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  1. 1. Tenet’s Q2 2006 Earnings Call Prepared Remarks August 10, 2006 Trevor Fetter, President and Chief Executive Officer Thank you operator. Good morning everyone. I enjoyed seeing so many of you here at our investor day last month. For those of you who didn’t join us here in Dallas, I want to remind you that the transcript, slides and audio of all the presentations and Q and A are on our website. Let me quickly reiterate a few key points from the meeting. First, we demonstrated that when we set our minds on fixing something, we can do it. We do it through innovation, great people, hard work and the application of technology for better fact- based decision-making. This is the way we addressed our challenges in pricing, quality, cost, compliance and litigation. Reynold Jennings laid out our strategies for using these same skills to build volumes and Steve Newman unveiled for you our innovative Targeted Growth Initiative. I am confident we will be successful in growing our business through differentiation and superior execution. That’s what targeted growth is all about. Speaking of execution, I also reiterated our strategy, which emphasizes execution over transactions. We are seeking to differentiate Tenet hospitals on quality and service. We believe that this is the most sustainable way to generate organic growth in the future. My colleagues explained how each of their activities contributes to our strategy of execution, including our new greater emphasis on the outpatient business. Because those seven hours of presentations are still available and fresh, my remarks this morning will be very brief, as I want Reynold Jennings to have ample time to discuss our initiatives to grow our business and for Biggs Porter to provide a detailed review of our financial performance. Summary Results At a very high level, we continued to demonstrate strong gains in pricing and excellent cost control, in spite of weak volumes and high bad debt expense. These were the same drivers of earnings in the last several quarters. Our earnings, margins and cash flow were a bit better than expected and our volumes and bad debt expense were weaker. 1
  2. 2. We would rather achieve your expectations, and ours, through a combination of good results in volumes, pricing and costs, but in the absence of volume growth, the skills we’ve developed in the areas of pricing and cost control are essential. At our investor day, I was asked whether we could achieve our outlook for earnings absent volume growth. It may only be achievable in the short term, but this quarter demonstrates that it is possible. Admissions Soft admissions continue to be our biggest challenge. I’m encouraged by the fact that after reporting five consecutive quarters of successively worse declines in admissions, Q2 was one- tenth of a percent better than what we reported in Q1. And, 25 percent of the admissions decline was deliberate. It’s premature to say whether volume declines have stabilized, but I’m glad that we’ve stopped the five quarter downward trend. It’s fair to say that while we answered many of your questions at our investor day, the big question remains about whether we can restore volume growth. I’ve asked Reynold to provide a concise summary of our strategies as part of his comments this morning. He has some positive initial results to share, which I think you will find encouraging. But just so we’re all clear, let me repeat the four main themes of our operating strategy for growing volumes. We intend to attract new volume: First, by increasing our emphasis on certain high margin and fast growing service lines through our targeted growth initiative; Second, through carefully targeted capital spending on those highly visible items that are of the greatest importance to physicians; Third, through our Centers of Excellence strategy that gains recognition, price advantages and directed volumes from payors; And fourth, making sure our physicians understand that we have emerged from the settlement process confident in our hospitals and committed to keeping them competitive through a deliberate and systematic physician communications program. Keep in mind, when we’re talking about admissions growth, it is important to recognize that we already have a large number of hospitals doing very well. Twenty-one of our hospitals in continuing operations, over a third, achieved positive growth in second quarter patient admissions versus the prior year quarter. Conversely, 11 of our hospitals were cumulatively responsible for 100 percent of our volume losses in the quarter. The point is that the negative admissions numbers that we’re reporting this quarter are generated by about one-fifth of our hospitals; this weakness does not exist throughout the entire company. 2
