FORT WORTH, Texas--(BUSINESS WIRE)--A fund affiliated with Q Investments, L.P. today issued a letter to the Board of Quorum Health Corporation (NYSE: QHC) (“Quorum”), urging the Board to conduct an independent investigation of the conduct of Quorum management and the management team of Community Health Systems, Inc. (NYSE: CYH) (“Community Health”) regarding disturbing and potentially unlawful financial projections related to the spin-off of Quorum from Community Health. In the letter, Q Investments outlines a clear fact pattern that it believes indicates Community Health management was aware of or in direct control of key factors impacting Quorum’s financial performance and either did not reveal these costs or knowingly misrepresented them to investors. Q Investments expects the Quorum Board to conduct a complete investigation of the issues raised, report the findings to investors and take the appropriate legal action against Community Health and all those liable for the massive destruction of shareholder value these actions have created.
A copy of the letter, sent to Quorum on October 12, 2016, is included below:
October 12, 2016
The Board of Directors
Quorum Health Corporation
1573 Mallory
Lane, Suite 100
Brentwood, Tennessee 37027
Dear Ladies and Gentlemen:
As one of the largest bondholders and shareholders of Quorum Health Corporation (“Quorum”) when Quorum shocked the market with its abysmal second quarter earnings and slashed its financial guidance, we write to you today to draw attention to the troubling actions which we think led to this massive destruction in stakeholder value. Only a few months after Community Health Systems, Inc. (“Community Health”) spun-off Quorum, the unprecedented miss in earnings caused bond prices to tumble and the stock price to be cut in half. For reference, in June 2016, we owned $50 million of bonds and 1.3 million shares of stock.
Specifically, we write you to bring to your attention disturbing and potentially unlawful behavior surrounding the initial guidance used to market Quorum to new investors. Consistent with your fiduciary duties to shareholders, we believe that a special litigation committee should conduct an independent investigation of the conduct of both your management team and the management team of Community Health with regard to the Quorum spin-off. As detailed below, we believe Community Health knew that the EBITDA guidance provided to investors was wrong. The conduct of Quorum’s management team also raises questions whether they were complicit in the possible fraud. This potential deception has cost your stakeholders, including us, deeply. The conduct has already given rise to potential class actions against Quorum, and we would think that the SEC may conduct its own investigation. In the face of such judicial and regulatory scrutiny, we think it is in the board’s best interest to conduct an independent investigation, providing disclosure to investors as to the outcome of this investigation.
You are well acquainted with the peculiar saga of Community Health’s spin-off of Quorum. On August 10, 2016, less than four months after the spin-off from Community Health, Quorum reported second quarter earnings in which it cut 2016 guidance from a midpoint of $270 million of EBITDA to a midpoint of $187.5 million. Community Health first provided EBITDA guidance to potential Quorum investors on March 22, 2016, and then specifically used this inflated guidance to both market Quorum’s over $1.2 billion of primary debt financings in April 2016 and also attract new Quorum equity investors in May 2016. This surprise reduction in guidance of over 30%, or $82.5MM in EBITDA, resulted in a staggering stock price drop of 50% on the day after the earnings announcement.
We understand that positive and negative surprises are a regular characteristic of investing. Companies miss guidance all the time because of slower than expected volumes or unexpected increases in costs. While this may lead to shareholder frustration, both items are realistically outside the ability of management to predict.
What makes this case so unusual is that Community Health’s management team, who prepared all of the guidance for Quorum as a standalone entity, likely had to have known about the increased cost --- because, in fact, they were the ones charging Quorum for those very costs. And yet, Community Health’s management team failed to properly disclose these higher costs in the financial model they developed. This financial model was the key marketing document provided to investors to attract interest in the new securities.
There clearly appears to have been pressure on Community Health to inflate projections so it could raise as much financing as possible. Since announcing its intention to spin-off Quorum on August 3, 2015, Community Health’s stock price collapsed under the weight of its over-leveraged balance sheet that had over $18 billion in debt. By February 2016, Community Health’s share price had fallen from nearly $50 to below $15. Quorum served as an easy avenue for the desperate company to raise much needed cash to help pay down its debts, and it used Quorum as a vehicle to raise over $1.2 billion of debt, which Community Health then used to fund a $1.2 billion dividend back to itself. Undeniably, the better Community Health’s management team made Quorum’s profitability look, the more debt Community Health would be able to raise on Quorum’s balance sheet and then use to pay itself a dividend.
