Thank you for standing by. This is the conference operator. Welcome to the Surgery Partners, Inc. Third Quarter 2018 Earnings Call. As a reminder, all participants are in listen-only mode, and the conference is being recorded. [Operator Instructions] I would now like to turn the conference over to Tom Cowhey, Chief Financial Officer. Please go ahead.

Good morning, and welcome to Surgery Partners' third quarter 2018 earnings call. This is Tom Cowhey, Chief Financial Officer. Joining me today is Wayne DeVeydt, Surgery Partners' Chief Executive Officer. As a reminder, during this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in this morning's press release and the reports we filed with the SEC. The company does not undertake any duty to update such forward-looking statements. Additionally, during today's call, the company will discuss certain 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 these measures can be found in our earnings release, which is posted on our Web site at surgerypartners.com and in our most recent quarterly report, when filed. With that, I'll turn the call over to Wayne. Wayne?

Good morning. Thank you, Tom, and thank you all for joining us today. We have a lot to cover this morning. I would like to start by reviewing some highlights from the quarter and then provide an update regarding the progress we've been making in building our foundational platform and executing on our key strategic initiatives to position Surgery Partners for sustainable long-term growth. I will then turn the call over to Tom to discuss the financial results in greater detail. Starting with the quarter, this morning we reported third quarter 2018 revenues, a $443.9 million and adjusted EBITDA of $59 million, each representing strong year-over-year growth, primarily as a result of the acquisition of National Surgical Healthcare in August of last year, along with early results from our strategic initiatives that continue to take hold. As we look deeper into the quarter, surgical case volume and revenue grew by 13.9% and 44.9%, respectively over the prior year period. Same-store revenue increased by 11.4% from the prior year quarter, sequentially, adjusted EBITDA margins improved by 80 basis points to 13.3%, and our private payer mix remains consistent with our prior quarter. These trends continue to be encouraging, and I'm pleased with the progress that our team and organization have made this year across a wide array of high-value, but complicated initiatives. I'm especially encouraged that our positive trends in same-store growth, and accordingly, we are increasing our revenue guidance for the full year 2018 to a range of $1.75 billion to $1.8 billion. That being said, while our success to date has increased my confidence that we have the right people and assets to drive meaningful, long-term growth, we made the decision to take a more conservative posture on our full year profit outlook and modified our projection from greater…

Thank you, Wayne. Today I'll spend a few minutes on our third quarter and year-to-date 2018 financial performance starting with some of our key revenue drivers, then moving on to adjusted EBITDA and finally, some updates on cash flows. Our third quarter revenue of $443.9 million reflects a 45% increase over the prior year quarter, primarily as a result of the acquisition of National Surgical Healthcare in the third quarter of 2017. As a reminder, prior year results were impacted by a $15.6 million reserve adjustment book to revenue in the third quarter of 2017 and also suffered from the impacts of hurricanes on our operations, which were estimated to have lowered revenues by approximately $8 million in over 2,800 cases. We have not normalized our results this quarter for the impact of hurricanes, nor are we normalizing any prior quarter comparisons, unless specifically noted. Surgical cases increased to approximately 127,000 in the quarter, which is a slight increase over the prior year period. As a reminder, we typically experience our lowest-case volume in the third quarter of each year. On a same-store basis, total company revenue was up 11.4% from the prior year quarter, consisting of a 10.5% increase in net revenue per case and a 0.9% increase in case volume. Year-to-date, our same-store revenue is now up 4.6%, driven by higher net revenue per case. Note that consistent with past practice, our same-store calculations are inclusive of revenues associated with our ancillary services business, which experienced higher revenue when compared to the prior year periods. As Wayne mentioned previously, our strategic initiatives around physician recruitment are taking hold, which has been a key driver of our improving case volume. As a reminder, we've focused on getting the right docs in the right facilities rather than simply increasing our…

We will now begin the question-and-answer session. [Operator Instructions] First question is from Ana Gupte of Leerink Partners. Please go ahead.

Good quarter, thank you. The first question was just on the pricing growth, which has impacted a lot. How long is this expected to continue? You say it's about acuity and it sounds like your mix -- pay mix is the same, but maybe your contract negotiations are proceeding well. How should we think about the fourth quarter and into next year?

