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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

 

x       Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the quarterly period ended June 30, 2012

 

or

 

o          Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the transition period from                      to                    

 

Commission File Number: 000-20086

 

UNIVERSAL HOSPITAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

 

Delaware		41-0760940
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

 

6625 West 78th Street, Suite 300

Minneapolis, Minnesota 55439-2604

(Address of principal executive offices, including zip code)

 

(952) 893-3200

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  o  No  x

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T  (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  o  No  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

 

Large accelerated filer  o		Accelerated filer  o
Non-accelerated filer  x		Smaller reporting company  o
(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   o  No  x

 

Number of shares of common stock outstanding as of August 1, 2012:  1,000

 

 

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Universal Hospital Services, Inc.

Table of Contents

 

		Page
PART I - FINANCIAL INFORMATION
ITEM 1.	Financial Statements (unaudited)
	Consolidated Balance Sheets — June 30, 2012 and December 31, 2011	1
	Consolidated Statements of Operations and Consolidated Statements of Other Comprehensive Income (Loss) —Three and Six months ended June 30, 2012 and 2011	2
	Consolidated Statements of Cash Flows — Six months ended June 30, 2012 and 2011	4
	Notes to Consolidated Financial Statements	5
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	47
ITEM 4.	Controls and Procedures	47
PART II - OTHER INFORMATION
ITEM 1.	Legal Proceedings	48
ITEM 1A.	Risk Factors	49
ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	49
ITEM 3.	Defaults Upon Senior Securities	49
ITEM 4.	Mine Safety Disclosures
ITEM 5.	Other Information	49
ITEM 6.	Exhibits	51
Signatures		52

 

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PART I - FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements — Unaudited

 

Consolidated Balance Sheets

(in thousands, except share and per share information)

(unaudited)

 

		June 30,			December 31,
		2012			2011
Assets
Current assets:
Cash and cash equivalents		$	332		$	1,161
Accounts receivable, less allowance for doubtful accounts of $2,016 at June 30, 2012 and $1,922 at December 31, 2011		80,535			70,592
Inventories		8,319			6,023
Deferred income taxes		11,012			12,328
Other current assets		5,794			4,392
Total current assets		105,992			94,496
Property and equipment, net:
Medical equipment, net		248,887			235,887
Property and office equipment, net		30,593			28,460
Total property and equipment, net		279,480			264,347
Other long-term assets:
Goodwill		335,416			326,952
Other intangibles, net		239,151			241,440
Other, primarily deferred financing costs, net		11,857			13,106
Total assets		$	971,896		$	940,341
Liabilities and Equity
Current liabilities:
Current portion of long-term debt		$	6,701		$	5,627
Interest rate swap		—			4,755
Book overdrafts		2,887			3,614
Accounts payable		31,760			31,359
Accrued compensation		10,772			11,571
Accrued interest		4,074			4,937
Dividend payable		780			771
Other accrued expenses		11,590			10,054
Total current liabilities		68,564			72,688
Long-term debt, less current portion		696,663			665,470
Pension and other long-term liabilities		13,655			12,981
Payable to Parent		20,547			19,019
Deferred income taxes		76,357			75,657
Commitments and contingencies (Note 9)
Equity
Common stock, $0.01 par value; 1,000 shares authorized, issued and outstanding at June 30, 2012 and December 31, 2011		—			—
Additional paid-in capital		214,294			214,294
Accumulated deficit		(109,623		)	(108,327		)
Accumulated other comprehensive loss		(8,940		)	(11,827		)
Total Universal Hospital Services, Inc. equity		95,731			94,140
Non controlling interest		379			386
Total equity		96,110			94,526
Total liabilities and equity		$	971,896		$	940,341

 

The accompanying notes are an integral part of the unaudited financial statements.

 

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Consolidated Statements of Operations

(in thousands)

(unaudited)

 

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2012			2011			2012			2011
Revenue
Medical equipment outsourcing		$	88,460		$	73,847		$	168,497		$	140,086
Technical and professional services		22,350			11,361			42,479			22,231
Medical equipment sales and remarketing		9,264			5,876			15,631			11,482
Total revenues		120,074			91,084			226,607			173,799
Cost of Sales
Cost of medical equipment outsourcing		32,591			28,466			64,569			52,900
Cost of technical and professional services		16,885			8,227			32,654			16,110
Cost of medical equipment sales and remarketing		7,345			4,600			12,099			8,900
Medical equipment depreciation		17,321			17,505			34,225			34,673
Total costs of medical equipment outsourcing, technical and professional services and medical equipment sales and remarketing		74,142			58,798			143,547			112,583
Gross margin		45,932			32,286			83,060			61,216
Selling, general and administrative		28,709			27,111			56,367			49,491
Acquisition and integration expenses		190			1,225			294			1,999
Operating income		17,033			3,950			26,399			9,726
Interest expense		14,504			12,745			30,003			24,450
Income (loss) before income taxes and non controlling interest		2,529			(8,795		)	(3,604		)	(14,724		)
Provision (benefit) for income taxes		197			(7,520		)	(2,674		)	(7,307		)
Consolidated net income (loss)		$	2,332		$	(1,275	)	$	(930	)	$	(7,417	)
Net income attributable to non controlling interest		184			138			366			138
Net income (loss) attributable to Universal Hospital Services, Inc.		$	2,148		$	(1,413	)	$	(1,296	)	$	(7,555	)

 

The accompanying notes are an integral part of the unaudited financial statements.