Quorum didn’t make it past its first quarter as a standalone company before experiencing an EBITDA miss of unprecedented proportion. Going back to the second quarter of 2009, the worst EBITDA miss by a public hospital peer is 36% by Health Management Associates (HMA) in the third quarter of 2013, and that miss was caused by many unique issues. Quorum can point to no such unique issues. When comparing Quorum’s miss to the average of the 10 worst quarterly misses in the public hospital sector in recent history of 15%, Quorum’s staggering 54% miss is nearly 4x worse than this average.
Quorum’s terrible quarter was caused, in part, by higher standalone costs, which costs were very likely known by Community Health’s management team since they allocated these costs to Quorum. In the first two months as a public company (May and June 2016), Community Health allocated $28MM of annualized standalone costs to Quorum – $20MM higher than the $8MM noted below, which Community Health’s management team had disclosed as part of the original guidance provided to investors. The $20 million in higher costs is split between: $10 million more in corporate staff that Community Health’s management team saddled Quorum with before the spin-off, an inexplicable $6 million increase in higher payments directly back to Community Health, and $4 million in higher costs due to Quorum no longer being able to benefit from its participation in a purchase organization associated with Community Health (something which Community Health could easily have known and disclosed months prior).
Quorum was also stuffed with higher medical specialist fees – we believe Community Health’s management team had to know about the increase since they renegotiated this contract in the fourth quarter of 2015, but mysteriously these higher costs never made it into Quorum’s forecast disclosed to and relied upon by investors. As part of this contract renegotiation, Quorum was left with $18 million in annualized higher medical specialist costs, an eye-popping 22% increase. One would expect that such an increase would also have a tremendous impact on Community Health’s earnings since it is part of the same contract and that Community Health would have been required to specifically disclose such an impact in detail in its quarterly SEC filings; however, Community Health made no such disclosure in either its 10-Q or the earnings call. In every negotiation there are gives and takes, and we believe it is highly likely Quorum was stuffed with the higher costs so that Community Health’s management team could make this increase more palatable to its own business. While it is certainly questionable for a parent to favor one set of its hospitals in a negotiation over another, the real issue comes again with the fact that Community Health clearly knew, or should have known, which hospitals reaped the benefit of the contract renegotiation and which hospitals did not. We believe that Community Health’s management team knew in the 4th quarter 2015 that Quorum’s costs were going up by $18 million (because they negotiated the contract), and yet they never disclosed the higher costs in the guidance or the financial model relied upon by investors. A forthright management team, who did not have any incentives to hide the truth, would have disclosed these higher costs to investors during the marketing of Quorum’s new securities; however, we believe Community Health’s management team instead concealed them so they could maximize the amount of cash they could raise at Quorum to pay down its own over-leveraged balance sheet. Consider this simple breakdown of Quorum’s Adjusted EBITDA rollercoaster.
|
Midpoint of Community |
Midpoint of Surprise |
Difference | ||||
| Adjusted EBITDA | $270 million | $187.5 million | -$82.5 million | |||
|
Causes of EBITDA Reduction: Highly Likely Known Prior |
||||||
| More Corporate Staff Than Community Health Said | $10 million | |||||
| Higher Payments By Quorum to Community Health | $6 million | |||||
| Quorum No Longer Part of Community Health’s GPO | $4 million | |||||
| Higher Medical Specialist Costs Negotiated by Community Health | $18 million | |||||
| Total Highly Likely Known Prior | $38 million | |||||
|
Causes of EBITDA Reduction: Likely Known Prior |
||||||
| Unexplainable Poor Performance of 38 Independent Hospitals | $45 million | |||||
It is one thing when a company experiences unexpected cost increases, which hit its bottom line; however, it is another thing altogether when the parent company puts together a “make believe” model showing one set of costs for the spin-off and then decides to charge that spin-off another set of costs without exposing the truth until after the fact. We believe that is what happened here.
