Physician Management Companies Exploding, Will Transform Healthcare

Affecting pathology & clinical laboratories

CEO SUMMARY: Consolidation and integration of healthcare services will be the dominant trend during the next five years. It happened to commercial laboratories from 1985-95. Widespread hospital consolidation began around 1990 and continues today. Now consolidation is coming to physicians. As physician practices consolidate and come under the management of multi-billion dollar national corporations, both pathologists and clinical laboratories will need to respond with appropriate market strategies if they are to retain and expand business relationships with these physician practice management companies.

PHYSICIAN PRACTICE MANAGEMENT COMPANIES (PPMs) are probably the fastest growing consolidators of healthcare in today’s marketplace. Yet few pathologists and clinical laboratory executives appreciate the profound changes to be triggered by PPMs during the next five years.

Pathologists will be impacted in two ways. First, pathology-based PPMs are already in the marketplace seeking to purchase pathology practices. Pathologists now find themselves asking: “Should I sell my practice to a PPM? To which PPM should I sell? At what price?”

Readers of THE DARK REPORT are already familiar with the business strategies of such emerging pathology-based PPMs as AmeriPath, Physician Solutions and American Pathology Resources. (See TDR, November 4, 1996 and April 21, 1997.) These companies are the first wave of physician practice management companies to enter the pathology market/place.

Changes To Contracting

Second, just as pathology-based PPMs will change the structure and business organization of pathology practices, so also will family practice and specialty PPMs impact the way pathology services are contracted and delivered. Clinical laboratories can expect to experience similar changes. This will occur as PPMs participate in new forms of healthcare service organizations. (See sidebar below.)

Pathologists and clinical laboratory executives should anticipate the needs of PPMs and prepare effective strategies to partner with them in profitable ways. The development of PPMs is a major trend. As PPMs increase their market clout in certain cities, they will seek to control costs and enhance clinical effectiveness by cutting innovative deals with responsive pathologists and clinical laboratories.

In the fee-for-service healthcare world of the past, the great majority of physicians practiced medicine as individuals, in small groups or regional clinics. This fragmented marketplace is inappropriate to serve managed healthcare.

Physician practice management companies became the way to consolidate fragmented physician practices into national chains. These PPMs start by purchasing clinics and group practices. They attempt to generate short term cost reductions by centralizing administration, billing, purchasing, managed care contracting and similar functions.

PPMs are not the only group seeking to acquire and consolidate physician practices. Hospitals and integrated delivery systems comprise the other physician practice consolidator in the marketplace Because they are local, hospitals and integrated systems will not have national influence in the same way as national PPMs.

Fast-Growing Segment

Physician practice management companies represent a fast-growing segment of healthcare. To better understand the phenomenon, a close look at the leading industry PPM explains why investors are willing to pour tens of millions of dollars into these companies. Just as Columbia/HCA dominates the for-profit hospital marketplace, MedPartners, Inc. of Birmingham, Alabama is the major player among physician practice management companies.

Founded just four years ago, MedPartners manages over 10,000 physicians and will finish 1997 with projected revenues of $6.4 billion! That performance makes it one of the fastest-growing corporations in the nation’s history.

Whereas most PPMs are looking to gain economic benefits through the consolidation of administration, billing, purchasing and similar internal cost containment measures, MedPartners has an expansive view for the future. It wants to become an integrated, comprehensive provider of clinical services. Like Columbia/HCA, MedPartners wants to create a national, brand-name, profit-driven delivery system.

To make that vision a reality, MedPartners is carefully acquiring companies with unique expertise. MedPartners recently purchased InPhyNet Medical Management, which is the nation’s largest manager of hospital-based physicians practices. MedPartners also acquired one of the five largest pharmacy benefit managers in the country when it purchased Caremark International in September 1996. Besides pharmacy benefit management, Caremark brought a rapidly developing disease management capability to MedPartners.

In order to take advantage of these comprehensive resources, MedPartners wants to become a national, branded healthcare service. The company is pursuing two strategies to make this happen. The first is to build physician networks in the top 55 markets within the United States. Coincidentally, this is the same goal for the national HMOs. MedPartners seeks to position itself as a single, national solution for such HMOs.

