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[February 26, 2013]
IPC THE HOSPITALIST COMPANY, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion highlights the principal factors that have affected our financial condition and results of operations as well as our liquidity and capital resources for the periods described. This discussion should be read in conjunction with our consolidated financial statements and the related notes included in this Report. This discussion contains forward-looking statements that are subject to known and unknown risks. Actual results and the timing of events may differ significantly from those expressed or implied in such forward-looking statements due to a number of factors, including those set forth in the section entitled "Risk Factors" and elsewhere in this Report. The operating results for the periods presented were not significantly affected by inflation.
Company Overview and Recent Developments We are a leading provider of hospitalist services in the United States.
Hospitalist medicine is organized around inpatient care, primarily delivered in hospitals, and is focused on providing, managing and coordinating the care of hospitalized patients. We believe we are the largest dedicated hospitalist company in the United States based on revenues, patient encounters and number of affiliated hospitalists. As of December 31, 2012, either through our wholly-owned subsidiaries or our affiliated professional organizations, we employ or affiliate with over 1,410 hospitalists who provide hospitalist services at over 350 hospitals and 810 other patient and post-acute care facilities in 28 states. We have had 14.1 million patient encounters since the beginning of 2010. Our early entry into the emerging hospitalist industry has permitted us to establish a reputation and leadership position that we believe is closely identified with hospitalist medicine.
We began operating our first hospitalist practice in 1998 and have increased the number of our practice groups to over 255. Since the beginning of 2010, we have acquired 43 practice groups and successfully integrated them into IPC and onto IPC-Link®, our proprietary technology-based management system. Our affiliated hospitalists are primarily full-time employees of our wholly-owned subsidiaries or our affiliated professional organizations. We also employ over 660 other physicians and non-physician providers and contract with over 210 independent contractors, who provide episodic care as needed.
Subsequent to December 31, 2012, we completed the acquisition of the assets of one hospitalist physician practice.
Practice Acquisitions During the year ended December 31, 2012, we acquired the assets of 15 hospitalist physician practices for a total estimated purchase price of $67,595,000. In connection with these acquisitions, we recorded goodwill of $66,321,000, property and equipment of $10,000 and intangible assets of $1,264,000. Total transaction costs of $261,000 for our acquisition activities in 2012 were expensed as incurred.
In connection with these acquisitions, we recorded liabilities of $27.5 million representing the fair value of contingent consideration to be paid based upon the estimated achievement of certain operating results of the acquired practices as of certain measurement dates. The fair value of such contingent consideration is re-evaluated on a quarterly basis based on changes in our estimate of the future operating results of the acquired practices. The changes, if any, in fair value are recognized in our results of operations.
Key Performance Indicators We manage our business by monitoring certain key performance indicators that impact our revenue and profitability. The most important key performance indicators for our business are: • Patient encounters - billable encounters generated by our affiliated hospitalists. Typically we have one billable encounter per patient per day although our affiliated hospitalists may have several interactions with a patient during a twenty-four hour period.
• Revenue per encounter - net revenue from patient billings divided by patient encounters.
• Average encounters per hospitalist per day - the number of patient encounters for a day divided by the number of hospitalists, adjusted for full or part-time status, measured for the same period. We use this metric to monitor our affiliated hospitalists' productivity.
Geographic Coverage and Revenue During 2012, 2011 and 2010 approximately 60%, 62% and 64%, respectively, of our net revenue was generated by operations in five states: Arizona, Florida, Michigan, Missouri and Texas. Over those same periods, our operations in Florida and Texas accounted for approximately, 33%, 32% and 36% of our net revenue, respectively. Although we continue to seek to diversify the geographic scope of our operations, primarily through acquisitions of physician group practices or by recruiting new hospitalists or entering into new hospital contracts, we may not be able to successfully implement or realize the expected benefits of any of these initiatives. Adverse changes or conditions affecting states in which our operations are concentrated, such as healthcare reforms, changes in laws and regulations, reduced Medicaid reimbursements, or government investigations, may have a material adverse effect on our business, financial condition and results of operations.
34 -------------------------------------------------------------------------------- Table of Contents We generate approximately 94% of our net revenue from billings to third-party payors such as Medicare, Medicaid, managed care organizations and insurance companies. We generate the remaining 6% of our net revenue from hospitals and other inpatient facilities for organizing and managing hospitalist programs, providing medical directorships and providing coverage for patients admitted from the emergency department who otherwise have no assigned admitting physician.
