXISTING REQUIREMENTS, OR CHANGES IN THOSE REQUIREMENTS OR INTERPRETATIONS THEREOF, COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND RESULTS OF OPERATIONS. We are subject to many comprehensive and frequently changing laws and regulations, and interpretations thereof, at both the federal and state levels, requiring compliance with burdensome and complex billing and record-keeping requirements in order to substantiate our claims for payment under federal, state and commercial health care reimbursement programs. On an ongoing basis, we have implemented policies and procedures designed to meet the various documentation requirements of government payors as they have been interpreted and applied. Examples of such documentation requirements are contained in the Durable Medical Equipment Medicare Administrative Contractor ("DME MAC") Supplier Manuals which provide that clinical information from the "patient's medical record" is required to justify the medical necessity for the provision of DME. Auditors working on behalf of the DME MACs 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, health care 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. Other government auditors have recently taken the same or a similar position. It may be difficult, and sometimes impossible, for us to obtain such documentation from other health care providers. If these or other burdensome positions continue to be adopted by auditors, DME MACs, other contractors or CMS in administering theMedicare program, we 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 toMedicare and our future revenues fromMedicare would likely be substantially reduced. We have also experienced a significant increase in pre-payment reviews of our claims by the DME MACs, which has caused substantial delays in the collection of ourMedicare accounts receivable as well as related amounts due under supplemental insurance plans. We estimate that accounts receivable subject toMedicare pre-payment review were approximately$59.9 million as ofJune 30, 2012 . We can not currently predict the adverse impact that these new, more burdensome interpretations of theMedicare documentation requirements might have on our financial position or operating results, but such impact could be material. EXPANDED GOVERNMENT AUDITING AND OVERSIGHT OF MEDICARE AND MEDICAID SUPPLIERS AND MORE STRINGENT INTERPRETATIONS BY THOSE AUDITORS OF REGULATIONS AND RULES CONCERNING BILLING FOR OUR PRODUCTS AND SERVICES COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND RESULTS OF OPERATIONS. Current law provides for a significant expansion of the government's auditing and oversight of suppliers who care for patients covered by various government health care programs. Examples of this expansion include audit programs being implemented by the DME MAC contractors, the Zone Program Integrity Contractors ("ZPICs"), the Recovery Audit Contractors ("RACs") and the Comprehensive Error Rate Testing contractors ("CERTs") operating under the direction of CMS. We work cooperatively with these auditors and have long maintained a process for centrally tracking and managing our responses to their audit requests. However, unlike other government programs that are subject to a formal rulemaking process, there are only limited publicly-available guidelines and methodologies for determining errors or for providing clear and timely communications to DME suppliers in connection with these new types of audits. As a result, there is significant lack of clarity regarding the authority of the auditors, their expectations for document production requested during audits and the methodologies for issuing claim denials, determining billing errors and calculating billing error rates. Along with other health care providers and suppliers, we have recently been subject to a significant increase in the number of pre-payment audits conducted under these new programs. Many of these audits have resulted in claim denial rates at our audited locations that are significantly higher than we, and others in the industry, have experienced in the past. In some cases, these high claim denial rates appear to be based on the auditors' incomplete or erroneous review of our submitted documentation or unclear scoring methodologies used by the auditors. In other instances, high claim denial rates have resulted from the auditors' use of inconsistent interpretations of the types of medical necessity documentation required for CMS to pay for the services we provide. We are appealing the results of these recent audits and making 40
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changes to our operating policies and procedures. We can not predict the adverse impact that the government's expanded auditing activities may have on our business, financial condition or results of operations, but such impact could be material. We have been informed by these auditors that health care providers and suppliers of certain DME product categories are expected to experience further increased scrutiny from these audit programs. When a government auditor ascribes a high billing error rate to one or more of our locations, it generally results in protracted pre-payment claims review, payment delays, refunds and other payments to the government and/or our need to request more documentation from referral sources than has historically been required. It may also result in additional audit activity in other company locations in that state or DME MAC jurisdiction. We can not currently predict the adverse impact that these new audits, methodologies and interpretations might have on our operations, cash flow and capital resources, but such impact could be material. COMPLIANCE WITH REGULATIONS UNDER THE FEDERAL HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT OF 1996 ("HIPAA"), THE HEALTH INFORMATION TECHNOLOGY FOR ECONOMIC AND CLINICAL HEALTH ACT ("HITECH ACT"), RELATED RULES, RELATING TO THE TRANSMISSION, SECURITY AND PRIVACY OF HEALTH INFORMATION AND SIMILAR CANADIAN REGULATIONS COULD IMPOSE ADDITIONAL SIGNIFICANT COSTS ON OUR OPERATIONS. Numerous federal, state and provincial laws and regulations, including HIPAA and the HITECH Act, govern the collection, dissemination, security, use and confidentiality of patient-identifiable health information. HIPAA and the HITECH Act require us to comply with standards for the use and disclosure of health information within our company and with third parties. HIPAA and the HITECH Act also include standards for common health care electronic transactions and code sets, such as claims information, plan eligibility, payment information and the use of electronic signatures, and privacy and electronic security of individually identifiable health information. HIPAA requires health care providers, including us, in addition to health plans and clearinghouses, to develop and maintain policies and procedures with respect to protected health information that is used or disclosed. The HITECH Act expands the notification requirement for breaches of patient-identifiable health information, restricts certain disclosures and sales of patient-identifiable health information and provides a tiered system for civil monetary penalties for HIPAA violations. If we do not comply with existing or new laws and regulations related to patient health information inthe United States andCanada , we could be subject to criminal or civil sanctions. New health information standards, whether implemented pursuant to HIPAA, the HITECH Act, congressional action or otherwise, could have a significant effect on the manner in which we handle health care related data and communicate with payors, and the cost of complying with these standards could be significant.
