Lakeland Regional tried to address financial challenges in February 2017 through a merger with Orlando Health, whose officials told The Ledger they knew Lakeland's financial picture would present challenges.
LAKELAND — Lakeland Regional Health is struggling for financial survival.
It is not alone among many U.S. public and not-for-profit hospital operators fighting to survive in a climate of rising costs and declining revenue while in a fight for leverage against large national insurers, and increasing competition from outpatient medical providers, such as physician groups and surgical centers.
The trend for Lakeland Regional has not been encouraging.
Since its 2012 fiscal year, Lakeland Regional has seen total revenue increase just 33.6 percent while its costs have risen 43.6 percent, according to financial filings with the Municipal Securities Rulemaking Board, a clearinghouse for financial information in the municipal securities market.
As a result, its operating income, equivalent to a profit for a private company, has shrunk 98 percent from $41.4 million in 2012 to $888,000 in the recently completed fiscal year 2018.
That's a decline in margin (operating income divided by total revenue) from 7 percent in 2012 to 0.1 percent in 2018. Lakeland Regional's operating margin, a key indicator of financial performance, has declined every year over that six-year span.
Lakeland Regional tried to address some of its financial challenges in February 2017 through a merger with Orlando Health. Officials at Orlando Health told The Ledger they knew Lakeland's financial picture would present challenges.
“Going into it we felt one way. Going out we felt a different way,” said Jamal Hakim, Orlando Health's chief operating officer who worked most closely on managing the affiliation. “Going into it, we didn't feel the financials were good, particularly regarding cash on hand. Checking expenses and growing revenues had been challenging for them.”
But the alliance was initially attractive because it fit Orlando Health's growth strategy, he said.
“Among our strategies is to have a presence in counties we're not already in,” he said. “Everybody that has a national presence wants to be in Polk County. Polk County has a lot of folks interested. It has our interest.”
Hakim also felt he could improve Lakeland Health's financial picture based on his own experience since becoming Orlando Health's COO five years ago.
“Orlando Health was in the same position five years ago. We knew what it's like to be on your knees,” he said. “It's my opinion their situation requires some urgency.”
Other U.S. not-for-profit hospital systems have fought similar financial trends by merging with other, larger public or private hospital organizations.
Lakeland Regional announced plans to affiliate with Orlando Health in February 2017. The agreement went into effect the following Oct. 1.
The marriage was neither a long nor happy one, according to an investigation conducted by The Ledger after the affiliation was dissolved exactly a year later. Lakeland Regional requested dissolution of the agreement.
“The request (to dissolve) was theirs,” Hakim said. “We did throw out options. They were not accepted.”
The partnership went awry almost immediately.
Among issues The Ledger uncovered:
• Under the original affiliation agreement, Elaine Thompson, the Lakeland Regional CEO, was to manage the human resources and information technology departments for the entire joint entity while she retained her supervisory authority over Lakeland operations.
Thompson resigned from the personnel and technology positions six weeks into the affiliation.
• Lakeland and Orlando could not agree on a joint plan for key functions, including purchasing and information technology.
Thompson told The Ledger she had anticipated saving money by combining supply chain management. It eventually became clear Lakeland Regional could save more money by retaining its supply management system, she said.
Hakim disputed that. In fact, Hakim said, Orlando Health offered to guarantee Lakeland Regional would increase its annual operating margin by nearly $100 million at the end of five years if the latter remained in the affiliation.
• The supply chain issue was just one aspect of a larger fundamental difference between Orlando Health and Lakeland Regional over management authority and accountability.
“You have to be willing to be managed,” Hakim said. “We use standard hospital metrics; you have to be willing to hold yourself accountable to them. When you don't agree on those metrics, it's going to be difficult to control you.”
The financial environment for U.S. hospitals
Lakeland Regional faces the same kind of financial pressures most other non-for-profit hospitals are facing, according to an Aug. 30 article on the Healthcare Financial Management Association's website (see http://bit.ly/2q4uRiv). It cited a recent Moody's Investor's Service analysis of audited FY17 financial statements from 303 U.S. not-for-profit hospitals.