 

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Consolidated Statements of Comprehensive Income (Loss)

(in thousands)

(unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2012			2011			2012			2011
Consolidated net income (loss)		$	2,332		$	(1,275	)	$	(930	)	$	(7,417	)
Other comprehensive income:
Gain on cash flow hedge, net of tax		1,167			1,583			2,887			3,284
Total other comprehensive income		1,167			1,583			2,887			3,284
Comprehensive income (loss)		3,499			308			1,957			(4,133		)
Comprehensive income attributable to non controlling interest		184			138			366			138
Comprehensive income (loss) attributable to Universal Hospital Services, Inc.		$	3,315		$	170		$	1,591		$	(4,271	)

 

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Universal Hospital Services, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 

		Six Months Ended
		June 30,
		2012			2011
Cash flows from operating activities:
Consolidated net loss		$	(930	)	$	(7,417	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation		39,673			39,414
Amortization of intangibles, deferred financing costs and bond premium		9,312			8,676
Provision for doubtful accounts		392			400
Provision for inventory obsolescence		182			76
Non-cash stock-based compensation expense		2,150			2,196
Non-cash gain on trade-in of recalled equipment		(14,122		)	(3,292		)
Gain on sales and disposals of equipment		(695		)	(801		)
Deferred income taxes		(1,450		)	(7,109		)
Changes in operating assets and liabilities:
Accounts receivable		(9,372		)	(1,310		)
Inventories		(1,678		)	(125		)
Other operating assets		(2,001		)	(252		)
Accounts payable		(608		)	(2,111		)
Other operating liabilities		(3,179		)	2,745
Net cash provided by operating activities		17,674			31,090
Cash flows from investing activities:
Medical equipment purchases		(32,082		)	(48,116		)
Property and office equipment purchases		(3,637		)	(3,235		)
Proceeds from disposition of property and equipment		3,935			1,496
Acquisitions, net of cash acquired		(11,445		)	(65,039		)
Net cash used in investing activities		(43,229		)	(114,894		)
Cash flows from financing activities:
Proceeds under senior secured credit facility		72,000			132,250
Payments under senior secured credit facility		(39,000		)	(185,150		)
Payments of principal under capital lease obligations		(3,398		)	(2,714		)
Payment of deferred financing costs		—			(3,500		)
Payoff of acquired debt		(3,163		)	—
Proceeds from issuance of bonds		—			178,938
Accrued interest received from bondholders		—			661
Distributions to non controlling interests		(373		)	(147		)
Proceeds from exercise of parent company stock options		150			40
Dividend and equity distribution payments		(763		)	—
Change in book overdrafts		(727		)	1,173
Net cash provided by financing activities		24,726			121,551
Net change in cash and cash equivalents		(829		)	37,747
Cash and cash equivalents at the beginning of period		1,161			—
Cash and cash equivalents at the end of period		$	332		$	37,747
Supplemental cash flow information:
Interest paid		$	29,424		$	22,645
Income taxes paid		798			352
Non-cash activities:
Medical equipment purchases included in accounts payable (at end of period)		$	8,016		$	8,627
Dividend declared to Parent		—			34,500
Capital lease additions		3,113			2,636

 

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Universal Hospital Services, Inc.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.                                       Basis of Presentation

 

The interim consolidated financial statements included in this Quarterly Report on Form 10-Q have been prepared by Universal Hospital Services, Inc. (“we”, “our”, “us”, the “Company”, or “UHS”) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted, pursuant to such rules and regulations.  These consolidated financial statements should be read in conjunction with the financial statements and related notes included in the Company’s 2011 Annual Report on Form 10-K filed with the SEC.

 

Acquisitions are described in Note 3, Acquisitions, and results of acquisitions are included in UHS’s consolidated results of operations since the date of acquisition.

 

The interim consolidated financial statements presented herein as of June 30, 2012, reflect, in the opinion of management, all adjustments necessary for a fair presentation of the financial position and the results of operations and cash flows for the periods presented.  These adjustments are of a normal, recurring nature.  The results of operations for any interim period are not necessarily indicative of results for the full year.

 

We are required to make estimates and assumptions about future events in preparing consolidated financial statements in conformity with GAAP.  These estimates and assumptions affect the amounts of assets, liabilities, revenues and expenses at the date of the unaudited consolidated financial statements.  While we believe that our past estimates and assumptions have been materially accurate, our current estimates are subject to change if different assumptions as to the outcome of future events are made.  We evaluate our estimates and judgments on an ongoing basis and predicate those estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances.  We make adjustments to our assumptions and judgments when facts and circumstances dictate.  Since future events and their effects cannot be determined with absolute certainty, actual results may differ from the estimates used in preparing the accompanying unaudited consolidated financial statements.

 

A description of our significant accounting policies is included in our 2011 Annual Report on Form 10-K. There have been no material changes to these policies for the six months ended June 30, 2012.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of UHS and its wholly owned subsidiary, UHS Surgical Services, Inc. (“Surgical Services”) since the acquisition of its predecessor companies, Emergent Group Inc. (“Emergent”) and PRI Medical Technologies, Inc. on April 1, 2011. In addition, in accordance with guidance issued by the Financial Accounting Standards Board (“FASB”), we have accounted for our equity investments in entities in which we are the primary beneficiary under the full consolidation method. All significant intercompany transactions and balances have been eliminated through consolidation. As the primary beneficiary, we consolidate the limited liability companies

 

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(“LLCs”) referred to in Note 11, Limited Liability Companies, as we effectively receive the majority of the benefits from such entities and we provide equipment lease guarantees for such entities.