Our affiliated hospitalists generally document and submit billing codes daily through the use of IPC-Link®. IPC-Link® captures all our patient demographic and clinical information for billing and submits this data electronically after a series of automated edits and manual review of any exceptions. Our automated edit procedures follow specific business rules to correct billing errors. We utilize a sophisticated tracking and monitoring system to obtain receipt of appropriate reimbursement from our payors and identify billing issues and trends early in the reimbursement process. Our monitoring system is able to identify when we are reimbursed less than what we are contracted to receive and report when we have not received appropriate payment or other issues have developed.
Based on the information from our monitoring system, our collection department contacts third party payors to resolve billing issues and to expedite our collections. If we have a contractual relationship with the payor, we pursue the collection until the issue is resolved. If we are unable to collect from third-party payors and we do not have a contractual relationship with the payor, we bill the patient for the unpaid balance. We use outside service organizations to invoice and collect co-payments and/or deductibles from insured patients and discounted fees from uninsured, or self-pay, patients. After a period of internal collection efforts, we write off the unpaid accounts and send them to an outside collection agency.
We determine our net revenue from patient billings based on our estimate of collections from payors. Our fee schedule is the same for all parties regardless of geography or party responsible for paying the bill for our services. We are reimbursed by Medicare and Medicaid at government established rates, by managed care and insurance organizations at contracted rates or other discounted rates and have various arrangements with other third-party insurers. In addition, patients may be personally responsible for a deductible or co-payment under their third-party payor coverage. We may provide discounted or free services to self-pay patients who require hospital admission when we are providing admission coverage for emergency departments, if our collection attempts are unsuccessful.
Due to the uncertainty regarding collectability of charges associated with services we provide to uninsured patients and patients with co-pay or deductible balances, our net revenue recognition for these patients is based on our expected cash collections.
With respect to our revenue generated from billings to third-party payors, the table below summarizes our approximate payor mix as a percentage of patient encounters for the periods indicated: Years Ended December 31, 2012 2011 2010 Medicare 47 % 46 % 45 % Medicaid 5 % 5 % 6 % Other third parties 43 % 43 % 44 % Self-pay patients 5 % 6 % 5 % 100 % 100 % 100 % The percentage of our net revenue related to self-pay patients is significantly smaller percentage of our net revenues compared to other payors, as higher percentage of these services are uncompensated.
Seasonality and Quarterly Fluctuations We have historically experienced and expect to continue to experience quarterly fluctuations in net revenue and income from operations. Absent the impact and timing of acquisitions, our net revenue has historically been higher in the first and fourth quarters of the year primarily due to the following factors: • the number of physicians we have on staff during the quarter, which may fluctuate based upon the timing of hires due to the end of the academic year for graduating resident physicians, the schedule of the Internal Medicine Board exams and terminations in our existing practices; and • fluctuations in patient encounters, which are impacted by hospital census, which can be volatile, physician productivity and seasonality due to the higher occurrence of illnesses such as flu and pneumonia in patient populations in the first quarter.
35 -------------------------------------------------------------------------------- Table of Contents We have significant fixed operating costs, including physician practice salaries and benefits and, as a result, are highly dependent on patient encounters and the productivity of our hospitalists to sustain profitability. Additionally, quarterly results may be affected by the timing of acquisitions.
Factors Affecting Operating Results Rate Changes by Government Sponsored Programs The Medicare program reimburses for our services based upon the rates set forth in the annually updated Medicare Physician Fee Schedule, which relies, in part, on a target-setting formula system called the Sustainable Growth Rate (SGR).
Many private payors use the Medicare Physician Fee Schedule to determine their own reimbursement rates. Based on the SGR, the annual Medicare Physician Fee Schedule update is adjusted to reflect the comparison of actual expenditures to target expenditures. Because one of the factors for calculating the SGR is linked to the growth in the U.S. GDP, the SGR formula may result in a negative payment update if growth in Medicare beneficiaries' use of services exceeds GDP growth, a situation which has occurred every year since 2002 and the reoccurrence of which we cannot predict.
The Middle Class Tax Relief and Job Creation Act of 2012 delayed implementation of the negative SGR payment update again until January 1, 2013, when the cut would have been 26.5 percent. Similarly, the American Taxpayer Relief Act of 2012, enacted on January 2, 2013, delays the implementation of the negative SGR payment update until January 1, 2014. While Congress has repeatedly intervened to mitigate the negative reimbursement impact associated with the SGR formula, there is no guarantee that Congress will continue to do so in the future.
Moreover, the existing methodology may result in significant yearly fluctuations in the Medicare Physician Fee Schedule amounts, which may be unrelated to changes in the actual costs of providing physician services. Unless Congress enacts a change in the SGR methodology, the uncertainty regarding reimbursement rates and fluctuation will continue to exist.
