Practical Finance in the Age of Rapid Obsolescence

To lease or not to lease? That is the question when it comes to buying rapidly obsolete imaging technology. Hospitals, large and small—not to mention centers affected by the Deficit Reduction Act of 2005 (DRA)—continue to compete for declining reimbursements while trying to stay cutting edge without breaking their capital budgets. In the past, a radiology director could count on a CFO to write a check for a $1.5 million technology replacement every 5 years or so; but that CFO might not be as generous when approached only 3 years later and asked again.

The short answer for rapid obsolescence: lease. The long answer is that original equipment manufacturers (OEMs) and capital leasing companies have different leasing and pay-per-use solutions that they will tailor to each institution for a particular product. At the same time, institutions must do some self-assessment and work with their top finance people to carefully consider the accounting, the tax consequences, and the fine print.

Is Replacing That CT or MRI Essential?

Richard Helsper, vice president of Clarian Health Partners, Indianapolis, struggles every day with technology obsolescence and the question of how, when, and why it is necessary to replace imaging equipment within Clarian’s network of five nonprofit hospitals and multiple outpatient imaging centers. “I have a big pool,” he says. “We have roughly 18 MR scanners downtown within the five hospitals in the central Indianapolis area, including outpatient centers. Well, I can’t keep all 18 at the same [cutting-edge] level. However, I do need to keep certain key places state of the art.”

Helsper names several reasons why providers and radiology departments are keen on having technology upgraded now rather than relying on current units—which were perfect until someone saw the latest and greatest multislice CT.

“The vast, vast majority of the patients can be served very well, clinically, from a 40 slice,” he says. “But a handful of situations—cardiac applications, for example—are better suited with a 64.” However, Helsper says that providers are increasingly forced to make upgrade decisions based more on competitive factors rather than the majority of patients’ needs. The three most common reasons are:

1. to stay competitive, radiology chairmen say they must be the first on the block with the latest and greatest;
2. because another hospital became the first on the block with the latest and greatest, market competitors say they have no choice but to keep up with the Joneses; and
3. having the latest and greatest, regardless of patient need, is a market differentiator, especially when the competition cannot afford or has no plans to get one—at least not yet.

Martin E. Zimmerman, president and CEO of LFC Capital, Chicago, understands how important it can be to keep up with the Joneses. “There’s no doubt today that a horsepower race is going on,” Zimmerman says. “A certain percentage of physicians refer to where the technology is really up-to-date. You see it in the independent imaging centers that do not refresh their technologies: Their revenues flatten and begin to decline, and by that time, it’s maybe too late to recover all those lost revenues.”

Whatever the reason for deciding to replace the old gray MR, Helsper advises institutions to carefully look at the technology sector, talk to vendors and colleagues, and determine how fast the technology is moving. Although no one has a CT crystal ball, making this assessment will help determine the method for paying for the technology, whether through a residual-based lease, a capital expense, or even a pay-per-use contract.

Bob Ford, vice president of global customer finance for Philips Medical Systems, Andover, Mass, echoes Helsper’s advice, but adds that customers should come to the finance table with a good estimate of the technology’s usage patterns, the reimbursement rate, and the equipment’s expected total cost of ownership (TCO).

“I think that customers need to be looking at suitability of use and the true reality of the practice patterns in the customer base,” Ford says. “And frankly, we, as the manufacturer, have to make sure that we are selling the correct product for the customer needs.”

Will That Be Capital or Credit?

After deciding to stay cutting edge, the next question is how to pay for these upgrades without getting a poor return on investment due to rapid obsolescence.

In the past, department heads have been forced to use precious capital dollars to buy whatever equipment is available at the time of the budget allocation. If they did not buy the equipment outright, they would structure “capital leases”—which are really equipment loans, but for accounting purposes, are leases with a $1 residual buyout at the end of the term, typically 5 years.

Even with rapid obsolescence, an outright buy or capital lease still can make financial sense, but only when hospital administrations allow departments to do their due diligence and purchase equipment when the technology is stable rather than on a set budget allocation time line. (This assumes market forces allow such patience.) However, this strategy may be difficult to implement if department heads fear that their earmarked dollars will not be saved for later, but instead allocated to another department’s wish list.

Capital purchases also could save money in the age of rapid obsolescence, with vendors aggressively discounting technology and with some OEMs offering 0% financing.