 

2.                                       Recent Accounting Pronouncements

 

Standard Adopted

 

In September 2011, the FASB issued an amendment to the authoritative guidance on goodwill impairment testing. The objective of this amendment is to simplify how entities, both public and nonpublic, test goodwill for impairment. The amendment permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles — Goodwill and Other . If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. The adoption of this amendment did not have a material effect on our consolidated financial statements.

 

3.                                       Acquisitions

 

On January 3, 2012, we completed the acquisition of all of the outstanding stock of a Florida-based surgical laser equipment service provider for total consideration of approximately $16.1 million. The consideration total consists of $11.0 million of cash paid at closing, $3.2 million of debt assumed that was paid off upon closing, and $1.9 million of holdback amounts expected to be paid by January 2013.  The acquisition was funded through our $195.0 million Senior Secured Credit Facility.

 

We have allocated the following asset and liability amounts related to the acquisition within our consolidated balance sheet:  holdback amounts payable $1.9 million, other working capital items $0.4 million, fixed assets $5.4 million, identifiable intangible assets $5.3 million, non-deductible goodwill $8.4 million, deferred income tax liabilities $3.4 million and long-term debt (paid off subsequent to closing) $3.2 million. We will utilize additional information, particularly as it relates to intangible assets and income taxes, as it becomes available in order to finalize this purchase price allocation as soon as practicable, but no later than January 1, 2013, one year from the acquisition date.

 

On March 31, 2012, we completed the acquisition of certain assets of the southern California equipment rental division of a medical equipment manufacturer. Total purchase price of the transaction was approximately $0.8 million, including approximately $0.4 million in contingent consideration to be paid over four years based on future revenues. Assets acquired consisted of medical equipment of $0.4 million and customer relationship intangibles of $0.3 million.

 

Acquisitions completed during the first quarter of 2012 are not material individually or in the aggregate.

 

On April 1, 2011, we completed our acquisition of Emergent Group, which was, at December 31, 2011, merged into its principal operating subsidiary, PRI Medical, whose name was subsequently changed to UHS Surgical Services, Inc., and which we refer to as “Surgical Services”. Surgical Services is a provider of laser and mobile surgical equipment services primarily for the urology community.

 

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We acquired Surgical Services (previously, Emergent Group), for a total purchase price of approximately $65.3 million, which represents the sum of $60.0 million of cash paid for equity, $4.8 million of capital lease liability assumed and $2.0 million of transaction costs, less cash acquired of $1.5 million. All outstanding shares were purchased at a price of $8.46 per share. The acquisition was funded primarily by drawings under our $195.0 million Senior Secured Credit Facility, which is described below in Note 8, Long-Term Debt.

 

During the quarter ended June 30, 2012, we finalized our purchase price allocation as of the April 1, 2011 acquisition date with the amounts noted in the table below:

 

(in thousands)
Cash and cash equivalents		$	1,480
Accounts receivable		4,517
Deferred income taxes		827
Inventories		1,222
Other current assets		1,403
Medical equipment		7,540
Property and equipment		234
Intangible assets		22,150
Other assets		79
Total identifiable assets		39,452
Accounts payable		1,972
Accrued expenses		1,905
Other liabilites		1,618
Deferred income taxes		9,523
Capital leases		4,763
Total liabilities assumed		19,781
Net identifiable assets acquired		19,671
Non controlling interests		(379		)
Goodwill		40,727
Net assets acquired		$	60,019

 

In the second quarter of 2012, we recorded a measurement adjustment of $0.3 million, increasing the fair values of goodwill and accrued expenses assumed in the acquisition as of the acquisition date. We have retrospectively adjusted the previously reported fair values of goodwill and other accrued expenses.

 

The amounts of revenue and net income of Surgical Services included in the Company’s consolidated statements of operations from April 1, 2011 to June 30, 2012 are as follows:

 

		Revenue and income included in the Consolidated Statements of Operations from:
(in thousands)		April 1, 2012 to June 30, 2012			January 1, 2012 to June 30, 2012			April 1, 2011 to June 30 ,2011
Revenue		$	12,288		$	24,129		$	8,055
Net income (loss) attributable to Surgical Services		$	(1,483	)	(1,661		)	191

 

The following unaudited supplemental pro forma information presents the financial results as if the acquisition of Emergent Group had occurred on January 1, 2011 for the six months ended June 30, 2011. This supplemental pro forma information has been prepared for comparative purposes and does not purport to be indicative of what would have occurred had the acquisition been made on January 1, 2011, nor are they indicative of any future results.

 

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		Six Months Ended
(in thousands)		June 30, 2011
Revenue		$	181,628
Net loss attributable to Universal Hospital Services, Inc.		(9,241		)

 

These amounts have been calculated after applying the Company’s accounting policies and adjusting the results of Emergent Group to reflect the additional depreciation, amortization and interest that would have been charged assuming the fair value adjustments primarily to medical equipment and intangible assets, and draws on the line of credit to fund the acquisition had been applied on January 1, 2011, as applicable, together with the consequential tax effects.

 

4.                                       Fair Value Measurements

 

Financial liabilities measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011, in accordance with Accounting Standards Codification (“ASC”) Topic 820, are summarized in the following table by type of inputs applicable to the fair value measurements:

 

		Fair Value at June 30, 2012												Fair Value at December 31, 2011
(in thousands)		Level 1			Level 2			Level 3			Total			Level 1			Level 2			Level 3			Total
Interest Rate Swap		$	—		$	—		$	—		$	—		$	—		$	4,755		$	—		$	4,755
Contingent Consideration		$	—		$	—		$	349		$	349		$	—		$	—		$	—		$	—

 

A description of the inputs used in the valuation of assets and liabilities is summarized as follows:

 

Level 1 — Inputs represent unadjusted quoted prices for identical assets or liabilities exchanged in active markets.

