Center chains keep low profile as physician-investors fret over Stark II

October 26, 1994

The passage in 1993 of legislation sponsored by Rep. Pete Stark(D-CA) banning Medicare and Medicaid payments to physicians whoself-refer seemed to create an environment ripe for imaging centerconsolidation. Many experts believed that passage of the law,known as Stark II, would prompt an imaging center fire sale asdoctors sold their interests in joint-venture imaging centersto large imaging center chains. Things haven't worked out thatway, for a variety of reasons.

The passage in 1993 of legislation sponsored by Rep. Pete Stark(D-CA) banning Medicare and Medicaid payments to physicians whoself-refer seemed to create an environment ripe for imaging centerconsolidation. Many experts believed that passage of the law,known as Stark II, would prompt an imaging center fire sale asdoctors sold their interests in joint-venture imaging centersto large imaging center chains. Things haven't worked out thatway, for a variety of reasons.

Perhaps the biggest damper on imaging center acquisition activityis the conservative position taken by center management companiesthat are already in the market. Some, like TME of Houston andDiagnostic Health of Birmingham, AL, have raised financing tosupport center acquisitions, but are proceeding slowly and cautiously.

Others have cut back operations and overhead in order to maintainprofitability in the context of scanner overcapacity and decliningreimbursement, according to Charles Booth, an imaging center consultantand former president of Diagnostic Health. The financial performanceof many of these companies has improved this year, but they arenot eager to spend limited cash on expansion at this time.

In the case of Health Images of Atlanta, the pickings are justnot good enough. HI is the only public imaging company with shareholderequity in excess of the federal threshold of $75 million for issuingstock to physician investors as payment for ownership interests.

"There are certainly very profitable centers out there,even though the business is quite competitive," Wilson toldSCAN. "We have concluded that there is just not a lot togain by owning additional centers right now. The return on investmentis not adequate yet."

Some mobile imaging companies, which have previously showedinterest in moving into more fixed sites, are either too strappedfor cash or not interested.

"We don't want to expand our horizons at this point andexpend cash on buying centers," said Richard Zehner, presidentand CEO of Alliance Imaging of Orange, CA. "Our stock istoo low to use that as a medium to purchase something. Plus, therisk involved in buying a freestanding center is so great at thispoint that, even if I had the money, I don't think I would wantto do it."

Medical Diagnostics of Burlington, MA, has maintained a profitableimaging services business by using mobile systems to meet customers'needs and then converting into fixed site only when volume warrants.Purchasing independent centers from referring physicians is notappealing to the company, said vice president Eileen H. Kirrane.

"What we fear is that, when the physician owner goesaway, much of the business goes with him. That is not an attractivescenario for us," she said.

American Health Services of Newport Beach, CA, hopes to pickup three to four new centers by the end of the year, which isfewer than it anticipated when the federal self-referral legislationfirst passed. The company is not interested in purely freestandingcenters, said Larry Atkins, president and CEO. Hospital or otherhealth-care provider connections are a must in any center acquisition.

"It will be hard to survive with a true freestanding,company-store operation in this managed-care integrated deliverysystem environment we are headed into," Atkins said. "Weare working to close (center acquisition) deals, but we are notengaged in massive buying."

The lack of activity in terms of outside investment pools setup to acquire and build large center networks has been one ofthe biggest surprises this year, Atkins said.

"I am not seeing a lot of new players trying to gathertogether centers," Booth agreed. "There are some smallregional operations, buying maybe two to four centers, but I havenot seen the emergence of a new national company that is out buyinga lot of centers all over the country."

Some Florida sunshine. The success of Consolidated TechnologyGroup of New York City in acquiring a group of centers run byradiologist Dr. Stephen Schulman may be a sign that more outsidefinanciers will enter the center market.

"I know of loads of groups out there all trying to wheeland deal to get a foothold in this market," said Lewis S.Schiller, Consolidated president and CEO.

Structuring a large imaging center deal is not a hayride, however.Investors must be prepared to spend heavily on attorneys' feesto structure the deals.

"This (acquisition) was an extremely complicated transactionbecause of all the different entities that were involved,"Schiller said. "I had to set up a corporation for every entityI bought, including the limited and general partners, managementand radiology groups. This was a major packaging. The legal feesran over 5% on both sides."

Consolidated gained an advantage in not having to acquire all14 centers that Schulman and his firm, IMI, owned and operated.Nine centers were purchased on Sept. 30, while two more are pending.Seven centers are in Florida. Two are in Kansas City, KS, andSan Juan, Puerto Rico. All of the centers in the continental U.S.involved some degree of referring-physician ownership.