  3. 3. Pricing Turning to pricing, once again we did very well. As you heard at investor day, our managed care team has been working diligently to bring up the lowest priced contracts in our portfolio. Revenue per commercial managed care admission was up 15 percent in the quarter, as evidence that our approach is working. Cost Efficiency We also continued the strong discipline in controlling costs. Total controllable costs per adjusted patient day were up only 4.4 percent, which is better than our peer companies and a notable achievement given the declines in volume this quarter. Bad Debt The increase in bad debt expense was similar to the results reported by others in the industry. On a Compact-adjusted basis, bad debt was 14.2 percent in the quarter. The trend in the reported number was better. The primary driver of the increase in Compact-adjusted bad debt was the continuing pressure that we’re getting from the growth in the uninsured. Uninsured admissions have now reached 4 percent of total admissions. Increases in the uninsured of this magnitude are disturbing because they offset much of our progress on the collections front. These increases also make it increasingly difficult to predict future trends in bad debt. As you heard at our investor day, we are adding innovative approaches to improve our performance in the revenue cycle for self-paying patients. Cash Flow Cash flow from operations strengthened on a sequential basis and, before the settlement payments, we produced $86 million in free cash flow. Keep in mind that our capital expenditures should increase for the balance of the year, so we expect that free cash flow will decline from this level. I’ll let Biggs take you through the details. Finally, I’m very pleased to tell you that in the latest U.S. News & World Report issue on America’s Best Hospitals, our USC University Hospital was among only 176 of hospitals in the United States to make the cut. I’ll now ask Reynold Jennings, Tenet’s chief operating officer, to provide you with an update on our initiatives to improve volume growth. 3
  4. 4. Reynold Jennings, Chief Operating Officer Thank you Trevor and good morning everyone. The Case for Volume Growth I’m going to focus my comments on a single topic this morning: Tenet’s strategy for growing patient volumes. Given the questions at our investor conference, I want to make the pieces of this strategy very clear to everyone. I also want to talk about the preliminary results that we have achieved. I am optimistic about our early results and I hope you will share my same enthusiasm. The foundation for our strategy is built on extensive market research. We have talked to physicians in every one of our markets and, last year, we conducted two independent third party physician focus groups. Through these actions, we’ve refined and deepened our understanding of the decision process that our physicians use to direct their patient flow. A leading concern among splitter physicians was the size of our ultimate settlement with the Department of Justice. Physicians were worried that a large settlement could threaten our ability to sustain an appropriate level of investment in our hospitals. We also know that many of our competitors, largely not-for-profit competitors, exploited this fear and that clearly harmed our volumes. As you know, this fear has now been eliminated. In the aftermath of our settlement, a review of our financial strength and our ability to sustain investments in our hospitals has been added to our sales presentations to physicians. Our recently announced strategy of accelerating investments in our hospitals dovetails perfectly with this sales message. Doctors like the promise of additional investments, but they are even more impressed by the tangible evidence of financial strength. PSSP Results We refer to our sales outreach program as our “Physician Sales and Service Program” or “PSSP” – not an acronym which rolls off the tongue easily, but quite descriptive. Our preliminary results from this program are very encouraging. Our 57 hospitals in continuing operations have relationships with just over 10,000 practicing physicians. PSSP was launched in November of 2005 and by the end of May 2006, we had visited with roughly 8,000, or 80 percent, of those doctors. 4
  5. 5. Our hospitals chose, based on information from the first visits, to concentrate in the second quarter on about 1,300 physicians. Those physicians increased their admissions by about 1,200 in the second quarter over the first quarter, for an approximate 3.5 percent increase. If those admissions hold for a full year, the increase would equate to about 4,800 admits per year improvement for these physicians and would add approximately 0.8 percent to the whole company’s current base of admissions. Also remember that our first quarter is seasonally about 8 to 9 percent higher in the first quarter in Florida and 4 to 5 percent higher in the other regions than the second quarter. This seasonality makes the approximate 3.5 percent increase in the admissions from these physicians all that much more impressive. Let me also point out that this was accomplished despite some temporary obstacles, which should no longer inhibit our ability to grow the business: • First, recall that California was in the aggressive implementation phase of the margin purification part of the Targeted Growth Initiative during the very time period when these admissions were generated. So, we were fighting some self-imposed headwinds in those markets. • Second, we had not yet settled with the government, so our sales presentation was somewhat handicapped; and • Third, we had not yet announced our $180 million enhanced cap-ex program. So, what are some key lessons that we’ve learned so far