 

Level 2 — Inputs include directly or indirectly observable inputs other than Level 1 inputs such as quoted prices for similar assets or liabilities exchanged in active or inactive markets; quoted prices for identical assets or liabilities exchanged in inactive markets; other inputs that are considered in fair value determinations of the assets or liabilities, including interest rates and yield curves that are observable at commonly quoted intervals.  The level 2 inputs used to determine the fair value of our interest rate swap include interest rates and yield curves that are observable at commonly quoted intervals.

 

Level 3 — Inputs include unobservable inputs used in the measurement of assets and liabilities. Management is required to use its own assumptions regarding unobservable inputs because there is little, if any, market activity in the assets or liabilities or related observable inputs that can be corroborated at the measurement date. Unobservable inputs require management to make certain projections and assumptions about the information that would be used by market participants in pricing assets or liabilities.

 

As of March 31, 2012, we initially recorded a contingent consideration liability, in the form of an earn-out payment, related to our acquisition of certain assets of the southern California equipment rental division of a medical equipment manufacturer in the amount of $0.3 million. The contingent consideration payments are based on achieving certain revenue results. The fair value of the liability was estimated using a discounted cash flow approach with significant inputs that are not observable in the market and thus represents a Level 3 fair value measurement as defined in the FASB’s ASC Topic 820 . The significant inputs in the Level 3 measurement not supported by market activity included our

 

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assessments of expected future cash flows during the earn-out period, related to the assets acquired, appropriately discounted considering the uncertainties associated with the obligation, and calculated based on estimated revenues in accordance with the terms of the agreement. These inputs are classified as level 3 inputs.

 

The assumptions used in preparing the discounted cash flow analysis included estimates of interest rates and the timing and amount of incremental cash flows. At June 30, 2012 no earn-out had been paid.

 

Fair Value of Other Financial Instruments

 

The Company considers the carrying amount of financial instruments, including accounts receivable, accounts payable and accrued liabilities, as the approximate fair value due to their short maturities. We use the market approach to determine the fair value of our financial liabilities. We utilize observable market information of identical assets including trade dates, price and quantities provided by a third party pricing service for the selected reporting period. These inputs are considered level 2 inputs. The fair value of our outstanding PIK Toggle Notes and Floating Rate Notes as of June 30, 2012 and December 31, 2011, based on the quoted market price for the same or similar issues of debt, is approximately:

 

		June 30,			December 31,
(in millions)		2012			2011
PIK Toggle Notes		$	413.1		$	417.0
Floating Rate Notes		218.5			208.2

 

5.                                       Equity

 

The following tables represent changes in equity attributable to our shareholders and non controlling interests for the six month periods ending June 30, 2012 and 2011.

 

								Accumulated
		Additional						Other
(in thousands)		Paid-in			Accumulated			Comprehensive			Non controlling			Total
(unaudited)		Capital			Deficit			Loss			Interests			Equity
Balance at December 31, 2011		$	214,294		$	(108,327	)	$	(11,827	)	$	386		$	94,526
Net income (loss)		—			(1,296		)	—			366			(930		)
Unrealized gain on cash flow hedge, net of tax of $1,868		—			—			2,887			—			2,887
Cash distributions to non controlling interests		—			—			—			(373		)	(373		)
Balance at June 30, 2012		$	214,294		$	(109,623	)	$	(8,940	)	$	379		$	96,110

 

								Accumulated
		Additional						Other
		Paid-in			Accumulated			Comprehensive			Non controlling			Total
(in thousands)		Capital			Deficit			Loss			Interests			Equity
Balance at December 31, 2010		$	248,794		$	(87,276	)	$	(14,779	)	$	—		$	146,739
Consolidation of Emergent Group non controlling interest		—			—			—			379			379
Net income (loss)		—			(7,555		)	—			138			(7,417		)
Dividend declared		(34,500		)	—			—			—			(34,500		)
Unrealized gain on cash flow hedge, net of tax of $2,044		—			—			3,284			—			3,284
Cash distributions to non controlling interests		—			—			—			(147		)	(147		)
Balance at June 30, 2011		$	214,294		$	(94,831	)	$	(11,495	)	$	370		$	108,338

 

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6.                                       Stock-Based Compensation

 

During the six months ended June 30, 2012, activity under the 2007 Stock Option Plan (the “2007 Stock Option Plan”), of UHS Holdco, Inc., our parent company (“Parent”), was as follows:

 

(in thousands except exercise price)		Number of  Options		Weighted average exercise price			Aggregate intrinsic value			Weighted average remaining contractual term (years)
Outstanding at December 31, 2011		38,195		$	1.05		$	25,046		5.7
Granted		—
Exercised		(150	)	$	1.00		$	107
Forfeited or expired		(311	)	$	1.17
Outstanding at June 30, 2012		37,734		$	1.05		$	24,771		5.2
Exercisable at June 30, 2012		29,704		$	1.02		$	20,411		5.0
Remaining authorized options available for issue		5,952

 

The exercise price of each stock option award is equal to the market value of Parent’s common stock on the grant date as determined reasonably and in good faith by Parent’s board of directors and Parent’s compensation committee and based on an analysis of a variety of factors including peer group multiples, merger and acquisition multiples, and discounted cash flow analyses.

 

The intrinsic value of a stock award is the amount by which the market value of the underlying stock exceeds the exercise price of the award.

 

We determine the fair value of stock options using the Black-Scholes option pricing model. The estimated fair value of options, including the effect of estimated forfeitures, is recognized as expense on a straight-line basis over the options’ expected vesting periods. There were no stock options granted during the six months ended June 30, 2012.