In fact, MedPartners already has an agreement with one such HMO to provide services on a national scale. In March 1997 it was announced that Aetna U.S. Healthcare would utilize MedPartner physicians in any city where both Aetna and MedPartners do business.

Global Capitation Next

MedPartners’ second strategy is to con- vert its physicians to global capitation. Such arrangements would include hos- pital and pharmacy services. “This is not about acquiring a lot of practices and trying to squeeze profits out of them,” stated Larry House, President and CEO of MedPartners. “It’s about fundamental change in the healthcare delivery system.”

Unlike most of his PPM competitors, House intends for MedPartners to become a full-fledged competitor for the healthcare dollar. By striving toward global capitation, MedPartners becomes a competitor with some hospitals. For HMOs, there may be reluctance to allow physicians to manage pharmacy benefits. It could prove difficult for MedPartners to establish a market presence if these players choose not to cooperate. However, MedPartners’ $6.4 billion in annual revenues gives it the clout necessary to compete for this business.

How much business does this represent? MedPartners wants to develop a 10%-15% market share in each of the 55 largest markets. To date, it has only achieved 15% market share in Southern California. In MedPartners’ other regions, marketshare does not exceed 5%.

Sizeable Laboratory Volume

MedPartners’ goal of 15% market share in the top 55 markets gives clinical laboratories an indication that MedPartners will control a sizeable amount of laboratory test volume. For the three blood brothers, Laboratory Corporation of America, Quest Diagnostics, Inc. and SmithKlineBeecham Clinical Laboratories, MedPartners represents an important chunk of business. It should not surprise anyone if MedPartners announced a national laboratory testing agreement with one or more of these three laboratories during the next 24 months.

In the meantime, Southern California is the market to watch. MedPartners will use Southern California as the test bed for its business strategies. That process is already under way. In March, MedPartners inked an agreement with Tenet Healthcare Corp. to create a single contracting network between MedPartners’ 4,000 physicians and Tenet’s 33 hospitals. (See sidebar below.) The MedPartners name is also beginning to appear on its Southern California offices. This is the first move to implement the national branding strategy.

Physician practice management companies are not without their detractors. Many physicians point out the loss of control that results when a corporation purchases a physician’s practice. There is also the perception that corporate executives are more inclined to compromise the quality of healthcare in favor of cost management.

Continued PPM Growth

While examples may exist to justify these criticisms, healthcare industry analysts predict continued rapid growth among PPMs. According to Sherlock Co. of Gwynedd, Pennsylvania, during 1996, publicly traded PPMs closed 368 acquisitions. This was up from 1995 and 1994, when acquisitions totaled 250 and 141, respectively.

For pathologists, the arrival of PPMs on the healthcare scene triggers important decisions. Should the pathologist sell to a pathology-based PPM? If the decision is not to sell, what kind of market strategies are necessary to protect existing contracts and revenues? Are colleagues in the pathologist’s practice ready to compete against whatever PPM pathology services might be offered in their local market?

These are difficult questions. They require skills in market assessment, business planning and financial analysis which most pathologists have yet to develop. Even organizers of the early pathology PPMs are not 100% confident that these infant companies can find success in today’s rapidly evolving healthcare marketplace. The financial exposure from making the wrong decisions can propel some pathology PPMs and individual pathology practices into bankruptcy.

An entirely different issue which confronts both pathologists and clinical laboratories is the market impact of PPMs on contracting and service issues. Will PPMs buy anatomic pathology and laboratory testing in different ways? Will PPMs develop sufficient market clout to radically transform current industry practices for contracting, for pricing and for bundling of pathology and laboratory testing services?

If PPMs continue their growth and influence in local markets, then the answer will be yes. As the largest PPMs achieve national capability, it will make them logical partners for the national HMOs, self-insuring corporations and similar healthcare service purchasers.