Another provision that affects physician payments is an adjustment under the Medicare statute to reflect the geographic variation in the cost of delivering physician services, by comparing those costs to the national average. This concerns the "work" component of the Geographic Practice Cost Indices (GPCI). If Congress does not block this adjustment, payments would be decreased to any geographic area with an index of less than 1.0. The Middle Class Tax Relief and Job Creation Act of 2012 prevented the GPCI payment adjustment through the end of 2012. With enactment of the American Taxpayer Relief Act of 2012 on January 2, 2013, again, the GPCI payment adjustment has been delayed through the end of 2013. Although Congress has delayed the GPCI payment adjustment several times, there is no guarantee that Congress will block the adjustment in the future, which could result in a decrease in payments we receive for physician services.
Congress has a strong interest in reducing the federal debt, which may lead to new proposals designed to achieve savings by altering payment policies. The Budget Control Act of 2011 (BCA) established a Joint Select Committee on Deficit Reduction, which was tasked with achieving a reduction in the federal debt level of at least $1.2 trillion. That Committee did not draft a proposal by the BCA's deadline. As a result, automatic cuts in various federal programs were scheduled to take place, beginning in January 2013. Although the Medicare program's eligibility and scope of benefits are generally exempt from these cuts, Medicare payments to providers are not exempt. The BCA did, however, provide that the Medicare cuts to providers would not exceed two percent. The American Taxpayer Relief Act of 2012, signed into law on January 2, 2013, delayed implementation of the BCA's automatic cuts until March 1, 2013. Thus, Congress and the White House will be forced to confront this matter again.
In fact, the situation with the federal budget remains in flux. First, if an agreement is not reached and legislation is not enacted by March 1, 2013, the BCA's automatic cuts will go into effect, including the two percent cut in payments to providers and Part D health plans. Second, the appropriations law that is funding operations of the federal government will expire on March 27, 2013, and there may be a partial government shutdown if a new appropriations law is not enacted. Third, the statutory debt ceiling was reached on December 31, 2012. The Treasury Department was using what it calls "extraordinary measures" to avoid defaults by the federal government on its financial obligations, but the Department expected those measures to be exhausted at some point during the period mid-February to early March. Many Members of Congress have made public statements indicating that some or all of these budget-related deadlines should be used as leverage to negotiate additional cuts in federal spending. The Medicare program is frequently mentioned as a target for spending cuts.
Legislation was enacted on February 4, 2013 that suspends the statutory debt ceiling until May 19, 2013, and beginning on that date the Treasury Department is again expected to use extraordinary measures to delay a government default.
This new law is a temporary measure that does not resolve the debt-limit issue.
Moreover, it addresses only one of the three budget deadlines noted above. The bill does not affect Medicare's status as a target for spending cuts.
The magnitude of Medicare cuts that may be made through budget agreements is unclear. However, under our provider compensation plan, any decrease in reimbursement rates would reduce our physician incentive payments. For example, the BCA's automatic two percent net reduction in Medicare reimbursement rates for the codes applicable to the services performed by our affiliated hospitalists could reduce our net income by approximately 0.2 percent.
36-------------------------------------------------------------------------------- Table of Contents Healthcare Reform In March 2010, the Affordable Care Act (ACA) was enacted. The ACA includes a number of provisions that may affect our Company, although the impact of many of the changes will be unknown until they are implemented, which in some cases will not occur for a couple of years. The impact of some of these provisions may be positive, such as the expansion in the number of individuals with health insurance, the ten percent Medicare bonus payment for primary care services (including outpatient and nursing home visits) from 2011 through 2015 to primary care practitioners for whom primary care services represented a minimum of 60 percent of Medicare allowed charges in a prior period, and the increase in Medicaid rates in 2013 and 2014 for primary care services. The impact of other provisions is unknown at this time, such as the establishment of an Independent Payment Advisory Board that could recommend changes in payment for physicians under certain circumstances not earlier than January 15, 2014, which the federal Department of Health and Human Services (HHS) generally would be required to implement unless Congress enacts superseding legislation. Fraud and abuse penalty increases and the expansion in the scope of the reach of the federal False Claims Act and government enforcement tools may adversely impact entities in the healthcare industry, including our Company.
The impact of certain provisions will depend upon the ultimate method of implementation. For example, the ACA requires HHS to develop a budget neutral value-based payment modifier that provides for differential payment under the Medicare Physician Fee Schedule for physicians or groups of physicians that is linked to quality of care furnished compared to cost. HHS has begun implementing the modifier through the Medicare Physician Fee Schedule rulemaking for 2013, by, among other things, specifying the initial performance period and how it will apply the upward and downward modifier for certain physicians and physician groups beginning January 1, 2015, as well as all physicians and physician groups starting not later than January 1, 2017. During this rulemaking process, HHS considered whether it should develop a value-based payment modifier option for hospital-based physicians, but ultimately, HHS decided to deal with this issue in future rulemaking. The impact of this payment modifier cannot be determined at this time.
