Surgery Partners, Inc. ($SGRY)

Welcome back to the Barclays Global Healthcare Conference. My name is Andrew Mok. I'm the facilities and managed care analyst here at Barclays. And pleased to welcome on stage Surgery Partners' CEO, Eric Evans. Eric, welcome. Eric, you framed 2025 as a tale of 2 halves with solid momentum in the first half, giving way to headwinds in the second half.

So to start, can you talk about what changed over the course of the year, both at the macro level and at the facility level? And it would be helpful to highlight some of the actions you're taking to tighten execution as you move into 2026.

Sure. And I guess before I get started, my CFO is not with me up here on the stage today. I'll just remind everyone that I'll be making forward-looking statements and our risk factors and GAAP reconciliations are in our 10-K. So yes, no, I think you -- that is the way I framed the year. We had a really solid start to the year. second half of the year fell short of expectations. Really a couple of things happened. If you guys may recall on our Q3 call, we had started to see in the third quarter going into the fourth quarter, softer volumes than we expected. I think if you looked at our volumes overall, they compared pretty well to peers, but they were below our expectations and some payer mix pressure. As you guys know, in our business, fourth quarter is an all-important quarter where you typically see a pretty big flip in payer mix, particularly in our surgical hospitals. And we had noted that, that really wasn't happening at the pace we had seen historically. So we noted that in the third quarter, we adjusted for that. If you'll recall, we adjusted for 2 things. One is timing of M&A, which we'll talk about later. We're changing our approach on guidance there. The second was this kind of softer volume, a little bit weaker payer mix. And then what changed in the back half of the year, mostly that was correct. So if I think about big picture, let's talk about we were a little softer on our mix, a little softer on volume. And really, that had a lot to do with our physician transitions this year. You guys know we recruit on average somewhere around 700 new docs a year into our facilities. In any given month, that represents something around 10% of our business. And we can look at every cohort, and we have -- we track very closely what that payer mix looks like. And last year, the new docs we brought in definitely skewed higher government. Some of that's transition timing, right? We got to try to marry that up as well -- as good as we can. And some of that was just the mix of doctors this year that retired and departed. And so that put pressure we weren't really expecting in the big picture. That particularly affected the national group. The national group is our surgical hospitals. Our surgical hospitals tend to be in marketplaces where we're actually recruiting in new-to-market docs. And you can imagine those kind of transitions take a bit longer. And so big picture, we had that pressure. That also then affected our expenses when it came to anesthesia coverage. And so -- and we'll talk about that a little bit later. Beyond that -- so that's big picture. Beyond that, so fourth quarter, we did hit our consensus revenue, but we did not get there on the bottom line. And we -- there's really 3 markets that accounted for that. If you look back over the 6 years I've been with the company, we've had just an amazingly consistent payer mix. So we haven't seen these shifts. And if you're anything like me, the first time I started seeing these mix shifts, the first question I had, the data must be wrong, right, because things just don't move this quickly. So I will admit that can raise some skepticism. But we spent a lot of time kind of looking about what happened to us, and there were really 3 markets that explained the entire miss on the bottom line. And I'll just spend a second kind of walking through those 3 different stories. In one market, we really had a change in competitive dynamics. So we had a marketplace where we compete with 2 large integrated nonprofit systems, when I say integrated employment models, closed systems that had been moving away and pushing out and canceling MA contracts were the loan independent kind of surgical facility along with an independent primary care base. And we didn't react fast enough to the fact that we were the MA access point and that we were not doing a good enough job of saving capacity for commercial patients. And when you think about that, it may sound simple, but keep in mind, our physician partners are not employed by us and the primary care base is not employed by us. And so some of this stuff is coordination that we're going to have to tighten up when you look at payer mix. Again, in the 6 years I've been here, we haven't had that dynamic change. So that was one market that we -- I would say that's not going to be an overnight thing. We did not expect that to bounce back overnight, but we are going to go work on that. That's a marketplace where we've consistently earned and taken commercial market share. We've got the best value product. We got great positions. And so I have every expectation we'll recover that over time. The second market was -- is an anomaly that I still struggle with we had a market where we grew our acuity -- high acuity procedures by 18%. If you would have told me in this market, we're the leading market share provider of orthopedics and a relatively good-sized MSA. Peter told me we grew high-acuity procedures by 18%, I'd say we had a fantastic quarter. Unfortunately, in that particular marketplace, all of that growth was Medicare. And that's the only market, and I'll point out, we don't have a lot of exchange patients. Exchange patients tend to -- tend to access the health care system through the ER, and we are primarily an elective business. And so we don't tend to get a lot of exchange patients. In this particular market, we did have exchange pressure with the Affordable Care Act subsidies going away for the exchange patients. And so within our commercial base, we also had pressure. So at a market that grew 18% on high-acuity patients that actually had less net revenue with 18% more cases. I'll come back to that. You can imagine our positions had a lot of questions around working that hard and not seeing that come through their dividends. The good news about our business is we are perfectly connected. And then the third market was a rural market where it really was about physician transitions. We had some retirement timing around new recruits that didn't match up particularly well. We also had some docs that were out for personal reasons. And the fact that I'm up here talking about a handful of docs is probably surprising but in a rural market that big can have a big impact, and those physicians are already back. So there's a mix of reasons in there. Those 3 markets really drove the entire difference on the earnings line. We feel like we've ring-fenced it. The question was as I talked to you about what are we going to do about it. First and foremost, those specialists, we sit with every day and they look at the fourth quarter our margins were compressed, I'm going to get lower -- I'm going to get my lower dividends. We have a real opportunity to talk to them about a bunch of things. So number one is taking out cost. So we are already -- we've been actively taking out costs, getting more efficient these surgical hospitals, if any of you have been to them, these are the facilities you would want to go to get care. It's where you send your grandparents. These are kind of our physicians built their Taj Mahal. I would say, in many ways, these are really high patient experience facilities, often in top 5% in the country, great outcomes. And when things are going really well, physicians, they tend to want to have a little extra staffing. They don't want to be pushed on their physician preference items. And if you're growing and you've got great margins and you can have a great case, you'd probably get a little more leeway. Those doctors that have felt the pressure, we've got their attention that the payer mix has changed. We had to do some things on cost. We have to change our approach on anesthesia. So if you think about anesthesia coverage, we have obviously a payment difference between commercial and Medicare that's pretty large. Anesthesia, it's 3 to 4x, right? And so for anesthesia, we had subsidies in place that were higher because of that mix. The doctors are now more aware of that. I would just say on the anesthesia point, loss -- often physicians don't want to move away from an NDA model. They don't want to move away from the coverage they're used to on flip rooms unless they have to, unless there's a compelling reason. And we now have a compelling reason. So we've taken action on cost. In those markets, we've made some leadership changes. Clearly, these are dynamics we need to be sure we react to quickly. So I'm excited about also our new Chief Operating Officer that we've added to the company, Justin Oppenheimer, who's very, very focused on these dynamics. And then thirdly, we are very focused on working with our physician partners on having access in those offices to commercial patients, making sure we're really, really focused not just at our level because I do think, ultimately, while we don't control those offices, our physicians do care deeply about competing for those patients, and we're very, very focused on that. So we leave that 2025 headed to '26 in a position where we feel like we put together a great plan, a conservative plan for this year that we're excited about for 2026.

