2015 Healthcare Industry Report

Transcription

1 2015 Healthcare Industry Report MAZZONE & ASSOCIATES, INC.

2 Table of Contents Industry Overview... 4 Healthcare Industry Defined by M&A... 4 Key Factors for Success... 7 Key Drivers of External Growth... 8 Mergers & Acquisitions Marketplace... 9 Healthcare Industry Mature Life Cycle Emergency & Other Outpatient Care Centers Current Performance Segment Outlook Competitive Landscape Cost Structure Benchmarks Emergency & Other Outpatient Care Centers Key Statistics Home Care Providers Current Performance Segment Outlook Competitive Landscape Cost Structure Benchmarks Home Care Providers Key Statistics Hospitals Current Performance Segment Outlook Competitive Landscape Cost Structure Benchmarks Hospitals Segment Key Statistics

3 Pharmacies & Drug Stores Current Performance Segment Outlook Competitive Landscape Cost Structure Benchmarks Pharmacies & Drug Stores Segment Key Statistics Specialist Doctors Current Performance Segment Outlook Competitive Landscape Cost Structure Benchmarks Specialist Doctors Segment Key Statistics MAZZONE & ASSOCIATES, INC. OFFICE TOWER AT THE FOUR SEASONS 75 FOURTEENTH STREET, NE SUITE 2800 ATLANTA, GA (404) Firm Overview Mazzone & Associates, Inc. is a mergers and acquisitions advisory firm serving the middle market. We provide comprehensive transactional services for middle market companies, private equity groups and individuals buying and selling companies, raising capital and structuring debt. Mazzone & Associates has experience working on more than 300 transactions valued in excess of $50 billion across a broad range of industries. We are relationship focused and appreciate that assignments are life events for many of our clients. Mazzone & Associates goal is to achieve the maximum results and value for its clients and their shareholders by executing transactions with the integrity, premium service and confidence they want, require and deserve. The sources for this industry report were National Retail Federation, IBIS World. Capital IQ, and interviews with leading industry executives. 3

4 Healthcare Industry: Defined by M&A Mazzone & Associates has continued to specialize in transactions in the Healthcare Industry, amongst its other key industry focuses. The Healthcare Mergers and Acquisitions (M&A) environment in the U.S. is anticipated to continue its strong growth trends with continued transparency in regulations and focus on improving outcomes, where the United States annually spends 17% of its gross domestic product on healthcare for patient care, treatments, services and technology. Strategic and private equity acquisition appetites for strong healthcare companies continue to grow, and this offers tremendous liquidity opportunities for business owners. As strategic acquirers become increasingly aggressive in their pursuit of new sources of growth, the robust public and private capital markets welcome the next wave of growth companies. Despite significant challenges in reimbursement and other operating factors, many healthcare providers continue to grow profitably by scaling their businesses. The Supreme Court s recent decision last month to uphold President Barack Obama s cornerstone reform fired the final flare to start the race to consolidate healthcare entities in the United States. The Affordable Care Act (ACA) has increased the insured population by 16 million Americans, in large part, due to the expansion of Medicaid, the government program for low-income Americans. With over 10% of the U.S. population still lacking insurance, there is still plenty of room to continue to grow. This growth will be fueled by the federal mandate to require insurance as well as subsidies. Coupled with a growing U.S. insured population, ACA and government payors have tightened margins for healthcare companies through lower reimbursement rates through initiatives like competitive bidding programs and the bundling of care. With ACA provisions ensuring lower profit margins for insurers and providers alike involved in the program, the businesses that can get bigger sooner gain a bigger stick and louder voice at the negotiating table with the payors. Although it has slightly slowed down in 2015, acquisition financing and non-bank lending over the last two years have been easier to obtain and have fueled mergers by limiting the amount of capital required from acquirers. Numerous opportunities for growth exist in the U.S. market for healthcare providers of all sizes, including the evolution and utilization of healthcare technology, tools and information. The U.S. government has increased healthcare spending to over $1.3 trillion in 2014 up from $1.0 trillion in Health reform over the last 7 years has been brought upon through a broad set of policies and programs leveraging databases and enabling healthcare champions to redefine the way we measure the quality of care. Although most people think about ACA when it comes to healthcare reform, the big data initiative within healthcare has been largely supported through the $19 billion set aside from the American Recovery and Reinvestment Act of 2009, equal to approximately $44,000 per physician for electronic record technology today. This program has fueled the rapid growth of the healthcare IT industry over the last few years and equipped providers and service companies with the tools to more effectively manage services and ensure compliance. On October 1st of this year, the U.S. Centers for Medicare and Medicaid Services will require all Health Insurance Portability and Accountability Act-compliant healthcare providers to transition to the 10th version of the International Classification of Diseases (ICD-10). The first update to the coding systems 4

5 in more than three decades, ICD-10 includes 68,000 codes roughly 50,000 more than its predecessor and has been adopted by more than two dozen countries around the globe. A universal theme in healthcare technology has been the increased utilization of cloud data and mobile devices. These systems are enabling sub sectors such as telemedicine to utilize tools like text, voice, and video-based case management to become a more cost efficient alternative to traditional healthcare. Patients increased use of phone apps and wearables for data gathering purposes have improved the capabilities of home monitoring tools and enabled healthcare providers to more efficiently perform preventative care measures. Over the long-term, one - third of doctors visits in the U.S. may be done remotely, which would be a huge step forward in convenience, access, and cost savings. With improvements in these three pillars, healthcare companies are looking to invest internally and acquire entities providing operating leverage through big data and remote technologies. Currently, the average physician needs 4.7 support people, defined as clinical and clerical roles, to administer care in a private practice setting. Through process improvements for these roles, technology is shifting the model from a provider centric model to a patient centric model. This increased utilization and reliance on technology allows physicians to spend more time with their patients and more effectively manage the practices. Utilizing big data to evaluate patient populations is being applied in systems to find common traits that could reveal disease risks and more successful treatments. For both consumers and healthcare providers, the increased use of big data and applications has also provided more transparency in local markets in a traditionally opaque industry. These elements are driving more competition on price and quality, more ability for patients to choose how, where and when they manage their own health and the rising standards of care. In this newsletter, Mazzone & Associates has focused on a few sub-industries listed below that the firm has recently advised on and executed transactions within. Emergency & Other Outpatient Care Centers. This segment includes establishments with medical staff primarily engaged in providing emergency, general or specialized outpatient care not included in other industries. This segment also includes centers or clinics that include a variety of health practitioners, each with different specializations and operating in different industries, who practice within the same establishment. Home Care Providers. Companies in this segment primarily provide services in the home. These services may be medical or nonmedical and include skilled-nursing care, personal care, homemaker and companion services, physical therapy and medical social services. This segment also includes inhome hospice care providers. Hospitals. This segment includes operators licensed as general medical and surgical hospitals that provide surgical and nonsurgical diagnostic and medical treatment to inpatients with medical conditions. Hospitals maintain inpatient beds and usually provide other services such as outpatient 5

6 services, operating room services and pharmacy services. The segment excludes psychiatric and other specialty hospitals. Pharmacies & Drug Stores. Pharmacies and drug stores retail a range of prescription and over-thecounter medications, health and beauty items, toiletries and consumable goods directly to consumers on a walk-in basis. Segment companies may also provide basic health and photo processing services. The segment includes retail stores with a pharmacy but excludes mail-order retailers, hospitals and clinics. Specialist Doctors. A specialist doctor is a physician whose practice is limited to a particular branch of medicine or surgery. This segment includes establishments or health practitioners with a doctor of medicine or doctor of osteopathy degree. These individuals primarily practice specialized medicine, such as anesthesiology, oncology and ophthalmology, or surgery. This segment does not include primary care physicians or mental health specialists. Revenue ($billions) Profit ($billions) Annual Growth ( ) Annual Growth ( ) Businesses Wages ($billions) Emergency & Other Outpatient Care Centers $98.0 $ % 2.3% 21,670 $32.9 Home Care Providers $74.8 $ % -2.2% 330,190 $38.1 Hospitals $988.1 $ % 3.9% 3,007 $365.2 Pharmacies & Drug Stores $262.9 $ % 2.9% 25,701 $30.3 Specialist Doctors $312.3 $ % 3.9% 219,064 $

7 Key Factors for Success The key factors for success in the Healthcare Industry that Mazzone & Associates looks for are set forth below. Access to highly skilled workforce: Attracting and retaining quality medical, nursing and administrative staff enables operators to provide superior medical care. Proximity to key markets: Consumers prefer to access facilities in close proximity to their homes or offices. Understanding government policies and their implications: A solid understanding of Medicare, Medicaid and private health insurance regulations and compliance can help minimize costs and maximize income. Having a good reputation: Patients and their referrers often seek out hospitals with a reputation for procedural expertise, good facilities and good patient outcomes. Provision of needed services: Certain specialties are in higher demand than others, and some specialties are more successful in areas with demographics that support them. For instance, geriatrics specialties are growing in demand due to the aging population. Recommendation/accreditation from an authoritative source: Accreditation with an acceptable organization can enhance a company's reputation, attract staff, and help gain access to private and government insurance reimbursement programs. Successful healthcare providers and service companies are able to bring better care for patients by improving quality, leveraging technology, ensuring compliance and increasing access. Companies providing multiple levels of care and a full suite of ancillary services along the patient value chain have been able to drive profitability in an increasingly competitive and consolidating market. -Stuart Sanford, Vice President of M&A 7

8 % change % change % change Key External Drivers of Growth Mazzone & Associates believes that the key external drivers of the Healthcare Industry continue to slowly rebound from the Great Recession. Our analysis of those factors is set forth below. Number of people with private health insurance. More than half of specialist doctors revenue is generated by private health insurance payments. Therefore, an increase in individuals with private health coverage benefits the industry. Factors such as unemployment rates, government policies and income levels in the United States affect the number of people with coverage. The number of people with private health insurance is expected to increase in Federal funding for Medicare and Medicaid. Increased federal and state funding of Medicare and Medicaid stimulates demand for healthcare services and determines the prices charged for those services. Although government funding for these programs is expected to increase in 2015, Medicare reimbursement is forecast to decline for home care providers, posing a potential threat to the industry. Number of adults aged 65 and older. Older adults are major users of healthcare services due to the development of diseases and assistance required later in life. The aging population and its increasing preference for home care over hospital stays are factors that make home care a growing part of the healthcare sector. The number of adults aged 65 and older is expected to increase during 2015, growing at a faster rate than the general national population. This signifies that Year Year Year Number of people with private health insurance Federal funding for Medicare & Medicaid Number of adults aged 65 and older 8

9 % change the elderly will make up an increasingly larger share of the population, which may represent a growth opportunity for the industry. Per capita disposable income. As per capita disposable income rises, 1 individuals are more likely to purchase insurance plans or be able to afford 0-1 out-of-pocket healthcare expenses, -2 such as home care services. Out-ofpocket Year payments make up about 10.0% of industry revenue. Per capita disposable income is expected to increase during Per capita disposable income Number of physician visits. The number of physician visits will rise due to healthcare reform enabling more individuals to afford healthcare services, particularly preventive care. As a result of consumers visiting their doctor more frequently, they will be more wary of their health issues, thus increasing demand for prescriptions. The number of physician visits is expected to increase in Healthy eating index. The healthy eating index is indicative of health trends that affect demand for several industry services. An increase in the healthy eating index indicates that people are making healthier choices, which may decrease the incidence of chronic conditions such as obesity and diabetes, which drive patients to outpatient facilities. The healthy eating index is expected to increase in Mergers & Acquisitions Marketplace M&A activity over the trailing twelve months (TTM), ending June 2015, marked a five year high for M&A in the Healthcare Industry. Although reported spending in the industry has shown steady growth since 2009, the number of transactions consummated in 2012 and 2013 declined for a brief period and has grown ever since the path to ACA became clearer for providers, insurers and consumers alike. Over the last two years, deal volume has been greater than any other time over the last six years; however there has been remarkable growth in the number of transactions consummated at values over $1 billion in the last two years. Furthermore, the ever growing trend driven by reimbursement to providing care through outpatient clinics and surgery center models has continued to drive growth in the middle market. The shift in policies and reimbursement from government payors and private insurance has driven consolidation for the mega healthcare payors as well, including the recent announcement of Aetna s pursuit in acquiring Humana. Overall, the TTM period through June 2015 has already had twenty-two (22) reported mega transactions, acquisitions in excess of $1 billion, compared to fourteen in 2014 and only eleven in The second quarter of 2015 saw a significant jump in these mega transactions with nine deals closed compared to only two deals closed in the second quarter of Most of the increase in these mega deals has come from strategic buyers. Although financial buyers have targeted deals in excess 9

10 of $1 billion, much of their focus has been on transactions between $ million. With the exception of a notable dip in 2013, reported spending by financial buyers has remained relatively unchanged since The increase in spending since 2012 has primarily come from strategic buyers looking to consolidate within their industry. Healthcare Services and Healthcare Facilities acquisitions represent the majority of deals that took place over the past few years, with Services accounting for a much larger share than Facilities in terms of reported value due to its larger average transaction size. The proportion of deals falling under each category remained relatively stable throughout the period. The only major shifts were a steady decline in the number of Healthcare Equipment deals from 2011 onwards, and a temporary shift away from Healthcare Services and toward Healthcare Facilities during the period from Although the volume of healthcare deals has declined slightly in 2015, the total reported value of these deals grew substantially. This increase in reported value can largely be attributed to Anthem Inc. s acquisition of Cigna Corp. for $53 billion. This same deal also accounts for some of the divergence between the total reported value of strategic deals and that of financial deals during the June 2015 TTM period. However, even excluding Anthem s transaction, strategic deals represent a growing portion of total reported transaction value. In terms of the number of transactions closed, the breakdown between strategic and financial buyers has remained relatively stable throughout the period. The overall increase in spending over the last two years within the Healthcare Industry is evidenced by the increase in transaction comps since The median EV/EBITDA for 2014 was 9.9x and EV/Revenue was 1.4x. These premiums are likely contributing to the increase in the number of transactions as value buys in the space have become scarce. Turning to the public equity markets, the Healthcare Industry has recovered with the rest of the market and experienced above average performance in As of December 31, 2014, median EV/EBITDA was 13.2x and median EV/Revenue was 2.0x, both up from prior years. Behind the increase in transaction and trading multiples in the Healthcare Industry is the increased transparency of ACA, its subsidies and the increased coverage of patients. Furthermore, non bank and traditional bank financing have become easier to obtain over the last 18 months, which has pushed purchase prices to levels over the last two years not seen since the mid-2000s. With stable and improving market conditions, this industry is likely to attract additional buyers and receive continued investment from the private equity sector. Comparable Median June TTM Transaction Multiples EV/EBITDA 10.2x 9.2x 9.8x 9.9x 13.2x 10.9x EV/Revenue 1.1x 1.0x 1.3x 1.4x 2.0x 1.6x 10

11 % of Deals Closed Billions Number of Transactions Billions Number of Transactions $160 $140 $120 $100 $80 $60 $40 $20 $0 Financial & Strategic Activity TTM 1,600 1,400 1,200 1, Strategic Deals Financial Deals Strategic Reported Value Financial Reported Value $160 $140 $120 $100 $80 $60 $40 $20 $0 Mergers & Acquisitions Activity TTM Reported Unreported Reported Value 1,600 1,400 1,200 1, % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Deal Volume by Transaction Size TTM <$10M $10M-$50M $50M-$100M $100M-$1,000M $1000M+ 11

12 June 2015 TTM Noteworthy Closed Transactions Noteworthy Transactions in Drug Retail Date Target Buyer/Investors Size ($ in millions) 6/15/2015 Target Corp., Pharmacy and Clinic Business CVS Pharmacy, Inc. $1,887 7/3/2014 MedPro RX, Inc. Diplomat Pharmacy, Inc. 75 3/25/2015 Reeves-Sain Drug Store, Inc. Fred's, Inc. 66 Noteworthy Transactions in Healthcare Technology Date Target Buyer/Investors Size ($ in millions) 9/14/2014 TriZetto Corporation Cognizant Technology Solutions Corporation $2,700 10/21/2014 Relias Learning, LLC Bertelsmann SE & Co. KGaA /19/2014 Change Healthcare Corporation Emdeon Inc /11/2015 Acclaris, Inc. Extend Health, Inc /30/2014 Simbionix USA Corporation 3D Systems Corporation 120 Noteworthy Transactions in Healthcare Distribution Date Target Buyer/Investors Size ($ in millions) 1/12/2015 MWI Veterinary Supply, Inc. AmerisourceBergen Corporation $2,525 3/2/2015 American Medical Systems Holdings, Inc. Boston Scientific Corporation 1,650 6/5/2015 The Harvard Drug Group, L.L.C. Cardinal Health, Inc. 1,115 5/4/2015 Animal Health International, Inc. Patterson Companies, Inc. 1,100 2/26/2015 BioRx, LLC Diplomat Pharmacy, Inc. 350 Noteworthy Transactions in Healthcare Facilities Date Target Buyer/Investors Size ($ in millions) 4/6/2015 AHS Medical Holdings LLC Ventas, Inc. $1,750 4/8/2015 MedExpress Urgent Care, PLLC Optum, Inc. 1,500 3/23/2015 Concentra, Inc. Welsh, Carson, Anderson & Stow e; Select Medical Holdings Corporation; Cressey & Company, LP; 1,055 Welsh, Carson, Anderson 3/17/2015 CSH Master Care USA Inc. HCP, Inc.; Brookdale Senior Living Inc /10/2014 Daughters of Charity Health System, Six California Hospitals Prime and Medical Healthcare Foundation Services, Inc. 843 Noteworthy Transactions in Healthcare Services Date Target Buyer/Investors Size ($ in millions) 3/30/2015 Catamaran Corporation OptumRx, Inc. $14,227 5/21/2015 Omnicare Inc. CVS Pharmacy, Inc. 11,631 10/9/2014 Gentiva Health Services Inc. Kindred Healthcare Inc. 1,906 6/4/2015 Bio-Reference Laboratories Inc. Opko Health, Inc. 1,541 10/29/2014 CRC Health Group, Inc. Acadia Healthcare Company, Inc. 1,229 Noteworthy Transactions in Managed Healthcare Date Target Buyer/Investors Size ($ in millions) 6/20/2015 Cigna Corp. Anthem, Inc. $53,516 12/8/2014 Care1st Health Plan, Inc. Blue Shield of California Life & Health Insurance Company 1,250 Noteworthy Transactions in Healthcare Equipment & Supplies Date Target Buyer/Investors Size ($ in millions) 10/5/2014 CareFusion Corporation Becton, Dickinson and Company $13,794 3/5/2015 Ikaria, Inc. Mallinckrodt Enterprises LLC 2,300 6/17/2015 Welch Allyn, Inc. Hill-Rom Holdings, Inc. 2,051 10/27/2014 Wright Medical Group, Inc. Tornier N.V. 1,541 12/17/2014 Volcano Corporation Philips Holding USA Inc. 1,

13 % Growth in share of economy Healthcare Industry Mature Life Cycle The different segments within Healthcare Industry are in various phases of their life cycles. Typically, an industry or industry segment is considered to be in a decline phase of its life cycle when industry value added (IVA), a measure of an industry or industry segment s contribution to the U.S. economy, falls below GDP. In contrast, a growth phase occurs when IVA outpaces GDP, while a mature phase occurs when IVA mirrors U.S. GDP. U.S. GDP is anticipated to rise at an annualized rate of 2.5% in the 10 years to The Emergency & Other Outpatient Care Centers segment is declining. During the 10 years to 2020, IVA, which measures the value that the segment adds to the overall economy, is forecast to increase 3.6% per year on average. In comparison, U.S. GDP is projected to increase by an average annual rate of 2.5% during the same period, illustrating that the segment will make up a growing percentage of the economy. The Home Care Providers segment is growing. Over the 10 years to 2020, IVA is forecast to grow at an average annual rate of just 0.1%, well below the expected 2.5% annualized growth of U.S. GDP during the same period. Segment performance is expected to be significantly different in the next five years than it was during the past five years, and future performance is highly dependent upon the continued implementation of significant Medicare funding cuts. The Hospitals segment is growing. IVA is forecast to grow an average 4.5% annually during the 10 years to This increase is faster than the projected average annual growth of U.S. GDP (2.5%) during the same period, which is characteristic of a segment in its growth phase. The Pharmacies & Drug Stores segment is mature. IVA is anticipated to grow at an annualized rate of 1.4% during the 10 years to Comparatively, GDP is expected to grow at an annualized rate of 2.5% during the period. High competition, coupled with many segment players consolidating, is indicative of a segment in the mature life cycle stage. The Specialist Doctors segment is growing. During the 10 years to 2020 IVA is forecast to increase 5.2% per year on average. In comparison, we project that U.S. GDP will grow at an average annual rate of 2.5%, meaning the segment will grow faster than the overall economy Maturity Company consolidation; level of economic importance stable Quality Growth High growth in economic importance; weaker companies close down; developed technology and markets Hospit als Home Care Quantity Growth Many new companies; minor growth in economic importance; Specialist substantial technology change Emergency & Other Outpatient Care Pharmacies & Drug Stores Decline Shrinking economic importance % Growth in number of establishments 13

