Michael Doyle - Chief Executive Officer Teresa Sparks - Executive Vice President and Chief Financial Officer.

Kevin Fischbeck - Bank of America Merrill Lynch Brian Tanquilut - Jefferies & Company, Inc. Ralph Giacobbe - Citigroup Frank Morgan - RBC Capital Markets John Ransom - Raymond James Financial William Sutherland - Emerging Growth Equities, Ltd. .

Greetings and welcome to the Surgery Partners, Incorporated, Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr.

Mike Doyle, CEO. Thank you, sir. You may begin..

Thank you, operator. I would like to welcome everyone to Surgery Partners’ second quarter 2016 earnings call. Joining me today is Teresa Sparks, our Executive Vice President and Chief Financial Officer. I’ll turn it over to Teresa to review the Safe Harbor statements..

Thanks Mike. Before we begin, let me remind everyone that during this call Surgery Partners’ management may make certain statements that constitute forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995.

These include remarks about future expectation, anticipation, believes, estimates, plans and prospects. Such statements are subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from those indicated or implied by such statements.

Such risks and other factors are set forth in the Company’s earnings release posted on the website, provided in our final prospective and subsequently filed Form 10-Q as filed with the Securities and Exchange Commission. The Company does not undertake any duty to update such forward-looking statements.

Additionally during today’s call the Company will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP.

A reconciliation of adjusted EBITDA to net earnings calculated under GAAP can be found in our earnings release, which is posted on our website at surgerypartners.com and in our most recent Form 10-Q. With that, I’ll turn the call back over to Mike..

Thanks, Teresa. Our second quarter marked another strong period of growth for Surgery Partners. And I’d like to thank our physicians and employees for their hard work in delivering exceptional care to our patients on a daily basis.

During the quarter, our revenue growth continued to accelerate as we generated a 24.4% increase compared with the same period last year. As a reminder, we reported a 19.2% increase in the first quarter.

These figures reflect expansion of our service lines, recruitment of new physicians in existing markets and the addition of new locations over the past year. On a same facility basis revenue increased 14.9% with strong case growth of 7.9%.

Our same facility revenue continues to benefit from our differentiated operating model, as we continue to add integrated and higher acuity services. We are at the forefront of this outpatient focus as our model meets the needs of patients, physicians, and payers.

There’s been a great deal of attention on orthopedic procedures in recent quarters with growing payer interest regarding outpatient joint surgeries. We now perform total joint procedures at 23 of our facilities.

With our expanding range of services and physicians, we are well-positioned for an environment of integrated services and improved measurements that better demonstrate both quality and value.

Supporting this effort, our dedicated recruiting team has played a key role in attracting physicians in specialties that perform higher acuity procedures as we have expanded these programs in key areas. Our experienced team has a deep understanding of coordination of physician, staff, payers, and vendors required to continue our success in this area.

Our integrated approach appeals to physicians and payers alike, continuing to be a key driver in our growing network of healthcare facilities. In the second quarter we completed five transactions, as we previously announced, we closed an integrated physician practice in Jacksonville, Florida in April.

Jacksonville is an attractive market for us and in addition to the physician practice this transaction added a second surgery center anesthesia and related ancillary services. We also complemented our existing market in Idaho with an acquisition of a multi-specialty physician practice and an additional urgent care facility.

Also during the quarter we entered into a strategic relationship with the health system and physicians in a new market in Texas, with the acquisition of an ambulatory surgery center and an anesthesia practice in Houston.

Finally, our acquisitions of independent physician practices remain an efficient use of our capital and during the quarter we completed an acquisition of an independent practice in Sarasota, Florida. Our ancillary group’s performance will continue to improve as our acquired and de novo physician practices mature and benefit from our infrastructure.

As most of you know, CMS has proposed a 1.2% increase for the ASC and a 1.6% increase for our surgical hospitals in 2016. In addition, a CMS advisory panel has reconsidered the rate on definitive drug testing with the majority vote in support of an increase. The decision is now in the hands of the Secretary of Health and Human Services.

This change could provide a 40% to 50% increase in Medicare reimbursement for the same services that received a significant cut in reimbursement this year. Our network now consist of 103 surgical facilities across 29 states as well as providing anesthesia services to over 45 locations and operating 51 physician practices.