Ana, thanks for the question. So if you think about the organic growth engine, there's two key components, one being the case volume, which we are very encouraged with those results, and obviously while October, we just got a flash report on that, those trends do continue to be strong, even stronger than we posted year-to-date in terms of the trajectory. So we think we're moving that in the right direction. But the other component is clearly on the revenue piece. If you look at our contracts, in general, they have renewals around three years, which is fairly typical for most contracts that we know from our experience in the managed-care side. And so as a result, you think about -- you get about 1/3 of your renewals happening each year. In the current year, for those that did renew, we actually were able to renew them at rates higher than our targeted range, which is very encouraging, along with a kicker in the out years that is commensurate with our targeted range that we know get a nice inflationary multiple. But we've got 2/3 of the book that is still subject to the historical contracts, and those have historically been below that targeted range. All this being said, you'll see kind of a continual ramp-up. So, you'll start to see some of that value creation incrementally occur next year. By mid next year, you end up getting about half of those now renegotiated, and then by the following year, you've got almost all of them through the cycle. So if we can continue the current trends, we should easily be able to be at the upper end of that targeted range, if not better.

Should we, for the next year, think about the second half of the year, the 1/3 of those contracts that you negotiated, annualizing for the full year, and then the remainder the other 2/3 of seeing the ramp-up so maybe, kind of, mid-single digit pricing growth instead of the 3% that you've guided.

The only thing I would caution on, as you know, is that we have a substantial government book in there as well, and obviously government falls below that percentage. So if you think about commercial being more mid-single digit, using a midyear convention, that's not unreasonable of where we're heading on the commercial book. But then you had average in the government, although we are pleased with the recent CMS rates around Medicare and how they're going to basically treat ASCs in that process, and so that will actually improve a little bit as well. So blending in though, I think we'll definitely be in the targeted range by next year with the buyers towards the higher end of that range. And then, of course, from there, we'd like to see that ramp-up. Going into 2020, you start getting more full run rate benefit of 2/3 of the book being renewed with that remaining book, kind of, midyear convention in 2020.

Great, thanks, Wayne. I appreciate the color.

The next question is from Kevin Fischbeck, Bank of America Merrill Lynch. Please go ahead.

Great, thanks. Just wanted to follow up on your comment, I think you said that you expect to get back to double-digit EBITDA growth in 2019. Just wanted to make sure I understood that. Is that correct? And if so, is that half of this 2018 guidance? Or is that, kind of, on a normalized number depending on how much you end up putting the portfolio and it's kind of a same-store number that we might see company-wide number a little bit less than that.

Yes, Kevin, good morning thanks for the question. Let me start by saying that what we try to lay out in our prepared remarks was the long-term growth framework. And so while we're not giving 2019 guidance yet, and we don't want to get ahead of our board, I would say all those components of the framework we fully expect to achieve, not only over the long term, but we expect those to start in '19. So while I think -- again, I don't want to get ahead of our budget process or our board in this process, I think our words in the script are intentional that we do believe will be double-digit growth next year.

Okay. And then when we think about the three things that caused you to take down Q4, maybe just provide a little bit more color into each of them. And you said the seasonality didn't come in the way that you have forecasted, is there something that you're seeing in the business that now makes you less comfortable about? It sounds that you had some pretty positive commentary on October as far as the pruning efforts, do -- are you saying that there's, kind of, an acceleration than what you had previously? And then, I guess, continued growth investments, again, is that an acceleration in that, that made you think differently about the guidance today versus what you thought Q4 might look like when you provided guidance previously?