Following the sale, Schulman agreed to serve as president ofConsolidated's new operating subsidiary, IMI Acquisition. He willhave prime responsibility for evaluating further center acquisitions,Schiller said.

Consolidated hopes eventually to spin this imaging center groupinto a separate public company, he said. The parent company isalready public, with a listing on the NASDAQ stock exchange (symbol:COTG).

The nine centers acquired by Consolidated so far earned $2.8million in revenue for the first six months of 1994 (end-June).In 1993, the centers earned $3.5 million for the entire year.This places the $27 million purchase price at a high multiplein the range of four to seven times after-tax earnings. Consolidated,however, spent almost nothing of its own money on the deal.

Third-party debt financing raised about $6 million in cash,which was then combined with subordinated notes equal to $21 milliongiven to the former owners. A $2 million cash deposit put downby Consolidated was returned to the company at closing.

Company obligations to the third-party lender take precedenceover the subordinated notes given the centers' former owners.This gave the third-party lender confidence to provide financingfor the highly leveraged deal, Schiller said.

While Florida self-referral legislation (effective Oct. 1)allows the use of debt to pay referring-physician owners, thefederal Medicare rules do not. It would be possible, however,noted one industry observer, for Consolidated to pay off the referringphysicians at a low multiple using the cash, while reserving thenotes for the remaining nonreferring investors. Another possibilityis that some of the notes could be converted to cash before theJanuary deadline.

Consolidated is taking a substantial risk entering the Floridaimaging center market, said Lon W. Gillette, senior vice presidentof acquisitions for Prime HealthCare of Rosemont, IL. Prime hadlooked at Florida centers and even bid against Consolidated, butthe company withdrew from the market because of uncertaintiesregarding implementation of the Florida law's fee cap on procedures.

"If you ran an analysis as to what a center is currentlyworth and then what it would be worth under a fee cap, almostnobody would remain profitable," Gillette said.

No written regulations have yet been issued by state authoritiesin Florida to back up the legislation, which increases marketuncertainty further.

Many center owners hope that the Florida legislation will bechanged, although this is by no means certain, Gillette said.The law is being contested in court. In addition, a potentialchange of party control of the state legislature might lead toa change in the state's position regarding health-care reformlegislation.

Feds gear up enforcement effort. On the federal side, lessthan three months are left before Stark II takes effect. One questionmany in the industry are asking is how the federal governmentwill enforce the new law. Many self-referring physicians may begambling that the feds are too preoccupied with other mattersto crack down on wayward doctors.

They may be right, at least initially. Reviewing every referralarrangement in the country is a herculean task that will provedifficult for even the U.S. government. Self-referring physiciansmay have at least a few months of breathing room before any majorenforcement effort kicks in.

At a conference with health-care attorneys and consultantsheld this month, representatives from the Health Care FinancingAdministration and the Department of Justice's Office of InspectorGeneral indicated their strategy for enforcing Stark II, accordingto Gary I. Fields, an attorney with Proskauer Rose Goetz Mendelsohnof New York City.

HCFA is preparing a detailed questionnaire on referral arrangementsthat will be mailed to some 400,000 physicians and health-carefacilities in the spring of 1995, Fields said. That questionnairewill provide HCFA with the necessary data for a nationwide analysisof referral arrangements.

The results of the questionnaire will probably not lead tomany investigations of questionable referral activity, as respondentswill be unwilling to disclose illegal arrangements in which theyare involved, Fields said. Instead, the federal government willprobably rely on leads from other sources, such as patient complaints,disgruntled employees or center competitors. While this effortmay lead to a few well-publicized busts, for the most part manyillegal referral arrangements may go unpunished.

"This will be a tough law to enforce. It is overwhelming,"Fields said. "The prohibition is simple, but the exceptionsare so complex it will take a while for (the federal government)to get a handle on how to enforce this."

The feds remain committed to clamping down on fraud and abusein the health-care industry, however, and are adding hundredsof FBI agents to health-care related investigations, accordingto Fields.

"They had 125 to 150 FBI agents two years ago, and areapproaching 300 agents this year in the health-care arena,"Fields said. "The prediction is that by fiscal 1995 therewill be 500 FBI agents and a commensurate increase in U.S. attorneysdedicated to health-care investigations. The clear trend is towardmore enforcement."