14 Emergency & Other Outpatient Care Centers Demand for emergency and other outpatient care centers has grown steadily in recent years. Factors such as the aging population and the nondiscretionary nature of this segment's services helped bolster revenue throughout the five years to Despite the economic downturn, the segment grew at a strong pace throughout 2010 and 2011, largely due to the aging population and the growing incidences of obesity and diabetes. In more recent years, many Americans have returned to work and regained healthcare coverage, further contributing to demand for segment care. At the same time, the Patient Protection and Affordable Care Act has expanded public healthcare coverage in the United States and established exchanges providing even more Americans with access to private health insurance. Insurance payments account for the majority of segment revenue, so increased healthcare coverage is expected to drive revenue growth at an average annual rate of 3.4% during the five years to 2015, to total $98.0 billion. Revenue growth of 2.7% is expected in 2015 alone, due to the recent influx of newly covered patients. As the economy continues to grow during the next five years, we project that revenue will continue to rise. Revenue is forecast to increase at an annualized rate of 2.3% to $110.0 billion by 2020, when private exchanges will likely have increased the number of Americans with private insurance coverage by 32.0 million, according to the Congressional Budget Office. Since commercial insurance payments make up a significant portion of revenue and most of the segment's profit margin, this trend will raise both revenue and segment profitability. In addition to the growing number of privately insured Americans, consolidation across the healthcare sector is expected to boost segment margins. Larger operators will be better positioned for growth during the next five years, encouraging segment companies to expand and acquire competitors. Large companies will have more to gain from bundled Medicare reimbursements and will be better able to negotiate reimbursement rates with private insurers. Enticed by growing margins and the potential to strike lucrative acquisition deals with larger segment players, new operators will continue to enter the segment in the next five years, pushing the number of companies upward at an annualized rate of 3.6% during the period. Products and Services Segmentation (2015) $98.0bn HMO medical centers 8.6% Kidney dialysis centers 22.1% Other outpatient care centers 41.4% Freestanding ambulatory surgical and emergency centers 27.9% 14

15 Current Performance The Emergency and Other Outpatient Care Centers segment includes several types of healthcare facilities, with kidney dialysis providers and ambulatory surgery centers (ASCs) representing its largest segments. The demographics of the patient population, the high value of quality care and the nondiscretionary nature of many outpatient services have fostered segment growth. In fact, the number of dialysis patients has increased in the past five years, driven by the aging U.S. population and growing incidences of obesity and diabetes. Over the five years to 2015, we expect segment revenue to grow at an average annual rate of 3.4% to $98.0 billion. This includes a forecast 2.7% increase in 2015, due to expanded health insurance coverage resulting from implementation of insurance exchanges under the Patient Protection and Affordable Care Act. ASCs, in particular, have become increasingly successful. Historically, these units began as offshoots of the emergency room, but now provide a broader range of care. Every year, about 20.0 million surgical procedures take place at ASCs across the country, according to the Ambulatory Surgery Center Association. As the population becomes more mobile, people are becoming less committed to particular physicians. The prevailing culture in the United States also increasingly values convenience in most services, including healthcare. Finally, modern physicians have sought ways to meet their patients' needs without having to be on-call at all times. These factors boosted the popularity of ASC services. Additionally, as the baby boomer generation ages, demand for outpatient surgery has risen because older individuals typically experience more health issues. Most notably, colonoscopic, orthopedic, eye and plastic surgery procedures are in greater demand because of the aging population. From competition to consolidation Having recognized that they share the same mission, hospitals have increasingly developed freestanding facilities under joint ventures with physicians in recent years. Outpatient centers benefit from these ventures because hospitals can bring their managed-care contracts and purchasing power to ASCs. At the same time, hospitals can take advantage of outpatient centers' lower operating costs and convenient locations. As hospitals have increasingly acquired independent outpatient centers, growth in the number of segment operators has decelerated. During the five years to 2015, the number of segment establishments is expected to increase 3.9% per year on average to 36,183. Consequently, employment is expected to rise an annualized 3.1% to 586,418 workers during the same period. This indicates that the rate of new entrants offsets the amount of consolidation occurring in the segment. Aside from physician joint ventures, consolidation among outpatient centers has been modest over the past five years. Only a small percentage of companies own 10 centers or more, mainly because there are few benefits in the segment to having a large operation. However, larger operators may be able to institute best practices that improve patient care or cut costs, and they may be more efficient at payment processing and regulatory compliance. Larger companies can also leverage purchasing power and properly capture claims data for billing. 15

16 $68.4 $70.4 $74.8 $79.4 $83.1 $86.6 $90.3 $92.5 $95.5 $98.0 $101.2 $103.0 $105.2 $107.7 $109.9 ($ MILLIONS) Medicare and Medicaid reimbursement Medicare and other health insurance programs recognize that freestanding surgical centers are more cost-effective for outpatient surgery than hospitals, contributing to growth in the number of procedures performed in ASCs. The list of Medicare- and Medicaid-approved procedures also continues to grow. However, the reimbursement rate for providing these services has increased more slowly than inflation in the past five years. In November 2014, the Centers for Medicare and Medicaid Services issued a final rule that increased payment rates for outpatient services by 2.3%. In addition, the final rule provides incentives to improve quality of care and outcomes for patients through the End-Stage Renal Disease Quality Incentive Program. In general, Medicare's new approach is expected to favor the segment, particularly major players DaVita HealthCare Partners and Fresenius Medical Care. The main benefits of the new system include an annual update mechanism to reflect inflation and a single payment that reduces administrative burdens. In addition, a formal process to track quality outcomes will enable larger companies to demonstrate superior performance over smaller chains and independent clinics, gaining greater pricing power over commercial insurers. Further, large operators can trim costs more effectively than independent companies because of their ability to purchase supplies in more substantial quantities. For example, DaVita and Fresenius provide supplies and dialysis services, and Fresenius also manufactures and sells equipment, so both companies can significantly reduce costs while maintaining a flat rate for all Medicare patients. The continuous shifts in reimbursement rates have forced providers to become more efficient, encouraging consolidation and shifting the economic burden to private-sector payers. Medicare reimbursement bundling, which bases payments on the expected cost of healthcare services, is expected to boost segment profit. In the original reimbursement system, the base rate was not linked to inflation; therefore, over time, service providers experienced losses and became overly reliant on selling prescription drugs to generate profit. $120.0 $100.0 $80.0 Emergency & Other Outpatient Care Centers $60.0 $40.0 $20.0 $- 16

17 Segment Outlook The Emergency and Other Outpatient Care Centers segment will likely play a large role in the healthcare delivery system over the next five years. With increasing focus on quality, cost and access, consumers and payers alike will seek out the convenient, cost-effective outpatient setting. Over the five years to 2020, we project that segment revenue will rise at an average annual rate of 2.3% to $110.0 billion; this revenue will increasingly be derived from private health insurance due to government budget pressures. Healthcare reform has already begun to provide more consumers with access to affordable insurance, and will likely continue to do so in the next five years, driving demand for healthcare services. Furthermore, the segment will continue to benefit from favorable demographic trends. Over the next five years, the number of U.S. residents aged 65 and older is projected to grow more quickly than the total population. As the population ages, the number of patients suffering from strokes or chronic diseases may increase, raising demand for segment services. Climbing rates of obesity and diabetes will further underpin demand; the Centers for Disease Control and Prevention projects that as many as one in three U.S. adults could have diabetes by Consolidation on the rise For some companies, such as dialysis centers, operating costs have risen faster than revenue. In response, large centers will continue to consolidate to better negotiate with suppliers and increase the sophistication with which they address supply purchasing. Consolidation and improved techniques for purchasing will help boost profit margins, despite rising costs for some supplies and flat to moderate increases in Medicare reimbursement. However, in response to growing demand for segment services, the number of segment enterprises is projected to grow at an annualized rate of 3.6% to 25,832 during the five years to This growth is, in turn, expected to expand employment by 2.6% per year on average, to 668,088 workers. New centers will continue to be built in select markets with committed groups of physicians. However, a number of operators will also close or merge with hospitals or other segment companies. Physician-owners of standalone centers will struggle to maintain their independence and financial security in the face of Major Market Segmentation (2015) Contributions, gifts & grants 5.3% Other 14.6% Patients (out-of-pocket) 4.9% Private insurance 39.8% $98.0bn Government 35.4% 17

18 volume, cost and regulatory pressures. Larger operators can negotiate with suppliers more effectively and have greater resources to meet quality measures mandated by Medicare. Reform affects physician ownership About 180 physician-owned outpatient centers exist in the United States. Physician ownership generally violates the Stark Law through the creation of a financial relationship between the physician and the facility. However, a longstanding exception to the Stark Law, the so-called "whole hospital exception," has allowed physicians to own hospitals and refer patients to them without breaking the general prohibition. Since the early 2000s, however, Congress and the Centers for Medicare and Medicaid Services (CMS) have attempted to slow the growth of physician-owned hospitals or eliminate physician ownership altogether. The most recent and significant challenges to the physician-ownership model have come from healthcare reform. Provisions of the Affordable Care Act amend the Stark Law's whole hospital exception and, as a result, will halt new construction of physician-owned hospitals and limit the expansion of grandfathered hospitals. To expand operations, grandfathered hospitals have to meet requirements that virtually no physician-owned hospital currently meets. These requirements are in addition to conditions already in place, such as disclosure of ownership, disclosure of physician coverage and other financial disclosure requirements. As a result of stricter enforcement of the Stark Law, growth in the number of establishments is forecast to slow during the five years to Medicare payments remain flat Medicare is also expected to undergo several changes due to healthcare reform and budgetary issues. The CMS has already started applying a new mechanism, the "productivity adjustment," that will reduce annual payment updates for most healthcare providers. This mechanism, which applies to many categories of healthcare providers, will keep Medicare reimbursement for ambulatory care centers roughly flat or in line with inflation. This will result in continued dependence on high payments from commercial insurance companies, which constitute the majority of profit for most segment players. Favorably for the segment, cuts to Medicare spending may result in an extension of the Medicare Secondary Payer (MSP) provision. This provides for the coordination of a benefits period between Medicare and private health insurance plans for individuals entitled to Medicare solely on the basis of end-stage renal disease (ESRD). If an individual is entitled to Medicare because of ESRD and is covered by an employer group health plan (EGHP), the EGHP is the first payer (primary) for the first 30 months. An extension of the MSP provision would positively affect the dialysis segment of the segment, because more patients would be covered by relatively generous private insurance. 18

19 Competitive Landscape The Emergency and Other Outpatient Care Centers segment has a low level of market share concentration. The two largest segment operators combined are expected to account for less than 20.0% of segment revenue in The largest segment operators include both for-profit and nonprofit entities. Market share concentration varies by industry segment, with the health maintenance organization (HMO) medical center segment having the highest level of concentration. Census Bureau data indicates that in 2007 (latest available data) the top four HMO medical center companies accounted for 78.0% of revenue in their segment, while the top four kidney dialysis companies accounted for 72.4% of revenue in their segment, the top four freestanding ambulatory surgical and emergency center companies accounted for 15.6% of revenue in their segment, and the top four other outpatient care center companies accounted for 14.5% of revenue in their segment. In the dialysis market, strict regulation of prices and rising costs are resulting in an increase in concentration. The dominance of large companies in the dialysis segment has provided operators with the ability to set high prices with commercial insurance payers. The most commonly cited reason for the pricing ability of dialysis providers is their high degree of local market penetration. Dialysis providers have successfully employed a facility clustering strategy that has often left them with a high degree of local market share and, often, local monopolies. Data from the Centers for Medicare and Medicaid Services show that over 65.0% of counties have only one dialysis provider option, and more than 90.0% of counties have a market leader with more than 50.0% of facilities. This facilitates bargaining power with commercial insurance companies among locally dominant companies. Basis of Competition Competition varies by industry segment, due mainly to differences in the types of services rendered and the sources of payment. Throughout the segment, however, most providers compete with hospitals that offer similar services. For instance, kidney dialysis centers compete with hospitals that operate dialysis facilities, although some dialysis centers also provide services to patients in hospitals. Because of their expertise in managing efficient centers, outpatient companies sometimes have contracts to manage inhospital centers. These are usually smaller facilities that do not compete directly with larger independent centers. Some commercial centers provide mobile in-house services as needed to hospitals without inhouse facilities. Many outpatient centers also compete with home healthcare solutions and providers. Ambulatory surgery centers Ambulatory surgery is a big piece of hospital business. Typically about half of all care is outpatient, and a significant portion of that is surgery. Outpatient surgery tends to be elective, scheduled and profitable. Outpatient procedures are representing an increasing proportion of all surgeries; consumer preferences and advances in technology and medical care are driving the explosion. In response, hospitals are developing programs focused on the most popular outpatient areas, among them gastroenterology, 19

20 orthopedics, gynecology, podiatry, pain management, general surgery and ophthalmology. Hospitals and freestanding outpatient centers are both responding to consumer demand for convenience and a noninstitutionalized environment by opening outpatient surgery centers closer to patients, most notably in the suburbs. Freestanding ambulatory surgical centers compete within local areas on the basis convenience, cost, quality of service and physician loyalty and reputation. Freestanding ambulatory surgical centers are usually at least partly owned by physician partners who utilize the center for a significant portion of their procedures. Increasingly, freestanding ambulatory surgical centers are offering extended recovery stays. Center owners will typically seek out physicians with a high volume of cases and a favorable case mix in terms of reimbursement. Kidney dialysis centers Kidney dialysis centers compete mainly on the basis of quality of care. Medicare offers a service to patients that compares dialysis facilities. Companies also compete based on convenience of location, office environment (patients spend up to 15 hours a week at a center) and the ability to attract and retain nephrologists (who, among other things, are a source of patients). An end-stage renal disease (ESRD) patient generally seeks treatment at an outpatient dialysis center near his or her home where his or her treating nephrologist has practice privileges. A company's relationships with local nephrologists and its ability to meet their needs and the needs of their patients are key factors in the success of dialysis operations. A few physicians, including the center's medical director, usually generate a significant portion of an outpatient dialysis center's patient base. Additionally, participation in the Medicare ESRD program requires that dialysis services at an outpatient dialysis center be under the general supervision of a medical director who is a licensed physician. Therefore, companies must engage physicians or groups of physicians to serve as medical directors for outpatient dialysis centers. The availability of kidney transplants is also a competitive factor, as recipients of kidney transplants will usually no longer require dialysis. Some large companies also manufacture and sell dialysis equipment and consumables, and such horizontal diversification has the potential to provide cost advantages. Barriers to Entry Barriers to entry in this segment are moderate, but vary significantly by industry segment. Barriers include regulatory hurdles, the up-front costs of establishing a center and the market power of incumbents. Regulation can represent a major barrier in establishing healthcare facilities. The healthcare sector is subject to regulation by federal agencies, states and local governments. States with certificate of need (CON) programs place limits on Barriers to Entry checklist Competition Concentration Life Cycle Stage Capital Intensity Technology Change Regulation & Policy Segment Assistance Level High Low Growth Medium Medium Heavy High 20

21 the construction and acquisition of healthcare facilities and the expansion of existing healthcare facilities and services. At the state level, CON programs were initially established in an effort to reduce healthcare costs by preventing unnecessary capital outlays for facility expansion in addition to assisting with patient safety and access to care. Many states, however, have eliminated the need to obtain a CON for dialysis centers. Healthcare facilities may also require licensure at the state or local level. Some facilities require certification at the federal level. Concentration is high in the kidney dialysis center segment, suggesting there are relatively higher barriers to entry in this segment. According to Fresenius Medical Care, a major segment player, vertically integrated global dialysis companies supplying both products and services have the best chance to retain and grow market share. Although the cost of establishing a dialysis center is not prohibitive, incumbents in this segment, as in other segments, benefit from relationships with hospitals and other healthcare providers that take time and resources to develop. Major Companies DaVita HealthCare Partners Inc. 8.9% Other 80.8% Fresenius Medical Care AG & Co. KGaA 10.3% Fresenius Medical Care AG & Co. KGaA Market Share: 10.3% Fresenius Medical Care AG & Co. KGaA is a Germany-headquartered kidney dialysis company offering dialysis products and services. The company's dialysis business is vertically integrated, providing dialysis treatment at its own clinics and supplying these clinics with a range of products. In addition, the company sells dialysis products to other dialysis service providers. No other company is dominant in both dialysis product and service businesses. Vertical integration provides unique control over supply costs in markets that are moving to a more comprehensive payment scheme. It also enables the company to participate in markets where it cannot provide services due to regulatory restrictions or market volatility. In 2014, the company provided dialysis treatment to more than 286,000 patients at 3,361 dialysis clinics in more than 45 countries. Through its segment-relevant Fresenius Medical Care segment, the company employs more than 95,000 workers worldwide, including 60,000 in the United States. In the United States, the company also performs clinical laboratory testing and provides inpatient dialysis and other services to hospitals under contract. 21

22 Operating Income ($ millions) Revenue ($ millions) Fresenius has been actively involved in several mergers and acquisitions in recent years. In late 2011, the company acquired Liberty Dialysis Holdings Inc. Liberty cares for about 19,000 patients and operates an estimated 260 clinics. These clinics are primarily situated in the western United States, whereas Fresenius is dominant in the east. Liberty has strong quality outcomes, with a segment-leading percentage of patients without catheters. This has become increasingly relevant since 2014 when quality measures, which include vascular access, began being used to determine reimbursement rates. Fresenius also acquired American Access Care Holdings in 2011, which almost doubled its vascular access operations. The company has also been engaged in international acquisitions, particularly in Europe and Asia. These acquisitions are in line with the company's strategy, which focuses on external growth. Financial performance Fresenius has experienced consistent revenue growth and, given segment trends, this growth is projected to continue in the years ahead. During the five years to 2015, we expect that Fresenius' U.S. dialysis services revenue will grow at an average annual rate of 7.0% to $10.1 billion. Fresenius has also been growing faster than the overall segment due in part to its size and acquisition strategy. The company generates the majority of its revenue from dialysis services, with the remainder coming from dialysis product sales. Geographically, North America is Fresenius' most important market, which has grown moderately on an organic basis from increased volume. Fresenius' profile in the United States mirrors the rest of the market in that the government covers most of their patients, yet a disproportionate level of revenue and profit is derived from commercial insurers. In addition, the company's operating profit has been on the rise. Fresenius has been able to reduce its operating costs, boosting its margins. With the introduction of bundled pricing in the U.S. dialysis market in 2011, Medicare created a major incentive for dialysis service providers to expand the use of homebased treatments. Under the new payment system, Medicare reimbursement is now equal for traditional in-clinic hemodialysis and home-based peritoneal dialysis. However, the company has faced several issues, including cuts to reimbursement, quadrupling of heparin prices and continued cost inflation on Fresenius Medical Care - Financial Performance* $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Operating Income Revenue *Estimates 22

23 other fronts. Nevertheless, the company has managed to maintain profitability, and Fresenius's segmentrelevant margin is expected to expand in DaVita HealthCare Partners Inc. Market Share: 8.9% Headquartered in Denver, DaVita HealthCare Partners Inc. is a provider of dialysis services in the United States for patients suffering from chronic kidney failure, also known as end-stage renal disease (ESRD). The company employs more than 53,000 workers and consists of two lines of business: dialysis and related lab services and HealthCare Partners (HCP). Accounting for about 66.0% of revenue, DaVita's U.S. dialysis and related lab services business provides kidney dialysis services to patients suffering from ESRD. HCP is a patient- and physician-focused integrated healthcare delivery and management company that provides outcome-based medical care. The company's dominant market share provides it significant scale benefits in purchasing drugs and equipment. For example, DaVita has preferred pricing contracts with Amgen for Epogen, the most commonly prescribed drug for dialysis. In November 2011, DaVita signed a supply agreement with Amgen under which Epogen will account for at least 90.0% of the dialysis provider's anemia drug requirements through DaVita also provides acute inpatient dialysis services in about 1,000 hospitals and related laboratory services. DaVita depends heavily on Medicare and private insurance programs. More than half of the company's U.S. dialysis and related lab services revenue stems from Medicare, making the government program its largest source of revenue. Although a small percentage of DaVita's clients pay using private insurance, DaVita charges these patients two to three times more than those affiliated with Medicare, and 34.0% of the company's revenue comes from nongovernment sources. In July 2012, DaVita agreed to pay $55.0 million to settle a lawsuit related to overuse of an anemia medication. The lawsuit was filed in 2002 and is based on a whistleblower's claim that DaVita overused Epogen, an anemia drug made by Amgen, over a 10-year period. DaVita contends its physicians did nothing wrong and stand by their anemia management practices, but says the settlement was in the best interest of its shareholders. In November 2012, the company acquired HealthCare Partners (HCP), the California operator of medical groups and physician networks, to capitalize on the growth of the Medicare-eligible population. Financial performance During the five years to 2015, DaVita's segment-relevant revenue is expected to grow at an average annual rate of 7.5% to $8.7 billion. Total company revenue jumped 43.7% in 2013 due to the acquisition of HCP, but this growth did not have a direct impact on segment-relevant operations. The company's segmentrelevant success is due to a rising number of treatments and growth in pharmacy services, infusion therapy services and other services. The company gained significant revenue from the acquisition of DSI Renal in September Additionally, tight control over costs helped DaVita maintain its profit margin 23