We believe there’s a significant opportunity to grow in existing and new markets, and our pipeline remains robust. I’ll now turn the call over to Teresa, to review the financials for the quarter..

As Mike mentioned, we were very pleased with the continued strong performance of our operations this quarter. Second quarter revenue increased 24.4% to $289.7 million with cases up 10.3%. Same facility revenue increased 14.9% and same facility cases increased 7.9%.

By business segment our surgical facilities revenue increased 21.8% and ancillary services increased 80%. Ancillary services are now approximately 15% of revenues including anesthesia. Adjusted EBITDA increased 19.6% to $46 million compared to $38.5 million in the second quarter 2015.

Last quarter, we discussed the CMS lab rate reduction, which had an adjusted EBITDA margin impact of approximately 1% in this quarter as compared to the prior year. As expected, margins improved over the first quarter this year. Our adjusted EBITDA margin was 15.9% compared with 16.5% last year and 14.4% in the first quarter.

From a segment perspective, the adjusted EBITDA margin at our core surgical facilities increased 50 basis points compared to the prior year to 20.6% in 2016 from 20.1% in 2015. Our surgical facilities continue to benefit from our differentiated model.

As it relates to our ancillary services segment, we continue to focus on the integration of our physician practices and capital investment in the infrastructure associated with this rapidly growing segment.

The adjusted EBITDA margin in this segment reflects the lab rate reduction, along with the growth in our physician practices, which operate at a lower margin. We remain very active on the acquisition front.

We closed on four in-market transactions during the quarter, including the integrated physician practice in Jacksonville, Florida and an ASC in Houston, Texas, representing a new market.

Through the first six months of 2016, we’ve spent approximately $117 million, including $16.6 million of contingent acquisition consideration, of which approximately $109 million occurred in the second quarter. We continue to estimate that our acquisition spend for the full-year will be in the range of $150 million to $160 million.

We ended the quarter with cash and equivalents of $51.6 million and availability of $146.9 million under our revolving credit facility. Net operating cash flow, including operating cash less distributions to non-controlling interest, was $33.9 million for the second quarter.

Free cash flow for the second quarter was $27.6 million as normalized for merger transaction cost of $1.3 million and integration-related capital of $900,000. At the end of the second quarter, our ratio of total debt-to-EBITDA as calculated under the Company’s credit agreement was 6 times.

We expect to end the year with leverage below 6 times and are targeting a ratio of 4.5 times by the end of 2018. Overall, we are very pleased with our results for the quarter. With that, I’d like to turn the call back to Mike to discuss our 2016 outlook..

Thanks, Teresa. It’s been another solid quarter for the business, and we continue to find compelling opportunities for growth. We have a strong network of physicians and facilities. Our expansion pipeline remains full, and we continue to attract new physicians through both recruitment and employment opportunities.

Before moving to the Q&A, I would like to reiterate our 2016 guidance. We expect adjusted EBITDA growth of 16% to 21% or a range of $184 million to $191 million. We expect revenue growth of 14% to 18% or a range of $1.1 billion to $1.4 billion.

Thank you for your interest and support, and let me turn the call back over to the operator to begin the question-and-answer session..

Thank you. The floor is now open for questions. [Operator Instructions] Our first question is coming from Kevin Fischbeck of Bank of America Merrill Lynch. Please proceed with your question..

Great. Thanks. I was wondering if you could talk a little bit about the surgical margins in the quarter. You mentioned that margins grew up due to the performance of your model.

Can you just give more color on what was really driving the year-over-year improvement in margins there?.

Yes. Thanks, Kevin. So one of the drivers is just the overall improvement on a quarter-over-quarter basis, but specifically, we have talked in the first quarter about some pressure we had from the relocation of our hospital at Great Falls and some of the anesthesia-related expenses that occur in the first quarter by nature.

And so we saw improvement in both of these areas as we expected. So when you look at that segment just on a sequential basis, we had about a 280 basis point improvement in our margins, again really as those being improved in the second quarter. So the model continues to drive an increase in surgical cases.

As we focus on in-market development and physician practices, those will continue to have a benefit related to our surgical cases in that segment as well as anesthesia, which falls in that segment..