in our PSSP initiative? • First, it takes about three to six months after the first visit to see increased admits on the inpatient side. • Secondly, it takes about three to four visits to the same physician to “close the sale” and get the increased business. • And third, outpatient business is easier and quicker to win than inpatient business. And, what are some issues that we’ve identified that need improvement? • First, we need to pick the best practices and systematize them. We have too much variability in approach right now. • Second, some of our managers need formal sales training. • Third, some managers just don’t have the skills for sales calls and need to be replaced. • And fourth, our software tracking tool needs some refinement for ease of use. Obviously, our problem is far from solved. However, for a new program fighting some start-up issues as well as general industry headwinds, we are very pleased with these early results. Our upcoming October 2006 annual hospital leadership conference agenda is geared toward actively sharing best practices across our regions with the goal of making PSSP even more effective going forward. 5
  6. 6. As we implement PSSP, we are tailoring it to leverage the unique strengths and capabilities of each of our hospitals. The size of our sales team can vary from four to 20 local managers, depending on the size of the hospital. In addition to the four senior managers at each hospital, which are the chief executive, the chief operations officer, the chief financial officer and the chief nursing officer, we also involve clinical managers and hospital-based physicians in the sales calls whenever possible so we align the interest and needs of the admitting physician with the manager most able to solve a problem or improve a service. Our goal is to have at least 500 local managers actively and consistently working on bringing back volumes from splitter physicians. COE Strategy Changing gears a bit, you should take note that our market research also helped us to work more effectively with our managed care payors. I’m referring to the Centers of Excellence programs being introduced by the major payors like United Healthcare, Aetna and Cigna. The managed care companies see Centers of Excellence as a powerful strategy to control their costs through better clinical outcomes. We see it as an equally powerful strategy to capture incremental volumes. These numbers are preliminary, but nonetheless clear; that where Tenet has earned a Center of Excellence designation, we have achieved highly attractive volume growth. Our first four hospitals to earn a Center of Excellence designation in cardiology from United Healthcare have shown a 22 percent growth in cardiology volumes from the prior year. That is astonishing growth! It’s is even more remarkable that this is in the cardiology service line where our non- Center of Excellence-designated hospitals saw volumes decline by 3 percent. The fact that the redirection of volume can be this dramatic should not be surprising. Managed care payors are creating very attractive financial incentives for plan participants to make greater use of Centers of Excellence-designated service lines. These incentives include the waiving of patient co-pays and sometimes cash deposits to the patient’s personal HSA account. These incentives are clearly having the intended effect. This impact should only increase as plan participants become more familiar with these incentives to use them to reduce their out-of-pocket cost. This strategy of enhancing our value proposition as defined by the payors creates a win-win outcome with clear advantages for Tenet’s volume growth objectives. Our early adoption of a quality strategy for our clinical services is beginning to produce material financial returns. Tenet has earned a Center of Excellence designation at 28 percent of its hospitals – a unique achievement in the industry. United has granted such designations to only 4.5 percent of the approximately 4,500 hospitals in its network. Tenet’s quality accomplishments are also impressive with Cigna. Cigna identifies Centers of Excellence in 19 clinical lines of service. Tenet has received Center of Excellence status 6
  7. 7. designations in 149 service lines for a 6 percent rate relative to the number of lines of service where Tenet has approved eligibility. This rate is three times Cigna’s national rate of 2 percent of Centers of Excellence designations. Outpatient Strategy Next, I would like to make a few comments about our evolving outpatient division. Steve Corbeil and Chris Bird have completed the hiring of five experienced front line mangers from ambulatory surgery, diagnostic imaging, urgent primary care and outpatient business development. Groundwork is anticipated to be done by the end of the third quarter on assessing the value of 37 high priority free-standing projects. This timing will allow us to choose the best high value projects for the 2007 budget. Early information is that we are losing outpatient imaging business due to service and convenience factors compared to free standing competitors, and we are losing ambulatory surgery business due to physician syndication opportunities with competitors. The outpatient division will work with Dr. Daley to design and institute