Jenks Healthcare Business Report April 2003

In the April 2003 issue:

Heading South: The Burglar of Birmingham

The corporate game of made-up profits is exposed at HealthSouth. How did things go so wrong, and what should investors expect? See page 1

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Public Equity Market

With public equities dead in the water, eight public companies turned to private equity to raise a total of $66.3 million. Plus, the latest at Imclone, and GSK’s image issues. See page 3

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Venture Capital Market

With 40 deals worth $462 million, the health care VC market heats up again, including the biggest deal in more than a year. Increasingly, the deals are giving clues as to what investors are looking for. See page 10

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Feature Stories

One To Watch: Digene Corp. got fast approval for a test to rival the Pap Test. Can it gain a foothold in this $400 million market? See page 4

Follow The Bouncing CEOs. Four health care CEOs swap jobs and position their new employers (two public, two private) for big changes. See page 10

Profile: Hypnion, Inc. Sixth in a series of closer looks at firms successfully attracting VC. See page 14

Jenks Healthcare Business Report

Heading South: The Burglar of Birmingham

It all began with a new "interpretation" of Medicare reimbursement regulations last summer, something of which HealthSouth’s (NYSE: HRC) management informed startled shareholders, which was going to lower annual EBITDA by up to $175 million. That little bit of news sent the company’s shares down by 50% and left suspicious shareholders wondering when the other shoe would drop. Investors were split: Some believed that when the dust settled you still had the predominant rehab and surgery center player in the country that held some value for shareholders above $4.00 per share (we were in that camp), while others held that this type of misstep had occurred one too many times and regardless of whether any "value" was left, they would abandon the stock for good.

As the world now knows, the other shoe dropped, and it made quite a thud. With charges that the company made up more than $1.4 billion in profits over the past decade, class action lawyers are lining up. Reimbursement scandals are nothing new, and unfortunately, accounting scandals are nothing new, and investors have had their share of both in the past two years. Remember when a Business Week writer stated that the Cendant accounting "problem" of made-up profits of a predecessor company would be the financial scandal of the decade? It was nothing in comparison with what has transpired since. But in the case of HealthSouth, what is truly unbelievable is 1) how long the alleged phony profits went on for, 2) how many people were involved, 3) how quickly people started pleading guilty to conspiracy to commit fraud (among other things) and 4) the apparent fact that the fraud was passed on from one CFO to another . . . and another.

With more than a half-dozen executives already charged with various criminal counts, and in most cases pleading guilty, it is ludicrous that Richard Scrushy, the fired founder, still maintains he knew nothing and is "shocked" by the allegations. Although still not charged with any criminal wrongdoing (SEC charges have already been made), it is only a matter of time until the lawyers build their case against the Burglar of Birmingham.

Switching back and forth between news reports from Baghdad and Birmingham, it was amusing, and sad, to watch events unfold in Birmingham. Mr. Scrushy’s outsized ego, with classic examples of the cult of personality, was well known within his company and state. His various "palaces" and other play-toys have been put on display over the past few weeks. Mr. Scrushy’s name or picture is displayed everywhere, usually connoting benevolence of some sort (it’s easy to give money away when it really is not yours). And now, with the images of statues being pulled down thousands of miles away, a statue of Mr. Scrushy in Birmingham with "thief" spray painted across it appeared in a New York-area newspaper (to our knowledge it is still standing). Finally, some of the participants in the fraud have apparently admitted to the U.S. Attorney handling the case that they feared physical or psychological retribution if they came forward with details of the fraudulent accounting practices.

Then, in early April, Mr. Scrushy asked to have $10 million of emergency living expenses and $600,000 per month for business expenses unfrozen from his pool of assets (plus $33 million to pay taxes). Just like the Iraqi information minister, it seems that reality has not yet set in.

Although Mr. Scrushy’s attorney initially stated that his client had no knowledge of the alleged fraud and was as shocked as anyone, the possibility that this is true is, as we all know, rather remote. His grip on the company was so tight that one analyst stopped covering the company because he was not allowed to have one-on-one meetings with the various division heads or the CFO. During visits to Birmingham, they apparently all gathered in one room with, of course, Mr. Scrushy at the head of the table answering all of the questions. If that is not an eyebrow-raiser, we do not know what is.

Financial fraud is a difficult thing to uncover, as any auditor will admit, especially when there has been no suspicion of fraud. Nevertheless, the magnitude of the HealthSouth fraud is such that Ernst & Young, the now fired auditors, should have been able to pick something up over the years. In addition, if members of the board had not been so involved financially with Mr. Scrushy, they may not have been caught asleep at the wheel as well. Last August, with the earnings plunge revelation, was the opportune time to fire Mr. Scrushy, especially because the timing of his stock sales just did not smell right. Instead, the board wimped out and allowed him to return as CEO of the parent company after the decision to split the company in two was suspended. A rather pathetic show of corporate governance, if there ever was one.

The various trials may begin later this year, and more facts will certainly become known. But the company’s declaration that no financial statements since the late 1980s should be trusted is certainly a blow to creditors, who will eventually end up controlling the company. And even though some of the surgery center partners are trying to sever their ties to HealthSouth, and in one case reported in the media no longer using the HealthSouth name, the fact remains that the company is the dominant rehab and ambulatory surgery provider in the country. And they didn’t get to that position as a result of phony profits. Rather, there have been a lot of satisfied customers, and financial fraud or not, the company continues to be dominant in many of the markets it serves.

No one knows yet exactly where the accounting fraud has occurred, so it is difficult to determine how profitable the company really is. The ambulatory surgery business had a reported EBITDA margin of 30% to 35%, which is slightly higher than competitor United Surgical Partners (NASDAQ: USPI) but less than the most recent margin reported by Amsurg (NASDAQ: AMSG), so it is reasonable to suspect that what you see is what you get. Consequently, if the current management can keep the surgery center partnerships intact, then their actual cash flow, and the value of the business, should be determinable.

The rehab business will be more difficult, partly because that is where the reimbursement games were played and where the federal government will also be taking a closer look. Also, because it is made up of both inpatient hospitals and outpatient therapy centers, looking for competitor margins and values will not be as easy. Before the accounting scandal, it was believed that after separating the surgery center business and subtracting the $175 million in lost EBITDA as a result of the Medicare "change," the rest of HealthSouth was supposed to have produced up to $800 million of EBITDA in 2002, most of which was from the rehab businesses. Now, it is anyone’s guess, and that is exactly what it is until the new management is able to sort through the financial data and determine what is real and what is not. One thing is certain; no one expects that $800 million of EBITDA to materialize. The "change" in reimbursement? Our guess is that last summer management knew that its grip around the fraud was loosening, so what better way to lower investor expectations regarding the true level of profits than to blame it on Medicare?

If management is able to hold the pieces in place, HealthSouth should remain a viable business. It will be interesting to see what the creditors want to do, because they were the ones that prevented the spin-off of the surgery center business last year. Today, it may be in their interest, from a value perspective, to see this happen. For Mr. Scrushy and his partners in crime, jail time is unavoidable and certainly deserved. In our September 2002 Health-South lead story, we made reference to the phrase "three strikes and you’re out." Now, it looks like management tried to steal home one too many times and finally got caught.

Read the past headlines.