Great. Eric, 1 point I wanted to clarify was that total case volumes came in below expectations. There were some payer mix issues in the quarter that you just noted, yet you still exceeded the high end of revenue guidance. How does that happen? How should we reconcile those events?

Yes. No, it's very frustrating. I mean I'm going to go back to -- we had really, really strong acuity growth. So we pointed out in the quarter versus a very tough comp in the prior year, we grew total joints by 15%. So we created tremendous value for the health care system. Unfortunately, we didn't capture enough of that because of the mix of patients, right? So it certainly was an acuity story. I'm proud of the team and our focus on orthopedics, particularly on high acuity cases, both total joint and spine. So it was an acuity case where you're getting to the top line, but because of the mix of patients, your bottom line was impacted both by the fact that you're getting lower reimbursement and also by the need to subsidize anesthesiology.

Understood. While some of these issues you described earlier have seen transitory in nature, things like the ACA exchange crowding out physician time off, others may take time to address things like competitive dynamics, physician turnover. So from a guidance standpoint, can you help us understand what's already expected to rebound and what would represent potential upside.

Yes. So I'll start with, we did not assume this is going to bounce back, right? So our guidance takes into account the current trend. There are some things that will come back immediately, physicians that were gone that we know are back already for personal reasons. Certainly, the onetime HIX pressure with the subsidies going away, we don't expect that to happen again. But other things, like the dynamics around MA and commercial access, those will take time in coordination with our independent position base. So from a guidance point, we did not expect and did not guide to a number that would bounce back to where we were. We accepted kind of where we landed, allowed for a little bit of room on the trend to continue, but we have offset that with obviously cost actions. I look back, I want to remind everyone, our surgical hospitals are very highly managed care mix of facilities. So if you compare it to a traditional acute care hospital, we're running 50% managed care. It's a very -- these are great payer mix places. So I want to make sure, despite the pressures we've had, these are facilities we're really excited about, and they are great parts of our organization. And so when we think about our ability to go compete for commercial lives, we're higher value. We have outstanding patient service. We've got independent physicians who are highly motivated to provide great care for patients. So we think we're well positioned to maintain and build that back, but we did not assume that we're going to get back there overnight, and we did let some of that be through into 2026.