a Commitment to Quality approach on service and efficiency similar to our successful inpatient Commitment to Quality strategy. On the syndication front, we know we have to develop most, if not all, of the freestanding surgery centers as physician joint ventures. We are very pleased with the progress that Steve Corbeil has made in developing this division and laying the groundwork to start making a tangible impact in 2007 and forward. Summary So in summary, let me summarize our strategy and our actions to date. • First, we have identified physician needs through careful and exhaustive market research. • Second, we have accelerated our capital expenditures targeting immediate physician priorities, which impact their business models. • Third, we are fine-tuning our Physician Sales and Service Program, or PSSP, to effectively communicate our “value proposition” to our physicians. Included in those messages are four points: o Tenet’s commitment to their hospital; o Tenet’s sustainable financial strength to adequately invest in their hospital; o Describing, in detail, the specific incremental investments in that hospitals; o And, assigning specific individuals to each physician and to the doctor’s office staff to ensure that these messages are being delivered; • And fourthly, we are enhancing our “value proposition” as defined by the major managed care payors to help them improve their own profitability. Conclusion In conclusion, our ultimate success is tied to the success of the Physician Sales and Service Program, our Commitment to Quality and efficiency initiatives and our managed care Center of Excellence strategy. With the strength of our pricing and cost initiatives over the past several months, as well as the fact that only about 20 percent of our hospitals are causing the weaker volumes year over year, we have the balance of 2006 to continue to gain momentum on these 7
  8. 8. two companion programs, PSSP and COE (Centers of Excellence), to our overall successful Commitment to Quality initiative. As we indicated at the recent investor conference, we need to be producing net volume growth starting in the first quarter of 2007 to balance the contributions of price and cost control toward our two to three year outlook goals. So there it is, our strategy for growing volumes. Simply stated, we will provide efficient, high quality services, give every physician a means to have their voice heard on needs at the hospital, and provide new patient volume to our physicians by becoming managed care Centers of Excellence. Now, I will turn the floor over to Biggs Porter, Tenet’s chief financial officer. Biggs Porter, Chief Financial Officer Thank you Reynold and good morning everyone. First, let me apologize for missing the opportunity to meet many of you at our investor day last month. The situation was unavoidable, but my wife is now recuperating and we appreciate the expressions of concern we have received. Let me start off by summarizing our results. To begin with earnings, EPS for the quarter came in at a negative 85 cents, including a negative 95 cents for continuing operations. The loss in continuing operations included a number of items listed in our earnings release. We encourage you to reach your own decision as to which of these are unusual. The largest item in the list is, of course, the charge of 98 cents per share for the global settlement and other litigation and investigation costs. Excluding just the after tax effect of the global settlement, EPS from continuing operations would have been at positive 3 cents. Although we still clearly have a long road ahead of us in our recovery, adjusted EBITDA for continuing operations modestly exceeded our expectations for the quarter at $209 million as strong pricing offset soft volumes. For the first six months, adjusted EBITDA for continuing operations totaled $426 million, excluding settlement payments, restructuring charges and insurance recoveries. As we have discussed before, there was an approximately $30 million favorable item related to cost reports in the first quarter, which we would expect not to repeat, so backing that out, we are at $396 million of adjusted EBITDA at the mid-year point. Our adjusted EBITDA margin was 9.5 percent in the second quarter, an increase of 240 basis points from the second quarter of 2005 at 7.1 percent, and above the high end of our range of 7.8 to 8.9 percent in our 2006 outlook as it was revised in our June 29 press release. Note, however, that our second half is typically the weakest for seasonal reasons, so we are not responding to this strengthening in the second quarter by modifying our EBITDA outlook at this point. Although this certainly gives us basis to be more optimistic that we will be near the mid to upper end of the range, and I don’t see any degradation from prior expectations as to what is in front of us, it is premature to move the outlook upward. 8
