Surgery Partners, Inc. (SGRY) Earnings Call Transcript & Summary

It's my pleasure to be introducing Surgery Partners. Surgery Partners is the largest pure-play provider of surgery center services throughout the country. Presenting today, we have Dave Dougherty, who is the CFO of the company. He has been foolish enough to jump right into Q&A. So I think I'll start. If anyone has any questions, by all means, raise your hand, but I'll start off.

Maybe the place to start is with the quarter. I guess you guys raised the guidance by about $5 million on an EBITDA basis. Can you just talk a little bit about what was the main driver behind that increase?

Sure. And first off, Kevin, thank you. I appreciate the opportunity to be here on behalf of Surgery Partners. Our first quarter, you're absolutely right, came out strong enough for us to feel comfortable raising our guidance this year. When we kind of look back at the first quarter, especially as we started the first quarter, we did experience some of the effects of the Omicron variant. Unlike prior variants, though, what we saw was a rapid rescheduling of those cases. And I think it's just the reality is we're all getting a little bit more comfortable with how to deal with this. We also didn't experience Omicron across all facilities at the same time. It was kind of almost like a wave that went through the country. We saw it in January. We saw it in February. We saw many of those cases. Instead of being canceled, we're simply rescheduled. So a lot of those happened within the quarter where we saw kind of an overall recovery inside the quarter. We were also pleased with the acquisitions. We completed 2 acquisitions inside the first quarter. As you know, we really do target highly accretive transactions, those that we can -- that will provide some immediate value and also those for which kind of serve our longer-term mission where we believe we can be successful. Those were contributing factor inside the first quarter for us. And we had a return to somewhat normalized levels. So in 2021, we were still very much feeling the effects of COVID. Our mix of business, predominantly orthopedic, GI, ophthalmology, those latter 2 cases inside the first quarter 2021 weren't fully back to normal. And as we ended the first quarter, we saw all of those kind of ramping up back closer to normal. And then finally, what we have been looking at is what's going on with inflation. It's hard not to kind of look at that from both the supply and labor side. And as we ended the quarter and look back at that, a lot of the activities that we put in place to help us, one, monitor and react to kind of inflationary pressures seemed to work for us as we saw kind of the numbers come out. So as a result of all of that, we were very comfortable raising our guidance [ post ] by $5 million at the midpoint and $50 million on the revenue side, again at the midpoint. As we sit here, we're still monitoring risks associated with the virus. We're still monitoring risks associated with inflationary pressures. And so we think we've kind of struck a balance of prudency, but also kind of recognizing that we're 1/4 of the way through the year.

All right. So that's helpful. I guess when we think about the comment about historical performance, you say that the deals came, but you guys -- your guidance includes some amount of deals for the year. So you said they came in better just more front-end loaded, is that the way to think about? Or are you saying that you now feel like you're on pace to do more than the $200 million?

Yes. So we're still inside our guidance, our expectations of deploying at least $200 million this year. In January, we completed 2 of them. In April, we completed 2 more and with $200 million under LOI as we sit here right now. The contribution from those, we -- you're absolutely right, Kevin. We do anticipate and built into our guidance this concept of the midyear convention of where those are going to come in. We also look as we do those acquisitions for how quickly we can take a turn off of the multiple for each we buy. Our acquisitions from both '21 and early signs of 2022 acquisitions are coming in, in line or more favorable than our expectations.

Okay. That's great. And then, I guess, what is kind of driving that deal activity? So -- I mean, obviously, you guys have an appetite, but why are surgery centers available for purchase?

Well, there's still a majority of surgery centers out there that are independent, so pure independent players. The other thing that we've all recognized is that trend continues to grow. So estimates range around 4% new ASCs popping up in a de novo capacity every single year. So I think this is largely a recognition of payer recognition and physician recognition that you can perform high-quality safe procedures inside an ambulatory surgery center setting. So we see the volume out there still relatively big. We see that continuing to grow. And the reputation of the Surgery Partners has developed in the marketplace to add increasing value to our physician partners. I think it's another key differentiator as we look at this space. Multiples have remained relatively consistent throughout this COVID period and even as we exited or hopefully exit it. And so we completed, in December alone, $185 million worth of acquisitions. Turned into January, another $35 million, and immediately refilled the pipeline. And our pipeline is, of course, stronger than the ones we have under LOI. We have $200 million or so under LOI right now. We've just introduced the new partnership we have with ValueHealth. These all give us great confidence that, one, we are a partner of choice; and two, there remains interest in strong -- robust interest in finding a good quality partner like us.