Moody's reported operating margins for not-for-profit hospitals fell to 1.6 percent in fiscal year 2017, the lowest level it has ever found, the association report said.
The average margin fell to 1.6 percent last year from 2.7 percent in 2016 and 3.4 percent from a recent peak in 2015. It attributed the decline to “significant income contraction” while operating costs continue to increase.
By comparison, Lakeland Regional's operating margins declined from 4.2 percent in 2015 to 3.9 percent in 2017.
Behind the income loss is a rise in the share of the hospital's income from Medicare and Medicaid compared to a decline in more lucrative payments from private insurers. Factors contributing to rising costs included labor shortages — forcing it to use high-cost temporary labor — and rising supply costs, including drugs.
“The profitability pressures are especially impacting smaller hospitals,” the article reported, citing a Moody's analyst. “Small and mid-size hospitals face the additional challenges of reduced negotiating power with health plans and greater difficulty attracting clinical staff.”
The article also cited an American Hospital Association survey that found 30 percent of hospitals lost money in 2016 and a Congressional Budget Office estimate that 40 percent to 50 percent of all hospitals will realize annual losses by 2025.
That financial picture is a major factor driving a surge in hospital mergers and acquisitions since 2009, according to a recent study by KaufmanHall, an Illinois management consultant.
There were 115 health care mergers or acquisitions in 2017, up from 50 such deals in 2009. Merger activity increased every year over the eight-year period except for 2016, when it dropped slightly to 102 deals, 10 fewer than the previous year.
“Organizational size and scale have mattered for decades, but today they are proving to be imperatives,” the KaufmanHall report said. “Nimble and well financed competitors see opportunities to cut costs, increase conveniences and improve outcomes by significantly upping the ante on size and scale and bringing more efficient and consumer-friendly business models to the market.”
Among the 115 deals made in 2017, 57 percent involved mergers between two not-for-profit entities, the firm reported.
The pace of deals this year is “show no signs of slowing,” it added.
Responding to financial challenges
Behind the merger strategy is growing the “patient base,” or the population area it serves, Orlando Health's Hakim said. That's the strategy behind Orlando Health's move into Polk County.
“Polk County is attractive as a location because of its location between Tampa and Orlando. The I-4 corridor is growing, and the growth inland is higher than coastal Florida,” he said.
Lakeland Regional was looking to drive down costs by taking advantage of economies of scale with the larger Orlando Health, Thompson said, and she denied financial issues were a factor in seeking the affiliation.
“Typically hospitals go into these agreements when they're in financial trouble. We did not do that,” she said.
The alliance between Lakeland Regional and Orlando Health, both non-profit entities, was not a traditional business merger in which one company purchases the assets of another.
Instead, they agreed to a “membership substitution,” a common merger arrangement among non-profit health systems, Hakim and Thompson said. The substitution did not involve a transfer of money.
Under that arrangement, the Orlando Health board of directors, with the addition of Lakeland directors, became the governing body of the combined entity while its CEO, David Strong, became its chief executive. But Lakeland Regional maintained a separate board, with the addition of Orlando Health directors, and retained Thompson as CEO with authority over local matters.
The agreement also called for Thompson to become the head of the information technology and human resources departments for the entire system. But in the middle of November, some six weeks into the merger, Thompson unexpectedly resigned from those positions, Hakim said in an Oct. 15 interview, two weeks after the Orlando Health-Lakeland Regional deal formally dissolved.
Hakim declined to release a copy of Thompson's resignation letter, referring the request to Lakeland. Lakeland Regional declined to give The Ledger a copy of the letter.
Thompson's resignation was the first indication the merger was not going well, Hakim said.
A resignation so soon into the merger would naturally have raised concerns, said Jay Wolfson, associate vice president for health law, policy and safety and senior associate dean at USF Health, part of the University of South Florida.
“It certainly raised a red flag,” he said. “That means she's just unhappy doing what she was doing, felt her hands were tied or that it was not to the benefit of Lakeland Regional.”