Okay.

And then I guess on the ancillary side, did you say how much the margins would have over impacted the lab cut in the quarter?.

I don’t think we mentioned in the tax, but if you normalized for kind of the rate reduction overall for the company, it was about 100 basis points related to our adjusted EBITDA margin..

To the consolidated EBITDA margin..

Right. That’s correct..

Okay. And I guess the margin has kind of bounced around the first couple of quarters in ancillary.

What do you think the rate kind of – what do you think about ancillary margins over the medium-term or longer-term are?.

Yes. So I think by the end of the year, we’ll be in the – around the 20% range. Some of the transaction or transition costs we incurred in the second quarter will continue to improve as we move through the rest of the year. So I think we’ll be in probably the18% to 20% range.

And I’ll just take a second just to note that we did transition from an off-income perspective in our segment reporting to adjusted EBITDA. We’ve found precedent other companies presenting in that manner and thought it would be more transparent and more useful to the reader. And so I’m speaking on that adjusted EBITDA basis..

Okay. All right. Great. Thanks..

Thank you. [Operator Instructions] Our next question is coming from Brian Tanquilut of Jefferies. Please proceed with your question..

Hey, good morning. Congratulations guys. So Mike, same-store was very strong during the quarter, and it has been strong.

So as you look forward and say over the next 12 to 18 months, what’s your outlook on organic growth and same-store, number one? And then as I look at the guidance that you just reiterated, it seems like based on the revenues that you’ve delivered for the first half of the year, just annualizing the Q2 numbers gets you above the guidance range.

How should we think about those moving parts? Would you mind just giving us some color on that?.

Yes, maybe starting with the same-store.

Again, we’ve been able to continue the same process we’ve had and as we mentioned during the IPO road show as we went through our first few quarters, post-Symbion deal and integrating our teams, the ability to accelerate and continue to get the momentum from both the combined recruitment team focused, having a dedicated equipment team focusing on bringing not only new physicians but new specialties and new types of procedures to our facilities has been really been performing very well.

On top of that giving us that extra tools to be able to employ physicians is another way that’s been it’s given us that capability. And again, most of the case growth is coming from the ability to bring in new physicians and new types of specialty, new types of procedures to our facility.

But there’s also some also being enhanced slightly by the ability to employ the physicians. So from a same facility perspective, we continue to see our target lists, our pipeline from a recruitment perspective, the number of locations where we can continue to increase the acuity of procedures and also just a number of those higher acuity procedures.

Again, we’re in the early stages of that. We seem to have a lot of running room there. So that will continue and again focusing – there’ll be some fluctuation between case and rate just depending on the types of specialties we’re recruiting, but again the strong, strong pipeline and strong future on that piece of it.

On the other side of the - looking at the revenue side of guidance, we continue to have a – it will depend on the mix of acquisitions as we continue to go forward.

As you know, the physician practices will have a lower margins so that revenue will convert to, just by the nature of the business, convert to less on the margin perspective and we’ll also – we continue to have, as we bring on new physician practices, our mature practices continue to perform very well, whereas our new practices have that transition period where we’re bringing them over, we have overlapping providers.

We are doing some integration work and transition work on these practices, combining physical plants, bringing them into new physical plants, adding marketing, adding ancillary services and converting ancillary services. And there has been a little bit of softer practice volume.

So that piece of it should get more clarity as the year continues, but I think from a guidance perspective, we are just – we’re comfortable on holding where we are, although we are on a little bit of that - on the high side, from a revenue perspective, we’ll continue to see improvement in that ancillary division..

Got it. I will jump back in the queue. Thanks Mike..

Thank you. Our next question is coming from Ralph Giacobbe of Citi. Please proceed with your question..

Thanks good morning. You mentioned the potential lab increase for next year of 40% to 50%. I guess is that determined already? Or help us with the next steps to getting visibility on that. And then just around the math of it.

If it was in the $11 million, $12 million hit this year, is it basically getting about half of it back next year? Is that how we should think about it?.

I think, yes, you’ve answered the question to that. So we’ll get 40% to 50% of it back. There’s still a little bit out there. So what we’re looking for is, we’ve had the advisory panel has had a positive reception and really the approval is now with Secretary of Health and Human Services.