Right. Sticking with guidance, you've taken a more conservative approach to 2026 guidance by excluding unannounced M&A, even as your capital deployment targets of at least $200 million remain unchanged. Can you walk us through the thinking behind that shift and how you're balancing conservatism in guidance with confidence in capital deployment?

For sure. I think back -- going into year 7, it's hard to believe. I think back when I joined this company, we, I think, rightfully have included M&A in our guidance because it's a big part of our story, right? We're in a very fragmented industry. There's over 12,000 ASCs, half of which are Medicare license, half of which are not. There's not that many players of scale. We think we're well positioned to be a consolidator. We feel good about that. It's a big part of our story. And I think for many years, it worked quite well for us. Over the last several years, I mean, as you guys know, timing on M&A can be quite fickle. We had one year where we were way above our target, and that ended up with extra costs associated with integrating all of those, which created issues for us. We had another year. We finished below that, and we missed guidance because we didn't -- just because of M&A timing. And then, of course, this year, I mean we ended the year close to our $200 million target, but it was very back-end loaded. And I think just from a -- the purpose of -- Dave and I both want to be a B company. We have historically been that. We don't want to find ourselves again where we were sitting for the Q4 situation this year. We thought it was prudent just to say, you know what, our target hasn't changed. We still want to do $200 million plus of M&A, but we want that to be additive and not something that is built into guidance in quite the same way. We did a lot of research on growth companies in the marketplace. And we think this is certainly the most prudent approach going forward.

Right. Understood. Last part, the BLS released the weak jobs report with negative February headline numbers and downward revisions to prior months. Commercial mix is a meaningful part of your business, which leads to strong reimbursement, but also introduces economic sensitivity. So can you speak to the changes in employment trends and consumer confidence on commercial mix or utilization. And how are you positioning the business in the event of a broader slowdown in employment?

Yes. I mean I think we're all reading the same jobs reports, right? In our local markets, we haven't seen a tremendous change in employment, but I've been in the business long enough. I think for those of you who are here the last time we had potential economic uncertainty in the rapid increase outside of COVID, the financial crisis, it actually led to an increase in procedures. Patients who -- if you recall, they were worried about getting it done while they still had care before they got -- before COVID ran out, you actually saw a spike the last time you had this. I don't know if that will be the case today. You've obviously got the exchanges. You've got more safety nets. But historically, that has not been a huge headwind for us. Clearly, I think that one of the benefits of our business model is we don't have the downside exposure that traditional acute care does to a payer mix change, meaning we're not going to see uninsured. We're not going to see -- Medicaid is a very small part of our business. So payer mix situation is not going to be an issue. We're not really exposed to that. From the commercial side, even in a world where there might be less covered lives, I'm going to go back to my point, we feel are really well positioned being a value player, right? If you think about across our portfolio, 40% to 60% cheaper when you think about our procedures, really great service, really great quality. So in an economic position where people are really concerned about paying for where the health care system needs savings, we think we're well positioned there. And -- look, again, it's hard to predict what exactly happens because sometimes it's counterintuitive. The only other thing I'd mention is the procedures we do, think about 50% of our business is MSK, knees, hips, cataracts, GI procedures. Most of those things -- you might be able to put off a bad knee or a cataract for a while, but they're not -- elective is probably not the right term over the long term. So there's pretty demand and there's a time frame around those. So we don't see that as a huge headwind for us, and it does happen, we think because of our value position, we're extremely well positioned.

Great. Let's move on to some of your portfolio optimization efforts. Surgical hospitals have always been an important and strategic part of your business, right? So can you help us understand the current exposure to surgical hospitals within the portfolio and the rationale for exploring divestitures now?