 

Expected volatility is based on an independent valuation of the stock of companies within our peer group.  Given the lack of a true comparable company, the peer group consists of selected public health care companies representing our suppliers, customers and competitors within certain product lines.  The risk free-interest rate is based on the U.S. Treasury yield curve in effect at the grant date based on the expected option life.  The expected option life represents the result of the “simplified” method applied to “plain vanilla” options granted during the period, as provided within ASC Topic 718, “Compensation - Stock Compensation.”   Parent used the simplified method as Parent does not have sufficient historical exercise experience to provide a basis upon which to estimate the expected term.

 

Although Parent grants stock options, the Company recognizes compensation expense related to these options since the services are performed for its benefit.  Along with this expense, which is primarily included in selling, general and administrative expense, the Company records an offsetting payable to Parent liability which is not expected to be settled within the next twelve months.

 

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At June 30, 2012, unearned non-cash stock-based compensation that we expect to recognize as expense over a weighted average period of 1.6 years, totals approximately $3.1 million, net of our estimated forfeiture rate of 2.0%. The expense could be accelerated upon the sale of Parent or the Company.

 

7.                                       Dividend and Equity Distribution

 

On June 8, 2011 the Company and Parent’s Boards of Directors declared a dividend of $0.12 per share to the Parent’s shareholders of record on June 10, 2011 and a $0.12 per share equity distribution to be paid to the holders of vested options on the Parent’s stock as of June 10, 2011, subject to the consummation of the note offering which occurred on June 17, 2011 (see Note 8, Long-term Debt), and payable on July 1, 2011.

 

Also on June 8, 2011, the Boards of Directors declared an equity distribution of $0.12 per option to holders of outstanding options on the Parent’s stock on June 10, 2011 that are scheduled to vest on December 31, 2011, 2012, 2013, 2014, and 2015.

 

Our consolidated balance sheets as of December 31, 2011 and June 30, 2012 reflect the decrease in shareholders’ equity for dividends paid to Parent shareholders and distributions to vested option holders on July 1, 2011 and distributions payable to vested option holders on December 31, 2011, as well as estimated amounts to be paid to holders of options expected to vest on December 31, 2012 though 2015 based on an estimated option forfeiture rate of 2% annually.  Our consolidated balance sheet also reflects the related current dividend payable and long-term dividend payable included in Payable to Parent.

 

8.                                       Long-Term Debt

 

Long-term debt consists of the following:

 

		June 30,			December 31,
(in thousands)		2012			2011
PIK toggle notes		$	405,000		$	405,000
Floating rate notes		230,000			230,000
Unamortized bond premium		2,985			3,433
Senior secured credit facility		47,500			14,500
Capital lease obligations		17,879			18,164
		703,364			671,097
Less: Current portion of long-term debt		(6,701		)	(5,627		)
Total long-term debt		$	696,663		$	665,470

 

PIK Toggle Notes. Our 8.50% / 9.25% Second Lien Senior Secured PIK Toggle Notes due 2015 (the “PIK Toggle Notes”) consist of $230.0 million aggregate principal amount of PIK Toggle Notes issued on May 31, 2007 and $175.0 million aggregate principal amount of PIK Toggle Notes issued on June 17, 2011 for a total aggregate outstanding principal amount of $405.0 million.  All of the PIK Toggle Notes were issued under a Second Lien Senior Indenture dated as of May 31, 2007 (the “Second Lien Senior Indenture”).

 

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The PIK Toggle Notes mature on June 1, 2015. Interest on the PIK Toggle Notes is payable semiannually in arrears on each June 1 and December 1. Beginning June 1, 2011, the Company was required to make all interest payments on the PIK Toggle Notes entirely as cash interest. Cash interest on the PIK Toggle Notes accrues at the rate of 8.50% per annum. The PIK Toggle Notes are redeemable, at the Company’s option, in whole or in part, at specified redemption prices (as defined in the Second Lien Senior Indenture) plus accrued interest to the date of redemption.

 

We may redeem some or all of the PIK Toggle Notes at the redemption prices (expressed as percentages of principal amount) set forth below plus accrued and unpaid interest, if any, on the PIK Toggle Notes redeemed, to the applicable redemption date, if redeemed during the 12-month period beginning on June 1 of the years indicated below, subject to the rights of noteholders:

 

Year		Percentage
2012		102.125	%
2013 and thereafter		100.000	%

 

In addition, the PIK Toggle Notes have a change of control provision, which gives each holder the right to require the Company to purchase all or a portion of such holders’ PIK Toggle Notes upon a change in control, as defined in the Second Lien Senior Indenture, at a purchase price equal to 101% of the principal amount plus accrued interest to the date of purchase. The PIK Toggle Notes, subject to certain definitions and exceptions, have covenants that restrict, among other things, the incurrence of additional debt, the payment of dividends and the issuance of preferred stock. The PIK Toggle Notes are uncollateralized.

 

Floating Rate Notes.  Our Floating Rate Notes were issued on May 31, 2007 in the aggregate principal amount of $230.0 million under the Second Lien Senior Indenture.  The Floating Rate Notes mature on June 1, 2015. Interest on the Floating Rate Notes is payable semiannually in arrears on each June 1 and December 1. Interest on the Floating Rate Notes is reset for each semi-annual interest period and is calculated at the current LIBOR rate plus 3.375%.  At June 30, 2012, our LIBOR-based rate was 4.112%, which includes the credit spread. The Floating Rate Notes are redeemable, at the Company’s option, in whole or in part, at specified redemption prices (as defined in the Second Lien Senior Indenture) plus accrued interest to the date of redemption. In addition, the Floating Rate Notes have a change of control provision, which gives each holder the right to require the Company to purchase all or a portion of such holders’ Floating Rate Notes upon a change in control, as defined in the Second Lien Senior Indenture, at a purchase price equal to 101% of the principal amount plus accrued interest to the date of purchase. The Floating Rate Notes, subject to certain definitions and exceptions, have covenants that restrict, among other things, the incurrence of additional debt, the payment of dividends and the issuance of preferred stock. The Floating Rate Notes are uncollateralized.