  9. 9. Moving to Admissions Admissions declined by 2.7 percent and commercial managed care admissions declined by 6 percent. 72 percent of the decline in commercial managed care admissions can be explained by the declines in just three service lines: pulmonary, cardiovascular and bariatrics. For the second half of the year, we will need to achieve a volume decline no larger than 1.2 percent if we are to achieve the 2 percent volume decline we have previously given as our 2006 outlook. Because we are facing some easier “comps” in the third and fourth quarters, we believe this volume performance remains achievable. The implementation of our Targeted Growth Initiative caused some of this volume loss. We estimate that TGI-induced losses totaled roughly 1,000 admissions, or about a quarter of the admissions decline. Looking deeper into our admissions patterns, it’s of interest to note that 21 of our hospitals, or 37 percent of our hospitals in continuing operations, achieved positive growth in patient admissions with aggregate growth of more than 2,400 admissions. When we rank order our hospitals by admissions growth, we note that the top 46, or 81 percent of our hospitals, taken in the aggregate, had flat admissions for the second quarter. Or conversely, that just 11 hospitals had declines, which in total were equal to our entire admissions loss for the quarter. Although still far from satisfactory, the picture improved somewhat in the quarter on the outpatient side. The loss of outpatient visits in the first quarter was 7.5 percent and moderated somewhat to a decline of 6 percent in the second quarter. To achieve our outlook for a decline of 4 percent in outpatient visits in 2006, the decline in the last half of the year will need to be no greater than 1.6 percent. This appears to be a stretch goal at this point, but we believe any shortfall here can be offset by pricing and other variables. Reynold discussed earlier, our proactive initiatives to generate stronger volume growth. 9
  10. 10. Moving to Pricing Pricing was again a notable bright spot in the quarter and made a crucial contribution to the bottom line. Net revenues per equivalent patient day increased by 6.8 percent. This pricing strength was sufficiently robust to drive total net revenues up by 2.5 percent, despite the volume declines. There was no material change in acuity, an increase of less than 1 percent, in the quarter. Limiting our focus to just the managed care piece of our business, net revenue per admission increased by 11.9 percent. This figure includes both commercial managed care as well as managed government programs. Revenue per commercial managed care admission was up 15 percent in the quarter, clearly reflecting the positive efforts of our managed care team. Reflecting our recent pricing strategy, stop loss revenue in the second quarter declined by 17 percent on a year-over-year basis to $83 million. On a sequential basis, the stop loss decline from the first quarter was 3.5 percent. This flattening-out of stop loss is evidence that the recent evolution in our pricing structure is reaching a point of stabilization. On Cost Efficiency The cost discipline you have seen in past quarters was also clearly evident in our second quarter results. As Trevor mentioned, total controllable costs per equivalent patient day were up only 4.4 percent. Not surprisingly, the source of the largest increase was supply costs, which were up 6.4 percent. Salaries wages and benefits per equivalent patient day rose by only 1.4 percent, despite soft volumes. This low rate of growth is unlikely to be sustained in the fourth quarter; however, since our salary increases for the year are to be effective for the fourth quarter, rather than the second quarter as in 2005. Other controllable expenses per equivalent patient day were up 8.8 percent. This increase was largely the result of the effects of lower volume on fixed or semi-variable costs, higher hospital provider taxes and increased IT expenditures for our clinical systems initiative. Partially offsetting these increases was a 16 percent decline in malpractice expense to $49 million in this year’s second quarter versus $58 million in the second quarter of 2005. With Respect to Bad Debt The sequential increase we experienced in bad debt was on a par with our peers. On a Compact- adjusted basis, bad debt was 14.2 percent in the quarter, or 5.9 percent on a reported basis. On a year-to-date basis, Compact-adjusted bad debt was 13.5 percent – inline with our outlook for the full year. On a sequential basis the Compact-adjusted bad debt ratio increased by 150 basis points from 12.7 percent in the first quarter. About 50 basis points, or a third, of this increase resulted from 10
  11. 11. the reclassification of some pending charity accounts to self-pay. Although this is a common process, the amount was more significant than usual or than would be expected in the future. One way to see past this discontinuity as balances move from charity to self-pay is to look at total uncompensated care, which is the sum of bad debt and charity care. Changes in total uncompensated care more accurately reflect the impact on the company’s underlying economics than looking at any one component in isolation. Our uncompensated care increased just 60 basis points from 18.9 percent for the first quarter to 19.5 percent in the second quarter. While this reclassification explains a third of the increase in bad debt, there is still a 100 basis point increase in Compact-adjusted bad debt which it does not explain. The main driver behind these 100 basis points is the continued growth in the uninsured. Total uninsured