24 Operating Income ($ millions) Revenue ($ millions) during the recession, despite price pressures from governmental and commercial payers. Medicare's move to bundle reimbursement for dialysis treatment is expected to boost the company's profit margin. DaVita should benefit from the move to bundling, given its ability to trim costs in a fixed reimbursement environment. DaVita Inc. - Financial Performance $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $- $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $- Operating Income Revenue *Estimates Other Companies AmSurg Corporation Estimated market share: 1.5% AmSurg Corporation is a hospital operator that owns surgical centers throughout the United States. The company has 246 ambulatory surgical centers in 34 states and the District of Columbia. These centers focus almost exclusively on gastroenterology and ophthalmology, which have higher proportions of senior patients than other specialties. As a result, AmSurg is positioned to benefit from the aging of the U.S. population. Ambulatory surgery centers (ASCs) are healthcare facilities that specialize in providing surgical, pain management and diagnostic procedures in an outpatient setting. AmSurg is the largest U.S. operator of ASCs. In addition, AmSurg is the only operator of ASCs to focus on gastroenterology and ophthalmology. Its primary competitors are hospitals located close to its facilities, and like other operators of ASCs, the company benefits from lower overhead because its centers do not provide services such as emergency care and intensive care units, which account for much of the overhead in traditional hospitals. AmSurg has been able to deliver strong revenue growth in recent years, primarily driven by the addition of several new centers, through acquisitions and the development of additional ASCs. In September 2011, the company acquired National Surgical Care, along with its 15 multispecialty centers and two gastroenterology centers. In addition, the company acquired two other centers during late 2011 and 24

25 disposed of one center. Demand for lower-risk, high-volume surgical procedures performed by ASCs continues to grow, consistent with the demographics of an aging U.S. population. In 2015, the company is expected to generate $1.4 billion in revenue. Cost Structure Benchmarks Profit Operating costs vary significantly between market segments due to the varying nature of services rendered. Consequently, profitability also varies by industry segment as well as by company ownership structure. Profit is also impacted by payer reimbursement policies and increases in employee benefit rates and material costs. In 2015, profit, measured as earnings before interest and taxes, is expected to account for 13.7% of revenue for the average segment company. However, some operators have significantly higher margins while others are nonprofit entities. For example, kidney dialysis centers are expected to make a profit as high as 17.5% and freestanding ambulatory surgical and emergency centers make a profit of about 19.5%, while HMO medical centers are expected to make a profit of only 6.1%. U.S. Census Bureau data suggest that companies exempt from federal income taxes account for just under half of total segment revenue. The large number of nonprofit operators in the segment brings down its average profit margin. In the freestanding surgery center segment, profit margins can vary significantly depending on area of specialization. In the kidney dialysis segment, commercial patients generate most profit, even though these patients represent only 13.0% of annual dialysis visits. Most dialysis centers break even on Medicare and Medicaid, which cover the other 87.0% of patients. While this phenomenon is not unique in the segment or the healthcare sector at large, it is significantly more pronounced in dialysis care. Profit margins have increased slightly since 2010 due in part to Medicare bundling. Wages Wages and associated payroll costs are estimated to absorb 33.5% of segment revenue. Differences in wage costs between segments and companies are partly due to variations in the extent to which they employ physicians outside their full-time payroll. Employee-related costs include fringe benefits and contract labor. Wages' share of total segment revenue has slowly increased during the past five years, and is expected to continue to do so during the five years to Segment operators compete for nurses with hospitals and other healthcare providers, and as the segment continues to grow, more companies will be able to offer high wages to attract these personnel. Purchases In addition to labor costs, patient care includes the cost of drugs and other medical supplies, which make up an estimated 21.8% of segment revenue. Costs vary according to the type of services delivered. For 25

26 example, kidney dialysis centers pay to acquire drugs to combat anemia, boost red blood cell production and prevent blood clotting during treatment. The drug regimen primarily includes erythropoiesisstimulating agents, namely Epogen, heparin, iron and injectable vitamin D. Purchase costs have decreased slightly during the past five years as Medicare bundling has made providers less reliant on drug sales to maintain profitability. Other costs Litigation is an ongoing risk from patients who become ill or die due to treatment received at a segment facility. Suits alleging negligence, malpractice and product liability are common. Dialysis patients are particularly vulnerable to infections because of the invasive nature of hemodialysis. Companies often pay for malpractice insurance or incur costs directly related to lawsuits. Another risk management cost is bad debt expense. Because Medicare and Medicaid only cover a portion of the cost of many segment treatments, patients are often responsible for paying some share of the cost out of pocket. Companies have a difficult time collecting out-of-pocket payments and must therefore expense bad debt. 26

27 Healthcare Industry vs. Emergency & Other Outpatient Care Center Costs (2015) 100% 90% % 70% Profit Wages 60% Purchases 50% Depreciation Marketing 40% Rent & Utilities 30% Other 20% 10% 0% 8.7 Average Costs of Healthcare Industry 13.7 Emergency & Other Outpatient Care Center Segment Costs 27

28 Year Revenue ($millions) IVA ($millions) Establishments (Units) Enterprises (Units) Employment (Units) Wages ($millions) People w/private Health Insurance ($millions) , , ,262 16, ,686 27, , , ,112 17, ,349 28, , , ,063 17, ,105 26, , , ,054 17, ,111 27, , , ,907 18, ,456 29, , , ,850 18, ,339 30, , , ,959 19, ,062 30, , , ,724 20, ,210 31, , , ,260 21, ,679 32, , , ,183 21, ,418 32, , , ,893 22, ,653 34, , , ,730 23, ,050 34, , , ,348 24, ,430 35, , , ,338 24, ,154 36, , , ,022 25, ,088 37, Year Revenue IVA Establishments Enterprises Employment Wages People w/private Health Insurance Year Emergency & Other Outpatient Care Centers: Key Statistics IVA/ Revenue (%) Revenue/ Employee ($) Annual Change Key Ratios Wages/ Revenue (%) Employees/ Establishments Wages/ Employee ($) , , , , , , , , , , , , , , ,

29 Home Care Providers Prior to December 2013, the Home Care Providers segment was quickly becoming one of the fastestgrowing healthcare industries in the United States. Home care saves billions of dollars every year by allowing patients to avoid high-cost healthcare settings, such as hospitals. During the past five years, segment growth has been fostered by an aging U.S. population, the prevalence of chronic disease, growing physician acceptance of home care, medical advancements and a movement toward cost-efficient treatment options from public and private payers. As a result of these trends, revenue has grown at an annualized rate of 1.5% during the past five years, to $73.1 billion in However, despite strong past growth, segment funding from government sources has come under intense pressure in recent years. Government programs (including Medicare and Medicaid) generate an estimated 80.0% of segment revenue. Over the past five years, federal and state budgets have been shrinking, and sequestration only exacerbated this decline. Decreasing federal funding has resulted in reimbursement cuts for the segment and has suppressed profitability. Healthcare reform expanded access to insurance for some segment patients, but many states chose not to expand access to federal healthcare. Moreover, to help pay for other provisions of the recent healthcare legislation, the Centers for Medicare and Medicaid Services (CMS) announced the implementation of a four-year 3.5% annual reduction to the Medicare base payment for home healthcare services beginning in January The National Association for Home Care and Hospice estimates that the magnitude of these reductions will likely render threequarters of all segment operators unable to run profitably by According to the Partnership for Quality Home Healthcare, the segment experienced its largest job loss in more than a decade in December 2013; although the Medicare reductions were not officially implemented until 2014, CMS's announcement was enough to spur segment operators to begin cutting costs. The segment is aggressively lobbying Congress to reconsider or revoke these reductions, but unless that happens, we expect segment revenue to decrease at an annualized 1.9% in the five years to 2020, to $66.6 billion. Spurred by an expected revenue loss of 5.1% in 2015, we anticipate significant profit losses across the segment during the next five years. Products and Services Segmentation (2015) Homemaker and personal services 6.1% Home therapy services 9.1% $74.8bn Home hospice 22.6% Other 4.9% Traditional home healthcare and home nursing care 57.3% Mazzone & Associates Healthcare Industry Report 29

30 Current Performance The Home Care Providers segment, wherein skilled professionals provide medical and caregiver assistance to patients in their own homes, is a highly fragmented segment, with many small players offering a wide variety of home care services to an aging population. Relatively low barriers to entry and increasing demand for services keep the segment competitive; in some states where licensing is not required for nonmedical care, an individual with a personal vehicle may be enough to constitute a business. Larger segment operators do exist, but the nature of segment services (largely labor intensive, with low capital requirements) provides few incentives to accomplish economies of scale. Nonetheless, the relatively low profit margins that come from serving well-established segment markets (home-bound, largely elderly people paying for services through government reimbursement programs) encourage operators to undertake mergers and acquisitions to boost profitability and cut costs. Home care providers have expanded their role in the healthcare sector as the population has aged and people have increasingly preferred home care over institutional care. Over the five years to 2015, it s estimated that the number of people aged 65 and older has expanded at an average annual rate of 3.4% to 47.8 million individuals. People from this generation appreciate the independence of home care versus hospital care, and baby boomers have greater disposable income than previous generations, which has benefited the segment significantly over the past five years. Segment revenue is expected to grow at an average annual rate of 1.5%, reaching $73.1 billion in the five years to However, in November 2013, the Centers for Medicare and Medicaid Services (CMS) issued a ruling that slashed Medicare funding for home health programs by 3.5% per year on average from 2014 to Because home care providers are unsure how this ruling will shape the segment, and whether or not proposed updates to the rule will pass for fiscal 2016, segment revenue is expected to fall 5.1% in Consolidation and specialization Increased demand has fostered revenue growth, but reimbursement cuts have pressured the segment's operating profit. The poor economic environment and the state of the U.S. healthcare system have induced the government to reduce spending; home care has been an easy target because the segment is highly fragmented and does not have strong political representation. In response to pressured profitability and the need to differentiate services in this highly competitive segment, operators have consolidated throughout the past five years. Still, because of the segment's low barriers to entry, the number of companies is estimated to increase an average 0.8% per year to 312,531 operators over the five years to As companies have consolidated, they have also focused on providing specialized services. Prominent segment operator Gentiva Health Services has introduced more than 400 specialty programs, including Gentiva Orthopedics, Gentiva Safe Strides and Gentiva Cardiopulmonary, and now generates more than 40.0% of its revenue from these programs. As Gentiva garnered success through specialized disease management programs, other agencies followed suit, developing their own programs. As a result of this 30

31 $55.6 $59.4 $65.5 $64.2 $67.7 $71.2 $76.2 $77.8 $77.1 $73.1 $71.2 $69.3 $68.2 $67.1 $66.6 ($ MILLIONS) emphasis on specialized labor, total segment spending on wages has grown an annualized 0.6% in the past five years, to $37.3 billion, even as segment employment has fallen an annualized 1.0% to fewer than 1.4 million workers. Reimbursement risk In recent years, the Home Care Providers segment has been thrust into the government spotlight with repeated reports from the Medicare Payment Advisory Commission about excessive profit margins and accusations of questionable business practices. With the passing of the Patient Protection and Affordable Care Act (PPACA) in March 2010, the government planned to reduce the total reimbursement that Medicare-certified home health agencies receive under the Home Health Prospective Payment System. Payments from Medicare account for about half of segment revenue and, according to the National Association for Home Care and Hospice, the Medicare home health benefit was cut by $78.0 billion between 2009 and Medicaid reimbursements, the second-largest source of segment revenue, have also been subject to federal reductions. Government payment rates for Medicaid are determined according to published fee schedules pursuant to statute, law or other regulatory processes. Home and community-based services (HCBS) waivers afford state Medicaid programs the flexibility to develop and implement creative alternatives to placing individuals in hospitals, nursing facilities or intermediate-care facilities. Developing home and community-based alternatives to institutional care has been a priority for many state Medicaid programs in response to consumer demand and cost benefits over the past five years. While the majority of Medicaid long-term care dollars still go toward institutional care, the national percentage of Medicaid spending on HCBS has tripled since 1999, and now comprises 45.0% of Medicaid spending on long-term care. However, operators' dependence on federal funds for home care exposes them to changes in policy from year to year. Home care providers were stunned to learn that other provisions of the PPACA would be paid for using the $22.0 billion cut to the Medicare benefit for home healthcare, and have aggressively Home Care Providers $90.0 $80.0 $70.0 $60.0 $50.0 $40.0 $30.0 $20.0 $10.0 $- 31

32 lobbied Congress in the months since that decision was made and implemented. As a result of these reimbursement reductions and the unsure political climate, it s estimated that the segment's average profit margin will remain suppressed in 2015, accounting for just 7.3% of revenue, despite growing demand for segment services. Segment Outlook Strong and steady revenue growth seems likely for the Home Care Providers segment in the next five years, as a result of an aging population, increasing interest in home healthcare and expanded access to Medicare and Medicaid under the Patient Protection and Affordable Care Act (PPACA). The aging population will continue to foster revenue growth because this demographic requires more healthcare services compared with other age groups and increasingly prefers home care. Payers will also progressively shift to home care because it is more affordable than inpatient hospital and nursing-home care. Despite these favorable trends, Medicare and Medicaid reimbursement cuts will continue to seriously threaten the segment. In late 2013, the Centers for Medicare and Medicaid Services (CMS) was asked to assess potential reductions to the actual base Medicare payment for home health services. Partly to offset the costs of implementing other PPACA provisions, CMS approved the largest possible reduction of funding to the Home Health Prospective Payment System, equivalent to a 3.5% deduction per year on average from 2014 to Since the announcement and implementation of this reduction, segment operators and the associations that represent their interests have lobbied hard to convince Congress to reconsider or revoke this decision. As a result, we expect segment revenue to decrease an annualized 1.9% in the next five years, to $66.6 billion. According to Bureau of Labor Statistics data reported on by the Partnership for Quality Home Healthcare, the segment lost 3,700 jobs in December 2013, as a direct result of the announcement of the pending cutback in Medicare funding. Unless the decision to drastically reduce Medicare funding is amended, we expect segment-wide uncertainty and job loss to continue in the five years to 2020, with segment revenue expected to decrease an estimated 2.7% in 2016 alone. Major Market Segmentation (2015) Out-of-pocket 10% Private insurance 8% Other 2% Medicare 50% $74.8bn Medicaid 30% 32

33 Demographic and reform benefits Home care providers have benefited from the aging population, a trend that is forecast to continue in the coming years. According to senior advocacy organization AARP, the majority of people older than 50 want to live in their homes as long as possible. Because this demographic makes up an escalating percentage of patients, the segment will likely introduce more services that address issues commonly faced by individuals aged 65 years and older, such as chronic-disease management. Chronic diseases afflict more than million Americans, and the number is anticipated to increase significantly as more aging baby boomers are diagnosed with diseases such as congestive heart failure, chronic obstructive pulmonary disease and coronary artery disease. Chronically ill individuals already account for about 76.0% of all hospitalizations, which puts stress on an already-burdened healthcare system. As a result, chronic disease management is expected to become a segment mainstay over the next five years and will provide a significant source of revenue for operators. PPACA's guaranteed long-term care insurance, which individuals can pay for through payroll deductions, will likely support segment growth. Moreover, other provisions of the law will provide additional support for people who want to remain at home, because the law has generated nearly three dozen experimental projects testing ways to help older individuals avoid institutional care. For example, the Independence at Home project is testing whether incentive payments to primary care doctors and nurses will promote better care coordination for Medicare patients with two or more chronic illnesses. Impact of Medicare cuts As the wave of baby boomers requiring home care services drives demand volumes higher, the Congressional Budget Office estimates that the PPACA will result in an aggregate $39.7 billion reimbursement cut for Medicare-certified home health agencies from 2010 to Medicare accounts for 50.0% of total segment revenue, and the National Association for Home Care and Hospice estimates that these reductions will severely impact more than 75.0% of segment operators. As a result of these reductions, CMS expects that 40.0% of small home healthcare companies could go into the red by the end of 2017, and similarly expects to see average segment profit margins fall during the next five years. As profit falls, we expect that drastic cost-cutting measures amid significant threats to revenue and profit will likely cause segment employment to drop an estimated 4.9% per year on average, to fewer than 1.1 million employees in Total segment spending on labor will likely also drop an annualized 2.2%, to $33.4 million. As segment operators look to reduce costs amid significant budget cutbacks, lower-paid nonessential workers will likely be the first to be cut, and average segment wage will likely increase somewhat, as segment operators maintain only the most skilled professionals. However, much of the anticipated employment loss will be attributable to business closings. Many small segment companies will likely be unable to survive drastic funding reductions, particularly those specialized, niche operators who cannot rely on other, more steadily funded business segments to keep their companies running profitably. These companies will likely get acquired by large segment businesses, or leave the segment altogether, 33

34 causing the total number of home care providers to decrease an annualized 5.1% in the five years to 2020, to 240,854 operators. Competitive Landscape The Home Care Providers segment is highly fragmented: we expect the four-largest segment firms to generate about one-tenth of total segment revenue in As hospitalization costs have increased and aging consumers have embraced the home healthcare trend, many new firms have entered the segment in the past five years. The total number of segment operators has grown at an annual average rate of 3.8% during this period, a rate only slightly behind that of the segment's 4.8% revenue growth over the same period. The discrepancy between growth in number of operators and growth in revenue is largely due to the mergers and acquisitions that the largest segment companies have undertaken in the past five years; Gentiva Health Systems, for instance, acquired home health services company Harden Healthcare in We expect growth in the total number of segment firms to slow in the next five years, indicating that companies will continue to consolidate, the market will become more concentrated and the largest segment firms will control increasingly larger shares of the total home healthcare market. In terms of establishments, nonemploying home care providers dominate the segment, with more than nine out of every ten segment establishments having no payroll. The majority of these companies are operated as sole proprietorships. Nonemployers are particularly prevalent within the Home Care Providers segment due to the low barriers to segment entry; individuals can enter the segment as sole proprietorships with little or no startup capital or expertise. Even though nonemployers make up a significant share of segment establishments, they still only generate about one-tenth of total segment revenue on an annual basis. Nearly half of all segment nonemploying establishments generate less than $10,000 per year in revenue. Basis of Competition Internal competition Home care providers mainly compete on the basis of price, quality of services offered to patients and brand reputation. Obtaining accreditation from an applicable regulatory body can also be a competitive advantage in the segment. Prices are not the most critical basis of competition, because many segment services are rendered under government reimbursement programs such as Medicare. However, pricing is important in instances of bidding. Effective April 10, 2007, the Centers for Medicare and Medicaid Services began implementing a program of competitive bidding for Medicare Part B Durable Medical Equipment (DME), which means that companies can lose their ability to bill and be reimbursed by Medicare for DME items supplied in a competitive bidding area for the time covered by the competitive bidding program. There is also an expectation that the competitive bidding process for DME under Medicare will become a new benchmark for reimbursement from private payers. 34