 

We may redeem some or all of the Floating Rate Notes at a redemption price equal to 100% of the aggregate principal amount thereof, plus accrued and unpaid interest, if any, to the applicable redemption date, if redeemed, subject to the rights of noteholders.

 

Interest Rate Swap. In June 2007, we entered into an interest rate swap agreement for $230.0 million, which had the effect of converting the interest rate applicable to our $230.0 million of Floating Rate Notes to a fixed interest rate.  The effective date for the interest rate swap agreement was December 2007 and it expired June 1, 2012.

 

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The interest rate swap agreement qualified for cash flow hedge accounting under ASC Topic 815, Derivatives and Hedging. Both at inception and on an on-going basis, we must perform an effectiveness test.  Before its expiration on June 1, 2012, the fair value of the interest rate swap agreement was included as a cash flow hedge on our balance sheet in accordance with ASC Topic 815.  The change in fair value was recorded as a component of accumulated other comprehensive loss on our balance sheet, net of tax, since the instrument was determined to be an effective hedge.

 

Second Lien Senior Indenture. Our PIK Toggle Notes and Floating Rate Notes (collectively, the “Notes”) are guaranteed, jointly and severally, on a second priority senior secured basis, by UHS Surgical Services, and are also similarly guaranteed by certain of our future domestic subsidiaries. The Notes are our second priority senior secured obligations and rank (i) equal in right of payment with all of our existing and future unsecured and unsubordinated indebtedness, and effectively senior to any such unsecured indebtedness to the extent of the value of collateral; (ii) senior in right of payment to all of our and our guarantors’ existing and future subordinated indebtedness; (iii) effectively junior to our Senior Secured Credit Facility and other obligations that are secured by first priority liens on the collateral securing the Notes or that are secured by a lien on assets that are not part of the collateral securing the Notes, in each case, to the extent of the value of such collateral or assets; and (iv) structurally subordinated to any indebtedness and other liabilities (including trade payables) of any of our future subsidiaries that are not guarantors.

 

The Second Lien Senior Indenture governing the Notes contains covenants that limit our and our guarantors’ ability, subject to certain definitions and exceptions, and certain of our future subsidiaries’ ability to:

 

·                   incur additional indebtedness;

·                   pay cash dividends or distributions on our capital stock or repurchase our capital stock or subordinated debt;

·                   issue redeemable stock or preferred stock;

·                   issue stock of subsidiaries;

·                   make certain investments;

·                   transfer or sell assets;

·                   create liens on our assets to secure debt;

·                   enter into transactions with affiliates; and

·                   merge or consolidate with another company.

 

Senior Secured Credit Facility. On May 6, 2010 we entered into an Amended and Restated Credit Agreement with GE Business Financial Services, Inc., as agent for the lenders, and the lenders party thereto, which amended the Senior Secured Credit Facility dated as of May 31, 2007. The Senior Secured Credit Facility is a first lien senior secured asset based revolving credit facility (as amended, the “Senior Secured Credit Facility”). The Amended and Restated Credit Agreement increased the aggregate amount the Company may borrow under the Senior Secured Credit Facility from $135.0 million to $195.0 million and extended the maturity date to November 30, 2014. Additionally, we capitalized deferred financing costs related to the Amended and Restated Credit Agreement in the amount of $1.7 million. As of June 30, 2012, we had $142.5 million of availability under the Senior Secured Credit Facility after giving effect to $5.0 million used for letters of credit, based on a borrowing base of $195.0 million.  Our obligations under the Senior Secured Credit Facility are secured by a first priority security interest in substantially all of our assets, excluding a pledge of our and Parent’s capital

 

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stock, any joint ventures and certain other exceptions. Our obligations under the Senior Secured Credit Facility are unconditionally guaranteed by Parent.

 

The Senior Secured Credit Facility requires our compliance with various affirmative and negative covenants.  Pursuant to the affirmative covenants, we and Parent agreed to, among other things, deliver financial and other information to the agent, provide notice of certain events (including events of default), pay our obligations, maintain our properties, maintain the security interest in the collateral for the benefit of the agent and the lenders and maintain insurance.

 

Among other restrictions, and subject to certain definitions and exceptions, the Senior Secured Credit Facility restricts our ability to:

 

·                   incur indebtedness;

·                   create or permit liens;

·                   declare or pay dividends and certain other restricted payments;

·                   consolidate, merge or recapitalize;

·                   acquire or sell assets;

·                   make certain investments, loans or other advances;

·                   enter into transactions with affiliates;

·                   change our line of business; and

·                   enter into hedging transactions.

 

The Senior Secured Credit Facility also contains a financial covenant that is triggered if our available borrowing capacity is less than $15.0 million for a certain period, which consists of a minimum ratio of trailing four-quarter EBITDA to cash interest expense, as such terms are defined in the Senior Secured Credit Facility.