admissions rose by 2.3 percent relative to last year’s second quarter. Uninsured admissions now comprise 4 percent of total admissions versus 3.8 percent of last year’s second quarter. There was a significant geographic concentration in the growth in the uninsured: • Florida saw an increase of 10 percent in uninsured admissions from the first quarter; • Georgia increased by 27 percent; and • Pennsylvania saw an increase of 28 percent. Our continued improvement in collections from managed care accounts has helped to offset some of this pressure from the uninsured. In the second quarter, we collected 98 percent of our AR from managed care, up from the 96 percent reported at year end 2005. Moving to Cash Flow Cash from operations strengthened on a sequential basis and, before the settlement payments, we were in positive territory for free cash flow. Net cash provided by operating activities before payments for discontinued operations and other charges was a positive $204 million, up from a negative $132 million in the first quarter. This swing reflects the reversal of the seasonal consumption of cash in working capital, which typically occurs in our first quarter, and the timing of our 401K match and interest payments. As we had not yet initiated our accelerated capital spending program in the second quarter, our capital expenditures were $126 million in the quarter, or an annualized run rate of just over $500 million. This spend rate was well below the $700 million of cash we expect to use to fund the portion of our increased capital investments expected to complete in this calendar year. If there is a variance at the end of the year to the $700 million, I would, of course, expect it to be a short term timing difference in nature. While settlement and other payments, including those in discontinued operations, of $524 million had a significant impact on cash flow, excluding these payments, we had positive free cash flow of $86 million in continuing operations. This is before receiving the Katrina insurance settlement of $240 million, which we received in early July. We still expect to have cash at year 11
  12. 12. end of around a billion dollars, consistent with our last outlook. We now expect net interest expense to improve to approximately $360 million. Before I conclude, I want to spend a few minutes on some of the topics I had intended to cover at the investor day. These comments focus on the setting of our financial objectives and how those financial objectives will contribute to guiding our strategies going forward. I am going to be brief, but will be happy to elaborate in Q and A, if desired. First, a few comments on our capital spending: The level of ongoing investment in the business is of crucial concern to all investors. This is particularly true at Tenet following our recently announced strategy of higher capital spending and the implications this spending could have for the timing of our sustained return to positive free cash flow. As we announced in our June 29 press release, our plans call for raising our capital commitment budget for 2006 to $800 million. Although we believe we will be able to afford this kind of level going forward, whether this is the right level of investment for 2007 and subsequent years has yet to be determined. The annual determination of our capital budget will be sensitive to the impact we are able to create with this year’s investments. In support of this, Reynold and I are tightening the assignment of accountability to achieving returns on these investments and ensuring that where we are spending discretionary money there is a well-based commitment to achieving improved results. I have heard the question asked in prior conference calls about hurdle rates. We do use hurdle rates; although I consider the rate used to be proprietary. I can assure you, however, that it is above our weighted average cost of capital. I might talk for a moment on EBITDA and return on invested capital. Following our settlement, we stated our return objectives in terms of EBITDA over the intermediate term. This was done largely to provide a measure frequently used and which could easily be compared to our peers. While we believe EBITDA growth is the primary driver of our recovery, it is just that – a value driver. Consistent with the accountability for returns I spoke to earlier, when I talked about our capital spending, we are also focused on the end result of increasing return on invested capital and achieving sustained free cash flow. Our focus on cash flow is also consistent with a desire to improve our credit ratings over the recovery period. We believe this is important to achieving financial efficiency. 12
  13. 13. At this point, let me step back and briefly summarize my comments in three points: • First of all, going back to my discussion of the quarter, although we continue to feel pressure on volumes and bad debts, we are successfully mitigating this through our pricing and cost control efforts. • Secondly, our investment program is focused and measured. • And then finally, at a more strategic level, our commitment is not just to growth in EBITDA, but also to return on invested capital and sustained free cash flow. Eduardo, our operator, we are now prepared to start our Q and A session. [END] 13