In addition, certain provisions of the ACA authorize voluntary demonstration projects, which include the development of bundling payments for acute, inpatient hospital services, physician services, and post-acute services for episodes of hospital care. The Medicare Acute Care Episode Demonstration is currently underway at five health care system demonstration sites. The impact of these projects on our Company cannot be determined at this time.
Professional Liability Rates Medical malpractice insurance premium rates are affected by a variety of factors both internal, including our own loss experience and the associated defense costs, and external such as medical malpractice loss experience for internal medicine physicians, which varies greatly across different regions. Other factors include varying state laws covering tort reform, the local climate for large jury awards, the rate of investment income and reinsurance costs, all of which can result in wide variations in premium rates not only from region to region, but also from year to year. Although our malpractice premium rates have remained relatively stable over the last three years, the factors discussed above could lead to variations in future costs.
Principles of Consolidation Our consolidated financial statements include the accounts of IPC The Hospitalist Company, Inc. and its wholly owned subsidiaries and consolidated professional medical corporations managed under long-term management agreements (the Professional Medical Corporations). Some states have laws that prohibit business entities, such as IPC, from practicing medicine, employing physicians to practice medicine, exercising control over medical decisions by physicians (collectively known as the corporate practice of medicine), or engaging in certain arrangements with physicians, such as fee-splitting. In states that have these restrictions, we operate by maintaining long-term management contracts with the Professional Medical Corporations, which are each owned and operated by physicians, and which employ or contract with additional physicians to provide hospitalist services. Under the management agreements, we provide and perform all non-medical management and administrative services, including financial management, information systems, marketing, risk management and administrative support. The management agreements have an initial term of 20 years and are automatically renewable for successive 10-year periods unless terminated by either party for cause. The management agreements are not terminable by the Professional Medical Corporations, except in the case of gross negligence, fraud, or other illegal acts by us, or bankruptcy of IPC.
Through the management agreements and our relationship with the stockholders of the Professional Medical Corporations, we have exclusive authority over all non-medical decision making related to the ongoing business operations of the Professional Medical Corporations. Further, our rights under the management agreements are unilaterally salable or transferable. Based on the provisions of the agreements, we have determined that the Professional Medical Corporations are variable interest entities (VIE's), and that we are the primary beneficiary because we have controls over the operations of these VIE's. Consequently, we consolidate the revenue and expenses of the Professional Medical Corporations from the date of execution of the agreements. All intercompany balances and transactions have been eliminated in consolidation.
37-------------------------------------------------------------------------------- Table of Contents Critical Accounting Estimates The preparation of financial statements requires management to make estimates and assumptions relating to the reporting of results of operations, financial condition and related disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from those estimates under different assumptions or conditions. The following are our most critical accounting estimates, which are those that require management's most difficult, subjective and complex judgments, requiring the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.
The following discussion is not intended to represent a comprehensive list of our accounting estimates. For a detailed discussion of the application of these and other accounting policies, see Note 1 to our audited consolidated financial statements included in this Report.
Revenues Net revenue primarily consists of fees for medical services provided by our affiliated hospitalists under fee-for-service and other professional fee arrangements with various payors including Medicare, Medicaid, managed care organizations, insurance companies and hospitals.
Net revenue is reported in the period in which services are provided at amounts expected to be collected, which excludes contractual discounts and an estimate of uncollectible accounts. The process of estimating the ultimate amount of revenue to be collected is highly subjective and requires the application of our judgment based on many factors, including contractual reimbursement rates, payor mix, age of receivables, historical cash collection experience and other relevant information. We write off uncollectible accounts receivable from our billing system after reasonable collection efforts have been exhausted. Revenue related to patient responsibility accounts, including both deductible and co-pays for insured patients and discounted fees for uninsured patients, is recorded at amounts reasonably assured of collection.
The evaluation of these factors, as well as the interpretation of governmental regulations and private insurance contract provisions, involves complex, subjective judgments. As a result of the inherent complexity of these calculations, our actual revenues and net income could vary from the amounts reported.
Accounts Receivable Accounts receivable primarily consists of amounts due from third-party payors, including governmental programs, such as Medicare and Medicaid, managed care organizations, insurance companies, hospitals and amounts due from patients.