The Tenet-MedPartners agreement in Southern California should be carefully watched by pathologists and clinical laboratory executives. It is an early, if not the first, model of how a large PPM, in combination with a strong regional hospital system, can create a healthcare service consortium unlike anything existing today in the United States. Arrangements between MedPartners and Aetna will provide further insights into how PPMs and national HMOs will transact business.

Important Clues

For clinical laboratories, the Tenet-MedPartners consortium may provide important clues about future opportunities. Which labs will be winners, which labs will be losers if the consortium goes to either an exclusive or limited laboratory provider panel? Will Tenet insist that, where feasible, MedPartners’ doctors send their outreach testing to the nearest Tenet hospital laboratory?

For pathologists at the Tenet hospitals, does the MedPartner agreement give them an advantage to pursue AP work originating in the physician’s offices? What if the tables were turned? Could MedPartners convince Tenet that it makes economic sense to have all of Tenet’s hospital-based physicians affiliated with, and be managed by, MedPartners?

These are fascinating questions. Unfortunately, answers will not be forth- coming until Tenet, MedPartners and the marketplace provide answers. In the meantime, perceptive observers can gain early insights into how national PPMs may alter current healthcare practices by watching the progress of MedPartners’
first regional agreements.

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Pathologists Beware…
Proposed Changes to PPM Accounting May Impact Pathology Practice Roll-Ups

MANY PATHOLOGISTS wonder whether they should consider selling their practice to one of the emerging pathology practice management (PPM) companies.

One appeal of these PPMs is the potential of their stock to become publicly traded. Were that to happen, and the pathology PPM generated ample profits, share prices could soar, enriching its pathologist stockholders. Indeed, this is precisely what occurred to some of the earliest public PPMs.

AmeriPath, Inc. is the first pathology-based PPM to flirt with an initial public offering (IPO). It acquired 12 pathology practices in five states, generating annual revenues of $82 million. In THE DARK REPORT’S analysis of the econom- ic justification and business design of Ameripath’s proposed IPO last January, it was noted that much of upside potential in the short term depended on the stock market giving AmeriPath the same earnings multiple as existing PPMs. Eventually AmeriPath’s IPO was cancelled and the company is revamping its business plan in preparation for another attempt at an IPO later this year.

It is important for pathologists to understand what types of accounting practices support some public PPMs. Typically, a PPM can purchase a physician’s practice for up to six times annual earnings, including goodwill. If Wall Street bids the stock price to a multiple of 25 times earnings, the difference between the price paid to the physician and the stock’s value is profit to the shareholders. Most PPMs currently trade at a multiple of 25-27 times earnings, so this is a realistic strategy in today’s stock market.

What makes this game possible is that the PPMs pay the physician a large amount of goodwill. (Goodwill is the difference between the value of tangible assets and the purchase price for the business.) In some cases, up to 80% of the purchase price may involve goodwill. This pumps up the purchase price the physician can get for selling his practice. Because the PPM can pay more, the physician has a motivation to sell to a PPM as opposed to another physician.

PPMs will pay an “overmarket” price because current SEC rules permit companies to amortize goodwill costs over an unspecified period of time. Many PPMs choose to amortize goodwill over a 40-year period. This reduces the annual charge from writing down goodwill.

What makes this questionable from an investor perspective is the fact that a PPM is really purchasing the physician’s services. Will the physician work for the PPM for 40 more years? What happens when the physician’s non-compete runs out?

The SEC is proposing that goodwill be amortized over ten years. Compromise proposals would cap it at 20 or 25 years. Should the SEC succeed in changing the way goodwill is written off, then the formulas Wall Street uses to value new PPMs could change dramatically for the worse.

For pathologists nearing the retirement age, selling to a PPM may be a good way to maximize the value of their practice. For pathologists with many years of career ahead, the motives of the PPM organizers should be carefully scrutinized. Once the pathologist sells his practice, he loses significant control over how the practice is managed.

Savvy pathologists realize that the goal of a pathology PPM should be to add value in the marketplace, not to pump share prices upwards through accounting tricks. The first is a formula for long-term success. The second is a short-term profit gambit.

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