Yes, yes. So let me break it into two buckets. If you would look at the change in guidance, I would break the first bucket as about 70% of it, it's just being cautious in the outlook. We have no reasons to believe at this point in time that we may not hit our payer mix or our acuity mix at this point in time. I don't have my October revenue yet and yesterday was only day 4, but we do have our case volume reports and those are quite strong versus our expectation. So my only comment, I would say, is that having strong case volume but not having the detail behind case mix yet is one that I wanted to maintain a cautious posture. The reasons for the cautious posture, this was my decision, I will tell you that, was that two reasons. One is, I'm new to this sector, and when you have 1/3 of your earnings all ramping up in one quarter, it's a little bit like retail, it's kind of like well is it happening, is it not happening. And while the case volume is there, the mix is important. And as you know, we've been pruning the asset and then investing in recruitment into these higher-dollar, high-equity procedures such as MSK. And so for me it's more just the newness to the sector and maintaining that cautious posture. And two is, what isn't new to me is the payer environment, and I've seen the strength that payers have posted for the first nine months of this year, and their [indiscernible] and the question is, is that the deductible issues that are occurring because of the high deductible. And what we see that impact the fact that many of our procedures are elective in nature and will that directly affect our higher-acuity procedures in Q4. As of today, I don't have reasons that would create concern, but I am being intensely cautious and that's about 70% of the outlook change. The other 30%, I'll let Tom go ahead and comment on, but it is around accelerating some of our pruning as well as some of the other items, but Tom?

Yes, Kevin, the other thing I would just point out, as you look at the fourth quarter, it assumes an uptick in volumes, and we're encouraged by what we've seen in October. But you have to see the corresponding increase in, essentially EBITDA per case, right? And that jump, as we looked at it, was pretty steep. And so -- and it was steep -- it's a little bit steeper than last year, which feels right, given the change in the business that has happened in our focus, but it really reflects a cautious outlook as we look at that ramp over the fourth quarter, it feels like we're half that is a little bit too far, which is why we pulled it back in the quarter. Time will tell whether or not, we're being a little too cautious on that. As you look at the rest of the guidance change, this is a seasonal business, and we've made some pruning efforts throughout the year. And so you would expect that the impact of those efforts would be the greatest in the fourth quarter. And beyond that, we have some underperforming assets that we're evaluating alternatives for. And as we looked at those and what we thought that they were going to contribute in the fourth quarter, it was clear to us that, that wasn't going to be achieved as well. But I think that some of that is partially offset by the acquisitions that we've actually just done, and some of that -- and then the -- kind of the last thing that's in there is, we do have a little bit of investment in staff as we, kind of, transition some of our business from Chicago, as we try to work on some of our internal control environment, as we think about eliminating the material weaknesses that we've had in our controls over the course of the last couple of years. And also, we're thinking about adding some additional staff in physician recruiting because we've seen such fabulous returns from that year-to-date. So as we looked at the mix of all those things, I'd say, Wayne's -- I'm completely concur with Wayne on how to think about the relativity of these. It's mostly about the cautious posture, given the ramp in the fourth quarter, but there were some other specific items that made us think that perhaps it was prudent to pull down the guidance at this point.

Okay, thanks.

[Operator Instructions] The next question is from Chad Vanacore with Stifel. Please go ahead.

Good morning all.

Good morning.

Good morning, Chad.

All right. So just thinking about your acquisition targets for the year, you opted for the high end of the range, $100 million from the EBITDA, $100 million that you laid out. How much of that did you -- say you completed year-to-date, was that $50 million?

Yes, so through the third quarter, we have completed $50 million. Recently -- as recent as last week, we actually were able to deploy an additional $50 million on three acquisitions that we're quite excited about. So our goal, Chad, is to get those integrated over the next couple of months, and then we should start seeing the full run rate benefits of those acquisitions as we go into next year. So we should -- our confidence in the 3% to 5% growth from M&A is high at this point. Now we still have to be able to continue to deploy throughout next, but the pipeline's been rebuilt, and we've got some pretty interesting prospects that we're working with right now.

Chad, when you get the Q, I think year-to-date number, we did one small deal in fact in the number, it's actually going to be $55 million, it will be in the cash flow statement.

Okay, all right. On those acquisitions, should we expect that maybe margins are little bit lower than your core portfolio if that ramp-up over times, is that the right way to think about them?

Yes, you get a little bit of that initial integration cost that we're trying to do. We'll get them on our platform. So you get the margins tapped down a little bit. It takes us good two to three months to get them integrated just into the SP strategic operations. And then you get a little bit more ramp-up in as the year progresses as we start migrating into our new purchasing platforms that we have and the value creation there. And then we start introducing to them our physician recruiting team, which then start creating even more, kind of, margin performance because then we get fixed cost leverage off the facility as you bring in new docs, new procedures.

All right. And then just on the disposition side. Year-to-date, how many more divestitures you plan through the year? I think you might have had an additional two practices and three ASCs that you disposed of this quarter?