Accounts receivable are recorded and stated at the amount expected to be collected, net of reserves for amounts estimated by management to be uncollectible. We write off uncollectible accounts receivable from our billing system after reasonable collection efforts have been exhausted. We also regularly analyze the ultimate collectability of accounts receivable after certain stages of the collection cycle using a look-back analysis to determine the amount of receivables subsequently collected and adjustments are recorded when necessary.
Goodwill and Other Intangible Assets We record acquired assets and liabilities and any contingent consideration at their acquisition-date fair values, and expense all transaction related costs under the acquisition method of accounting. Goodwill represents the excess of cost over the fair value of the net assets acquired. Other intangible assets primarily represent the fair value of hospital service contract agreements and non-compete agreements acquired in connection with certain asset purchase agreements. Goodwill and other indefinite-lived intangible assets are not amortized. Separable identified intangible assets that have finite lives are amortized over their useful lives.
38-------------------------------------------------------------------------------- Table of Contents In addition to the initial consideration paid at the close of each business combination, the asset purchase agreements for most completed practice acquisitions provide for additional future consideration to be paid, which is generally based upon the achievement of certain operating results of the acquired practices as of certain measurement dates. Pursuant to U.S. generally accepted accounting principles (GAAP), the estimated fair value of contingent consideration is accrued at the acquisition-date. Subsequent changes, if any, to the estimated fair value of contingent consideration are recognized as part of on-going operations.
We test goodwill for impairment on an annual basis, as well as when events or changes in business conditions indicate that the carrying value of goodwill may not be recoverable , at the entity level since we have only one reporting unit pursuant to GAAP. The testing for impairment is completed using a two step test.
The first step compares the fair value of our Company with its carrying amount.
The fair value of our Company is derived using the market-multiple valuation approach, which is based on our peer group's market capitalization computed using publicly available market quotes. If the fair value of our Company is less than its carrying amount, a second step is performed to determine the amount of any impairment loss. We review our finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.
During 2012, 2011 and 2010, no impairment indicators were present and no impairment was recognized.
Claims Liability and Professional Liability Reserves We maintain a medical malpractice liability insurance policy, which expires on December 31 of each year indemnifying us and our employed health care professionals on a claims-made basis. Our claims-made policy covers only those claims reported during the policy period. Our current claims-made professional liability insurance policy provides first dollar coverage up to our policy limits. Consequently, we establish reserves for our liabilities, on an undiscounted basis, for claims incurred and reported and claims incurred but not reported during the policy period. For claims incurred and reported, an insurance receivable from our carrier has been recorded pursuant to GAAP. See our discussion in Note 1 to the Consolidated Financial Statements for a summary of our accrued medical malpractice reserves and related insurance receivables.
These reserves are based upon actuarial loss projections, which are updated semi-annually. The actuarial loss projections consider a number of factors, including historical claim payment patterns and changes in case reserves and the assumed rate of increase in healthcare costs. Historical experience and recent trends in the historical experience are the most significant factors in the determination of these reserves. We believe the use of actuarial methods to account for these reserves provides a consistent and effective way to measure these subjective accruals. However, given the magnitude of the claims involved and the length of time until the ultimate cost is known, the use of any estimation technique in this area is inherently sensitive and subject to change when actual paid claims information becomes known. Accordingly, our recorded reserves could differ from our ultimate costs related to these claims due to changes in our incident reporting, claims payment and settlement practices or claims reserve practices, as well as differences between assumed and actual future cost increases.
Recently Adopted Accounting Principles See Note 1 to the Consolidated Financial Statements for information regarding recently adopted accounting principles.
39-------------------------------------------------------------------------------- Table of Contents Results of Operations and Operating Data Consolidated Results The following table sets forth operating data and selected consolidated statements of income information stated as a percentage of net revenue: Year Ended December 31, 2012 2011 2010 Operating data-patient encounters 5,496,000 4,762,000 3,810,000 Net revenue 100.0 % 100.0 % 100.0 % Operating expenses: Cost of services-physician practice salaries, benefits and other 73.2 % 73.2 % 72.0 % General and administrative 16.0 % 16.0 % 16.4 % Net change in fair value of contingent consideration 0.1 % (0.2 )% 0.1 % Depreciation and amortization 0.6 % 0.7 % 0.7 % Total operating expenses 89.9 % 89.7 % 89.2 % Income from operations 10.1 % 10.3 % 10.8 % Interest expense (0.1 )% (0.1 )% - % Income before income taxes 10.0 % 10.2 % 10.8 % Income tax provision 3.8 % 3.8 % 4.1 % Net income 6.2 % 6.4 % 6.7 % Year ended December 31, 2012 compared to year ended December 31, 2011 Our patient encounters for 2012 increased by 734,000 or 15.4% to 5,496,000, compared to 4,762,000 for 2011. Net revenue for 2012 was $523.5 million, an increase of $66.0 million, or 14.4%, from $457.5 million for 2011. Of this $66.0 million increase, 63% was attributable to same-market area growth and 37% was attributable to revenue generated from new markets. Same-market revenue increased 9.3%, same market encounters increased 11.3% and same-market patient revenue per encounter decreased 2.4%. The 2.4% decrease was due to a shift in service mix from acute to post acute care. Same-market areas are those geographic areas in which we have had operations for the entire current period and the entire comparable prior period. Because in-market area acquisitions are often small practice groups which become subsumed within existing practice groups and are managed by our existing regional management staff, we consider these as part of our same-market area growth.