 

The Senior Secured Credit Facility specifies certain events of default, including, among others, failure to pay principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, bankruptcy events, certain ERISA-related events, cross-defaults to other material agreements, change of control events and invalidity of guarantees or security documents.  Some events of default will be triggered only after certain cure periods have expired, or will provide for materiality thresholds.  If such a default occurs, the lenders under the Senior Secured Credit Facility would be entitled to take various actions, including all actions permitted to be taken by a secured creditor and the acceleration of amounts due under the Senior Secured Credit Facility.

 

Borrowings under the Senior Secured Credit Facility accrue interest (including a credit spread varying with facility usage):

 

·                   at a per annum rate equal to 1.75% - 2.00% above the rate announced from time to time by the agent as the “prime rate” payable quarterly in arrears; and

·                   at a per annum rate equal to 2.75% - 3.00% above the adjusted LIBOR rate used by the agent, for the respective interest rate period determined at our option, payable in arrears upon cessation of the interest rate period elected.

 

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At June 30, 2012, we had $47.5 million of borrowings outstanding that were accruing interest at the prime rate. At June 30, 2012, we did not have any borrowings outstanding that were accruing interest at the LIBOR-based rate.

 

On July 31, 2012, we entered into a Second Amended and Restated Credit Agreement with Bank of America, N.A., as agent for the lenders, and the lenders party thereto (the “Second Amended Credit Agreement”), which amended the senior secured credit facility originally dated as of May 31, 2007 and amended and restated as of May 6, 2010.  The amendment increased the aggregate amount the Company may obtain under revolving loans from $195.0 million to $235.0 million and extended the maturity date to the earliest of (i) July 30, 2017, (ii) 90 days prior to the maturity of the Second Lien Senior Secured Floating Rate Notes due 2015 or (iii) 90 days prior to the maturity of the 7.625% Second Lien Senior Secured Notes due 2020.  The Company’s obligations under the Second Amended Credit Agreement are secured by a first priority security interest in substantially all of the Company’s assets, excluding a pledge of its and Parent’s stock, any joint ventures and certain other exceptions.  The Company’s obligations under the Second Amended Credit Agreement are unconditionally guaranteed by the Company’s parent, UHS Holdco, Inc. and the Company’s restricted subsidiaries.

 

On August 7, 2012, we issued $425 million in aggregate principal amount of 7.625% Second Lien Senior Secured Notes (the “2012 Notes”) under an indenture. The 2012 Notes mature on August 15, 2020.  In connection with the issuance of the 2012 Notes, the Company entered into a registration rights agreement with the initial purchasers of the 2012 Notes.  The net proceeds from the 2012 Notes will be used primarily to fund the cash tender offer announced on July 24, 2012 to purchase $405 million of the Company’s 8.50%/9.25% PIK Toggle Notes due 2015 (the “PIK Toggle Notes”).  In conjunction with the tender offer, we solicited and received consent from the requisite number of holders that tendered the PIK Toggle Notes to eliminate the right of the remaining holders to benefit from substantially all restrictive covenants and certain event of default provisions of the PIK Toggle Notes.

 

9.                                       Commitments and Contingencies

 

On July 13, 2010, the U.S. Food and Drug Administration (“FDA”) issued a final order and transition plan to a medical equipment manufacturer to recall all infusion pumps of a certain model currently in use in the United States. The FDA order established the framework for the recall by providing for a cash refund, generally, $1,500 for single channel pumps and $3,000 for triple channel pumps, or a replacement pump to owners within a two-year period. At the time of the recall notice, we owned approximately 11,900 of the applicable infusion pumps.

 

For the six months ended June 30, 2012, we recognized recalled equipment net gains of approximately $15.4 million of which approximately $14.1 million were non-cash gains. Non-cash gains result from receiving a replacement pump for a recalled pump. The gains are a result of the fair market value of the replacement pump less the net book value of the recalled pump. At June 30, 2012, we owned approximately 1,460 of the applicable pumps. We are continuing the process of evaluating the course of action that best meets the infusion technology needs of our customers and our business. As such, we expect to continue to recognize gains and also expect to increase purchases of infusion pumps to replace recalled units as they are accepted by the equipment manufacturer. During the third quarter of 2012, we expect to recognize recalled equipment net gains between $2.0 and $4.0 million.

 

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The Company, from time to time, may become involved in litigation arising out of operations in the normal course of business. Asserted claims are subject to many uncertainties and the outcome of individual matters is not predictable with assurance.

 

On October 19, 2009, Freedom Medical, Inc. filed a lawsuit against the Company and others in U.S. District Court for the Eastern District of Texas. The federal complaint alleges violation of state and federal antitrust laws, tortious interference with business relationships, business disparagement and common law conspiracy in connection with the biomedical equipment rental market. Freedom Medical, Inc. is seeking unspecified damages and injunctive relief. Under the current scheduling order, fact discovery closes September 30, 2012 and expert discovery closes January 8, 2013. Summary judgment briefing will take place beginning January 18, 2013 and ending February 11, 2013. The final pretrial conference is set for April 4, 2013.  On January 30, 2012, the Company filed an amended answer, affirmative defenses, and counterclaim against Freedom Medical, Inc. The counterclaim alleges that Freedom Medical, Inc. engaged in improper business tactics, including baseless threats of litigation, illegal activity, and disparaging statements about the Company’s business, aimed at tortiously interfering with the Company’s business. The Company is seeking injunctive relief and an award of monetary damages in an amount equal to the losses caused by Freedom Medical Inc.’s tortious interference with the Company’s business relations. On March 8, 2012, the Company filed a motion to dismiss all of Freedom Medical, Inc.’s claims for failure to join indispensable parties, namely independent distributors of Freedom Medical, Inc. The motion is pending.  While we believe these claims are without merit, and will vigorously defend against them, we are unable at this time to determine the ultimate outcome of this matter or determine the effect it may have on our business, financial condition or results of operations. We have been seeking coverage for the Freedom Medical, Inc. lawsuit from a number of our insurance carriers.  On December 30, 2011, two of the insurance carriers, Lexington Insurance Company and National Union Fire Insurance Company of Pittsburgh, Pa., served us with a Minnesota state court complaint seeking a declaration that they have no obligation to cover certain claims of Freedom Medical, Inc.’s lawsuit.  This complaint was stayed by the Minnesota state court on March 14, 2012. On January 11, 2012, we filed our own suit, venued in Texas state court, against all of the carriers currently implicated by Freedom Medical, Inc.’s allegations.  This action seeks, among other things, a declaration of coverage as to Freedom Medical, Inc.’s suit.  We are unable at this time to determine the ultimate outcome of this matter or determine the effect it may have on our business, financial condition or results of operations.