On top of the concealed costs, Quorum’s EBITDA plunged despite a meager decline in net revenues during the quarter. Quorum reported a decline in net revenues of only $8 million from $538 million in the second quarter of 2015 to $530 million in the second quarter of 2016. In contrast, its quarterly adjusted EBITDA declined an astonishing $31 million from $60 million in the second quarter of 2015 to $29 million in the second quarter of 2016. An EBITDA decline of $31 million on a net revenue decline of $8 million illustrates the vast cost overruns. Such a massive cost overrun just does not happen overnight without a specific explanation. The best excuse the company could come up with was “they were performing poorly,” which we believe suggests the stand-alone 2015 and first quarter 2016 Quorum results were presented incorrectly because they had no connection to the true earnings power of Quorum’s hospitals.
Quorum’s management has attempted to explain the unexplainable by saying that the business deteriorated because Community Health’s management’s eye was off the ball during the spin-off process, and the business deteriorated without the corporate focus.
This simply does not compute with the reality of operations. Each one of Quorum’s 38 hospitals is led by its own independent hospital “CEO”. How did all of these 38 individual “CEOs” lose focus even though they retained a great deal of control throughout the separation? How did 38 hospitals spanning 16 disparate states from Georgia to California to Wyoming all experience such an unparalleled decline, which all other public hospital companies experienced no such drastic comparable decline? How did the business happen to disintegrate in April 2016 in the exact quarter the spin-off was completed after operating for months since the spin-off was announced on August 3, 2015, without a significant hiccup?
While we believe that Quorum’s management will attempt to transfer blame to Community Health’s management team, as they should, this does not cleanse Quorum’s management of blame. We believe that either Quorum’s management team is complicit in this cover up or they are guilty of gross mismanagement for their inability to analyze the costs of their own business for months after the spin-off.
Quorum’s management team held an Investor Day on June 23rd, only seven days before the end of the second quarter, and Thomas Miller, Quorum’s CEO, continued to assure investors of prior guidance. He and CFO Michael Culotta had been running Quorum for approximately two months (since May 2nd) and both had decades of experience including running Community Health’s Division V and being CFO of LifePoint and PharMerica. How could they not have figured out what was happening by that time? It seems inconceivable.
“<Q>: Okay. Can you just sort of go through – you guys had to come out with, obviously, guidance. You did the financing. You had to talk to us. But I also get this sense as I talk to you that maybe the budgeting process, you weren’t fully involved in that when that happened? Where are you at with your comfort level with the guidance that’s out there? And are you in the process of sort of reviewing everything so we may come up with an upgrade or an update?
<A – Thomas Daniel Miller, CEO>: … Those are issues that we’ve been working through. We’re feeling much more comfortable today than we did on May 2. I will assure you of that.”
Source: Bloomberg
Where there is so much smoke there tends to be a raging fire. We believe Community Health was desperate to raise cash, and they saw an easy path to do so by stuffing new investors in Quorum with inflated guidance and concealing costs within what they knew was a disintegrating business. The over $80 million decrease in Adjusted EBITDA guidance is worth at least $560 million of value destruction using a conservative hospital sector multiple of 7x.
Timing is of the essence. Community Health recently announced it has begun a sale process. We believe that Quorum’s board of directors has a small window to pursue claims against Community Health as it will undeniably become much more difficult to collect any meaningful recovery of the millions in losses caused by Community Health’s improper and potentially fraudulent actions once Community Health sells itself.
Therefore, we request that Quorum’s board of directors immediately hire outside counsel and launch an independent investigation into the salacious fact pattern outlined above. If such investigation brings to light, as we believe it will, the fact that Community Health concealed costs from Quorum as well as renegotiated contracts to favor Community Health at the expense of the soon to be independent Quorum, then we expect Quorum to take the appropriate legal action against Community Health to hold it and its management personally liable for these damages. If the Quorum management team and board are not willing to launch such an independent investigation and hold Community Health and its management team accountable for over half a billion dollars in damages inflicted by it on the new Quorum investors, then it certainly raises questions as to whether the Quorum management team and board were complicit in the fraud. And if not complicit, it certainly points to the question as to whether Quorum’s board of directors and management are really the right team to lead this newly independent business enterprise.
Sincerely yours,
R2 Investments, LDC