Three optical businesses -- two of the three optical businesses; the third, we've continued to explore alternatives on and hope to execute on that in the near term, but M&A is obviously fickle. And then we also talked about there are some other items that we're evaluating alternatives for that are underperforming relative to our expectations.

I think, Chad, the one thing I would highlight is, I think every year good businesses look at their asset base for regular pruning and then how to redeploy in the high-growth businesses. I think it's very fair to say that in 2018, as we joined the company and the fact that this company was built over 20 years of acquisitions, but there were substantially more than normal pruning required, so we've been fairly aggressive in that to date with roughly 19 clinics to date. Obviously we said, we've got almost five ASCs to date, and of course, we've got two of the three optical businesses now sold, which we're very encouraged by and look to prune the remaining asset. And so I think the heavy-lift pruning has happened this year. I think it'll -- there'll be -- there'll still be some trail off on, what I call, the more than normal probably between now and second quarter. But I think we're getting to the end of where we want to be on that.

The next question is from Brian Tanquilut with Jefferies. Please go ahead.

Good morning.

Good morning, guys. Wayne, just going back to your comments about long-term organic growth, how do I balance that with idea that you are going higher acuity, you're doing a lot more development in MSK, which typically have longer surgical times, right? So as I think about that 2% to 3% volume outlook, and then also the track record that we've seen over the last four or five quarters, I mean, how do you -- where do you get the confidence that we can get to the 2% to 3% volume range?

Brian, thanks for the question. It's actually a quite intuitive question, we've asked it as well. Now let me start to by the fact and if you look at the history of the company, there was a fair amount of investments in, what I would call, pain over time. And as you know, with pain came many procedures, including injectables that recur, we have been shying away from that meaningfully in our rebuild of it, and so that creates a pretty heavy headwind on case flow. But just to give you an example of how that's translating, fairly our case volume that we reported for the quarter is inclusive of that headwind as we move from those into these higher-dollar, higher-cost procedures. While the procedures take more time, the direct contribution on a per minute in dollars is better than what we could make before as we look at our business shift and what we're doing. So we look at how do we use our surgical space in the most optimal way possible, we think this is the right strategy. What's kind of an interesting sight would be, if you would actually look at our same store, it's actually performed well in the quarter versus, kind of, how we're trying to regrow the growth. October has continued that trend much better than what we've seen so far. But in the quarter, this is a point of reference, where we had heavy, kind of what I'll call, low-dollar, but high-margin procedures, injectables et cetera, in that particular market, we actually had volume declination which, of course, is offset by other markets around the countries. But we actually outperformed our revenue expectations and outperformed our EBITDA expectations. And so there is going to be this dynamic shift in how you measure case volume in the shorter term. I expect that shift to continue between now and first half of next year, but we did a pretty heavy load of it this year. And so I'd like to see that we're going to start seeing same-store growth, actual same-store growth happening each quarter from this point forward. And I actually expect that with that you'll actually start to see the margin improvement begin to occur in early next year. And you'll actually see the actual dollar value of these longer-time procedures, but higher DCM per minute.

That makes a lot of sense. My follow-up, Wayne, just to that last part of your comment too. As I think about EBITDA margins and all the puts and takes and the efforts that you've put into improve efficiencies and do integration work, where do you think margins could go over time? Like what's the optimal margin target for all the initiatives that you've put in place through 2018?

Brian, I wish I could tell you that answer today. I don't -- honestly, I don't know it yet. One of the things I've been discussing with the board has been opportunities where I think we can invest some of our overperformance along the way. The board has been very supportive of those decisions to date, which is why they've allowed us to actually ramp up even more recruiters in the fourth quarter this year than we had originally budgeted or planned for. So one of the things I'm trying to figure out is when do we hit that curve, if you will, where you no longer get the [indiscernible], but you maximize those margins. But I think we should see in the next couple of years a few points, two or three points of just absolute improvement of things. I would say, we have high confidence in, and then the question is, do you reinvest above that back into the business for even longer-term growth? We have a very good pipeline point of view of the next three years, and those frameworks we gave on long-term growth, we think over the three-year period, we ought to build a bias towards the higher end of that range during that time frame. And then the only question is to the extent that we exceed that do we redeploy it. So Tom, I don't know if you want to expand of that?