35 Reputation is earned through providing quality services. Agencies that offer quality and consistent care can have a competitive advantage over players that do not. Companies that offer quick response times, quality service professional personnel and reliable quality assurance systems will also enjoy beneficial reputations. Reputation can also be promoted by marketing operations directly to potential patients, referrers and payers; home care providers often have a dedicated sales force to drive referrals. Some companies have sought to grow market share, including through acquisition activity, in order to better penetrate key geographic markets and more efficiently market products and services to physicians, hospital discharge planners and managed care organizations. Some operators believe that some referral sources and payers have a preference to purchase similar services from one provider. Gentiva Health Services, for example, indicates that its nationwide network of providers and financial resources is a valuable asset in seeking opportunities with managed care organizations. Some segment players align themselves with other health-care providers to raise their profile among managed care providers and provider networks. External competition Home care providers compete with alternative care settings, including hospitals, skilled nursing facilities and hospices. Generally, home care is cost competitive compared with other settings. This is particularly true for individuals who do not require extensive medical assistance. In contrast, during the recession, home care by segment operators met mounting competition from budget-strapped family members who opted to provide home care to their parents. As unemployment and disposable incomes have begun to recover, segment competition from family home care has decreased because professional home healthcare has become relatively more affordable. However, hospitals and other traditional alternative clinical care settings have similarly become more affordable as well, potentially threatening segment growth. Similarly, for individuals living alone who are self-sufficient, a phone call or occasional visit to the home from a friend, neighbor, or family member may be sufficient to help. An in-home alert system, which allows the individual to easily call for assistance, is a cost-effective alternative to home care. Technology is increasingly being used to aid seniors and other individuals who need basic help with daily activities at home or who require monitoring. For instance, if a senior is having difficulty with taking medications on time, automated medication dispensers (pill organizers that help ensure that medications and vitamins are taken properly and on time) are an easy and affordable solution. Other types of technologies, such as oxygen supplies, can be provided by companies that specialize in producing these products. Some industrial gas companies compete with home healthcare providers to provide oxygen to patients with respiratory illnesses. 35

36 Barriers to Entry Barriers to entry for the Home Care Providers segment are low, as evidenced by the large number Barriers to Entry checklist Level of segment players. The segment is highly fragmented with more than 310,000 different Competition High Concentration Low operators. A few companies hold significant market Life Cycle Stage Growth share positions in the respiratory and home Capital Intensity Low infusion therapy markets; nonetheless, there are Technology Change Medium also large numbers of regional and local providers Regulation & Policy Heavy in these market segments. Most segments of this Segment Assistance High segment are characterized by low capital costs (with the possible exception of the home respiratory therapy market segment) and the personalized nature of the services provided. These low capital costs make it relatively easy for a new firm to enter the segment because, instead of large upfront investments in equipment or property, most segment costs are limited to those associated with labor, including wage and transportation costs. Potentially significant barriers to segment entry include licensing and accreditation requirements, as well as the regulations required to obtain reimbursement from third party payers. These barriers vary by geographic business location: some U.S. states have licensing requirements, while others do not. For instance, California is not a licensure state for non-medical or custodial care services and therefore there are low barriers to entry in that state; consumers and their families adopt a "buyer beware" approach and hire caregivers that are bonded and insured. In contrast, Florida is a licensure state that requires different levels of licensing depending upon the services provided. This requirement makes it more costly, time consuming and difficult to open a segment firm in that state. Major Companies There are no major players in this segment. Other Companies The Home Care Providers segment is highly fragmented, with more than 90.0% of segment establishments consisting of sole proprietorships. No player in the segment accounts for more than 5.0% of segment revenue. 36

37 Gentiva Health Services Estimated market share: 2.8% Prior to its February acquisition by Kindred Healthcare, Gentiva Health Services (Gentiva) was one of the Home Care Providers segment s largest publicly traded operators. The company employed more than 39,000 people in its hospice, community care and home health operations, all of which are relevant to this segment. The company also delivered home health services through smaller specialty brands, such as Gentiva Orthopedic Services, which provided individualized home orthopedic rehabilitation services. As of year-end 2014 (latest available data), Gentiva operated 491 locations across 40 states. The company s revenue is highly dependent on federal funding, with Medicare and Medicaid consistently accounting for more than 80.0% of each segment s annual revenue. Over the past five years, revenue growth has been supported by acquisitions, organic volume growth and process enhancement changes. Revenue from the company s home healthcare segment alone is expected to grow by more than 10.0% in 2014, largely due to the Harden acquisition. In 2015, we expect Gentiva to generate more than $2.0 billion in revenue. However, the company s profit growth has been uneven in recent years due to fluctuations in federal reimbursement rates and the cost impact of large acquisitions. Gentiva operated at a loss in 2011 and 2013 and only posted an operating income margin of 1.6% in 2012; the company is expected to achieve higher margins in In October 2014, Gentiva agreed to merge with Louisville, KY-based Kindred Healthcare after months of negotiations. The merger, completed in February 2015, cost Kindred a reported $1.8 billion and will likely create a company with annual revenue in excess of $7.0 billion. However, the company s segmentrelevant holdings are not expected to change significantly, as Kindred primarily operates hospitals, nursing centers and rehabilitation facilities. Lincare Holdings Inc. Estimated market share: 2.7% Lincare Holdings (Lincare) is a provider of oxygen and other respiratory therapy services to patients. Lincare also provides a variety of durable medical equipment and home infusion therapies in certain geographic markets. Its principal products include home oxygen equipment, oxygen concentrators and liquid oxygen systems. Lincare operates 1,108 facilities in 48 states and differentiates itself from competitors by running small, lean branches with just seven or eight employees to increase labor productivity. Lincare s growth strategy includes expansion through acquisitions and opening new locations. Over the five years to 2015, the company has acquired local suppliers that have had trouble absorbing the Medicare cuts. The company s largest recent transaction was the purchase of Gentiva s oxygen and home infusion therapy business in February Lincare purchased roughly 45 Gentiva facilities in the deal, which is more facilities than the company has acquired in any single year in the past five years. In 2012, Lincare 37

38 was acquired by German industrial company Linde Group. Since then, the company has not publicly disclosed any financial information. We expect Lincare s annual revenue to exceed $2.0 billion in Amedisys Inc. Estimated market share: 1.6% Amedisys operates 367 Medicare-certified home health centers and 92 Medicare-certified hospice centers in 37 states, the District of Columbia and Puerto Rico. Home health services account for about 80.0% of company revenue, while hospice revenue generates the additional 20.0%. The company employs about 14,300 people and is headquartered in Baton Rouge, LA. Amedisys s services are primarily paid for by Medicare, which accounts for about 84.0% of company revenue. Amedisys s volume growth has been notably slow compared with its competitors, although the company has recently attempted to boost revenue by expanding its service offerings, developing referral relationships with physicians and hospitals and adding service centers in existing markets. Over the longer term, the company plans to develop from a home healthcare company into a post-acute chronic care company in the hopes of better serving the needs of seniors and diversifying the company s sources of payment so that the company will be less reliant on Medicare. The company s segment-relevant revenue, however, has fallen in recent years. In 2013, Amedisys consolidated, sold or closed 76 of its home health and hospice centers. Moreover, in 2014, Amedisys agreed to pay $150.0 million to the federal government for violations of the False Claims Act, the result of a 2010 federal lawsuit brought against the company by whistleblowers alleging that Amedisys billed Medicare for ineligible patients and service between 2008 and We expect the company s revenue to total $1.2 billion in Cost Structure Benchmarks Profit Segment profitability varies based on the size of a company and its specific healthcare offerings. Generally, respiratory therapy businesses have the highest profit margins, followed by infusion therapy businesses and home health agencies, which operate on significantly lower operating margins. Profit margins are further influenced by patient volumes and payer reimbursement. According to the Government Accountability Office, some segment agencies prefer Medicare to private or commercial-pay patients, because the Medicare system results in fewer visits per episode of treatment and a higher proportion of users categorized into higher payment groups. These factors increase a company's profitability; however, not all segment operators are shifting patient mix toward Medicare. Gentiva, one of the largest companies in the segment, has historically received about 80.0% of its revenue from Medicare and has not increased its patient mix. Instead, the company leverages its size to negotiate managed care contracts. 38

39 During the five years to 2015, operating profit, measured by earnings before interest and taxes, has generally remained steady, accounting for 7.3% of revenue for an average segment company. Significant profit growth has been largely suppressed by healthcare reform-related reimbursement cuts. According to the National Association for Home Care and Hospice (NAHC), the Medicare home healthcare benefit will face $22.0 billion in cuts by the end of NAHC estimates that about three-quarters of segment enterprises will be unable to operate profitably by 2017 if these payment reductions remain on the books. Therefore, although demand from baby boomers will grow in coming years, Medicare reimbursement cuts will likely cause average segment profit margins to decline to 4.6% by Purchases The Home Care Providers segment has only recently begun to view technology as a strategic asset, and, as a result, is several years behind other healthcare industries and has only recently begun to invest significantly in electronic data interchange (EDI). The Administrative Simplification provisions of the Health Insurance Portability and Accountability Act of 1996 require the Department of Health and Human Services to establish national standards for electronic healthcare transactions and national identifiers for providers, health plans and employers. The act also addresses the security and privacy of individually identifiable health information. Adopting these standards will improve the efficiency and effectiveness of the nation's healthcare system by encouraging the widespread use of EDI in healthcare. Electronic processing of transactions is expected to significantly reduce labor and error-related costs, but the initial investment in information technology may be a significant cost to many home care agencies. Purchases currently account for 7.5% of segment revenue, up slightly from In addition to growing purchase costs due to EDI implementation, this increase is partially due to a 2.3% excise tax on medical devices included in the Patient Protection and Affordable Care Act. Segment operators often purchase medical devices (such as respiratory aides) to provide home healthcare to patients and some device manufacturers have chosen to pass this cost on to customers (including home care providers) in the form of higher-priced devices. Although these prices will likely remain high in the five years to 2020, we expect segment companies to undertake drastic cost-cutting measures in the face of planned Medicare reimbursement cuts and accordingly purchase fewer medical devices. As such, purchases' share of segment revenue will likely remain steady during the next five years. Wages Home healthcare is considered a cost-effective alternative to extended hospitalizations, lengthy rehabilitation or nursing facility stays. Because the service is rendered in the patient's home, some of the large capital costs associated with facility-based care are avoided. As a result, home care costs are substantially labor-oriented. Wages account for 51.0% of segment revenue in 2015, down slightly from 2010, as labor costs have fallen slightly over the past five years due to cost-cutting initiatives. Unstable profit and revenue resulting from planned Medicare reimbursement cuts beginning in 2014 will likely force segment operators to continue to keep labor costs low. According to the Bureau of Labor Statistics, segment companies already began firing employees as early as December 2013, prior to the formal 39

40 implementation of the Medicare payment reductions. As segment-wide cost-cutting causes employment to fall an expected 4.9% during the next five years, we expect labor costs to decrease as well. Other Depreciation expenses vary depending on the equipment intensity of the business. For example, respiratory therapy businesses tend to invest highly in equipment. Gentiva Health Services, a provider of home health agency services, has depreciation and amortization expenses that consume 1.7% of revenue, while companies that focus more on home respiratory services, or other treatments that require heavy machinery, will likely face higher depreciation and amortization expenses. However, as the majority of segment revenue is generated by low-expense nursing care, depreciation only totals 1.1% of revenue for an average segment care provider. Other major costs for home care providers include administrative expenses (including those for legal and accounting services) and traveling expenses, which have increased over the past five years. A study by the National Association for Home Care and Hospice shows that the nurses, therapists, home care aides and others who serve elderly and disabled patients in their homes drive, on average, more miles annually than many driving professionals, including UPS drivers. This exposes the segment to rising gasoline prices and other transportation expenses, such as vehicle repairs and leases. 40

41 Healthcare Industry vs. Home Care Providers Costs (2015) 100% 90% % 6.8 Profit 70% Wages 60% Purchases 50% Depreciation Marketing 40% Rent & Utilities 30% Other 20% 10% 0% 9.7 Average Costs of Healthcare Industry 7.3 Home Care Providers Segment Costs 41

42 Year Revenue ($millions) IVA ($millions) Establishments (Units) Enterprises (Units) Employment (Units) Wages ($millions) Adults 65 years and over ($millions) , , , ,879 1,178,061 28, , , , ,332 1,239,410 30, , , , ,728 1,269,823 31, , , , ,023 1,361,610 34, , , , ,105 1,459,467 36, , , , ,085 1,549,487 37, , , , ,407 1,544,287 37, , , , ,274 1,584,437 39, , , , ,190 1,535,320 39, , , , ,531 1,384,858 37, , , , ,053 1,267,145 36, , , , ,434 1,156,904 35, , , , ,846 1,123,353 34, , , , ,600 1,088,530 34, , , , ,854 1,075,468 33, Year Revenue IVA Establishments Enterprises Employment Wages Adults 65 years and over Year IVA/ Revenue (%) Home Care Providers: Key Statistics Revenue/ Employee ($) Annual Change (%) Key Ratios Wages/ Revenue (%) Employees/ Establishment Wages/ Employee ($) , , , , , , , , , , , , , , ,

43 Hospitals As a primary provider of healthcare in the United States, hospitals are expected to generate $988.1 billion in revenue in Revenue is expected to increase 3.7% per year on average since 2010, including growth of 4.4% in 2015, as this traditionally fragmented segment has begun consolidating, largely due to the pressures of healthcare reform. Demand for segment services has steadily grown during the past five years, as healthcare reform legislation broadened insurance coverage and the sinking unemployment rate increased consumer disposable income. To maintain an advantaged position in this competitive segment, hospitals seek the most skilled and specialized healthcare professionals; therefore, labor costs are high. However, hospitals also face nurse and physician shortages and have struggled to recruit qualified personnel. As a result, wages' share of segment revenue has fallen during the five years to However, wages are expected to rise as a proportion of revenue during the next five years, as hospitals increase salaries and provide other employment incentives. Segment profitability has generally risen over the past five years due to increases in service prices. As the Patient Protection and Affordable Care Act continues to increase the number of insured Americans, demand for service will likely continue to increase, and the number of uninsured patients that hospitals treat will drop. As a result, we expect segment revenue to rise at an average annual rate of 3.9% to $1.2 trillion during the next five years. Average segment profit is estimated to rise over the same period from 6.6% to nearly 8.0% of revenue, buoyed by cost-cutting efforts and the Medicare and Medicaid Electronic Health Record (EHR) Incentive Programs. Still, reimbursement from Medicaid and Medicare will be strained while the federal government seeks to finance healthcare reform and individual states deal with budget deficits. Healthcare reform may also have the long-term effect of driving some patients out of the segment altogether. Hospitals are particularly expensive healthcare settings, and as Medicare and Medicaid begin imposing penalties for readmission, home healthcare will likely become more popular, eventually reducing demand for segment services. Technology will support this trend, as EHR and telemedicine apps enable patients to share information with healthcare providers from the comfort of their own homes. Products and Services Segmentation (2015) Outpatient care 46% Inpatient care 54% $988.1bn

44 Current Performance The Hospitals segment is expected to grow at an annualized rate of 3.7% during the five years to Demand has been high in recent years, and hospitals have been challenged to provide quality care while dealing with rising costs and increased competition for patients. In 2015, moderate improvements in the economy and further implementation of the Patient Protection and Affordable Care Act (PPACA) are expected to help boost revenue 4.4% to $988.1 billion. However, hospitals continue to face challenges from changes in reimbursement rates and a shortage of qualified personnel. Healthy revenue and profit Advances in healthcare have helped people live longer lives. According to the Centers for Disease Control and Prevention, the average U.S. citizen is currently expected to live more than 78 years. However, a longer life is generally accompanied by increased healthcare expenditure. As the median age of the U.S. population has increased, so has total domestic spending on healthcare. Hospital care is the largest single category of healthcare expenditure in the United States, so the aging population has generally contributed to segment revenue growth. The recession slightly reduced patient volumes, as individuals lost access to health insurance and decreased disposable income limited patients' ability to pay for services out of pocket. However, segment services are largely nondiscretionary, so many patients simply accepted care they could not afford, and profit margins for the average segment hospital fell as low as 5.8% in As segment operators moved to regain profit, many hospitals increased their prices for medical care. As the economy recovered and demand for segment services increased, high prices helped boost segment profitability. Profit margins have been further bolstered by the Medicare and Medicaid Electronic Health Record (EHR) Incentive Programs, which compensate eligible hospitals that demonstrate meaningful use of certified EHR technology. As a result, we estimate the profit margin for the average segment hospital will reach 6.6% in Consolidation and reform The enactment of major healthcare reform in 2010 through the PPACA has driven major changes in the segment. At its core, healthcare reform promises health insurance coverage for a large portion of the otherwise uninsured population; as a result, it will likely increase the number of patients that hospitals serve. In addition to expanding healthcare coverage, the PPACA prohibits insurance companies from denying coverage to children because of their health status, and allows them coverage under their parents' plans up to age 26. The law also provides that adults cannot lose their coverage when they get sick. These measures have already begun to reduce the number of patients who are unable to pay their healthcare bills. 44

45 $728.3 $757.9 $779.6 $794.0 $822.5 $844.8 $859.9 $900.3 $946.1 $988.1 $1,025.8 $1,061.6 $1,104.1 $1,146.9 $1,195.1 ($ MILLIONS) Medicaid expansion and the individual mandate to purchase insurance began to take effect in Coverage purchased in the health insurance exchanges must meet minimum benefit standards, and this requirement is expected to improve the segment's financial situation. However, many states have chosen not to expand Medicaid coverage, and widespread technical and bureaucratic issues plaguing the introduction of state exchanges have limited the expansion of private coverage. Cuts to Disproportionate Share Hospital payments, which provide additional compensation to care providers to offset the burden of treating an outsize number of uninsured patients, have further limited growth for hospitals in some states. In the midst of a tightened reimbursement environment, hospitals are consolidating to reduce costs by gaining better negotiating power with suppliers and payers. In the past five years, the total number of U.S. hospital companies is expected to decline at an average rate of 0.3% per year, to 3,007 in Reimbursement from government programs has grown at a slow pace, so hospitals have increasingly sought favorable contracts with nongovernment payers, including health maintenance organizations, preferred provider organizations and other managed-care plans. Revenue derived from these entities and other insurers is estimated to account for about 60.0% of patient revenue. Small hospitals are less able to compete for these lucrative contracts, while consolidated hospital companies can rely on economies of scale to offer a wider portfolio of providers and specialties. Hospitals are also consolidating to combat competition from other providers. Historically, the Hospitals segment has faced low competition because most communities are home to only a few hospitals. However, during the five years to 2015, the number of new facilities that deliver healthcare services, such as physician-run outpatient surgery centers, specialty hospitals and diagnostic centers, has grown rapidly. Independent competitors often have lower costs because of their smaller size and simpler infrastructure. Because hospitals use the income from high-margin operations to finance certain unprofitable services and procedures, increased competition has forced hospitals to use other strategies to decrease costs. $1,400.0 $1,200.0 $1,000.0 Hospitals $800.0 $600.0 $400.0 $200.0 $

46 Physician and nurse shortage To increase or maintain the breadth of specialized services they offer, hospitals must hire qualified physicians and nurses, which has become a segment-wide challenge because the nation faces a shortage in both professions. Hospitals have increased salaries to attract new hires, but while wages have grown an annualized 4.3% to $365.2 billion in the five years to 2015, segment employment has grown just 1.2% per year on average to 5.5 million employees. The nurse and physician shortage has occurred for a variety of reasons, including a scarcity of relevant education programs. According to a report from the American Association of Colleges of Nursing, U.S. nursing schools turned away 78,089 qualified applicants from baccalaureate and graduate nursing programs in 2013, due to budget constraints and insufficient faculty, clinical sites, classroom space and clinical preceptors. In addition, many physicians are getting older and have retired, or will in coming years. Segment Outlook In the five years to 2020, hospitals will face a wide variety of issues, including healthcare reform, reimbursement trends, electronic records and continued personnel shortages. Healthcare reform will likely continue to increase the number of insured patients, which will boost revenue. Other factors, such as the aging population, will also support revenue growth. As a result, we expect segment revenue to increase at an average annual rate of 3.9% to $1.2 trillion during the five years to In 2016 alone, revenue is forecast to grow 3.8%. Rising labor costs will continue to pressure segment profitability. However, the increasing number of people with health insurance will help offset these effects. Effects of reform The implementation of the Patient Protection and Affordable Care Act (PPACA) will likely continue to impact the segment in the five years to The total number of Americans with private health insurance is expected to grow an average 1.3% annually in the next five years, while funding for Medicare and Medicaid is expected to grow another 5.8% per year on average. As a result, demand for segment services will likely continue to grow in the next five years. However, hospitals may not benefit from more Medicaid patients unless these programs increase their reimbursement, which is often less than the cost of providing care. Despite a difficult reimbursement environment, a slowly growing insured population will likely lead to a moderate increase in profit margins to about 8.0% of segment revenue in 2020, up from 6.6% in Government incentives for hospitals to develop electronic health record (EHR) systems will likely have a long-term positive impact on segment profitability, although the initial costs of implementing this technology will somewhat hamper short-term growth. State and federal governments will soon institute new requirements for keeping electronic medical records. The Health Information Technology for 46