And I may have missed it, but I think you said the multiples are steady. Did you give a multiple number?

Yes. The multiples that we just executed on were sub-8, heavy orthopedic. In the past, we've been around 8 or so in orthopedic space, sub-7 for ophthalmology, GI cases. So based on the mix of specialties that we might acquire, you could expect us to be somewhere in that range. It will, of course, hover based on the strength of the asset, the specialties and the acuity that kind of sits underneath there. But even as we look at those acquisitions at that level, our approach constantly is to deploy our integration efforts and take at least 1 turn, 1.5 turns off within the first 18 months of owning it.

You mentioned this a little bit, but it is surprising to me because we've been following the sector since USPI went public 20 years ago. And back then, there was a lot of de novos. And then it kind of slowed down for a good 10 years or so, and now it seems like they're picking back up again. We were at the point where there's more surgery centers than there are hospitals in the country. So is it surprising to me that doctors are increasingly still seeing the opportunity here. So maybe you can just expand a little bit upon that dynamic and...

Well, I think it's the strong push coming out of the payer community, including CMS. So a greater recognition among all constituents -- so if you look at the payer side, clearly, the benefit is going to come through on reimbursement rates. Relatively speaking, the cost of maintaining an ASC is far less than the cost of maintaining an acute care setting. And so usually, the single largest component of a surgical procedure is going to be that facility payment. We represent a materially valuable cost basis compared to those higher acuity settings. But you're also seeing -- both physicians and patients now seeing that they can perform procedures in a more comfortable setting. Largely, it's just a little bit less intimidating to come into an ASC environment. They can see the clinical quality. The safety measures are consistently proving to be very safe. Patient satisfaction, physician satisfaction are higher. So I think as physicians look to venture out of an acute care setting, perhaps as they kind of roll off hospital contracts, they're looking for different opportunities to have their own value, to have their own independent say in the future of the facility that they're operating. I think that's why you're seeing ASCs continuing to grow at the clip that we are seeing and coming back into it. I don't see any reason why that trend should abate in the near-term future. I think you're seeing continued recognition from CMS that procedures can be performed safely. And we do anticipate this continued push on total joints, hips and knees were the latest. Cardiac, we view as next. So you are seeing just this greater demand from all constituents, which I think will just continue to increase that population out there.

And how do you draw those doctors to you? A number of larger chains, in theory, have some lower scale of purchasing. Like what differentiates you in the mind of doctors? What -- how do you market yourself?

Well, I think it's the individual value that we can provide to them. So -- and it's going to be different in the markets that you're in. But it does come down to -- first off, we're going to go into a market where we believe we can add value, right? We can bring the expertise that we have, either through our scale and the contracting ability that we have that may be beneficial to a physician partner. Anything that we can do to improve or at least maintain, but hopefully improve the clinical quality and outcome for their patients. And I think probably the most important and differentiating factor between us and some of those larger systems is the idea that they remain independent. If you think about how ASCs -- a fully independent ASC starts out, it's a group of doctors and physicians that want to control their own destiny, want to maintain that independence. What we offer as a pure play is the maintenance of that independence. We're not tied to any particular payer. We're not tied to any particular health system for the most part. And therefore, they still control their own destiny. We can provide additional capital. We can provide additional growth opportunities. And of course, we can provide them access to our scale.

That's helpful. And the labor costs have been an issue, a theme throughout the conference so far and will be over the next couple of days. So how are you dealing with it? What kind of wages are you seeing versus where they've been historically? And how do you offset that?