Physician practice salaries, benefits and other expenses for 2012 were $382.9 million or 73.2% of net revenue compared to $335.0 million or 73.2% of net revenue for 2011. These costs increased by $48.0 million or 14.3%. The increase in practice costs is largely related to the increase in the number of hospitalists added through hiring and acquisitions during the period.
Same-market area physician costs increased a total of $30.9 million, which was primarily the result of increased costs related to our new hires or acquired physician practices. In addition, $17.1 million of the $48.0 million overall cost increase is attributable to physician costs associated with our seven new markets.
General and administrative expenses increased $10.4 million, or 14.2%, to $83.7 million, or 16.0% of net revenue, for 2012, as compared to $73.3 million, or 16.0% of net revenue for 2011. The increase in expense was primarily the result of increased costs to support the continuing growth of our operations, including new regional office costs and other expenses and the significant increase in acquisitions. Excluding stock-based compensation, general and administrative expenses decreased by 20 basis points to 14.8% of revenue, compared to 15.0% of revenue for 2011.
Net change in fair value of contingent consideration increased by $0.3 million in 2012, as compared to a decrease of $1.0 million in 2011. Because the fair value of contingent consideration is generally based on a certain multiple of operating results of the acquired practices during a measurement period, changes to our estimate of projected operating results of the acquired practices impact the fair value of the related contingent consideration, resulting in gains or losses that are included in our consolidated results of operations.
40-------------------------------------------------------------------------------- Table of Contents Income from operations increased $5.6 million, or 11.9%, to $52.6 million, as compared to $47.0 million for 2011. Our operating margin was 10.1% for 2012 as compared to 10.3% for 2011. Excluding the net change in fair value of contingent consideration, income from operations for 2012 increased 15.1% to $53.0 million, or an operating margin of 10.1%, compared to income from operations of $46.0 million, or an operating margin of 10.1% for 2011.
Our effective tax rate for the years ended December 31, 2012 and 2011 was 37.7% and 37.5%, respectively. The increase in the overall effective tax rate was primarily related to a change in state tax laws. We expect our 2013 effective income tax rate to be approximately 38.3%. The effective tax rate differs from the statutory U.S. federal rate of 35.0% due primarily to state income taxes.
Net income increased to $32.6 million for 2012, as compared to $29.3 million for 2011, and our net income margin was 6.2% for 2012 as compared to 6.4% for the same period in the prior year. Diluted earnings per share for 2012 was $1.92, as compared to diluted earnings per share of $1.74 in 2011. Excluding the net change in the fair value of contingent considerations, net income for 2012 increased 14.5% to $32.8 million, or $1.93 diluted earnings per share, compared to net income of $28.6 million, or $1.70 diluted earnings per share for 2011.
Year ended December 31, 2011 compared to year ended December 31, 2010 Our patient encounters for 2011 increased by 952,000 or 25.0% to 4,762,000, compared to 3,810,000 for 2010. Net revenue for 2011 was $457.5 million, an increase of $94.1 million, or 25.9%, from $363.4 million for 2010. Of this $94.1 million increase, 68.9% was attributable to same-market area growth and 31.1% was attributable to revenue generated from new markets. Same-market revenue increased 17.9%, which is primarily the result of an increase of same-market encounters by 17.5% and an increase of patient revenue per encounter by 0.1%.
Physician practice salaries, benefits and other expenses for 2011 were $335.0 million or 73.2% of net revenue compared to $261.5 million or 72.0% of net revenue for 2010. These costs increased by $73.5 million or 28.1%. The increase in practice costs is largely related to the increase in the number of hospitalists added through hiring and acquisitions during the period and to continued investment in physician leadership initiatives. Same-market area physician costs increased a total of $51.9 million, of which $52.7 million was primarily the result of increased costs related to our new hires or acquired physician practices, offset by a net decrease of $0.8 million in existing physician costs. In addition, $21.6 million of the $73.5 million overall cost increase is attributable to physician costs associated with our eight new markets.