WE MAY UNDERTAKE ACQUISITIONS THAT COULD SUBJECT US TO UNANTICIPATED LIABILITIES AND THAT COULD FAIL TO ACHIEVE EXPECTED BENEFITS.
Our strategy is to increase our market share through internal growth and strategic acquisitions. Consideration for the acquisitions has generally consisted of cash, unsecured non-interest bearing obligations and the assumption of certain liabilities.
The implementation of an acquisition strategy entails certain risks, including inaccurate assessment of disclosed liabilities, the existence of undisclosed liabilities, regulatory compliance issues associated with the acquired business, entry into markets in which we may have limited or no experience, diversion of management's attention and human resources from our underlying business, difficulties in integrating the operations of an acquired business or in realizing anticipated efficiencies and cost savings, failure to retain key management or operating personnel of the acquired business, and an increase in indebtedness and a limitation in the ability to access additional capital on favorable terms. The successful integration of an acquired business may be dependent on the size of the acquired business, condition of the customer billing records, and complexity of system conversions and execution of the integration plan by local management. If we do not successfully integrate the acquired business, the acquisition could fail to achieve its expected revenue contribution or there could be delays in the billing and collection of claims for services rendered to customers, which may have a material adverse effect on our financial position and operating results.
WE FACE INTENSE NATIONAL, REGIONAL AND LOCAL COMPETITION AND IF WE ARE UNABLE TO COMPETE SUCCESSFULLY, WE WILL LOSE REVENUES AND OUR BUSINESS WILL SUFFER.
The home respiratory market is a fragmented and highly competitive industry. We compete against other national providers and, by our estimate, more than 2,000 local and regional providers. Home respiratory companies compete primarily on the basis of service rather than price since reimbursement levels are established byMedicare andMedicaid or by the individual determinations of private health plans. 41
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Our ability to compete successfully and to increase our referrals of new customers is highly dependent upon our reputation within each local health care market for providing responsive, professional and high-quality service and achieving strong customer satisfaction. Given the relatively low barriers to entry in the home respiratory market, we expect that the industry will become increasingly competitive in the future. Increased competition in the future could limit our ability to attract and retain key operating personnel and achieve continued growth in our core business.
INCREASES IN OUR COSTS COULD ERODE OUR PROFIT MARGINS AND SUBSTANTIALLY REDUCE OUR NET INCOME AND CASH FLOWS.
Cost containment in the health care industry, fueled, in part, by federal and state government budgetary shortfalls, is likely to result in constant or decreasing reimbursement amounts for our equipment and services. As a result, we must control our operating cost levels, particularly labor and related costs, which account for a significant component of our operating costs and expenditures. We compete with other health care providers to attract and retain qualified or skilled personnel. We also compete with various industries for administrative and service employees. Since reimbursement rates are established by fee schedules mandated byMedicare ,Medicaid and private payors, we are not able to offset the effects of general inflation in labor and related cost components, if any, through increases in prices for our equipment and services. Consequently, such cost increases could erode our profit margins and reduce our net income.
IF THE COVERAGE LIMITS ON OUR INSURANCE POLICIES ARE INADEQUATE TO COVER OUR LIABILITIES OR OUR INSURANCE COSTS CONTINUE TO INCREASE, THEN OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS WOULD LIKELY DECLINE.
Participants in the health care industry, including the Company, are subject to substantial claims and litigation in the ordinary course, often involving large claims and significant defense costs. As a result of the liability risks inherent in our lines of business we maintain liability insurance intended to cover such claims. Our insurance policies are subject to annual renewal. The coverage limits of our insurance policies may not be adequate, and we may not be able to obtain liability insurance in the future on acceptable terms or at all. In addition, our insurance premiums could be subject to increases in the future, which increases may be material. If the coverage limits are inadequate to cover our liabilities or our insurance costs continue to increase, then our financial condition and results of operations would likely decline.
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