Yes. Yes, certainly. And we saw this coming back in the early days of COVID. Actually, when you go back to the very early days, so March, April and that summertime of 2020, we had to take a really hard look at our cost environment, so on the labor side, on the supply side, on the fixed cost side. And we put in 2 things, 2 big things. We put in increased awareness, so monitoring, better data tracking tools that we can kind of put in place. And we started to look very specifically at the environment we create for the clinical staff and our other employees that kind of sit in the facility level. What we have in most of our environments is an environment that might be more sought after on a relative basis than some higher acute care settings. There's a degree of predictability in our centers. Our centers are largely open during office hours. So if you can picture clinical staff, knowing that they come in at 7:00 or 8:00 in the morning on Monday and they're done with last surgeries at 3:00, 4:00, 5:00 in the afternoon, really they're Monday through Friday, some Saturdays during peak times. They don't generally deal with COVID patients. So you're going to see a relatively safe environment. They're generally either single-specialty or multispecialty but relatively defined specialties. So for a lot of our clinicians who value patient safety take it very personally. The idea that they can come in every single day and experience the same type of procedures generally work with the same, doctors have greater confidence that the services they're providing is the high quality that they come to expect. We found that our environment will be generally viewed more favorably, not exclusively, but generally more favorably than some of the larger hospital systems that are out there. That helps us with retention. So we do see a relative same amount of retention as we've gone through this period of kind of higher sensitivity around labor costs. So pre-COVID to where we sit here today, we're still looking at relative levels of retention consistently. Our time to hire remains relatively the same. A little bit over a month it takes us from opening to filling the position. So we're still considered a desirable location. But that's not to say that we're immune from this. There's -- there are -- there, of course, are underlying pressures as individuals make the choice of coming to our setting or through an acute care setting. If the wage is that much greater in that setting at some point, they're going to choose that. So we do recognize that we are seeing inflation. We are driving that. We are trying to be more opportunistic to stay in front of that rather than defensive when some of those cases might come up for us and generally trying to stay in front of it. So what we're happy with is, as we reported our first quarter results, we've been able to maintain labor costs within our expectations. Our labor rates as a percentage of revenue actually are slightly better than they were on a pre-pandemic basis, if you go all the way back to the first quarter of 2019. Clearly, part of that is our focus on higher acuity cases and improving revenue. But I think another factor is kind of the approach that we have taken on the labor side. Another thing I think that differentiates us, it's not very well understood, is that the premium labor concept for us is not as needed as in an acute care setting. So during COVID, you needed a lot more clinicians to be there, you needed -- you lost a lot more clinicians because the environment was a little bit different. So COVID would have affected individuals differently. For us, if COVID were to happen in a particular facility and affect some of our clinicians in the field, they're relatively short-lived. And that's where we would bring in contract labor to kind of help or ask some of our existing employees to work on a different shift, maybe pull some overtime. So as a percent of our total salaries, wages and benefits, we're not that reliant on that type of premium labor. So that is where we are seeing, when you have to have access to that higher levels across the "inflation", even those rates which were high in some of the markets that we operate, have started to abate and come back down to normalized levels. But this is something that we've got to be super-careful that we're not seeing what we want to see, and we're letting the data kind of show us what it is. We're optimistic. We're happy with how the first quarter kind of turned out, but being a little bit prudent as we look towards the future here. And we'll continue to monitor it using all those tools available to us as we continue through the year.

And I think the guidance actually implies a 10 basis point lower margin than the original guidance does. Is that just the math of adding [ continual revenue of $5 million ] of EBITDA? Or is there something that you're signaling there that there actually is a pressure overall on the margin?

So when we -- first off, you're right, part of it is just the math of where you're going to take the midpoint and how sensitive it is. We are definitely being -- we're excited about the prospect of growing top line. We are prudent on where margin might be based on these inflationary factors that might exist out there. Again, first quarter, I think we managed it very effectively. But as we look towards the future, that's something that I think we have to be cautious of. And in this environment, there's no reason for us to kind of push too hard on that front. Even though if you look at those 2 guidance points, and again, you're relatively closer, I think within 10 basis points based on those midpoint conventions. Margins are still expanding. And it's because of all the things that Surgery Partners has been known for over the past several years, bringing in higher acuity cases, truly managing costs and providing those in both top line and bottom line that is simply flow through. So year-over-year, you can still expect to see margin expansion for us.

Yes. And so I guess, when we think about the balance sheet and the cash flow of the company, this year, you're now kind of talking about being free cash flow positive and kind of hitting that inflection point where EBITDA will increasingly drop through the bottom line. And your leverage at 6x, that seems to be where you want or expect the number to be over the next couple of years. Can we run through why that's the right area versus making more progress on deleveraging the balance sheet instead of focusing on M&A?

