Report 97122 Summary - September 1997

The UCSF and Stanford Health Services:

The Proposed Merger Should Make the Partners Fiscally Stronger, Although the Extent of Financial Benefits Is Potentially Overstated

Results in Brief

The University of California, San Francisco (UCSF) and Stanford University (Stanford) are proposing to merge their medical centers and form a new nonprofit public-benefit corporation, the UCSF-Stanford Health Care (USHC). Although both medical centers are presently sound financially, they are both concerned that changes in the Bay Area health services marketplace will prevent them from supporting their respective medical education programs at current levels while also reserving resources needed to support ongoing program requirements and initiatives at the medical centers such as repair and replacement of buildings and equipment.

In fiscal year 1995-96, the UCSF and Stanford medical schools received support from their medical programs of $22.7 million and $21.2 million, respectively, from medical center earnings. In addition to these payments, the UCSF and Stanford medical schools received $6.2 million and $8.2 million, respectively, from an assessed tax on the revenues of the faculty practice programs.

In response to marketplace changes, the proposed merger is intended to enable the two universities to maintain financial support for their academic missions, including recruitment and retention of the best faculty, students and residents. The intent is also to sustain an adequate patient base and to significantly improve graduate education, continuing medical education, and public education. Lastly, the universities anticipate that the proposed merger will create opportunities that will "ensure vibrant clinical research and winning collaborations among scientists, and between universities and the private sector, especially the pharmaceutical industries."

The proposed consolidation agreement provides UCSF and Stanford specific protections. For example, while UCSF and Stanford will transfer equipment and personal property to USHC at no cost, each entity will retain title to its buildings and land that will be leased to USHC. Also, either UCSF or Stanford can initiate dissolution proceedings if USHC does not meet the objectives of the merger.

Our financial analysis of the proposed merger is based on information currently available. However, significant provisions of the consolidation agreement, such as the specific assets to be transferred to USHC and the formulas to distribute earnings to the medical schools, are still being negotiated. We reviewed the changes occurring in the Bay Area health services marketplace to determine whether a merger was a reasonable response to those changes. Also, we performed a variety of analyses on the financial health and results of operations of the two medical centers to determine the extent to which they were equal partners. In addition, we evaluated the analyses performed in previous studies commissioned by UCSF and Stanford to determine if they correctly stated the financial benefits of the merger.

We do not believe that the fiscal viability of either medical center is immediately threatened. However, in order to survive in the long run, the two medical centers need to enhance the perceived value of their services through ongoing, aggressive cost reductions, improved consistency of results from medical treatment, and improved ability to document the quality of their medical care regardless of whether or not they merge.

While the merger should result in reduced costs and some additional revenues, the extent of the financial benefits of the merger have been potentially overstated. For example, UCSF and Stanford's latest estimate of the four-year net financial benefits derived from the merger as shown in the Third-Party Review of $152 million is potentially overstated by nearly $32 million.

Specifically, we found:

Survey of Health Care Marketplace:

· The proposed merger is an understandable response to the changing health care services market. Managed care in the Bay Area has dramatically changed the economic structure of health care through price declines and hospital-usage reductions in order to contain costs. As health maintenance organizations (HMOs) and physicians have increasingly consolidated to gain bargaining power, hospitals have sought to merge and affiliate with one another to gain leverage with these large HMOs and physician groups.

· Teaching hospitals such as UCSF and Stanford face particular challenges because they are traditionally the highest-cost, highest-price type of hospitals, and they have relied on hospital and clinical income to subsidize teaching and research. Hospital mergers are often an integral part of strategies to raise revenues and reduce costs. Some studies have found evidence that mergers result in lower cost per admission and operating efficiency; others found that mergers do not result in lower patient care costs or administrative costs.

Results of Historical Financial and Operational Analysis:

· The two medical centers are approximately financially equal in the merger. For comparability purposes, our analyses include an adjustment to audited financial statement data because Stanford's accounting policies are different from UCSF's. The adjustment was to allow for comparisons under similar accounting policies. Stanford's contribution to the $869 million equity (assets less liabilities) of the combined entity will be $483 million (56 percent) and UCSF's contribution will be $386 million (44 percent). While Stanford will be contributing more in liquid assets, UCSF will be contributing a greater amount of liquid assets (cash, stocks, and bonds) in relation to its long-term debt.

· For the five-year period between 1992 and 1996, we found that UCSF's net income (income after expenses from all activities), when adjusted for nonrecurring revenues and expenses and the distribution of earnings to the medical school, totaled $251 million while Stanford's totaled $215 million. Similarly, UCSF's income from hospital operations over the five-year period was $186 million while Stanford's was $150 million.

· Based on an analysis of data between 1991 and 1996, we found that each merger partner brings certain operating strengths to the merger based on such operating characteristics as number of inpatient days, occupancy rates on available beds, revenue per inpatient day and other measures of operating performance. However, UCSF's lower operating expenses per patient day could make it relatively stronger than Stanford as the health care services market becomes increasingly sensitive to hospital costs.

Analysis of Financial Benefits From the Merger:

· Proposed revenue increases, even at 50 percent of the business analysis estimates currently being used by UCSF and Stanford, are too optimistic based on the declining demand for hospital services and continued pressure from payors for price reductions.

· We estimated that the net benefit from the additional number of specialty care cases is likely to equal $28 million over the first four years of joint operation rather than $84 million presented by the Third-Party Review which results in a difference of $56 million.

· For most large operating expense reductions it proposed, the USHC appears to have a fairly clear and executable plan to achieve the cost savings identified in the business analysis for the merger. We analyzed the potential financial benefits of the merger assuming that various percentages of the projected new revenues and cost savings were achieved. In addition, we reduced the merger costs related to pension and severance payments by $25 million, because pension costs are lower than originally estimated and severance costs are now unlikely to occur. If USHC does not succeed in increasing its number of complex patient cases above pre-merger levels, it would have to achieve 84.2 percent of its projected cost reductions for the merger to be at a break-even proposition after a four-year period.

· The estimated increased income from the merger is likely to help ensure the present level of funding being transferred from the medical centers to the medical schools will continue in the future. Also, it may allow for increased funding that could be transferred to the medical schools if the merger is very successful. Further, the estimated increased income is likely to allow for funding of short-term (within three to five years) capital needs. However, the income is unlikely to reach the 5 percent of estimated net revenue that is recommended to meet long-term capital requirements.

Agency Comments

Generally, the University of California and Stanford University agreed with our conclusions.