And the word is that that’s unlikely that that’ll be a significant change from what’s been recommended. I think as we’ve talked about on our earlier calls, the cuts were greater than expected, significantly greater than expected although it didn’t change our strategy.

And I think what they’ve done is they’ve taken a look at it and understood that this is an important piece of the continuum of care that needs to be provided in these types of services. And looking at that 40% to 50% improvement from where we are today, it feels appropriate.

Again, we think there continues to be a room, but we’ll be pleased to have about 40% to 50% of that back..

Okay, great. One more if I could. You mentioned also in the call a growing interest in ortho. You talked about sort of expanding that out to 23 of your facilities. I am assuming growing interest meaning from the payer side.

I guess just help us in terms of maybe what payers are doing to potentially push that volume or help us understand the conversations you are having there to capture that category? Thanks..

As I mentioned in last quarter’s call, we have begun the strategic relationships with the payers more on a contracting basis and focusing on how can we bring things that are traditionally done on the hospital setting into the outpatient setting and obviously, total joints that are associated with orthopedics are really a key focus for the payers currently.

We have a significant ability to coordinate care on an outpatient basis through our surgical facility, our anesthesia, our vendors and our physicians to coordinate that care and provide appropriate post-op care and follow-up with the physicians in their office.

So they really see that as an opportunity to begin with their commercial patients and find ways to have us do those for the appropriate patients on an outpatient basis. Again, early stages for that both from a physician perspective and a payer perspective but continue to get a lot of traction there.

Our focus is really working with the physicians and ensuring that the clinical protocols are in place at our surgical facilities we’re not only being able to perform the procedure, which is we are very, very capable of and have the capabilities that many of our facilities to do that.

But it’s the post-op care and ensuring that we have that coordinated not only with the physician and the patient but also the vendors.

So I think we’ll continue to see focus and growth there and we have a very focused program on how do we systematically work through facility-by-facility and capture those opportunities both from a payer and physician perspective..

Okay. Thank you..

Thanks. Good question..

Thank you. Our next question is coming from Frank Morgan of RBC Capital Markets. Please proceed with your question..

Good morning. I was hoping to get a little bit of color around the case growth throughout the months of the quarter and maybe if you could also parse out was any of that impacted by these newer higher acuity procedures that you are talking about? Is that far enough along to have an impact? That would be my first question..

Yes. From a growth perspective, I mean, it’s very difficult to go to a facility-by-facility and parse out specialty-by-specialty and then within that specialty, the case mix of how much it’s higher acuity.

I think what we’ve looked at from an overall basis is that we have a combination of strong case growth and strong revenue growth; those are usually associated with some upticks in the higher acuity cases.

But difficult to parse that out as you have a portfolio of facilities with multiple specialties and then a pretty diverse case volume within those specialties.

The way we approach the growth and case growth specifically is, really, if we have capacity in the facility, we would like to bring in the appropriate, the appropriate specialties and the appropriate physicians that can bring cases to that center.

So we’re somewhat indiscriminate on the types of cases we bring, but understanding that the relationships that we have with orthopedic surgeons and people that do higher acuity cases have the ability to bring in and bring new relationships to those facilities..

In terms of just volumes across the months of the quarter, and maybe some – if there’s any geographical commentary about any color how volume transferred from a geographic perspective? Thanks..

Yes. From a geographic perspective, it’s been pretty consistent. As we look on a national basis, state-by-state and even market-by-market, we see continued performance in mostly in our multi-specialty. As we look at our single specialty in smaller markets, we see less growth there.

But it’s usually a single practice group of physicians with ASC and oftentimes being single specialty limits your ability to recruit into those.

Although, we’ve seen many of those, that we’ve been able to convert to multi-specialty or bring in new providers in the market, but for the most part, we see pretty consistent growth in our multi-specialty facilities..

And just what progression in most of the quarter and should we expect any softness going into the third quarter seasonally? Thanks..

I mean, typically, as the quarter goes, we’ll have a strong month, a softer month and one that kind of falls in the middle. And that’s pretty typical with each quarter. I think July is off to a little bit of a soft start, but that’s not unusual for the third quarter..