Sure. Yes. I mean you're absolutely right. The leverage at 5 to 6 is where we want it to be. We made that statement in the fourth quarter. It seems like the right approach. When you think about the trade-off of how we can deploy capital. And at a sub-8 multiple, with the company's equity currently trading at up in the upper teens, low 20s depending on how you look at that, there's a tremendous amount of equity value that can be gained by deploying cash that way. Over the past several years, we've grown into that leverage. There's nothing that would suggest that, that's going to change. Now you're right, we have turned free cash flow positive this year. We are getting past a lot of the historic noise associated with cash flows, a lot of the onetime pressure points that we had in managing our cash flow expectations. And so at approximately $350 million of earnings, every dollar after that 2/3 of that should translate into free cash flow. And that does a few things for us. One, it gives us greater buying capacity, which means we are less reliant on the capital markets. But also, quite frankly, if you marry that up with that market potential we talked about, the growing ASC space, really gives us greater opportunity to go after that a little bit more aggressively. We've done a really good job of integrating some of these companies. By the turns that we've been able to create, value is increasingly strong, its proceeds are strong. So -- and multiples have remained relatively constant. So I think it's reasonable to assume that 5 to 6 still represents the right approach. But as the company continues to get bigger and hopefully exponentially bigger, that may hopefully -- that may change, and the dynamic and how we address the market may change. Now the factor that's out there clearly is what's going on with rates. And so as we look to the future, this is more of a long-term future, we'll weigh the benefits of going either equity or debt side. But as we sit here today, $380 million on the balance sheet, $200 million of undrawn revolver, an LOI of $200 million, our commitment of $200 million of capital deployment a year, we're fine. We don't have to do anything right now to address that.

Okay. That's helpful. And then when we think about the organic growth, I mean, you guys have this growth algorithm of 2%, 3% volume, 2% to 3% pricing. And you've talked a lot about just the generic shift of volumes at inpatients to the outpatient side. Physician recruiting has been quite strong, and it seems like you're accelerating that. Like what's the right this recruiting metric to drive that 2%, 3% volume? Can you do 2%, 3% without really recruiting a lot more doctors? Or do you always have to be kind of adding 100 doctors [ or 100 doctors ] to get to that algorithm?

Yes, a little bit of both, right? So recruiting is a key element to managing an ASC. There is a life cycle that exists inside there where you will lose physicians through kind of just normal retention matters, retirement, maybe moves, things like that. So the recruiting engine is very important to us. Recruiting engine gives us the opportunity to really target the type of physicians that make sense in that market and really take advantage of this shift of higher acuity cases out of hospital setting. So for us, the recruiting engine is important. It's critically important for us just to maintain. We think we do a really good job of that. It's also a very key element of our growth strategy. And you heard us talk on the first quarter call last week, if you -- I know you were out there listening to us, and we talked about this. Each year, that recruiting class contributes more revenue on a per doc base and ultimately to our enterprise. So this year's recruiting class is contributing 38% more revenue just inside the first quarter than the recruiting class in the same period last year. But the ramp of these docs is also critically important. So after the first year in 2021, the 2020 recruiting cluster, I'm just looking at the first quarter, those docs have contributed greater revenue, as difficult as the comp period is a bit strange in a pre-COVID/COVID environment. That same group is now still contributing 35% more this year than the same point last year. So 2 years in a row, this same cohort is adding greater and greater value as they're bringing more and more cases into our business. Same phenomenon happened with our first cohort last year, 20% more revenue this year than what they contributed last year. So the effort that we focus on is really those physicians that we think can drive tremendous value in markets where it makes sense, that -- recognizing that shift of higher acuity cases out of acute care settings and into our environment. So it will be both, the maintenance of our business and the growth strategy that we continue to deploy. Last year, over 500 physicians came through that and, as you mentioned, 150 so far in the first quarter. There doesn't appear to be an end to that opportunity for us as we look towards the future. That will help us contribute to our growth in case count. But the other thing that's happening on the case count side, Kevin, is just this continued migration. We saw it during COVID, maybe because those procedures couldn't be performed in hospitals or certain hospitals. But we're still continuing to kind of see that as our story of -- I'm just repeating myself, our story of convenience for doctors and for patients and good, safe clinical quality outcomes for our patients. As more and more of that gets out there, it just -- it is a self-fulfilling prophecy, more and more cases will come.