Of course. So let me start by saying I love surgical hospitals. There's only 240 or so of them in the U.S. There won't be any more that are physician-owned. These are JV physician hospitals pre-moratorium. What's amazing about these assets is they allow us to have physician partnership across the acuity spectrum. So almost all of our surgical hospitals have ASCs that we -- an ASC network we built around them because we can't expand these hospitals, right? They're unique asset, they are set moment in time. And the idea with our physician partners is let's keep their higher-acuity patients in a facility they own and that controls the quality, have control of the experience. And then let's dean ourselves and build ASCs to pull that lower acuity stuff out. So we love the model. Surgical hospitals in general have payer mix that's very similar to ASCs. The traditional surgical hospital just so you guys can picture it, 10 ORs, 15 beds, right? May or may not have an ER. A lot of them don't, a few do. Even if they have any, not a very busy year, right? So payer mix and procedural mix that looks a lot like an ASC. So we really, really like them. Now with that said, going to part optimization, one of the points of feedback we've had over the last several years is we do have a few markets that go beyond just short-stay surge right? So these are markets where we -- there are still attractive markets, but we've expanded beyond that core ethos. And we hear from our investors, gosh, we really love the short-stay surgery space. We would like you to be even more pure play, right? That's one thing we've heard. The second thing we've heard is we'd like you to delever faster, we'd like you to drive free cash flow faster. And so what led to the portfolio optimization work is we think there's an opportunity to do all of those things, right? So we have a handful of facilities, let's call it, less than that are meaningful in size that are material that tend to have higher debt loads, right? These are bigger facilities Unlike our ASCs, they're not as easy to move or just expand. You're going to be in that facility for a while. They tend to have finance leases that goes on the books as debt. They tend to have a lower free cash flow conversion, a little higher a little bit higher cash needs than our typical short-stay surgical business. So the whole goal here is making moves that lower our leverage increase our free cash flow conversion, increase our growth profile going forward. And as we said on the call, we're in advanced discussions in one of those markets that's meaningful. And we would hope to kind of -- our goal will be to address all of those opportunities within the year. So do you think it's meaningful for investors. And again, we understand that there's a real need for us to delever faster and drive free cash flow in the business, and we think this is an opportunity to do that right?

And the Board also authorized the repurchase program, which gives you some optionality for capital allocation. Could you see the company buying back shares in advance of a hospital transaction? Or is the thinking that the authorization will give you flexibility soon after receiving those proceeds.

Yes, it's a great question. There's certainly nothing that keeps us from buying shares in advance. I would say you should read a couple of things into the Board's decision to our decision to approve a shareholder buyback of a reasonable size, a couple of hundred million dollars One is that's a pretty good sign that we think we're going to have funds coming in from portfolio optimization, right? Because the idea we know we have to do lever. There's no plans to lever up to buy back shares. So that should be a sign, I think, of the confidence we have in our portfolio optimization work. I think secondly, we're really disciplined around how we think about capital allocation, right? The cheaper. I mean our share, we -- obviously, everybody believes this, but we believe our shares are certainly undervalued where they said today. And as we look at that cost of shares, we compare that to our other options, right? Deleveraging, M&A. We have a very attractive M&A profile, typically can buy at 8x or less, take a turn off within 12 months. So from a capital allocation standpoint, we want to make sure we have all of those levers at our disposal, and we will be opportunistic, right? If it's the right use of capital that's most accretive for our shareholders to create shareholder value, we'll go after it.

Great. Maybe moving on to some of the policy items. Site-neutral payment has been an ongoing conversation in Washington if hospital outpatient reimbursement were to move closer to ASC rates for similar procedures, how do you ensure that ASCs continue to differentiate and retain their value proposition?

Yes. So first of all, let me just say from site neutrality in general, it's like -- it's basically the whole thesis of our company, right, which is we believe care should be delivered in the right place at the right time at the right cost. So again, our sites of care, even our surgical hospitals, we typically don't have health system partners in those, and we're 30% cheaper than traditional acute care. So we are deep believers in side of care inside neutrality as far as being part of the answer. With that said, I think that even if you had site neutrality on the Medicare side, there's so much cross subsidy that happens with the commercial side. It's hard to imagine. It's hard to imagine a world where you could move those payments fast enough to actually caused a real true difference. So number one, I think it's unlikely you get that kind of overall payer pressure on an ASC. With ASCs being 40% to 60% cheaper already, I don't think there's -- I don't think that's going to be a cost competitive fight. The other thing I would say, and people who are close to the ASCs and our surgical hospitals would know this. But if you survey positions, like why are they invested in our ASCs? Why do they come to our places. Yes, yes, there's the financial impact, that's not #1 on their list. Number 1 is convenient block time that's not disrupted, right? Do they have control of their day? And look, having run big surgical hospitals in my life, it's almost impossible when you have busy ER you're running, you're trying to be all things to all people. It's almost impossible to be as efficient as we can be in our surgical facilities, right? So they're time machines for physicians. Physicians don't have a lot of time. They want to get 6 procedures done in the morning and they want to go to their office and not have to cancel it. That doesn't happen very well in the acute care setting. So outside of the issue around price, these are time machines that are great for their lifestyle. They also like to have a voice. I've run hospitals that have a couple of thousand docs on the medical staff. For me to say that an individual doc actually has to say, is not really truthful, right? In our surgical facilities, we're trying to do a few things, do them exceptionally well. And our docs really do have a voice. Those 2 things matter a lot. We have our positions to stay independent by giving them another source of income. That's certainly part of it. So there's the price difference, which is meaningful, and I don't think actually that bridge can be -- I don't think that can be bridged given the cross subsidy requirements of the acute care space. But even further, it's really just about physicians efficiency and time.