Shannon Elswick, a health care management consultant and instructor at the University of Central Florida, said disputes over management authority and roles have upended many member substitution mergers.
“The members coming in have to be willing to give up control” he said. “You have to buy into a strategic vision.”
Elswick knows from 40 years of experience in health care, including time as the CEO of a Clermont hospital that merged with Orlando Health.
“If the mission and culture are not in alignment, it is not going to work. Somebody is going to back out,” he said. “The hardest thing to get agreement on is the whole leadership alignment and what roles administrators will play. In my personal experience, the more details you get in writing regarding alignment and strategy, the better it is in working relationships going forward.”
Other red flags would emerge, particularly over supply contracts.
“This is a merger in which I thought the scale might help in some purchasing practices,” Thompson said. “Once we were in, I found out it did not.”
The financial data give credibility to Thompson's statement. While its operating income and margin have consistently declined over six year, the most precipitous drop came in the 2018 fiscal year when expenses climbed 6.4 percent while revenue grew a more modest 2.4 percent. Its operating income — the sum of total revenue minus total expenses — fell from $29.5 million in 2017 to $888,000 in 2018, a decline of 97 percent.
Thompson declined The Ledger's request for a second interview to discuss statements from Hakim and other health experts who spoke to The Ledger.
"Out of respect for the process undertaken by both boards and the subsequent agreement reached, we will not be providing further comment on matters related to the relationship," Thompson said Friday in an email.
In health care, supply contracts are a bigger deal than paper and pencils, Elswick and Wolfson agreed.
In addition to costs, supply contracts involve clinical issues, such as who makes the best artificial joints or respiratory devices in the opinion of doctors and other providers. It becomes a quality of care issue that can generate significant debate among providers and between providers and administrators.
Supply contracts became a flashpoint in the Lakeland Regional-Orlando Health alliance, Hakim and Thompson said.
That would not have been an insignificant dispute, according to Paul Keckley, a Nashville-based health care analyst and editor of the Keckley Report, which covers the industry. In a typical health care organization, supplies would account for 25 percent of expenses, second to staff pay and benefits accounting for some 60 percent, he said.
But savings don't come immediately, the health care experts agreed.
“The thing that's interesting about consolidations is that the data shows there are no significant savings in the near term,” Keckley said.
Costs tend to go up at first, he added, and it could take three to five years before savings are realized.
“We found several million dollars in cost saving for them in their supply chain,” he said. “We were so certain we offered them a guarantee that we could increase their (operating) margin by almost $100 million over five years. We had a high degree of confidence in our numbers.”
Thompson and Lakeland Regional declined the offer, Hakim said.
“If that was the offer, did Orlando Health incorporate it in the (merger) deal and how was Orlando Health going to live up to it?” Elswick said. “It really goes down to how well the parties understood the terms and conditions before the affiliation.”
In Hakim's view, there was a resistance among Lakeland Regional Health administrators to accept direction from Orlando Health. He declined to name specific administrators.
“It's entirely possible the management style of Orlando Health was not as comfortable as they (Lakeland Regional officials) thought,” Wolfson said. “It sounds like it wasn't about money; it was about a culture clash.”
Early red flags
Signs of resistance emerged even during the seven-month negotiation period from the February 2017 announcement the two entities would seek a merger to the conclusion of the deal in October.
Orlando Health includes Arnold Palmer Hospital for Children. Lakeland Regional had an existing partnership with Nemours Children's Health System based in Jacksonville, which also has a hospital in Orlando.
Lakeland Regional did not want to give up the Nemours partnership and insisted it be maintained in the merger, Thompson said.
Orlando Health agreed reluctantly, Hakim said, although it maintained it would have been more efficient to have Arnold Palmer provide pediatric services to Lakeland Regional patients.
But Thompson was firm that ending Lakeland's Nemours partnership was “off the table,” he said.
“We didn't think it was wise, but we were willing to proceed despite that,” Hakim said.