Can you just talk a little about like better targeting your physicians and things like that? Like when you talk about these cohort analysis, is that -- is it impacted at all by mix? Like are you just more focused on orthopedic docs over GI, and that's part of the reason? Or is it like an apples-to-apples, like your orthopedic doc is going to be more efficient than last year's orthopedic doc because you're better able to source them or train them or what have you?

It depends on the facility, right? So we do have some facilities that are eye centers. And so we will target recruits inside that space. Obviously, we want to maximize the potential in that valuable OR space. We do obviously look at doctors and their ultimate performance as well as the longevity that they have and the potential that they can provide for us. So market dynamics will kind of dictate what types of physicians that we go after. But this is an opportunity, of course, for us to look at doctors who are looking to kind of migrate out of that setting where they can, as payers are allowing them to kind of move and migrate that business. So the opportunity for some of those [ accedes ] a wave of docs coming out of that hospital setting. So you're able to engage in more conversations with them, increasingly so compared to prior years. And that's how we see, again, one of the elements that allows us to move into this MSK space.

And we've talked it about volume and cost. If you look at the pricing side of the equation, what do you -- with labor costs going up and inflation broadly going up, I mean, how do you view your ability to get the pricing you need to kind of match that and maintain or expand our margins over time?

Yes. Yes. So I mean -- we have a good, strong, dedicated managed care team, a high level of professionals in that space, and they've done a great job over the past few years. Really, they started off with -- we've helped them reset at the moment to make sure that what we're getting reimbursed for from our physicians is, is that market kind of recognizes the value that we can kind of provide relative to some other settings. But they've -- this team has also spent a lot more time working directly with payer communities to talk about what's happening inside our facilities, which gives me confidence that they can address some of these inflationary factors if they show up in a meaningful way for us. But this team has also done a lot of work to talk with payers about service line expansion. So as we look for a particular facility, for example, to grow into an orthopedic space, take advantage of a particular market dynamic that might be happening there, really working with them to capture that value and maybe capture a little bit of steerage opportunity as payers attempt to kind of manage that kind of cost element as well. And lately, what we've been seeing on the managed care side is a greater interest in kind of really capturing the relative value of our setting. Again, as the facility cost represents usually the largest element of those billings, it gives us an opportunity to have conversations with them about bundles, about finding opportunities where they continue to kind of push. So in all of those situations, we get to have conversations with our managed care payer community. And in those conversations, we're allowed to tell our story a little bit more. And to the extent that we do see underlying inflationary pressures, we'll of course see that. The bigger driver of this is, of course, how CMS deals with rates. And you are seeing an increasing awareness by the government of these inflationary pressures. So we obviously will look to how CMS does recognize that as they reset their annual rates going forward. And there's a play, of course, as that kind of filters all the way through the commercial payer side as well.

And I'll kind of squeeze one last question in. So you're talking about bundles and value-based care. It seemed like with Privia and with ValueHealth, you're not actually taking risk, you're kind of -- you're enabling the site of care shift. I mean is it really just steerage? Or is there also some kind of kicker on top of the rate to kind of say you are participating in the value that you're creating besides this volume?

Yes. I mean you're absolutely right. Like when you think about value-based care, we are the value. So I think there's a greater recognition by those that are in this space that we are an enabler of that value that kind of sits out there. We will only do this where it makes sense for us to do it. So we have a pretty good understanding of what an appropriate market-based reimbursement is for our centers. So we'll look to partners like ValueHealth, Privia and others as well as just ourselves to kind of look at where we can demonstrate that value to them. You should get steerage. And in some cases, you may look to this as accepting a little bit more exposure. But we're not in the business of taking on risk to a material extent. So we're going to do this where it absolutely makes sense for us to do. And the opportunity there should be with increased case load, I would imagine.

All right. Great. Thanks for all of your time for it. Thank you very much.

Sure. Thanks, Kevin.