As a percentage of revenue, physician costs increased by 120 basis points year over year. During 2011, we had a net increase of 169 providers, 147 of which came on board during the second half of the year. This large increase in the number of providers resulted in lower productivity during this ramp up period.
In addition, several of our larger contracted practices experienced staffing challenges resulting in added costs for locum tenens, moonlighters and premium call pay and discretionary bonuses for employed physicians.
General and administrative expenses increased $13.6 million, or 22.8%, to $73.3 million, or 16.0% of net revenue, for 2011, as compared to $59.7 million, or 16.4% of net revenue for 2010. The increase in expense is primarily the result of increased costs to support the continuing growth of IPC's operations, including new regional office costs and increases in corporate development and other expenses to support acquisitions. General and administrative expenses decreased as a percentage of net revenue as IPC continues to leverage these costs over a larger revenue base. Excluding stock-based compensation, general and administrative expenses decreased by 50 basis points to 15.0% of revenue, compared to 15.5% of revenue for 2010.
Net change in fair value of contingent consideration decreased by $1.0 million in 2011, as compared to an increase of $0.2 million in 2010.
Income from operations increased $7.7 million, or 19.6%, to $47.0 million, as compared to $39.3 million for 2010. Our operating margin was 10.3% for 2011 as compared to 10.8% for 2010. Excluding the net change in fair value of contingent consideration, income from operations for 2011 increased 16.5% to $46.0 million, or an operating margin of 10.1%, compared to income from operations of $39.5 million, or an operating margin of 10.9% for 2010. The decrease in the operating margin was largely the result of the increase in physician costs as a percentage of revenue, partially offset by the decrease in general and administrative expenses as a percentage of revenue.
Our effective tax rate for the years ended December 31, 2011 and 2010 was 37.5% and 38.2%, respectively. The decrease in the overall effective tax rate was primarily due to a change in the state tax laws and increased state credits during 2011.
Net income increased to $29.3 million for 2011, as compared to $24.3 million for 2010, and our net income margin was 6.4% for 2011 as compared to 6.7% for the same period in the prior year. Diluted earnings per share for 2011 was $1.74, as compared to diluted earnings per share of $1.46 in 2010. Excluding the net change in the fair value of contingent considerations, net income for 2011 increased 17.5% to $28.6 million, or $1.70 diluted earnings per share, compared to net income of $24.4 million, or $1.47 diluted earnings per share for 2010.
41 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of December 31, 2012 we had approximately $71.0 million in liquidity, comprised of $16.2 million in cash and cash equivalents and an available line of credit of $54.8 million. We had borrowings of $20 million from our revolving line of credit outstanding at December 31, 2012.
Year ended December 31, 2012 compared to year ended December 31, 2011 Net cash provided by operating activities for 2012 was $39.8 million compared to $25.8 million for 2011. The primary changes in working capital during the year ended December 31, 2012 consisted of (i) an increase in accounts receivable of $11.6 million which is in proportion to the increase in our 2012 revenue, (ii) a net increase in medical malpractice and self-insurance reserves of $3.2 million, (iii) an increase in prepaid expenses and other current assets of $4.1 million, and (iv) an increase in accrued compensation of $7.0 million primarily related to timing of payrolls and physician bonus payments.
Our days sales outstanding (DSO), which we use to measure the effectiveness of our collections, was 52 and 51 DSO as of December 31, 2012 and 2011, respectively. We calculate our DSO using a three-month rolling average of net revenues.
Net cash used in investing activities was $66.2 million for 2012, compared to $31.1 million for 2011. Cash of $62.6 million was used in 2012 for physician practice acquisitions and earn-out payments on prior acquisitions compared to $27.8 million used in 2011. The remainder of cash used in investing activities was for purchases of computer hardware and software, and office furnishings.
For 2012, net cash provided by financing activities was $24.8 million, compared to $4.2 million provided by financing activities for 2011. In March 2012, we borrowed $15.0 million from our revolving line of credit, which was repaid in the second quarter of 2012. In December 2012, we borrowed $20.0 million from our revolving line of credit to fund new acquisitions and pay for contingent considerations of acquired practices.
Year ended December 31, 2011 compared to year ended December 31, 2010 Net cash provided by operating activities for 2011 was $25.8 million compared to $29.6 million for 2010. The primary changes in working capital during the year ended December 31, 2011 consisted of (i) an increase in accounts receivable of $13.8 million which is in proportion to the increase in our 2011 revenue, (ii) a net increase in medical malpractice and self-insurance reserves of $3.7 million, (iii) an increase in prepaid expenses and other current assets of $3.5 million, and (iv) an increase in accrued compensation of $2.2 million primarily related to timing of payrolls and physician bonus payments.