 

The Company, in the ordinary course of business, could be subject to liability claims related to employees and the equipment that it rents and services. Asserted claims are subject to many uncertainties and the outcome of individual matters is not predictable. While the ultimate resolution of these actions may have an impact on the Company’s financial results for a particular reporting period, management believes that any such resolution would not have a material effect on the financial position, results of operations or cash flows of the Company.

 

As of June 30, 2012, we were not a party to any other pending legal proceedings the adverse outcome of which could reasonably be expected to have a material effect on our financial position, results of operations or cash flows.

 

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10.                                Related Party Transactions

 

Management Agreement

 

On May 31, 2007, we and Irving Place Capital entered into a professional services agreement pursuant to which Irving Place Capital provides general advisory and management services to us with respect to financial and operating matters.  Irving Place Capital is a principal owner of Parent, and the following members of our board of directors are associated with Irving Place Capital:  Michael Feiner, Robert Juneja, Bret Bowerman and David Crane. We paid Irving Place Capital professional services fees of $0.5 and $0.5 million for the six-month periods ended June 30, 2012 and 2011, respectively.

 

Business Relationship

 

In the ordinary course of business, we entered into an operating lease for our Minneapolis, Minnesota district office with Ryan Companies US, Inc. (“Ryan”), which began on May 1, 2007.  One member of our board of directors is also a director of Ryan.  We made payments to Ryan totaling $173,000 and $172,000 during the six months ended June 30, 2012 and 2011, respectively.

 

The Company believes that the aforementioned arrangements and relationships were provided in the ordinary course of business at prices and on terms similar to those that would result from arm’s length negotiation between unrelated parties.

 

11.                                Limited Liability Companies

 

We participate with others in the formation of limited liability companies (“LLCs”) in which Surgical Services becomes a partner and shares the financial interest with the other investors. Surgical Services is the primary beneficiary of these LLCs. These LLCs acquire certain medical equipment for use in their respective business activities, which generally focus on surgical procedures. The LLCs will acquire medical equipment for rental purposes under equipment financing leases. At June 30, 2012, the LLCs had approximately $0.8 million of total assets. The third party investors in each respective LLC generally provide the lease financing company with individual proportionate lease guarantees based on their respective ownership percentages in the LLCs. In addition, Surgical Services will provide such financing companies with its corporate guarantee based on its respective ownership interest in each LLC. In certain instances, Surgical Services has provided such financing companies with an overall corporate guarantee in connection with equipment financing transactions. In such instances, the individual investors in each respective LLC will generally indemnify us against losses, if any, incurred in connection with its corporate guarantee. Additionally, we provide operational and administrative support to the LLCs in which it is a partner. As of June 30, 2012, we held interests in six active LLCs.

 

In accordance with guidance issued by the FASB, we account for equity investments in LLCs (in which we are the primary beneficiary) under the full consolidation method whereby transactions between Surgical Services and the LLCs have been eliminated through consolidation.

 

12.                                Segment Information

 

Our reporting segments consist of Medical Equipment Outsourcing, Technical and Professional Services, and Medical Equipment Sales and Remarketing. Certain operating information for our segments as well as a reconciliation of total Company gross margin to income (loss) before income tax was as follows:

 

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Medical Equipment Outsourcing

(in thousands)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2012			2011			2012			2011
Revenues		$	88,460		$	73,847		$	168,497		$	140,086
Cost of revenue		32,591			28,466			64,569			52,900
Medical equipment depreciation		17,321			17,505			34,225			34,673
Gross margin		$	38,548		$	27,876		$	69,703		$	52,513

 

Technical and Professional Services

(in thousands)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2012			2011			2012			2011
Revenues		$	22,350		$	11,361		$	42,479		$	22,231
Cost of revenue		16,885			8,227			32,654			16,110
Gross margin		$	5,465		$	3,134		$	9,825		$	6,121

 

Medical Equipment Sales and Remarketing

(in thousands)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2012			2011			2012			2011
Revenues		$	9,264		$	5,876		$	15,631		$	11,482
Cost of revenue		7,345			4,600			12,099			8,900
Gross margin		$	1,919		$	1,276		$	3,532		$	2,582

 

Total Gross Margin and Reconciliation to Income (Loss) Before Income Tax

(in thousands)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2012			2011			2012			2011
Total gross margin		$	45,932		$	32,286		$	83,060		$	61,216
Selling, general and administrative		28,709			27,111			56,367			49,491
Acquisition and integration expenses		190			1,225			294			1,999
Interest expense		14,504			12,745			30,003			24,450
Income (loss) before income taxes and non controlling interest		$	2,529		$	(8,795	)	$	(3,604	)	$	(14,724	)

 

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