47 Economic and Clinical Health Act, part of the American Recovery and Reinvestment Act of 2009 (ARRA), includes billions of dollars in Medicare and Medicaid incentive payments to providers and hospitals for the "meaningful use" of certified health information technology products. The ARRA called for hospitals to create an EHR for every American by According to the Centers for Medicare and Medicaid Services, the funding will be distributed until 2019, and hospitals that fail to comply by this year stand to lose up to 1.0% of their Medicare reimbursements. To ensure segment-wide adoption, the federal government has already begun distributing nearly $20.0 million in new technical support assistance to help critical-access and rural hospital facilities convert from paper-based medical records to certified EHR technology. Acquisitions and employment Cash-poor nonprofit hospitals, which are unable to borrow money for needed improvements in facilities and equipment, will likely seek for-profit benefactors in the five years to Concurrently, for-profit hospital operators and investment firms will look to the nonprofit sector for growth opportunities. Nonprofit operators will also face new challenges due to healthcare reform. Section 9007 of the PPACA adds new requirements for charitable hospitals to become, or remain, exempt from federal taxation, including performance of periodic community needs assessments and development of a policy on financial assistance to patients. These changes will trigger further consolidation between nonprofit and for-profit operators in the segment. For-profit acquisitions of nonprofits are expected to increase during the next five years, reducing the number of segment operators an average of 0.5% per year to an expected 2,935 in The total number of segment hospitals will decrease concurrently, albeit at the slower annualized rate of 0.3% to 5,232 in Unfilled faculty positions at nursing colleges, attrition and a shortage of students preparing to be faculty will pose a threat to the nursing education workforce during the next five years. In light of healthcare reform and the subsequent demand for nursing services, the shortage of nurses will adversely affect the segment. Hospitals will likely enhance wages and benefits to recruit and retain nurses and other medical support personnel. Moreover, they may hire more expensive temporary or contract employees. As a result, we expect segment spending on wages to increase an annualized 4.3% in the next five years to $449.9 billion. Major Market Segmentation (2015) Patients aged 45 to % Patients aged 15 to % $988.1bn Patients under the age of % Patients aged 65 and older 38.8% 47

48 Competitive Landscape Despite widespread consolidation in recent years, the Hospitals segment remains fragmented, with hundreds of providers of various sizes spread throughout the country. No player accounts for more than 5.0% of segment revenue, and the four largest companies combined are estimated to account for less than 10.0% of revenue in However, concentration varies among geographic markets. For example, Hospital Corporation of America, concentrated in Florida and Texas, holds 20.0% to 40.0% market share in most of the areas in which it operates. Universal Health Services seeks leadership in growth markets and concentrates on medium-size cities with populations of up to 500,000 people, avoiding larger cities with many competitors. Community Health Systems has similarly focused on markets outside metropolitan areas, and a large proportion of their hospitals are in markets where there are no competitors. The implementation of healthcare reform will likely accelerate consolidation in coming years, thereby altering the hospital business. Healthcare reform will likely lower segment prices and enforce reimbursement models that create powerful incentives for hospitals to form large systems of care; these incentives include bundled payments, payments for quality and accountable care organizations. As a result of these changes, reform is expected to increase both the number and size of segment mergers. Basis of Competition Internal competition Hospitals compete based on quality of care, breadth of services offered and the ability to attract and retain quality physicians, skilled clinical personnel and other healthcare professionals. Patients may also choose a particular hospital based on convenience. In recent years, hospitals have increasingly shifted toward outpatient care models, which allow more flexibility for patients and improved efficiency for providers. Hospitals that are located proximate to a large pool of potential customers, such as a major urban area or a nursing home, will also have a competitive edge on the basis of convenience. A hospital's level of care quality is highly correlated with the quality of providers it has on staff. Patients are often referred to hospitals by physicians and other healthcare providers, and these medical professionals will be more likely to refer a patient to a hospital if that hospital offers high quality services administered by high quality staff. The Centers for Medicare and Medicaid Services publishes performance data related to quality measures and data on patient satisfaction surveys that hospitals submit in connection with their Medicare reimbursement. Federal law provides for the future expansion of quality measures that must be reported. Additional quality measures and future trends toward clinical transparency will likely escalate the competitive importance of quality for operators. Another major factor in the competitive position of a hospital is the ability to negotiate contracts with group healthcare service purchasers. Employers and other traditional health insurers attempt to contain 48

49 costs through negotiations with hospitals for managed-care programs and discounts from established gross charges. Generally, hospitals compete for contracts with group healthcare service purchasers on the basis of price, market reputation, geographic location, quality and range of services, quality of the medical staff and convenience. External competition During the five years to 2015, the number of freestanding specialty hospitals, surgery centers and diagnostic and imaging centers is expected to increase, and these healthcare providers directly compete with hospitals for patients. Specialty hospitals owned by physicians are one of the fastest-growing segments in healthcare; such facilities focus on one area of care, such as cardiac, orthopedic or general surgical services. The emphasis on cost containment coupled with service delivery innovation during the past decade has created opportunities for freestanding ambulatory surgery centers (ASC). These centers are limited-service alternatives that treat surgery patients who do not need to stay overnight. They have a unique competitive advantage because the centers do not offer inpatient services, so they typically service patients who have a low likelihood of complications arising from surgery. If the centers systematically treat relatively low-severity patients, then ASC care may result in a rise in the average severity of hospital-based patients, which will in turn likely increase the segment's average cost per patient treated. This rise in average severity negatively influences hospital profit margins because such a rise in severity, while having real cost consequences for the hospitals, is generally not accounted for under payment reimbursement mechanisms, including those Medicare uses. Barriers to Entry Barriers to entry in the Hospitals segment are high due to the significant regulatory requirements and Barriers to Entry checklist Level the experience and strength of incumbents. Competition Low Concentration Low Licensure, accreditation and regulation Life Cycle Stage Growth Capital Intensity Low Medical licensure creates a barrier to entry in the Technology Change Medium healthcare sector. Operators must meet extensive Regulation & Policy Heavy federal, state and local laws and regulations when Segment Assistance High establishing and operating hospitals. These regulations relate to the adequacy of medical care, equipment, personnel, operating policies and procedures. Regulations also involve maintaining adequate records, preventing fires, setting rates and complying with building codes and environmental protection laws. These regulations make it difficult and costly to enter the segment. The technological specifications for modern hospital buildings, including wide corridors and doorways, large elevators, strongly supported flooring and extensive plumbing, require an estimated four to nine years of planning and construction time. Additionally, the relatively large investment in infrastructure represents a cost that may discourage new hospitals from entering the segment. 49

50 State certificate of need (CON) laws, which limit a hospital's ability to expand services and facilities, make capital expenditures and otherwise enact changes in operations, have the effect of restricting competition in the segment. Before issuing a CON, states consider the need for additional or expanded healthcare facilities or services. In states that have no CON laws or set relatively high levels of expenditures before they become reviewable by state authorities, competition more commonly comes in the form of new services, facilities and capital spending. Other barriers In addition to licensure and regulation, other conditions serve as barriers to entry. In particular, economies of scale, learning curve effects and system affiliation can make it prohibitively costly for new hospitals to enter the segment. While hospitals benefit to some degree from size, considerably large hospitals can also find it difficult to control costs and reach optimum occupancy. Nonetheless, appropriately sized hospitals benefit from supply purchase discounts and negotiating power with payers, such as managed-care organizations. Incumbent hospitals may have somewhat lower costs and better patient outcomes because their physicians and other staff members can learn from each other and therefore may be more efficient than the staff in a new hospital. Learning by watching imparts productivity and quality improvements that occur over time, regardless of an increase in the number of services provided. Therefore, the cost advantages from learning do not necessarily depend on scale. Systems, as defined by the American Hospital Association, are multihospital or diversified single hospital systems. A multihospital system is two or more hospitals that a central organization owns, leases, sponsors or contract-manages. Single, freestanding hospitals may be categorized as a system by bringing three or more, and at least 25.0%, of their own or leased nonhospital organizations into membership. These hospitals may be preacute or postacute healthcare organizations. Hospitals that have system affiliation benefit from referrals from other physicians and contracts and negotiating power with payers. The system arrangement may represent a barrier to entry, as new operators will either need to join a system or be able to compete without the benefit of in-system referrals. Major Companies There are no major players in this segment. 50

51 Other Companies Hospital Corporation of America Estimated market share: 3.7% Hospital Corporation of America (HCA) is one of the largest operators of hospitals and health systems in the United States. Founded in Nashville, TN, in 1968, HCA operates 165 hospitals, including 159 general acute care hospitals. HCA also operates five psychiatric hospitals, one rehabilitation hospital and 115 freestanding surgery centers. The company has facilities in 20 states and England, and employs 204,000 workers. HCA's general acute care hospitals typically provide medical and surgical services, including inpatient care, intensive care, cardiac care, diagnostic services and emergency services. These hospitals also provide outpatient services such as surgery, respiratory therapy and physical therapy. HCA hospitals do not typically engage in extensive medical research and education programs. However, some hospitals are affiliated with medical schools and may participate in the clinical rotation of medical interns and residents and other education programs. About one-third of HCA's annual revenue comes from Medicare and Medicaid. The company's wide geographic presence helps it reach a large number of customers, which in turn boosts HCA's ability to generate revenue. We expect HCA's patient volumes to grow through 2015, driven by increases in emergency visits and surgical volumes. Admissions and revenue per admission were up in the first three quarters of 2014 (latest available data) and due to this growth, HCA's U.S. revenue is expected to grow 5.1% to $36.7 billion in The company attributes consistent revenue growth to its diversified portfolio of assets and services, combined with improvements in operating efficiencies. To further these efficiencies, in 2014, the company announced it would purchase PatientKeeper, a private company that HCA has been relying on for years to provide software and mobile applications that allow medical professionals to easily access patient information and records. Despite HCA's strong market position, use of the company's hospitals has stagnated in previous years. A comparatively lower occupancy rate, a dwindling number of inpatient surgeries and slow admissions growth reflect lower hospital use. Open-heart surgeries have also been declining, which is significant because these procedures generate high amounts of revenue per procedure, and a decline in these operations squeezes HCA's revenue per admission. At 54.0%, the company's occupancy rate (proportion of licensed beds occupied by patients) is low compared with some competitors. To improve future revenue and profitability, HCA plans to manage its facilities more effectively. Ascension Health Estimated market share: 2.1% Ascension Health, the nation's largest Catholic and nonprofit health system, was formed in 1999 with the merger of the Daughters of Charity National Health System and the Sisters of St. Joseph Health System. Headquartered in St. Louis, the company operates facilities across the southern, midwestern and northeastern United States. Ascension Health's hospital network consists of 212,000 associates serving 51

52 more than 500 locations in 21 states. Ascension Health also operates community clinics and other healthcare facilities; its facilities have a total of about 18,450 available hospital beds. In April 2013, Ascension added 16 more hospitals to its portfolio through the acquisition of Marian Health Systems, which is based in Tulsa, OK. Ascension recently attempted to sell its two St. Louis-area hospitals to HCA, which operates ten other hospitals in that market, but dropped the plans in February 2014, reportedly in light of increasing Federal Trade Commission attention to healthcare antitrust issues. We expect Ascension Health's revenue to reach $20.8 billion by fiscal year 2016 (year-end June). Tenet Healthcare Corporation Estimated market share: 2.1% Founded in 1967 and headquartered in Dallas, Tenet Healthcare Corporation is a healthcare service company that principally operates general hospitals and related healthcare businesses. Its subsidiaries also operate various healthcare facilities, including a long-term acute care hospital, outpatient surgery centers, diagnostic imaging centers, occupational and rural healthcare clinics and a number of medical office buildings. In October 2013, Tenet acquired major segment company Vanguard Health Systems for $4.3 billion. In 2014, the company acquired a majority interest in Texas Regional Medical Center (70 beds) and opened Resolute Health Hospital, a 128-bed facility near San Antonio. As a result of this merger and acquisition activity, Tenet's operations now include 79 hospitals and 189 outpatient centers in 15 states. Through the first nine months of 2014 (latest available data), these acquisitions pushed Tenet's total admissions up by 64.4% from the same period in Having improved its hospital portfolio through acquisitions, divestments, closures and market focus, Tenet's revenue has grown during each of the past five years. We expect the company's recent acquisitions to push the company's segment-specific revenue to $22.0 billion in According to Tenet's most recent annual report, the company believes that generally poor economic conditions restrained the public's level of spending on elective procedures. Nonetheless, the total number of surgeries performed at Tenet hospitals has increased annually in recent years, and the company's operating profit has risen accordingly. However, the company's profit margin dipped slightly in 2013, to about 5.5% of revenue, as a result of expenses associated with the Vanguard acquisition. The company's margin is, however, expected to rebound to higher than the segment average in Community Health Systems Inc. Estimated market share: 2.0% Community Health Systems Inc. (CHS) was founded in 1985 and is headquartered in Franklin, TN. The company's general care hospitals offer a range of inpatient and outpatient medical and surgical services, such as general acute care, emergency room services, general and specialty surgery, critical care, internal medicine, obstetrics, diagnostic care, psychiatric care and rehabilitation services. CHS also provides outpatient services at urgent care centers, occupational medicine clinics, imaging centers, cancer centers, ambulatory surgery centers and home health and hospice agencies. In addition, the company offers 52

53 management and consulting services to nonaffiliated general acute care hospitals. CHS owns, leases or operates 206 hospitals in 29 states, with more than 20,000 licensed beds. CHS has been acquisitive during the past decade, and this trend has promoted company revenue growth. In July 2013, CHS agreed to acquire Health Management Associates Inc. (HMA), a segment company that operates 70 hospitals and generated $6.5 billion in revenue in The merger was completed in the first quarter of 2014, and CHS now operates more hospital facilities than any other segment player. CHS's profit margin approached 9.3% prior to this acquisition, but dipped to about 7.0% in 2013, due to the costs of acquiring and integrating HMA. As a result of the merger, we expect CHS's annual revenue to total $19.5 billion in 2014, with profit margins recovering from the hit they took in Other nonprofit hospital operators Some higher education institutions are major hospital operators, including Johns Hopkins University and the University of Pennsylvania. Catholic Health Initiatives is an amalgamation of four Roman Catholic healthcare systems (Catholic Health Corporation of Omaha, NE; Franciscan Health System of Aston, PA; Sisters of Charity Health Care Systems of Cincinnati; and Sisters of Charity of Nazareth Health System of Nazareth, KY). About 12 different congregations sponsor CHI, which operates in 18 states and includes 93 hospitals, 40 long-term care, assisted-living and residential facilities and two community health organizations. Through its Quorum Health Resources subsidiary, the company also provides hospital management, consulting and advisory services to more than 200 independent community hospitals and health systems in 43 states. Nonprofit managed-care consortiums may also operate their own hospitals. For example, Kaiser Permanente operates 37 hospitals across nine states and the District of Columbia through their Kaiser Foundation Hospitals branch. Kaiser Foundation Hospitals reports their yearly revenue and earnings combined with those of the company's managed-care entity, Kaiser Foundation Health Plan. In 2013, combined revenue for these two entities is estimated to have topped $50.4 billion, with operating income likely exceeding $1.8 billion (latest available data). However, Kaiser does not disclose what portion of revenue or earnings is solely attributable to Kaiser Foundation Hospitals, the company's only segmentrelevant segment. Cost Structure Benchmarks Profit Profit, measured as earnings before interest and taxes, is expected to account for 6.6% of revenue for an average hospital in During the past five years, the number of for-profit hospitals has increased as a percentage of total operators in the segment, while the number of nonprofit and government-run hospitals has moderately decreased; this factor has driven profit up during the past five years. Hospital profit margins are expected to continue to rise during the five years to 2020 due to increases in the prices 53

54 charged for hospital care. However, profit growth has been somewhat limited, as occupancy stagnated and uncompensated care rose slightly. Moreover, some hospitals faced losses by caring for Medicaid patients because Medicaid reimbursement does not fully cover the cost of care. The segment-wide trend toward consolidation will likely further limit profit margins as companies incur costs associated with new business acquisition and integration. Wages Total segment spending on labor is estimated to account for about 37.0% of segment revenue in 2015, up from 36.0% in 2010, though this percentage varies by hospital type. During the economic recession, many hospitals reduced administrative staff and struggled to employ more physicians and nurses. Labor shortages and greater use of relatively expensive agency staff and other contracted labor have driven up wage costs. As a result, the average segment wage has also increased during the past five years. In some markets, the availability of nurses and medical support personnel has become a significant operating issue. To address this challenge, hospitals have implemented initiatives to improve retention, recruiting and productivity. The segment will likely continue to enhance wages and benefits to recruit and retain nurses and other medical support personnel or hire more expensive temporary or contract personnel. As a result, labor costs are expected to increase during the five years to Labor unions often represent hospital employees. Potential changes in federal labor laws, including the proposed Employee Free Choice Act, may increase the likelihood of employee unionization attempts. If a significant portion of the segment employee base unionizes, wage costs would increase materially. In addition, several states will likely adopt mandatory nurse-patient ratios, which could significantly affect labor costs and negatively affect revenue if hospitals need to limit patient admissions to meet the required ratios. Provision for doubtful accounts The main sources of segment revenue are from the collection of payments from Medicare, managed-care payers, other third-party payers and patients. The primary collection risks relate to uninsured patient accounts, including patient accounts in which the primary insurance carrier has paid the amounts the agreement covers, but failed to pay the responsibility amounts (deductibles and co-payments). Provision for doubtful debts can represent more than 10.0% of revenue for some companies, though the percentage can change from year to year and from company to company, depending on payer profiles, management policies and bad and doubtful debt estimates. Large segment companies, such as Ascension Health and Tenet Healthcare Corporation, average between 7.0% and 8.0% of revenue as provision for doubtful accounts, whereas this cost accounts for more than 11.4% of annual revenue for the Hospital Corporation of America. The total provision for doubtful accounts is based on a company's assessment of historical write-offs and expected net collections, business and economic conditions, trends in federal, state and private employer healthcare coverage and other collection indicators. 54

55 Trends that can make it difficult to reduce doubtful debts as a percentage of revenue include payer mix shifts to managed care, with greater patient co-payments and deductibles, and an increase in the volume of services provided to uninsured and under-insured patients. An increase in unemployment can also contribute to growth in doubtful account provisions. Doubtful debt is expected to have decreased over the five years to 2015, and will likely continue to decrease in the five years to 2020, as people become more able to pay their hospital bills due to the improving economy and healthcare reform legislation. Other costs Other major expenses include the purchase of supplies (e.g. medical equipment and devices and pharmaceutical supplies), which accounts for an estimated 17.0% of segment revenue. Depreciation and amortization (mainly buildings and medical equipment) account for an estimated 3.0% of revenue. Other expenses include repair and maintenance, consulting, malpractice insurance and information systems. 55

56 Healthcare Industry vs. Hospital Costs (2015) 100% 90% % 70% Profit Wages 60% Purchases 50% Depreciation Marketing 40% Rent & Utilities 30% Other 20% 10% 0% 8.6 Average Costs of Healthcare Industry 6.6 Hospitals Segment Costs 56

57 Year Revenue ($millions) IVA ($millions) Establishments (Units) Enterprises (Units) Employment (Units) Wages ($millions) Number of physician visits ($millions) , , ,320 3,258 4,953, , , , ,404 3,225 5,041, , , , ,413 3,187 5,133, , , , ,475 3,227 5,188, , , , , ,184 3,054 5,162, , , , , ,267 3,067 5,184, , , , , ,281 3,080 5,226, , , , , ,277 3,051 5,310, , , , , ,319 3,048 5,405, , , , , ,312 3,007 5,486, , , ,025, , ,280 2,981 5,547, , , ,061, , ,224 2,947 5,591, , , ,104, , ,250 2,956 5,647, , , ,146, , ,217 2,929 5,669, , , ,195, , ,232 2,935 5,714, , ,306 Year Revenue IVA Establishments Enterprises Employment Wages Number of physician visits Year IVA/ Revenue (%) Hospitals: Key Statistics Revenue/ Employee ($) Annual Change (%) Key Ratios Wages/ Revenue (%) Employees/ Establishment Wages/ Employee ($) , , , , , , , , , , , , , , , , , , , , , , ,