Right. Another disruptive policy item ongoing is the expiration of enhanced ACA subsidies. I know that ACA is a relatively small part of your overall mix which is like time it's somewhat surprising that an isolated incident inside one of your surgical hospitals could contribute towards the fourth quarter miss. So maybe help us understand what's going on there? Is the mix of ACA seizures just different from a typical commercial patient or the reimbursement differential, is that significant?

Yes. So it's kind of a combination of all those things. I think Again, most of our business is not through an ER. We don't have ERs that over half our hospital hospitals. Obviously, our ASCs are completely elective. And so that flow of referrals tends to be a different flow than exchange patients. A lot of those patients do access the health care system through an ER in a more emergent way. That's one of the reasons. And then honestly, we just -- our facilities and positions have never really had that connection. So we haven't had a ton of that business. It was really a state-driven thing. In the market we were talking about pretty big MSA, we're 40% of the market. And I think as these patients realized they were up against the deadline, there were so many of them that did impact what came into the offices. And interestingly enough, when you think about exchange patients, they often come in under some kind of commercial plan. And so I don't think that our offices, our independent physician offices were always sophisticated enough to rise that this commercial patients is not a commercial patient, it's not a commercial patient. In our world, when you think about exchange patients, they pay very, very close to Medicare versus commercial. And so I do think that was -- and again, it's 1 market, a big picture, just Medicaid is less than 4% of our business. HIX is a very small percent of our business. But in that particular market was meaningful in the fourth quarter.

Right. And maybe circling back to one of the cost items we talked about earlier. You've highlighted a linkage between labor and anesthesia costs and shifts in government payer mix. can you walk through that relationship in more detail and explain how changes the payer mix translate to higher anesthesia costs?

Yes. I gave you a little detailed answer on this earlier. But just a reminder, anesthesiologists have not had an increase from Medicare pay increase for a long, long time. They've had a lot of challenges, obviously, on reimbursement with the No Surprises Act. And look, depending on who you talk to, there's no tier shed for anesthesiologist basing their payment, but it's been a real challenge on having enough capacity, both for NDA anesthesiology and CRNAs. Going back to my earlier comment, the way when I ran big hospitals, the way I'd bring my anesthesia study down was to allow them to get the coverage of ASCs and surgical hospitals. So we have a preferred site of care. Even with that, there's such a challenge on capacity that in order to ensure we have coverage, we often do have to enter into agreements that say there's going to be some kind of minimum collections to cover their expenses. For the most part, what's -- well, a couple of interesting points on anesthesiology. You guys may all know this, I find it fascinating. Anesthesiologist do really well in lower acuity ASC. So think about GI-only centers, ophthalmology, those are fantastic places for anesthesiologists. They love them because of what they're paid, because of the mix of patients, because of their efficiency. Unfortunately, it's not quite as good on orthopedics, which is where our focus is, right? So you have a mismatch of our economics and their economics that sometimes flows through. And then when you get into the pay rate differences, they're probably one of the most exposed specialties on just how different, I think their Medicare rate is something like $22 a unit, and it's easily 3 to 5x higher on commercial. And so that difference creates -- imagine if you're in a 70% Medicare facility versus a 30% Medicare facility, mean your revenue is dramatically swinging. And so they have choices on where to go. We often have to enter into agreements that give them some kind of collections guarantee. And when we see swings, it always hurt our revenue and increase kind of our cost statistics as a percent of revenue, but it requires then that we subsidize anesthesia coverage in a way that sometimes is counterintuitive.

Right. Understood. Well, with that, we're out of time. So Eric, thank you so much for joining us today. Please enjoy the rest of the conference.

Good to see you. Thank you. Appreciate the time.