Okay. Thanks..

Thank you. Our next question is coming from Matthew Borsch of Goldman Sachs. Please proceed with your question..

Hi. This is [Tejus Ujjani] on for Matt. Thanks for taking the question. Just to go back to the organic trends a little bit more on the pricing side. The same-store pricing was much stronger compared to first quarter.

Can you give us a sense of how much of this was just from simply higher price cases versus actual cross-selling of anesthesia?.

Yes.

We saw in the first quarter and we talked about this, it was kind of unusual that our cases drove 11.6% of our 13.3% same-facility revenue growth in the first quarter, really think it was attributed to just a higher growth in the quarter related to lower-acuity cases, which you would see that with the pressure on co-pays and deductibles all that kind of makes sense.

But we did speak to in the first quarter, we thought same-facility revenue growth would normalize to be a more even split between cases and net revenue per case, which we saw in the second quarter and is consistent with our historical results.

And so embedded in that net revenue per case is really where you see the pricing, the acuity and the ancillary services, which are all reflected in that component of the same-facility revenue growth and then also obviously cases to get the total revenue growth for the quarter.

So it kind of normalized as we thought it would to more of an even split, and we’re seeing pricing continue to be consistent. We’re seeing our ancillary services continue to benefit in terms of our same-facility growth. And then obviously, acuity is playing a role as well..

Great. Thanks very much..

Thank you. Our next question is coming from John Ransom of Raymond James Financial. Please proceed with your question..

Hi, good morning. So I think initially, your guidance, you’re $150 million to $160 million of acquisition spend was around $30 million of acquired EBITDA.

Is that still a good number?.

Yes. That’s still – we’re still on track to achieve that. We’ve acquired roughly $18 million with the transactions completed today and realized about the $11 million to $12 million. So we’re still on track as it relates to that acquired EBITDA embedded in our guidance based on timing. It’s about 50% of that, but yes, we are still on track.

It’s still a good number..

So that would imply the remaining spend would be at a pretty low multiple then like two, three times?.

Well, I think really as you look at this contingent consideration piece of the equation, that’s about $17 million. So if we set that aside that the cash for the next three years, use of cash for the next three years, we would have a little bit more room with that $150 million to $160 million..

I got you.

And what’s the mix in that spend of practice acquisitions versus ASCs? And what’s your thought about timing for the rest? Or is the remaining spend going to be mostly back-end weighted towards the end of the fourth quarter? Or should there be some incremental contribution this year?.

We’re looking at some incremental contribution this year, but obviously, the timing is sensitive as you roll into the last half of the year..

Right..

The spend so far has been more heavily weighted towards physician practices with a transaction in Jacksonville kind of being a large platform transaction for us in that market. And then the ASC in Houston was – it’s really our focus in terms of a stand-alone ASC in a new market. So that spend is pretty much just related to Houston.

But total spend, we’re heavily weighted towards the physician practices..

And for the balance of the year, is it going to be more ASC weighted?.

The pipeline is extremely active and there’s a lot of opportunities on both of those fronts and so it really will depend on just how quickly we can execute and bring one of them across the finish line. So it’s a mix in our pipeline, and so it’s a pretty balanced pipeline..

Okay. I’ll jump back in queue. Thanks..

All right. Thanks, John..

Thank you. Our next question is coming from Brian Tanquilut of Jefferies. Please proceed with your question..

Hey, guys. Thanks for taking the follow-up. Teresa, just on bad debt. It was below 2% of revenue. It’s been that way for the last few quarters.

Just wanted to ask you how we should be modeling that going forward?.

Yes. We are very pleased with the bad debt. Our results in the second quarter is 1.2%. I’d like to think that, that can continue. But if I were to model, I’m usually in that 2.5% range. That’s usually a more normalized approach to bad debt expense, 2.5% to 3%. But we have had great success of this year in terms of our overall bad debt and managing our AR.

So from modeling purposes, again, we’re pleased with our results, but I think that 2.5% is pretty consistent with our historical results..

Got it. And then last follow-up for me.

On the G&A side, it was up sequentially even if you adjust for the contingent acquisition charge? How should we think about that run rating for the back half of this year?.