Another sticking point in talks before the merger was Lakeland Regional's insistence on maintaining another partnership with the Mayo Clinic, which provides physician recruitment services. Orlando Health provides the same service but agreed to allow Lakeland to continue the Mayo Clinic partnership.
Lakeland Regional also wanted to maintain a separate information technology system, believing it is superior to Orlando's system, Thompson said.
Orlando Health is in the midst of upgrading its IT system, Hakim said.
“Among the reasons operators have (to merge) is consolidation of information systems,” Wolfson said. “They're very essential to an effective clinic and its financial system.”
In a typical private business merger, many of the issues would have been resolved during the “due diligence” period, in which both parties negotiate over terms of the combination and, crucially, get to examine each other's financial records.
But federal anti-trust law prohibited Lakeland Regional and Orlando Health from opening each other's records until they had agreed to the membership substitution, Thompson and Hakim said. So both organizations necessarily went into the merger with many of the management issues unresolved.
That's not unusual in mergers between health care organizations, Keckley said.
Keckley compared the initial October 2107 merger agreement to a prenuptial contract before a marriage.
“You can be dating someone and agree to the prenuptials, but that doesn't mean you walk down the aisle,” he said. “Everybody is dating everybody else these days.”
Elswick agreed federal law limits the amount of financial information that partners can share before making a merger agreement, but that doesn't mean they can't come to an understanding.
“There are not details too small to work out,” he said. “If those things aren't fully understood, there's going to be a problem.”
The road ahead
The financial challenges that face Lakeland Regional and non-profit health care providers continue apace.
One of the prime motivators for the recent merger trend is to gain bargaining leverage against private health insurance companies that, outside of Medicare and Medicaid, pay most of the patients' bills.
“Consolidations and affiliations are driven these days by leverage with insurance plans,” Keckley said.
It's basic economics: The bigger the customer — the health care provider — the more disposed the payer — an insurance company — should be to negotiate the prices to the provider's advantage. Conversely, the bigger the payer, the more power it has in negotiating those prices.
“The more consolidated hospitals are, the greater leverage they have against insurance companies,” Keckley said.
In the current market, that delicate balance favors the insurance companies, most of them large companies operating across the U.S.
Thompson and Hakim agreed that's a major issue in today's health care market and one reason behind seeking the merger.
Another factor driving the merger frenzy, particularly for operators of traditional hospitals such as Lakeland Regional Health Medical Center, is the competition with outpatient medical providers, such as urgent care centers for routine ailments and outpatient surgical centers for “minor” surgeries. Both can provide medical services at lower costs than those requiring multi-day stays in a hospital.
Advancements in medical technology are moving more surgeries and procedures out of the in-patient hospital category to single-day, outpatient procedures.
Already 20 percent of joint replacement surgeries, artificial knees and hips, are done as outpatient procedures, Keckley said. That's expected to rise to about 90 percent by 2023.
Traditional hospitals need to move into outpatient services to survive, Keckley and other experts said. They would capture a larger share of the health care market, increasing revenues and leverage with insurers.
Orlando Health has moved aggressively in that direction, Hakim said.
Lakeland Regional has also moved in that direction, Thompson said. For example, it owns 50 percent of the outpatient Lakeland Surgical Center next to the Medical Center and has a joint venture with the Radiology and Imaging Specialists in Central Florida.
While second-chance mergers are rare in the business world, they are not uncommon in the health care area, medical experts said.
“It doesn't mean they won't have the same discussions next year,” Keckley said. “There's nothing that's unattractive about Lakeland. The bottom line is does the combination of the two organizations create a more viable footprint in Central Florida health care.”
Hakim said Orlando Health would be willing to discuss another agreement with Lakeland Regional.
Thompson told The Ledger that Lakeland Regional is pausing to evaluate its current position and is not looking for new partners in the near future.
“Down the road, we will consider affiliating in the future,” Thompson said, adding that she would not rule out another try with Orlando Health. “In four years, we may go back to them.”
Kevin Bouffard can be reached at firstname.lastname@example.org or at 863-802-7591.