58 Pharmacies & Drug Stores The Pharmacies and Drug Stores segment has exhibited growth despite some negative side effects from the regulatory environment. For example, the segment has grappled with changing generic drug prices to reflect reimbursement rates. According to a survey by the National Community Pharmacists Association, 84.0% of pharmacists reported experiencing a spike in their generic drug acquisition price, or the price a pharmacy pays to pharmaceutical manufacturers, which has caused reimbursement rates set by Pharmacy Benefit Managers (PBMs) to lag. As a result of this trend, the segment has contended with PBMs not updating their payment benchmarks, thus causing the segment to not receive an adjusted reimbursement rate for their previous prescription sales, which has cut into segment revenue. Nevertheless, the patent cliff, which caused many blockbuster drugs to lose their patent exclusivity, has bolstered segment revenue. For example, new generic drugs typically provide high profit margins for pharmacies and drug stores due to pharmacies' purchasing of low-cost generic drugs in bulk and having more pricing power compared with brand drugs. To cut healthcare costs, many third-party payers, including Medicare, Medicaid and private health insurance providers, have implemented formulary tiers that favor generic utilization. For example, generic drugs are typically tier one drugs, which translates to low copayment costs for consumers. As a result of formulary tiers stimulating generic drug utilization, pharmacies and drug stores have benefited from more patients being able to afford their prescriptions. In the five years to 2015, segment revenue is anticipated to grow at an annualized rate of 1.2% to $262.9 billion, including slight 0.1% growth in 2015, which can be attributed to the burgeoning elderly population requiring medications to treat their chronic illnesses. Profit is expected to stagnate at 2.8% of segment revenue due to third-party payers increasing their negotiating power, which has constrained prescription drug pricing and profitability. In the five years to 2020, segment revenue is forecast to grow at an annualized rate of 2.9% to $303.3 billion. While healthcare reform will increase the number of individuals with health insurance, which increases the volume of pharmaceutical sales, the segment will contend with the government most likely initiating cost-cutting measures. Therefore, stringent reimbursement rates may cut into segment profitability. Products and Services Segmentation (2015) Cosmetics and toiletries 6.5% Personal health goods 7.5% Other merchandise and other photo processing services 8.0% Food and beverages 4.0% Generic prescription drugs 7.0% Branded prescription drugs 31.0% Specialty prescription drugs 12.0% $262.9bn Over-the-counter nonprescription medication 24.0% 58

59 Current Performance Over the past five years, many pharmacies and drug stores have included more preventive care services in their product portfolio, which has bolstered segment revenue. For example, many pharmacies and drug stores have included flu vaccines, immunizations and health screenings in their service offering, as well as monitoring patients' chronic conditions, which has stimulated segment revenue growth. Furthermore, as more individuals obtained health insurance thanks to healthcare reform, more patients were able to afford visits to their healthcare provider. As a result, more individuals were aware of their health conditions, prompting prescription sales volumes and benefiting the segment. In the five years to 2015, segment revenue is anticipated to grow at an annualized rate of 1.2% to $262.9 billion, including slight 0.1% growth in This growth can be attributed to the burgeoning elderly population requiring medications to address their numerous chronic health ailments. Profit is expected to stagnate at 2.8% of segment revenue in 2015 due to many third-party payers increasing their negotiating power, and thus constraining pricing and profitability for prescription drugs. Maintaining consumers Some budget-conscious consumers have cut their prescription costs by taking lower dosages, differing refills or switching from brand-name prescriptions to generic drugs. According to a study by Consumer Reports, generic drug prices are subject to substantial price disparities, with some alternative retailers, such as Costco, offering the least expensive options for prescriptions. Typically, prescriptions are about 10.0% more expensive at the drug store than at traditional grocers and 30.0% and 40.0% more expensive than at supercenters and dollar stores, respectively. To mitigate this trend and bolster front-end sales, many pharmacies and drug stores have offered discount products and discount rewards programs, evidenced by key player Rite Aid's wellness plus loyalty program. The segment derived an estimated 74.0% of total revenue from pharmaceuticals, including over-thecounter and prescription drugs, which demonstrates the segment's reliance on prescription sales to generate revenue. Nevertheless, the patent cliff has changed the segment's landscape over the period. From 2010 to 2013, many blockbuster drugs lost their patent exclusivity, which has allowed generic equivalents of the brand-name drugs to inundate the market. According to data from IMS Health, 86.0% of prescriptions dispensed in the U.S. were generic in 2014 (latest data available). Typically, new generic drugs are highly profitable for the segment, which has provided a boon for pharmacies and drug stores over the period. Furthermore, in response to rising healthcare costs, many health insurance providers, as well as federal programs such as Medicare and Medicaid, have implemented incentives to increase generic drug utilization. For example, generic drug utilization has saved the U.S. healthcare system an estimated $1.2 trillion from 2003 to 2012 (latest data available), according to the National Health Expenditure Accounts' (NHEA) report. By having reimbursement rates set into formulary tiers, third-party payers have increased generic- 59

60 $226.3 $233.5 $238.9 $244.5 $247.3 $251.7 $246.5 $259.5 $262.6 $262.9 $271.0 $279.1 $287.1 $295.2 $303.3 ($ MILLIONS) drug use among patients in their network by setting low co-payment costs for individuals that have purchased drugs in a low formulary tier, such as generic drugs. As a result, the segment has benefited from more individuals being able to afford their medications over the period, stimulating medication sales for the segment. However, spikes in generic acquisition costs have caused reimbursement rates to lag, posing an issue to the segment. According to a study by the National Community Pharmacists Association, 77.0% of pharmacists reported 26 or more occurrences of a spike in a generic drug's acquisition price over a six-month period, with 86.0% of pharmacists reporting that it took the Pharmacy Benefit Manager (PBM) two to six months to update its reimbursement rate. As a result of this trend, the segment has grappled with reimbursement rates being slow to reflect acquisition costs, which, in some instances, has incited some pharmacies and drug stores to refrain from filling prescriptions altogether. PBMs expand their role PBMs are third-party administrators of prescription drug programs and are responsible for processing and paying prescription drug claims. In 2014, more than million Americans nationwide received drug benefits administered by PBMs. As PBMs have consolidated, their ability to negotiate low reimbursement prices has increased, hampering segment revenue. For example, PBM leader Express Scripts Inc. (ESI) makes up an estimated 40.0% of the PBM market. Over the past five years, many PBMs have strengthened their preferred pharmacy networks and forced segment operators to accept unfavorable reimbursement rates, with some reimbursement rates being set below segment operators' costs. As a result, competition for operators is forecast to intensify. Nevertheless, the number of segment enterprises has increased at an estimated annualized rate of 0.9% to 25,701 companies in the five years to Many independent and small chain pharmacies and drug stores have entered the market to take advantage of a burgeoning elderly population, coupled with many pharmacies having robust front-store sales. Nevertheless, according to the IMS Health's 2013 Channel Distribution by U.S. Dispenses Prescriptions report, the number of prescriptions dispensed by chain stores has grown from 2,048 in 2008 to 2,230 in 2012 (latest data available). Comparatively, independent retail channels dispensed fewer prescriptions while food stores have captured a slightly larger share of the prescription market. While independent and $350.0 $300.0 $250.0 Pharmacies & Drug Stores $200.0 $150.0 $100.0 $50.0 $- 60

61 small chain pharmacies did not fare well over the past five years, many chain pharmacies and drug stores have expanded their product portfolio to cater to a customer base that increasingly used segment services as a form of preventive healthcare. The number of segment employees is expected to decline at an annualized rate of 0.6% to 721,320 workers, as automation has allowed many pharmacies to hire fewer front-end store employees. Segment Outlook Pharmacies and drug stores will prove to be indispensable over the next five years, as the segment will be an integral component in providing preventive care. As the number of insured individuals is expected to rise over the period, thanks to healthcare reform, many individuals will have lower out-of-pocket costs for their prescriptions. This trend, coupled with rising per capita disposable income, will enable more individuals to be compliant with their prescription dosages and refills, thus benefiting the segment. Over the five-year period, segment revenue is forecast to rise at an annualized rate of 2.9% to $303.3 billion due to the projected shortage of primary care physicians, according to the U.S. Department of Health and Human Services. This trend will enable more pharmacies and drug stores to provide preventive care services. Profit is expected to slightly rise from 2.8% of segment revenue in 2015 to 3.1% in 2020, which can be attributed to the segment dispensing more high-margin drugs, including biologic drugs. Patent cliff As the patent cliff is expected to continue through 2015, many brand-name drugs will lose their patent exclusivity. As a result, generic equivalents of the brand-new drugs will inundate the market, benefiting the segment. Generic drugs will bolster segment revenue due to low-cost drugs enabling more consumers to be compliant with their medication dosage and refills. However, the segment will grapple with less blockbuster drugs losing their patent, compared with the previous period. As a result, fewer new generic drugs will enter the market, which will constrain segment revenue growth. Further exacerbating this trend, consolidation among generic manufacturers will lower price-based competition among generic drug makers, thus causing the segment's generic acquisition cost, or the price of purchasing generic drugs from manufacturers, to rise over the period. While new generic drugs garnered high profit margins for the segment over the previous period, a smaller patent cliff will result in fewer new generic drugs, thus causing the segment to contend with generics being less profitable. For example, according to Drug Channels, the most widely dispensed generic drug has an average prescription price below $10.00, which demonstrates how low margins are for generic drugs. According to Express Scripts, the number of generic prescriptions dispensed in the United States comprised 80.2% of total prescriptions in 2014 (latest data available), which is anticipated to increase to 87.0% by Nevertheless, the segment will move toward bolstering revenue and profitability by offering a large product portfolio of high-margin biologic drugs. 61

62 According to McKinsey & Company, eight of the 10 top pharmaceutical drugs will be biologics by 2017, allowing the segment to play a growing role in preventive healthcare by ensuring that individuals adhere to their therapeutic regimens. For example, many biologic drugs have different dosing schedules based on the specific disease being treated, the patient's side effects or the patient's radiation schedule. This will prompt many pharmacists to provide an integral component in promoting patient prescription compliance and overall health. Additionally, according to a 2013 report (latest data available) by Health Affairs, an estimated 7.0 million people may be adversely affected by a shortage in primary care physicians after healthcare reform expands healthcare insurance coverage. As a result, many individuals will likely use retail clinic services for their preventive care, including immunizations, vaccinations, chronic illness management and other services. Competition and consolidation Over the next five years, competition will intensify, particularly due to mass merchants, mail order pharmacies and online pharmacies that compete with the segment for sales volumes, which cuts into prices for segment products. Additionally, Pharmacy Benefit Managers (PBMs) will consolidate, which will increase their ability to negotiate low reimbursement rates with pharmacies and drug stores, as well as establish their preferred networks. In particular, PBMs with strong bargaining power will constrain segment revenue for independent and small chain pharmacies, which will not have the leverage necessary to terminate unfavorable contracts. For example, PBMs can set stringent maximum allowable costs (MACs), which is a list of the maximum amounts a plan will pay for generic and brand-name drugs. Further limiting segment revenue growth, PBMs can choose the prescriptions on their MAC list, which will enable PBMs to set low reimbursement rates and charge high prices for MAC prescriptions. Due to high competition, particularly from external operators such as mail order pharmacies, coupled with low reimbursement rates, many pharmacies and drug stores will consolidate. Over the next five years, many large players will acquire small chain and independent pharmacies and drug stores to strengthen their market share and have the leverage necessary to negotiate favorable rates with PBMs. In the five years to 2020, the number of segment enterprises is expected to slightly increase at an annualized rate of 0.8% to 26,788 operators. As the segment contends with the shortage of pharmacists, many pharmacies and drug stores will raise the average wage to attract and retain their pharmacists. As a result, segment wages are anticipated to grow at an annualized rate of 3.1% to $35.4 billion over the period. Major Market Segmentation (2015) Consumers aged 18 and younger 9% Consumers aged 19 to 44 21% Consumers aged 45 to 64 40% $262.9bn Consumers aged 65 and older 30% 62

63 Competitive Landscape In 2015, the top four segment players generate less than 96.0% of segment revenue. The Pharmacies and Drug Stores segment primarily reflects an evolving duopoly, with Walgreens and CVS dominating the segment. The segment will consolidate over the next five years, with consolidation primarily occurring among independently operated pharmacies and drug stores as well as small chains. As a result, key segment players will strengthen their market share. Furthermore, rising Medicaid and Medicare prescription reimbursement rate pressures will create an increasingly competitive segment landscape for many pharmacies and drug stores. In response to consolidation, many key segment players will have larger operations by acquiring independent retailers or small chains to expand their geographical reach. As a result, small stores will grapple with competing against key players' brand recognition. Many key players will move toward lowering their costs by combining distribution networks, negotiating lower purchase costs and streamlining their management. Typically, independent community pharmacies, which are generally pharmacist-owned and privately held, employ about 10 individuals and account for 17.0% of firms. As major players continue to expand their market presence by acquiring other players, the share of small players within the segment is expected to decline. However, surviving independent pharmacies have started expanding in terms of revenue and volume per location, and they continue to receive the highest marks for customer satisfaction, based on surveys by JD Power & Associates. Basis of Competition Competition within the Pharmacies and Drug Stores segment is anticipated to rise, as many segment operators aim to benefit from the burgeoning elderly population's strong demand for prescriptions. As a result of the population aging, which translates to the rising prevalence of multiple chronic illnesses, the volume of drugs being prescribed by doctors is increasing. Due to this trend, segment operators are struggling to remain competitive and provide prescription dispensing services for this customer base. The segment is also exposed to external competitors, such as supermarket chains, mass merchandisers, online retailers and mail-order pharmacies. Operators compete on the basis of price and convenience; however, as more retailers sell pharmaceuticals, offering a diverse front-store product mix and developing customer loyalty is becoming more prevalent. Traditional drug store chains have also become more reliant on seasonally-specific merchandise. In particular, Halloween and Christmas are vital selling periods for drug chains, ranking similarly to the flu and allergy seasons, according to the National Association of Chain Drug Stores. Internal competition In response to high competition within the segment, many pharmacies and drug stores have consolidated. Many key players are acquiring small stores, thus causing the number of independent and small segment 63

64 operators to decline. Consolidation will enable key players to have larger operations, increase their purchasing power to leverage low-cost pharmaceuticals from brand-name and generic drug makers and have stronger advertising abilities. In particular, the segment is dominated by two chains, Walgreen Company and CVS Caremark, which are anticipated to comprise 85.0% of revenue in However, small and independent pharmacies and drug stores are trying to compete with convenient locations, full operational hours or private-label merchandise to attract a market niche. The segment is highly price competitive, especially for general product categories and consumables, such as aspirin and bandages. Operators' profitability also depends on their ability to negotiate favorable discounts from drug manufacturers. Due to the standardized nature of the segment's products and services, pharmacies and drug stores compete with each other on the basis of price and product selection. Location is another key competitive factor; stores located near other retailers, such as grocery stores or shopping mall stores, which can increase their foot traffic on the basis of convenience. Additionally, customer service plays a role in competition. For example, having highly trained and experienced staff that can provide quality advice on a range of ailments and products is a particularly valuable tool. High quality service produces customer loyalty and will be vital as pharmacies and drug stores provide a wider range of services, such as flu shots and health risk assessments. External competition External competition is blurring as many segment operators and competitor retailers offer similar products. For example, competitor retailers, such as supermarkets, supercenters and warehouses increasingly offer over-the-counter (OTC) drugs and prescriptions. Drug stores and pharmacies also offer additional products, such as milk, frozen foods and other consumable items to attract time-strapped consumers. Due to many operators consolidating, competition from external operators, like supercenters, has intensified. In particular, Walmart is the most competitive drug retailer, because the company sells more than 360 generic drugs for only $4.0 per prescription. Unfortunately for segment operators, Walmart's price is significantly lower than the price a typical pharmacy can offer and still cover costs, thus cutting into consumer demand for the segment's pharmaceuticals. In addition, Walmart's strategy has also adversely affected the segment's higher margin front-stores sales, which are heavily dependent on the segment's foot traffic of customers that purchase prescriptions. As the unemployment rate declines, which causes more consumers to be time strapped, mail-order pharmacies are developing a strong foothold in the segment. To attract time-strapped consumers, many operators are offering better service, customer-friendly refund policies, knowledgeable staff, product advice and free home delivery. As mail-order prescriptions becomes more common, segment operators will also contend with growing import competition from websites in Canada, for example, that ship relatively discounted products to customers. 64

65 Barriers to Entry The Pharmacies and Drug Stores segment is typified by moderate barriers to entry, although barriers to entry are increasing. Due to segment consolidation, which allows larger players to develop large networks and favorable supply-side contracts with pharmaceutical manufacturers, the segment is expected to have more barriers to entry over the next five years. Further offsetting potential segment entrants, the segment is subject to federal and state laws that make retailing certain products subject to stringent regulations. Barriers to Entry checklist Competition Concentration Life Cycle Stage Capital Intensity Technology Change Regulation & Policy Segment Assistance Level High High Mature Low Medium Medium Low Market concentration raises barriers Large drug store chains dominate the market; however, no single operator has control over pricing, advertising, distribution or customer loyalty. Potential segment entrants will contend with current pharmacies and drug stores having a range of locations, which will cause potential segment entrants to struggle to develop a market presence in an already saturated market. Large segment players have developed favorable supply contracts with wholesale distributors. As large operators negotiate low prices with distributors, they can pass these cost savings to customers, which expands their market share in line with lower cost prescription prices. Due to many key players using their leverage to secure favorable purchase and distribution costs, potential segment entrants will grapple with developing low-cost purchase contracts and distribution networks as well as generating brand awareness. Other possible barriers to entry The level of product differentiation among operators in this segment is relatively low, as most players tend to stock similar products and brands. Furthermore, the majority of products sold by this segment may be purchased from other retailers, such as supermarkets, supercenters and online merchandisers. Additionally, another barrier to entry is the trend of prescription drugs becoming increasingly over-thecounter (OTC). While OTC drugs generate large sales volumes, OTC drugs typically command low prices and many consumers purchase OTC products at supermarkets and other competitor retailers. As a result, potential segment entrants face rising competition from other retailers also selling prescriptions and OTC drugs. In addition, large segment operators' use of technology may prevent potential entrants from entering the segment. For example, major player Walgreens acquired an online pharmacy in 2011, which enabled the company to develop a market niche in the emerging online pharmacy market. While technology is not required to enter the segment, potential segment entrants may be at a disadvantage with their inability to attract an increasingly technologically-savvy consumer. 65

66 While this segment is not highly technical, considerable levels of capital are required to establish a new store or purchase an existing location. In particular, establishing a pharmacy or drug store in areas of high foot traffic is costly. Segment operators compete for locations near high levels of shopping traffic, which drives up rental costs or real estate values. Additionally, capital costs include acquiring and maintaining merchandise inventory. Many participants provide drive-through services, which generally require more space than a strip-mall store. Major Companies Rite Aid Corporation 9.8% CVS Caremark 54.0% Walgreen Co. 31.0% Other 5.2% CVS Caremark Market Share: 54.0% CVS Caremark Corporation (CVS) was formed in March 2007 from the merger of CVS Corporation and Caremark Rx Inc. and became an integrated provider of prescription drugs and related healthcare services. Headquartered in Woonsocket, RI, the company operates about 7,822 retail pharmacy stores throughout 44 states in the United States. CVS operates three business segments: pharmacy services, retail pharmacy and corporate. The pharmacy services segment offers a number of services through its pharmacy benefit management (PBM) services, such as plan and design administration, formulary management, Medicare Part D services and other services. The corporate segment provides management and administrative services to support the overall operations of the company. The retail segment, which is relevant to this segment, operates drug stores in 42 states, Puerto Rico and Washington, DC. In 2014, the retail pharmacy segment accounted for roughly million retail prescriptions. Prescription drugs account for 70.7% of the segment's total revenue, followed by general merchandise and other (13.6%), over-the-counter and personal care products (11.0%) and beauty and cosmetics (4.7%). The segment's strategy is to focus on shifting from primary dispensing prescriptions to also providing services, such as flu vaccinations and face-to-face patient counseling. In addition, the segment operates more than 971 retail healthcare clinics under the MinuteClinic name. The company also provides services that 66

67 Operating Income ($ millions) Revenue ($ millions) diagnose and treat minor health conditions, performs health screenings and delivers vaccinations. In 2011, the company acquired the Medicare prescription business of Universal American Corporation, supporting the company's PBM revenue growth. Additionally, the company has focused on developing mobile applications that enable users to easily refill their prescriptions and view potential drug interactions. Financial performance In the five years to 2015, revenue is anticipated to grow at an annualized rate of 8.0% to $141.9 billion. In 2015, revenue is expected to grow 1.8%, driven by many consumers transferring their prescriptions from Walgreens. In response to falling prescription reimbursement rates, CVS continues to expand its frontend business to increase customer traffic and purchases. CVS focuses on convenient store locations, customer service and satisfaction, product selection and price. For example, the company's loyalty card program, ExtraCare, has over 70.0 million cardholders, making it one of the largest loyalty card programs among the retail sector. In 2010, CVS introduced the urban cluster stores initiative, which includes stores with slight variations to appeal to local preferences. CVS completed 420 urban cluster stores in 2011, with the company expecting to add more stores with expanded grocery offerings, fresh and on-the-go food items and self-service checkouts. This strategy is anticipated to bolster revenue over the next five years. CVS Caremark - Financial Performance* $5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 Net Income Revenue *Estimates 67