Yes. So we had – the two things you mentioned, just to be clear, the contingent acquisition consideration is now amortized, and that is a change this quarter. There’s about $1.5 million included in corporate G&A as we noted on the face of the financials.

We also had a little bit of increase in non-cash stock compensation expense with equity changes this year and so that increased just a little bit. That rolls into corporate G&A, but I think it’ll be consistent. If you normalized for those things, we’re at 4.5% of revenue, and I would expect that to stay in that range..

All right. Got it. Thanks guys..

Thanks..

Thanks..

Thank you. Our next question is coming from Bill Sutherland of Emerging Growth Equities. Please proceed with your question..

Thanks. Good morning. Where do things stand with the Symbion synergies year-to-date? I think you were targeting something around $10 million for the year..

Yes. I think from a synergy perspective, we are there on what we expected to get for the year. As we break into the cost synergies versus our revenue synergies, we continue to make progress from a revenue perspective. Ancillary services, now about 15% of our total revenues, which is where we expected to be by the end of the year 2016.

From the cost perspective, that piece of it has been done and continue to realize it in the run rate of the $15 million that we expected..

Great. And if I could just sneak in a follow-up. The Texas market, Mike, and your move into Houston, maybe you can just give us some color on what you think of the possibilities in that market for you? Thanks..

That continues to be an active market. So this was our first step into this market. And our feeling was, in order to come into this market, we want to make sure that we can have the ability to bring in multiple service lines and we’re able to do that with this acquisition. So Houston appears to be a good market. It started very well for us.

Again, that market has and the ability to partner with a Health System in that market is really something that brings along the capabilities for success. And as we’ve seen in different markets in Texas, there’s a different market-by-market. There’s a different assessment.

And in this market, our best – our thought process, the best way to enter was with a Health System partner..

Great. Thanks again..

You are welcome. Thanks..

Thank you. Our next question is coming from John Ransom of Raymond James Financial. Please proceed with your question..

Hi. Going back to your acquisition. Is that – the requisite question for the call, so was this a hit to EBITDA that wasn’t contemplated originally in guidance? Or was this contemplated? Was this a change that happened? I just wasn’t clear. Sorry..

Can you ask that one more time, John?.

So you talked about the acquisition amortization going through corporate G&A.

Is that something that was different than what you thought about in guidance?.

Yes..

I’m just not clear about the accounting. Sorry..

Yes. So from a deal perspective, basically, it’s a great deal for us in terms of business transaction where we have the physicians tied into the business over the next 30 years based on their employment and continued employment. So from a business perspective, it makes perfect sense, gives us an enhanced protection related to our physicians.

It just happens to have poor accounting treatment. So basically, you’re just amortizing part of the purchase price. And you’ll amortize that over the next three years, which matches the term of their employment. So good business decision, bad accounting treatment, but....

So it’s not part of DNA then as an expense? I thought this will sort of be through DNA?.

No. It’s a contingent acquisition consideration. We’ve got some comps that we look at team house is one of those, and you can see it clearly on their income statement. And so there’s some other pretty notable comps that have the same issue. So, anyway, again, a good business decision for us, just poor accounting treatment..

And then the other thing, to go back to labor margin, I know you guys are looking for some, what, a couple of 100 basis points sequential improvement by the end of the year.

As we think about 2017, is there further improvement expected? I think it’s around 30% for the back half, but should that continue to get better? Is that going to be kind of a level set based on your current mix of business?.

Yes. I think it’s really as our mix of business continues to shift towards anesthesia and physician practices, we’ll see that, and we’ll pretty much stay in that 30% range. As you look at the income statement, the kind of the offset has been supplies where those lines of business have higher salary-related cost, but very little supply.

So that’s kind of that mix you’re seeing there in terms of the line items as a percent of revenue..

Okay. Thank you..

Thanks. End of Q&A.

Thank you. At this time, I’d like to turn the floor back over to Mr. Doyle for any additional or closing comments..

Thanks, operator. I appreciate everyone joining us today. Again, a good quarter, we’re pleased with the results, and we look forward to catching up with everybody following the third quarter and appreciate the support. Thanks..

Ladies and gentlemen, thank you for your participation. This concludes today’s teleconference. You may disconnect your lines at this time. And have a wonderful day..