No, I think that what you've said -- I agree with what you've said. I think the -- I would point out there's two dynamics here, right? The first would be that as we shift the business towards the higher proportion of MSK that the -- those businesses and those procedures inherently have the implant cost that we get passed through, and so we've talked about this a lot. And so as you shift the business into that higher-dollar, higher-implant business, and then you see that business, which is actually supposed to grow in that targeted market actually faster than the overall business. That actually is going to put pressure on the gross margins, if you want to think of them that way because of that shift that's inherent to both, our growth strategy and where we're targeting growth, but also where we're naturally going to see more growth. Offsetting that is going to be some of the things that we're doing, specifically in that fit-for-growth bucket, right? As you think about some of those initiatives there, though should drop to the bottom line and help to improve the overall margins, and it's going to be the, kind of, the combination of the two that, I would say, margin should continue to go up over time from where we are today. But there's going to be a little bit of a natural fight between those two line items.

I appreciate that. Thanks, guys.

Thanks, Brian.

[Operator Instructions] The next question is from Bill Sutherland with The Benchmark Company. Please go ahead.

Hey, thanks, good morning guys. Hey, Wayne, I might have missed some of this discussion, but maybe an update on your efforts on payer alignment and initiatives there?

Good morning, Bill. I'm very excited about our efforts to date on payer alignment. I would bucket it into a couple of different categories. One is, we've been exploring, what I would call, some nontraditional partnerships with a number of both national carriers and we're also getting some good -- we're getting some good tailwinds in terms of local blues that, I would call, kind of, mono state blues that are not part of the national carrier programs. So these are -- as I mentioned even in the first quarter call, this is, kind of, long ball on these things. These are long digestive periods that you, kind of, work through the strategies and what you're going to be moving forward. But on the strategic partnerships in that -- this first bucket, we've been really encouraged, not only at the meetings we've had to date and some of the strategies we're working on, but what probably the more encouraging has been the pre-backward getting about more and more authorities wanting to actually meet with us to discuss some of this creative. I actually spent Monday night in a blue state with the CEO and their head of managed care around some meeting partnership opportunities. And candidly, I will tell you, they all recognize in their markets where they need leverage and they don't have it, and they recognize that our product is a high-value, high-patient satisfaction, great clinical quality leverage point. And so we're looking at not only ways to actually take joint ownership in some facilities together right now or some of the payers, but other ways. Another bucket I would highlight is around bundling, and we made a very good progress in a couple of our markets with two large national carriers, and we've been very specific in…

So Wayne, your -- is there a risk component to the bundling that you're talking about, particularly in Florida and California?

No, great, great question. So today there's really not a risk component, because what we've done is we've been able to negotiate new bundles at rates that are much higher than we would have gotten before, meaningfully higher in one case as much as 5x higher than what we received before, but substantially less cost than what they paid today in the hospital environment. And so for us, the idea that we're able to move these over what we've done is created bundling that is specific to the procedure and the day. So in essence, we get a flat fee. We need to essentially cover anesthesia with that, but nothing of any consequence that isn't difficult to manage, and that's what we have today. So that really take the prof fee out, pay the anesthetists, pay our surgeons and then the rest goes to facility. What we are exploring is whether or not we want to take risk over time on an even enhanced bundle that goes over a 90-day window. And in that case, we would mitigate our risk, in theory, by working with the right partner to basically take our fees of the top, because, again, we don't want to expand the outlook we're great at, and then allow another partner who is great at something else, which would be that post-rehab care to take that portion of the bundle. That is our -- I would call, our innovative next step that we're looking at doing.

Great, thanks a lot for the color.

This concludes the question-and-answer session. I would like to turn the conference back over to Wayne DeVeydt, Chief Executive Officer of Surgery Partners, for any closing remarks.

Great, thank you. Before we conclude our call, I do want to take a moment to say thank you to the 10,000-plus associates for their contribution. This year has been a very heavy lift for the team, and I know we all feel privileged to be able to participate in this journey of improving health care and making it more affordable to Americans. As we execute against our goal to become the preferred partner for operating short-stay surgical facilities across the U.S., it is the daily efforts of each and every Surgery Partners employee that will get us there. Thank you for joining our call this morning, and have a great day.

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.