Our days sales outstanding (DSO), which we use to measure the effectiveness of our collections, was 51 DSO as of December 31, 2011 and 2010.
Net cash used in investing activities was $31.1 million for 2011, compared to $43.9 million for 2010. Cash of $27.8 million was used in 2011 for physician practice acquisitions and earn-out payments on prior acquisitions compared to $41.2 million used in 2010. The remainder of cash used in investing activities was for purchases of computer hardware and software, and office furnishings.
For 2011, net cash provided by financing activities was $4.2 million, compared to $1.7 million provided by financing activities for 2010.
Credit Facility and Liquidity Our secured revolving credit agreement (Credit Facility) provides a revolving line of credit of $75.0 million and contains an "accordion" feature that allows an increase of $25.0 million to the Credit Facility with lender approval. The Credit Facility has a maturity date of August 4, 2016 and is available for working capital, practice acquisitions, capital expenditures and general business expenses. During March 2012, we borrowed $15.0 million under the Credit Facility bearing interest at 1.0% per annum, which was repaid during the second quarter 2012. In December 2012, we borrowed $20.0 million under the Credit Facility bearing interest at 1.0%. As of December 31, 2012, we had borrowings of $20.0 million and letters of credit of $0.2 million outstanding, and $54.8 million available under the Credit Facility.
The revolving line of credit is limited by a formula based on a certain multiple times the trailing twelve months of earnings before interest, taxes, depreciation, amortization and certain non-cash items. Interest rate options for each borrowing under the Credit Facility, to be selected by us at the time of each borrowing, include either LIBOR plus 0.75% to 1.25%, or the lender's prime rate plus 0% to 0.25%, both based on a leverage ratio. We pay an unused commitment fee equal to 0.25% per annum on the difference between the revolving line capacity and the average balance outstanding during the year. Outstanding amounts advanced to us under the revolving line of credit are repayable on or before the maturity date.
42 -------------------------------------------------------------------------------- Table of Contents The Credit Facility is guaranteed by our subsidiaries and affiliated Professional Medical Corporations and limited liability companies, and is secured by substantially all of our and our guarantors' tangible and intangible assets. The Credit Facility includes various customary financial covenants and restrictions, as well as customary remedies for our lenders following an event of default. As of December 31, 2012, we were in compliance with such financial covenants and restrictions.
We anticipate that funds generated from operations, together with our current cash on hand and funds available under our revolving credit agreement will be sufficient to finance our working capital requirements and fund anticipated acquisitions, contingent acquisition consideration and capital expenditures.
Contractual Obligations and Reserves The table below summarizes by maturity our significant contractual obligations and reserves, including interest, as of December 31, 2012: Due in Years Ended December 31, Total 2013 2014 2015 2016 2017 Thereafter (dollars in thousands) Operating lease obligations $ 7,347 $ 3,245 $ 1,569 $ 1,127 $ 773 $ 442 $ 191 Acquisition earn-out payments(1) 29,533 16,303 13,230 - - - - Medical malpractice reserves-reported claims (2) 26,920 9,846 7,258 4,101 2,111 1,365 2,239 Subtotal-contractual obligations 63,800 29,394 22,057 5,228 2,884 1,807 2,430 Medical malpractice reserve-incurred but not reported (2) 21,351 504 2,627 5,367 5,859 3,731 3,263 Total contractual obligations and reserves $ 85,151 $ 29,898 $ 24,684 $ 10,595 $ 8,743 $ 5,538 $ 5,693 (1) In addition to the initial consideration paid pursuant to most asset purchase agreements entered into, additional contingent consideration is to be paid based upon the achievement of certain operating results of the acquired practices as of certain measurement dates. The undiscounted amounts of these additional payments are estimated to be approximately $29.5 million at December 31, 2012 and the majority of such payments are expected to be made during 2013, with the remaining amounts to be paid in early 2014. Such additional consideration is not contingent upon the future employment of the sellers.
(2) We are fully insured on a claims-made basis up to our policy limits through a third party malpractice insurance policy, which ends December 31 of each year. Consequently, we establish reserves, on an undiscounted basis, for claims incurred and reported and claims incurred but not reported (IBNR) during the policy period. These reserves and the timing of payment of such amounts are estimated based upon actuarial loss projections, which are updated semi-annually. For claims incurred and reported, an insurance receivable from our carrier is recorded pursuant to GAAP. So long as we maintain third party malpractice insurance policies, the IBNR claims will be covered by such third party policy up to the policy limits.
Off-Balance Sheet Arrangements As of December 31, 2012, we had no off-balance sheet arrangements.
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