68 Walgreen Co. Market Share: 31.0% Walgreen Co. (Walgreens) is the largest U.S. drug store chain, providing multichannel access to consumer goods and services, as well as pharmacy, health and wellness services to communities across the United States. Walgreens offers its products and services through drug stores, mail, telephone and the internet. The company sells prescription and nonprescription drugs and general merchandise, including household products, convenience foods and personal care and beauty items. Also, the company's pharmaceutical services include retail, specialty, infusion, medical facilities, long-term care, mail and respiratory services. Adding 258 new establishments in New York City through the acquisition of Duane Reade in 2010, Walgreens currently boasts more than 8,385 total locations. This transaction was a deviation from the company's traditional reliance on organic growth to drive its expansion. The company's main product segments are in pharmaceuticals, which comprise 63.0% of total prescription drug sales. Generic prescriptions account for about two-thirds of sales and are poised to increase as a share of total revenue in the five years to The remaining 12.0% of Walgreens' sales are derived from nonprescription drug revenue and general merchandise sales, including cosmetics, toiletries, food, beverages and tobacco products. Unlike its top competitor, CVS Caremark, Walgreens does not operate a pharmacy benefit management business. Pharmacy benefit managers (PBMs) administer drug benefits for employers and health plans. In 2010, Walgreens entered into a multiyear agreement with CVS Caremark, which includes Walgreens as an in-network pharmacy. In March 2011, Catalyst Health Solutions Inc. acquired Walgreens' pharmacy PBM business, Walgreens' Health Initiatives Inc., which indicated Walgreens' intentions to focus more on its pharmacy services. Also, in 2012, Walgreens acquired BioScrip's community specialty pharmacies and mail-service pharmacy business to diversify the company's product portfolio and include specialty pharmaceuticals. In 2013, the company acquired Kerr Drug, which included 76 retail drugstores, a specialty pharmacy business and a distribution center. Also in 2013, the company, along with Alliance Boots and AmerisourceBergen Corporation, has announced a 10-year pharmaceutical distribution agreement that will require the company to source all branded and generic pharmaceuticals from AmerisourceBergen. Financial performance In the five years to fiscal 2015, Walgreens' revenue is expected to increase at an annualized rate of 3.9% to $81.5 billion. In fiscal 2012, revenue declined an estimated 0.8% when the company left the Express Scripts pharmacy provider network, inciting many Walgreens customers to switch to other drug stores. In fiscal 2013, revenue increased 0.8%, propelled by the company's alliance with Alliance Boots, a European pharmacy operator. This alliance makes Walgreens one of the largest global purchasers of prescription drugs, which allows the company to secure low prices and pass on these low costs to consumers in the form of marked down prices. In fiscal 2015, the company is expected to benefit from the aging population, which will continue to drive demand for prescription drugs. 68

69 Operating Income ($ millions) Revenue ($ millions) The chain's revenue also benefited from improving health clinic performance. The company estimates that its clinics can provide 75.0% of the treatments that doctors have historically handled through nurse practitioners. For Walgreens, which operates 363 Take Care Clinics and 370 worksite health centers, the increased role of retail clinics allows the company's pharmacies to become a form of healthcare. Walgreen Co. - Financial Performance $5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $- $90,000 $80,000 $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $- *Year-end August Operating Income Revenue **Estimates Rite Aid Corporation Market Share: 9.8% Rite Aid Corporation is the third-largest drug store chain in the United States, based on the company's revenue and number of stores, with an estimated 4,623 stores in 31 states. Prescription drug sales comprise 67.6% of total sales. Other products include front-end products, such as over-the-counter medications, health and beauty aids, personal care items and cosmetics. The company tries to differentiate its store through wellness and loyalty programs, such as wellness plus, private brands and its strategic alliance with GNC, a leading retailer of vitamin and mineral supplements. Rite Aid offers a variety of private-brand products, which contribute 17.0% of its front-end sales; the company plans to increase the number of private-brand products in Over the next five years, the company anticipates to increasingly derive revenue from pharmacy sales due to the aging population, longer life expectancy and growth in federal funding for the Medicare Part D prescription program from newly eligible baby boomers enrolling. Financial performance Over the five years to fiscal 2015, we estimate that Rite Aid's revenue will grow at an annualized rate of 0.1% to $25.9 billion. In fiscal 2015, revenue is expected to grow 1.3%, as the company aims to develop a 69

70 Operating Income ($ millions) Revenue ($ millions) market niche among local clientele by becoming a destination for health and wellness. By investing in remodeling establishments, such as the Wellness store remodel program for example, the company will expand its operations to include immunizations and other key healthcare services. In fiscal 2013, revenue declined an estimated 2.8%, as pharmacy sales declined due to consumers purchasing more generic drugs. Further hampering revenue, reimbursement rates fell and the company closed stores. In fiscal 2012, the company benefited from a higher number of prescriptions, partly due to a dispute between Walgreens and Express Scripts. In addition, an increase in stores sales in 2012 reflected the positive impact of Rite Aid's wellness and loyalty programs, as well as other management initiatives to increase front-end sales. As of December 2012, the company's number of active wellness and loyalty members reached 25.0 million. In particular, the company's wellness plus loyalty program for seniors bolstered revenue in 2012, as well as the company's implementation of a strong flu immunization campaign for its flu shot services. In addition to the recession's impact on the company's operations, lower pharmacy reimbursement rates and higher markdowns associated with the company's wellness and customer loyalty program have further pressured profit. Rite Aid has historically faced financial problems, having narrowly avoided bankruptcy in In 2008, the company went through another deep financial crisis, attributing its fifth consecutive quarter of net losses to trouble integrating its acquired Brooks Eckerd pharmacies. Rite Aid has closed several stores in the five years to $1,000 $800 $600 $400 $200 $- $(200) $(400) Rie Aid Corporation - Financial Performance* $26,200 $26,000 $25,800 $25,600 $25,400 $25,200 $25,000 $24,800 $24,600 *Year-end March Operating Income Revenue **Estimates Other Companies Walmart Stores Inc. Estimated market share: N/A Walmart and Sam's Club, a division of Walmart Store Inc., operates retail pharmacies in 49 states and Puerto Rico. Walmart operates more than 4,200 pharmacies and employs more than 25,000 workers, 70

71 including 11,500 licensed pharmacists. The company's pharmacies operate throughout the country, in large, urban centers and small, rural communities. Walmart's pharmacies operate under the company's health and wellness segment, which makes up about 10.0% of total revenue. Since Walmart operates in a variety of industries and pharmaceutical sales are not the company's primary source of revenue, the company is not considered a major player within the Pharmacies and Drug Stores segment. Nevertheless, the company's introduction of $4.00 generic prescription drugs forced other pharmacies, particularly chain pharmacies, to reduce prices to remain competitive. In May 2008, the company announced the third phase of its $4.00 prescription drug plan; in addition to offering a month's supply of generic drugs for $4.00 as it had before, Walmart began offering $4.00 over-the-counter drugs and a 90-day supply of about 350 different generic drugs for $ The company's massive buying power and expansive retail stores created considerable competition in the segment. In November 2010, Walmart and Humana announced the 2013 Humana Walmart Preferred Rx Plan, a new Medicare Part D prescription drug plan with lower consumer co-payments for prescriptions filled at Walmart pharmacies. The $18.50 monthly premium makes it the lowest cost plan in every U.S. state, according to Kaiser Permanente's "2010 Fact Sheet." The discount retail prescription pricing will influence pharmacy choice while undermining the economic model of the three big pharmacy benefit managers: CVS Caremark, Express Scripts and Medco Health Solutions. Walmart serves Medicaid recipients in all states except North Dakota, where state law prevents it from operating pharmacies. A large majority of the company's pharmacy revenue comes from private insurers and cash paying customers. Its Medicaid business constitutes 11.0% of pharmacy revenue. Medicare Part B drug reimbursements account for less than 1.0% of revenue, as Medicare does not currently pay for most drugs sold in pharmacies. Costco Wholesale Corporation Estimated market share: N/A Costco Wholesale Corporation's first pharmacy opened in The company operates two central filling facilities. The locations fill all online prescriptions and orders for many Costco locations. The central fill facilities have reduced the cost of filling a prescription from $6.00 per prescription to $3.00 per prescription. Costco's pharmacies have consistently ranked among the leaders in customer satisfaction and prescription pricing. In the J.D. Power and Associates 2012 National Pharmacy Study, Costco has been among the top three pharmacies in terms of customer satisfaction in the three years leading up to Furthermore, Costco is considered a community pharmacy with the lowest prices for a wide range of prescription drugs, according to Consumer Reports. More than 50.0% of Costco's pharmacy business is paid for with cash; therefore, the company caters its products and services to people that do not have insurance. The company attracts these individuals by offering low prices. Costco's pharmacies operate on small margins. The company also tries to attract more 71

72 customers by offering more patient consultations than it did in the past. Costco's new pharmacies have private consultation and education rooms where it can show films to customers on healthcare subjects. However, because Costco operates in a variety of industries and pharmaceutical sales are not the company's primary source of revenue, it is not considered a major segment player. Target Corporation Estimated market share: N/A Target Corporation has prescription counters in most of its stores and the pharmacy has become a vital business segment. Along with other beauty, personal care, baby care and cleaning products, the company includes pharmacy sales under the household essentials segment, which accounts for about 25.0% of the company's revenue. For the past four years, the Target pharmacy has been recognized for delivering outstanding customer satisfaction in the J.D. Power and Associates National Pharmacy Study. In addition, the company continues to grow its retail health clinics, with about 10 more clinic locations underway. As such, Target opened 54 Target clinics in six states in 2012, with the company having a total of 79 clinics. These clinics will provide customers with more convenient access to healthcare products and medical expertise. Target pharmacy has distinguished itself by offering a wide range of generic drugs at $4.00, in addition to offering the Target Pharmacy Rewards program. In August 2012, Target began providing flu vaccinations on a walk-in basis at its pharmacy locations nationwide, which total more than 1,600. In selected markets, the company also offers medication therapy management, which provides customers with a comprehensive medication review by a specially trained pharmacist. Although the pharmacy is an essential business segment for the company, Target is not included as a major segment player because it operates in various business industries and pharmaceuticals are not the company's primary source of revenue. Cost Structure Benchmarks Profit Operating costs vary significantly between market segments due to the varying nature of services rendered. Consequently, profitability also varies by segment as well as by company ownership structure. Profit is also impacted by payer reimbursement policies and increases in employee benefit rates and material costs. In 2015, profit, measured as earnings before interest and taxes, is expected to account for 13.7% of revenue for the average segment company. However, some operators have significantly higher margins while others are nonprofit entities. For example, kidney dialysis centers are expected to make a profit as high as 17.5% and freestanding ambulatory surgical and emergency centers make a profit of about 19.5%, while HMO medical centers are expected to make a profit of only 6.1%. U.S. Census Bureau data suggest that companies exempt from federal income taxes account for just under half of total 72

73 segment revenue. The large number of nonprofit operators in the segment brings down its average profit margin. In the freestanding surgery center segment, profit margins can vary significantly depending on area of specialization. In the kidney dialysis segment, commercial patients generate most profit, even though these patients represent only 13.0% of annual dialysis visits. Most dialysis centers break even on Medicare and Medicaid, which cover the other 87.0% of patients. While this phenomenon is not unique in the segment or the healthcare sector at large, it is significantly more pronounced in dialysis care. Profit margins have increased slightly since 2010 due in part to Medicare bundling. Wages Wages and associated payroll costs are estimated to absorb 33.5% of segment revenue. Differences in wage costs between segments and companies are partly due to variations in the extent to which they employ physicians outside their full-time payroll. Employee-related costs include fringe benefits and contract labor. Wages' share of total segment revenue has slowly increased during the past five years, and is expected to continue to do so during the five years to Segment operators compete for nurses with hospitals and other healthcare providers, and as the segment continues to grow, more companies will be able to offer high wages to attract these personnel. Purchases In addition to labor costs, patient care includes the cost of drugs and other medical supplies, which make up an estimated 21.8% of segment revenue. Costs vary according to the type of services delivered. For example, kidney dialysis centers pay to acquire drugs to combat anemia, boost red blood cell production and prevent blood clotting during treatment. The drug regimen primarily includes erythropoiesisstimulating agents, namely Epogen, heparin, iron and injectable vitamin D. Purchase costs have decreased slightly during the past five years as Medicare bundling has made providers less reliant on drug sales to maintain profitability. Other costs Litigation is an ongoing risk from patients who become ill or die due to treatment received at a segment facility. Suits alleging negligence, malpractice and product liability are common. Dialysis patients are particularly vulnerable to infections because of the invasive nature of hemodialysis. Companies often pay for malpractice insurance or incur costs directly related to lawsuits. Another risk management cost is bad debt expense. Because Medicare and Medicaid only cover a portion of the cost of many segment treatments, patients are often responsible for paying some share of the cost out of pocket. Companies have a difficult time collecting out-of-pocket payments and must therefore expense bad debt. 73

74 Healthcare Industry vs. Pharmacies & Drug Stores Costs (2015) 100% 90% % Profit 70% Wages 60% Purchases 50% Depreciation Marketing 40% Rent & Utilities 30% Other 20% 10% % Average Costs of Healthcare Industry Pharmacies & Drug Stores Segment Costs 74

75 Year Revenue ($millions) IVA ($millions) Establishments (Units) Enterprises (Units) Employment (Units) Wages ($millions) Total health expenditure ($trillion) , , ,740 23, ,842 32, , , ,172 24, ,721 33, , , ,701 24, ,846 31, , , ,198 24, ,277 31, , , ,762 24, ,161 31, , , ,540 25, ,046 30, , , ,903 24, ,730 28, , , ,143 25, ,501 31, , , ,041 25, ,411 31, , , ,938 25, ,320 30, , , ,169 25, ,230 31, , , ,066 26, ,139 32, , , ,964 26, ,049 33, , , ,190 26, ,958 34, , , ,646 26, ,867 35, Annual Change (%) Year Revenue IVA Establishments Enterprises Employment Wages Total health expenditure Year IVA/ Revenue (%) Pharmacies & Drug Stores: Key Statistics Revenue/ Employee ($) Key Ratios Wages/ Revenue (%) Employees/ Establishment Wages/ Employee ($) , , , , , , , , , , , , , , ,

76 Specialist Doctors In recent years, the Specialist Doctors segment benefited from a rise in demand for its services, due to an aging population and the growing prevalence of chronic diseases. As a result, revenue is estimated to grow an annualized 2.6% to $312.3 billion over the five years to 2015, and this includes a rise of 1.3% in Even as unemployed individuals lost insurance coverage during the recession and disposable incomes fell, revenue continued to increase mainly because healthcare is less discretionary than other purchases. This increase was consistent over the period, despite many patients passing over primary care and attempting to self-diagnose before visiting a specialist. Increased revenue has relieved the burden of increasing cost pressures, including rising labor and liability expenses and the price of new technology. These trends have pushed the average profit margin from 9.2% of revenue in 2010 to 12.8% in In response to heightened costs, specialists are increasingly working in group practices, which is evidenced by a stagnant number of segment operators. The number of operators in the Specialist Doctors segment is expected to grow only marginally at an average annual rate of 0.3% over the five years to Due to increased demand for specialist services, the average wage for a specialist doctor is high, motivating more medical students to train as specialists. Currently, only about 20.0% of medical students choose to enter primary care. Consequently, regulators and government authorities are expected to structure reimbursements to encourage more students to become generalists and cut down on the cost of care for Medicare and Medicaid patients. This regulation, which is part of the newly implemented Patient Protection and Affordable Care Act (PPACA) of 2010, could threaten segment profitability in the future. While the economic environment is forecast to improve over the next five years, profit growth is expected to be mild through Meanwhile, healthcare reform will bolster demand for segment services, as more people have gained healthcare insurance coverage as a result of the PPACA. An uptick in the number of patients demanding care will help boost revenue 3.9% per year on average over the next five years to $377.7 billion in Products and Services Segmentation (2015) General surgery 4.3% Obstetrics and gynecology 6.0% Dermatology and cosmetic surgery 2.7% Anesthesiology 5.6% Emergency medicine 3.7% Pediatrics 9.4% Other 48.7% $312.3bn Internal medicine 19.6% 76

77 Current Performance The Specialist Doctors segment has been resilient recently, expanding throughout the past five years despite broad challenges across the economy. In 2015, segment revenue is expected to continue on this upward trajectory with a 1.3% increase to $312.3 billion, representing annualized growth of 2.6% since Health insurance coverage, and therefore demand for specialist doctors, is expected to continue rising as the healthcare exchanges established by the Patient Protection and Affordable Care Act (PPACA) of 2010 enter a second year. The segment, however, was not completely immune to the recession's effects on consumers. The economic downturn caused widespread unemployment, which led to decreases in disposable income and health insurance coverage, causing patient volume to fall. According to an IMS Institute for Healthcare Informatics survey, the number of physician visits declined in 2010 and continued into the current fiveyear period, dropping 4.7% in Fortunately for segment operators, however, the decline was not significant enough to bring about a decrease in revenue. The decline mainly hit primary care providers, as many patients attempted to self-diagnose before going straight to a specialist doctor. Specialty care outpaces primary care Although primary care is regarded as a cost-effective way to promote good health, the number of specialists has risen more quickly than the number of general practitioners (GPs) over the past five years. On average, there are now two specialists for every GP. Additionally, specialists earn substantially higher wages than GPs, partly contributing to concerns of a GP shortage in the United States. While GP income is high relative to the U.S. average, it remains less than half that of many procedure-oriented specialties, and wage disparities are widening. Furthermore, medical students are often swayed toward specialization because they perceive that generalists have less leisure time. The considerable educational debt that GPs incur also diverts many graduates from primary care. Currently, only about 20.0% of medical students opt to enter primary care. A 2012 study conducted by the University of California, Davis, found that over a lifetime, a primary care doctor is likely to make $1.5 million less than a classmate entering specialty care. Profit and employment During the recession, increased financial hardship caused many patients to miss payments, driving segment profit margins down. Costs were pressured by a variety of factors, including increases in drug supply costs and professional liability fees. In addition, federal budget shortfalls over the past five years have pressured Medicare reimbursement for most specialty procedures. However, the growing economy is expected to boost average profit to 12.8% of revenue in 2015, up from 9.2% in Segment employment is expected to rise an annualized 3.0% to 1.9 million workers over the five years to 2015, especially as an increasing proportion of medical students have chosen to enter specialty fields. While obstetricians, gynecologists and gastroenterologists experienced declines in operating profit over 77

78 $238.5 $253.9 $265.2 $271.9 $274.8 $283.0 $287.6 $298.1 $308.1 $312.2 $325.3 $338.7 $351.2 $364.6 $377.6 ($ MILLIONS) the period, cardiology, family practice, anesthesiology, pediatrics, orthopedic surgery and urology groups fared better, reporting increased profitability. Multispecialist practices Traditionally, most office-based physicians have worked alone or in small group practices. However, many physicians have consolidated their offices into larger multispecialty groups and independent practice associations in hopes of reaping the referral benefits of primary care physicians while achieving a scale that keeps financial risks manageable. In 2015, this trend will likely persist, with a growing number of specialty doctors practicing as partners or paid employees of group practices. Over the five years to 2015, the number of segment operators is expected to rise at an average annual rate of only 0.3% to 219,064 businesses. The American Medical Association defines group practice as the provision of healthcare services by three or more physicians. The five most common specialties found in group practices are internal medicine, pediatrics, family medicine, general surgery and obstetrics and gynecology. Many specialist physicians are seeking hospital employment to relieve the stress of high malpractice rates and administrative duties, the struggle for adequate and timely reimbursement and the general risks and burdens of private practices. In addition, the cost of equipment and supplies can be distributed among multiple physicians or covered by the hospital. Many physicians view hospital employment favorably, so hospitals that offer permanent positions may have an advantage over those that do not. In addition, many hospital administrators view employing physicians directly as more practical than assisting them in establishing independent practices. Demographic influences U.S. population growth and an aging population have also helped maintain demand for segment services. Historically, older patients have had more complicated conditions, comorbidities (coexisting medical conditions), chronic conditions and treatments involving multiple medications. An increase in the average age of the population and, in some cases, the availability of new medical technologies, has bolstered $400.0 $350.0 $300.0 $250.0 Specialist Doctors $200.0 $150.0 $100.0 $50.0 $- 78

79 demand for specialties that address changing demographics, such as cardiology, ophthalmology, orthopedic surgery and urology. Similarly, rising obesity levels and the early onset of chronic health conditions, such as heart disease and diabetes, have boosted demand for endocrinologists (medical specialists dealing with disorders of the endocrine system and its specific hormones); cardiologists and cardiac surgeons; neurologists (medical specialists working with stroke patients or patients with diabetic neuropathy); and orthopedic surgeons. Consequently, we estimate the number of physician visits will rise at an annualized 3.5% over the five years to Segment Outlook D Revenue growth for the Specialist Doctors segment is forecast to accelerate during the five years to 2020, increasing an annualized 3.9% to $377.7 billion. This includes an expected 4.2% rise in 2016, indicating that the growing economy will have a positive effect on segment demand. In addition, the aging population and an increasing number of individuals with healthcare insurance coverage will boost demand for segment services in the following years, although healthcare reform will have mixed effects on the segment. Employment across the segment is projected to grow at an average annual rate of 3.9% to 2.2 million over the next five years. Job growth will occur due to continued development in healthcare-related industries, brought on by the aging population and expansion of insured coverage. Despite mounting demand for segment services, some factors will temper growth. Specifically, the rising cost of healthcare has the potential to considerably check demand for segment services, which is sensitive to changes in healthcare reimbursement policies. If changes to health coverage result in higher out-of-pocket costs for consumers, demand for physician services may fall. Meanwhile, the possibility of a decline in reimbursements from government insurance persists, while the percentage of the population covered by government insurance continues to rise, putting downward pressure on specialist doctors' margins. Aging demographics A study by the U.S. National Center for Health Statistics suggests that U.S. demographics will drive the use of physician services, possibly at a more rapid pace than in the past. In the next five years, the percentage of visits from individuals aged 65 and older will increase as baby boomers age. Growth in chronic diseases, obesity and the size of the geriatric demographic means that seniors are growing to comprise a larger market for nearly every physician's practice. As a result, the number of physicians who specialize in geriatrics will rise to meet demand for geriatric services. A program of 26 geriatric competencies for medical students in the fields of surgery, family medicine, internal medicine, emergency medicine and other specialties involved in treating older patients is already in development. 79

80 Consolidation and profit In the next five years, we forecast that the rising cost of liability insurance will motivate physicians to practice more defensively (i.e. order more tests and avoid performing high-risk procedures), reducing the number of physicians in some specialties. Practices will remain cautious and use the coming years to adjust their staffing patterns to the population's needs and to reimbursement levels from insurance companies and government programs. Despite consolidation over the next five years, the number of operators is forecast to grow modestly at an annualized rate of 0.7% to 226,906 in In particular, the next five years will favor the development of large multispecialty practices, primarily because of the greater leverage they can exert in negotiating payments with managed-care organizations. Specialist doctors can receive higher incomes and potentially lower productivity pressures in larger practices, because treatment demand is spread across more physicians. This trend will cause more physicians, especially those just entering the segment, to opt for larger and better-organized practices. Consolidation is expected to help maintain an operating profit margin of 13.0% in 2020, up slightly from 12.8% in However, rising liability costs and reimbursement pressures from Medicare and Medicaid will constrain profitability over the period. Healthcare reform The Patient Protection and Affordable Care Act of 2010 will influence many aspects of the Specialist Doctors segment. On a positive note, the healthcare reform law provides 100.0% Medicare coverage of annual preventive visits for seniors, benefiting practitioners with geriatric patients. By 2019, healthcare reform is projected to bring insurance coverage to about 32.0 million people who are currently uninsured, according to the Association of American Medical Colleges. However, some specialists are concerned that insurance coverage will not necessarily guarantee patients access to specialist care. Whether specialists continue to see these newly covered patients will depend partly on whether reimbursement rates adequately cover the costs of medical care that segment Major Market Segmentation (2015) People aged 17 and younger 12.5% People aged 65 and older 34.0% People aged 18 to % $312.3bn People aged 45 to % 80

81 operators provide. A focus on primary care physicians will also likely hurt specialists. Healthcare reform's increased payments to primary care providers may come at the expense of specialty providers. Competitive Landscape The Specialist Doctors segment is highly fragmented and has a low level of concentration. The largest four segment players are estimated to account for less than 4.0% of segment revenue and only one provider is expected to generate more than 1.0% of total segment revenue. About 45.3% of segment establishments are solo practices and nonemployers (i.e. companies with no employees) account for less than 4.0% of revenue. This share indicates that larger practices generate more revenue. During the past five years, consolidation has been increasing, albeit at a slow pace. Surveys conducted by the Center for Studying Health System Change (HSC) indicate that there was a decrease in the prevalence of small practices among medical and surgical specialists, reflecting consolidation and a decline in ownership among specialists. According to HSC, increased financial pressures provide incentives for physicians to aggregate into midsize practices in order to spread fixed costs over a larger number of physicians. In addition, physicians benefit from aggregating into larger single-specialty practices with greater capital and scale economies, which can invest in equipment and facilities in order to provide profitable procedures, such as high-end imaging and diagnostic testing. Basis of Competition Internal competition Competition in this segment is principally based on reputation, price, accessibility and quality. Reputation is derived from doctor-patient relationships, which, if positive, can improve a community's impression of a doctor. The prices that specialists charge can attract patients; although healthcare is a necessary service, a person's ability to pay for it can affect where and when they receive services. Accessibility refers to a doctor's location; specialists tend to locate in areas with large populations and in proximity to referring physicians and other healthcare providers. Differentiation of doctor services can also be on the basis of training and training experience, the quality of accommodation and staff competence and friendliness. External competition Specialist services compete with those services provided by other doctors in hospitals, home health organizations, community health centers and in other ambulatory centers. Some hospitals provide services to doctors (e.g. back-office systems, operating theaters and other equipment) and doctors compete for access to these services. Large practices may also be in a better position to negotiate with HMOs, hospitals, medical equipment suppliers and drug companies. According to the American Medical Association, more than 90.0% of doctors in a practice have at least one managed-care contract, with managed-care contracts accounting for nearly half of practice revenue. 81

82 Pediatricians, obstetricians, gynecologists and internists also compete in the primary care market with primary care physicians. Neurologists and pulmonologists compete in the sleep-therapy business. Ophthalmologists compete for patients with optometrists. Patients in the United States are progressively visiting specialist doctors for purposes that primary care physicians are able to address. This trend indicates that specialists are competing as well, which is somewhat attributable to rising accessibility to specialists and the cultural sentiment that specialist doctors are better equipped to handle most healthcare issues. Barriers to Entry Barriers to entry in the Specialist Doctors segment are moderate. The most notable entry barriers exist in the segment due to educational requirements, residency review committees and regulation. In addition, operators must develop a critical mass of patients to be viable. Depending on the specialty and location, it can be difficult or take considerable time for new entrants to establish a referral base and relationships with other physicians, hospitals and the local community. Barriers to Entry checklist Competition Concentration Life Cycle Stage Capital Intensity Technology Change Regulation & Policy Segment Assistance Level Medium Low Growth Low High Heavy High Although several barriers exist to new entrants, the large number of small establishments indicates that barriers are not extreme. This may be due to low levels of fixed capital costs in the segment and the high demand for specialist doctors. The strong demand results in high levels of compensation, which can help new entrants make a return on upfront investments in a reasonable time frame. Education and training Formal education and training requirements for specialist physicians are among the most demanding of any occupation. The education includes four years of undergraduate school, four years of medical school and three to 11 years of internship, residency and fellowship, depending on the specialty selected. Premedical students must complete undergraduate work in physics, biology, mathematics, English and inorganic and organic chemistry. Students also take courses in the humanities and the social sciences. The minimum educational requirement for entry into medical school is three years of college; most applicants; however, have at least a bachelor's degree and many have additional graduate degrees. Although the United States has several renowned medical schools, entry into the most respected schools is limited and highly competitive. There are 188 medical schools in the United States; of these, 158 teach allopathic medicine and award doctor of medicine (MD) degrees and 30 teach osteopathic medicine and award the Doctor of osteopathic medicine (DO) degree. Applicants must submit transcripts, scores from the Medical College Admission Test and letters of recommendation. Schools also consider an applicant's 82

83 character, personality, leadership qualities and participation in extracurricular activities. Most schools require an interview with members of the admissions committee. Following medical school, almost all MDs enter a residency, graduate medical education in a specialty that takes the form of paid on-the-job training, usually in a hospital. Most DOs serve a 12-month rotating internship after graduation and before entering a residency, which may last two to six years. A physician's training is costly. In fact, according to the Association of American Medical Colleges, more than 86.0% of medical school graduates are in debt for educational expenses. All states, the District of Columbia and U.S. territories license physicians. To be licensed, physicians must graduate from an accredited medical school, pass a licensing examination and complete one to seven years of graduate medical education. Although physicians licensed in one state usually can get a license to practice in another without further examination, some states limit reciprocity. Graduates of foreign medical schools generally can qualify for licensure after passing an examination and completing a residency at a medical facility in the United States. MDs and DOs seeking board certification in a specialty may spend up to seven years in residency and fellowship training, depending on the specialty. A final examination immediately after residency or after one to two years of practice is also necessary for certification by a member of the American Board of Medical Specialists (ABMS) or the American Osteopathic Association (AOA). The ABMS represents 24 boards related to medical specialties, ranging from allergy and immunology to urology. The AOA has approved 18 specialty boards, ranging from anesthesiology to surgery. For certification in a subspecialty, physicians usually need an additional one to two years of residency. Residency review committees Residency review committees (RRCs), which are private organizations that consist primarily of physicians from a particular specialty, have substantial control over the number of residents who can train in each specialty. Therefore, they control the flow of new physicians to a specialty. RRCs can also set the movement of residents, in order to achieve their desired combination of licensed physicians and physician salaries. Regulation Many states have certificate-of-need (CON) regulations and other laws that limit the number of physicianowned medical facilities. Many CON laws were initially put into effect across the nation as part of the federal Health Planning Resources Development Act of In spite of many changes in the past 30 years, about 36 states retain some type of CON program, law or agency. CON programs originated to regulate the number of beds in hospitals and nursing homes and to prevent overbuying of expensive equipment. Mandatory regulation through health planning agencies determined the most urgent healthcare needs, contributed to solutions for these needs and attempted to manage the fluctuations in prices often caused by a competitive market. The idea was that new or improved facilities 83

84 or equipment would be approved based only on a genuine need in a community. Statutory criteria often were created to help planning agencies decide what was necessary for a given location. By reviewing the activities and resources of hospitals, the agencies made judgments about what needed to be improved. Once need was established, the applicant organization (corporation, nonprofit, partnership or public entity) was granted permission to begin a project. These approvals are generally known as Certificates of Need. Over the past few decades, entrepreneurial doctors' efforts to separate out the most profitable business from general hospitals have been one of the most significant trends in healthcare. Niche providers have started providing services at the core of the general hospital's business model, including cardiac and orthopedic surgery. For various reasons, these are some of the highest-margin procedures under the Medicare system, and general hospitals have long used some profit from these departments to crosssubsidize care for the uninsured. When cardiac or orthopedics departments migrate away from the general hospital, it is not easy to find alternative funding for various public services. The resulting specialty hospitals often do not provide the type of emergency rooms, unsponsored care or other public health initiatives offered by competing general hospitals. Without emergency rooms, most specialty hospitals can more easily avoid serving Medicaid patients, costly Medicare patients and the uninsured than general community hospitals can. Defenders of cross-subsidization have used many tactics to stem the flow of dollars and entrepreneurial doctors to niche providers. After convincing Congress to put a temporary moratorium on specialty hospital participation in the Medicare program, general hospitals focused on lobbying the executive branch and state governments to stymie their spread. They also used the above-mentioned CON laws and other state level regulations to deter entry of niche competitors; to this day, virtually all specialty hospitals are in states that abandoned CON laws. An on-again, off-again moratorium on specialty hospitals has generated legal uncertainty about their viability. Major Companies There are no major players in this segment. Other Companies The Specialist Doctors segment is highly fragmented and about 75.0% of establishments in this segment have fewer than five employees. In previous years, U.S.-based hospitals and hospital systems acquired specialist practices and employed specialist doctors with the aim of providing more comprehensive healthcare services to patients. However, many such hospitals and health systems have since failed to meet financial performance expectations. Some hospital organizations encourage physicians practicing at their hospitals to form independent physician associations and join with other physicians and physician group practices to form physician hospital organizations. This helps small practices enter managed-care organization networks and other contracts. 84

85 Specialty practices tend to be very small but have grown larger in recent years. According to reports from the Physicians Foundation, the percentage of physicians practicing in independent or small-group practices has been falling, while the percentage of physicians in larger practices is on the rise. In a 2009 survey conducted by the Physicians Foundation, 32.0% of respondents worked in solo practices and, in 2012 (latest available data), the American Medical Association found only 18.0% of respondents practiced independently. Nonetheless, there are few sizeable hospitals that are dedicated to specialty healthcare. Memorial Sloan-Kettering Cancer Center Estimated market share: 1.0% The Memorial Sloan-Kettering Cancer Center (MSKCC) was founded in 1884 and is dedicated to cancer research and treatment. The center includes the 471-bed Memorial Hospital for Cancer and Allied Diseases, which provides pediatric and adult cancer care, and the Sloan-Kettering Institute, which conducts cancer research. With 935 physicians and 2,221 nurses, Memorial Hospital specializes in bonemarrow transplants, radiation therapy and chemotherapy. The center offers programs in cancer prevention, diagnosis, treatment, research and education. The Sloan-Kettering Institute conducts medical and clinical laboratory research on cancer genetics and therapeutics. MSKCC offers outpatient services from several New York and New Jersey clinic locations. MSKCC is expected to open a new suburban outpatient center in central New Jersey in the fall of In 2015, MSKCC is expected to generate about $3.2 billion in revenue. Children's Hospital of Philadelphia Estimated market share: Less than 1.0% A leading pediatric hospital since 1855, the Children's Hospital of Philadelphia (CHOP) also has one of the largest pediatric research programs in the world. CHOP, the nation's first hospital devoted exclusively to the care of children, has 527 beds and operates a pediatric healthcare network with owned or affiliated offices, clinics and research facilities in New Jersey and Pennsylvania. The hospital is a leader in pediatric medical training, pediatric emergency medicine and adolescent medicine. In the Best Children's Hospitals survey published by U.S. News & World Report, CHOP ranked first in neonatology and pulmonology; second in diabetes and endocrinology, cancer and neurology and neurosurgery; third in cardiology and heart surgery, nephrology and urology; and fourth in gastroenterology and orthopedics. CHOP's pediatricians also provide care at a number of other area hospitals. In 2015, the hospital is expected to earn about $2.4 billion in specialist revenue. NYU Langone Medical Center's Hospital for Joint Diseases Estimated market share: Less than 1.0% NYU Langone Medical Center's Hospital for Joint Diseases (HJD), founded in 1905, is the country's largest specialty hospital dedicated to the prevention and treatment of musculoskeletal diseases. Each year, more than 6,000 urgent-care patients are evaluated for orthopedic injuries and conditions, and the company's faculty performs more than 11,000 operative procedures. The clinical expertise of the 85

86 physicians at NYU HJD represents all subspecialty areas of orthopedic surgery, including spine, total joint replacement, sports medicine, arthroscopy, pediatric orthopedics, shoulder, hand, foot and ankle. NYU HJD is one of the world's largest providers of total joint replacements, with more than 1,200 joint replacement procedures performed annually. NYU HJD is projected to generate about $2.0 billion in revenue in Children's Hospital Boston Estimated market share: Less than 1.0% Children's Hospital Boston was founded in 1869 and is a 395-bed hospital offering acute healthcare and specialty services for children from birth to age 21. It is also Harvard Medical School's main teaching hospital for children's healthcare, and the world's largest pediatric research center. Its John F. Enders Pediatric Research facility provides research for the treatment of childhood diseases. Specialty services include cardiovascular surgery, digestive care, neurology, oncology, ophthalmology and fetal care. We anticipate Children's Hospital Boston will generate revenue of $1.8 billion in Cost Structure Benchmarks Profit Profit, measured as earnings before interest and taxes, is expected to rise from 9.2% of segment revenue in 2010 to 12.8% in The recovering economy has increased levels of disposable income, leaving Americans with funds for doctor visits. However, declining reimbursement from Medicare and Medicaid and costly administrative burdens have placed pressure on margins. Medicare and Medicaid reimbursement schedules have been hard to anticipate, making it difficult for operators to adjust their practices. Costs have been rising for drug supplies, support staff and professional liability coverage for most types of practices; yet, certain specialists have experienced higher increases than others for particular costs. For instance, drug supply costs have increased dramatically for pediatric practices, based on data from the Medical Group Management Association (MGMA). Obstetrics and gynecology specialists and pediatrics groups have experienced notable hikes in support staff costs, while cardiology groups have experienced the highest increase in malpractice insurance premiums. By contrast, electronic health records (EHRs) have helped specialty doctors increase savings. The use of EHRs leads to more efficiency in care, which is more cost-effective, creating wider profit margins. The data in EHRs has to be active, rather than static, like paper records. There are also alerts to prompt doctors of patients missing follow-up tests or preventive measures, which encourage patients to maintain regular visits, thereby increasing revenue. Higher profitability as a result of EHR use is significant because in 2015, Medicare will withhold reimbursement increases for physicians who do not demonstrate "meaningful use" of electronic health records. Current evidence of profit gains could provide additional incentives for physicians without electronic records to begin the process to purchase and install them. As a result, segment profit margins are estimated to increase to 13.0% by

87 Wages Wages are the largest segment expense, due to the high level of skill required of its employees, accounting for an estimated 50.5% of revenue. Costs for support staff, which include general administrative, accounting, information technology and maintenance employees, make up a significant percentage of this segment expense and have been on the rise over the past five years. The wages of specialist doctors have undergone scrutiny because of the pending primary physician shortage reported by various media outlets. According to the MGMA, median wages for specialists are almost twice those of primary-care physicians. This contrast has been associated with a decreasing number of doctors who are motivated to enter primary care because they are lured by the higher wages of specialty practices. A 2012 study conducted by the University of California in Davis found that over a lifetime, a specialist doctor is likely to make about $1.5 million more than a classmate who enters into primary care. Purchases Purchases are estimated to account for 21.0% of revenue in 2015, the second largest portion of segment revenue. Segment purchases generally include medical supplies (mainly pharmaceuticals) and anything else necessary to run and operate medical establishments. Over the past five years these costs have remained steady even in the face of the recession. Other Other major expenses include rent and utilities (4.0% of segment revenue), marketing (1.5% of segment revenue), depreciation (1.7% of segment revenue), professional liability expenses, medical supplies (mainly pharmaceuticals) and medical equipment, which vary by specialty. According to data from the American Medical Association, specialists, particularly in the areas of obstetrics and gynecology, general surgery and internal medicine, have experienced fewer insurance rate increases during the past five years, and the size of those increases has become smaller. Moreover, insurer withdrawals from markets are not happening with the frequency that they were prior to this period. The recent decreases notwithstanding, rates in many states remain at historic highs. Other expenses combine to account for 8.5% of segment revenue in

88 Healthcare Industry vs. Specialist Doctors Costs (2015) 100% % % 70% Profit Wages 60% 16.7 Purchases 50% Depreciation Marketing 40% 50.5 Rent & Utilities 30% 43.9 Other 20% 10% % Average Costs of Healthcare Industry Specialist Doctors Segment Costs 88

89 Year Revenue ($millions) IVA ($millions) Establishments (Units) Enterprises (Units) Employment (Units) Wages ($millions) Federal funding for Medicare & Medicaid ($billion) , , , ,309 1,428,230 90, , , , ,952 1,490,701 98, , , , ,745 1,546, , , , , ,521 1,606, , , , , ,457 1,603, , , , , ,831 1,600, , , , , ,475 1,641, , , , , ,417 1,697, , , , , ,325 1,782, , , , , ,064 1,856, , , , , ,625 1,933, , , , , ,314 2,009, , , , , ,270 2,086, , , , , ,446 2,164, , , , , , ,906 2,244, , ,148.6 Annual Change (%) Year Revenue IVA Establishments Enterprises Employment Wages Federal funding for Medicare & Medicaid Year IVA/ Revenue (%) Specialist Doctors: Key Statistics Revenue/ Employee ($) Key Ratios Wages/ Revenue (%) Employees/ Establishment Wages/ Employee ($) , , , , , , , , , , , , , , ,