Shorter loan terms might cut down interest costs, but not by much, according to Zimmerman. “There was a period of time when you could actually reduce your costs 10% by going from 5-year financing to 3-year financing,” he says. “To own the equipment, the depreciation is exactly the same in both cases, but you could save 10% in interest because 3-year money at that point was a lot less expensive than 5-year. Today, it’s virtually the same. It’s just a few basis points, a few hundredths of a percent that separates 3 from 5.”

8 Tips for Financing Obsolescence

Whether an institution decides to upgrade or replace the entire box, finance professionals offer the following eight tips. Negotiate the service contract at the same time as the equipment price, not separately or afterward. You could bargain them down for a great price or interest rate, only to realize later that the service contract brings the total cost of ownership (TCO) to a level greater than your budget. Try to be honest about how much this new piece of equipment or upgrade will benefit the bottom line. If buying a 16-slice CT addresses a majority of the needs of your patient demographic, the allure and added costs of a 64-slice might not make that much financial sense, even given that it is a market differentiator. Better to use the investment on a piece of equipment—or less-expensive upgrade—that will provide greater throughput. Before buying a new model, check original equipment manufacturers (OEMs) and outside resellers for refurbished equipment. For CT, 64-slice is still relatively new, but perhaps a refurbished 40-slice scanner can meet your needs. Plus, because 64-slice is now the gold standard, prices will be highly discounted for a 40-slice CT. Also, as 64-slice scanners come off short-term leases, some gently used equipment could be on the market in the coming year or so. If buying used equipment from a reseller or OEM, be sure to ask the OEM about the equipment’s planned obsolescence. Buy and hold strategies still may make sense for smaller hospitals, but the equipment’s lifespan will be much shorter if the OEM plans to obsolete it in less time than expected. If holding on to an older piece of technology, keep in mind that service costs remain about the same, but that the asset will keep depreciating over time, thereby increasing the overall TCO. OEMs may provide one-stop-shopping and other conveniences, but that convenience may cost a point or two in financing compared to a specialty health care leasing company’s rate. However, if you need to upgrade before the end of the leasing term or option window, a leasing company will have little reason to release you from any default or prepayment penalties, but an OEM might be more understanding if you are willing to upgrade to one of its products. Software and component upgrades possibly could meet your needs rather than a total replacement. When negotiating the initial contract, be sure to include pricing for these options, which may be installed in a day or two, perhaps even over the phone. Some OEMs might include these upgrades as part of the contract, or they might be a significant add-on. Finally, as with all transactions, caveat emptor. Work with the finance department, especially the experienced people who are not buying their first or second CT. Have these experts read the fine print, making sure there are no hidden charges or end-of-term financing restrictions or costs that could—or will—add to the TCO. Similarly, the accounting department should consider the tax, depreciation, and accounting ramifications that could add or subtract from the new equipment’s TCO, as well as the old equipment’s. —T. Valenza

Appropriately timed capital pur-chases and 0% financing can save thousands of dollars in interest costs; however, some institutions cannot afford to wait for the platform to stabilize. Consequently, finance companies are seeing more true operating leases that transfer the obsolescence risk to the finance company.

Peter Park, vice president of health care finance for Siemens Medical Solutions, Malvern, Pa, says, “[Leasing] offers the customers flexibility to upgrade to the latest technology, either if the technology becomes available or if they have different needs. It is not only that the technological development makes the customer upgrade; sometimes their situation changes. They have a higher patient volume, they start a new specialty, and they have different needs. Leasing gives them flexibility.”

Today’s leasing terms can be as short as 24 months, but are typically 60 months with an option at 36 or 48 months to upgrade to a new platform. If the technology is stable, institutions have the option to purchase the unit with capital dollars for a predetermined residual price. Likewise, a minor but cutting-edge upgrade also can be worked into the existing lease payment easily.

Another advantage to leasing is that it provides a low monthly payment, as the equipment is amortized over 5 years. For an unstable platform, this can mean significant savings when an institution opts out at 36 months and has paid only two thirds of the full purchase price.

However, Zimmerman cautions that the lowest monthly payment might not be the best deal after carefully reading the fine print and accounting for maintenance and service contracts.

Working with the Accountants

Helsper stresses the importance of the radiology and purchasing departments working with the accounting department about how leases appear on the books. “For [a nonprofit] to have an operating lease, I believe it has to be 42 months or less, and the residual value has to be a certain amount, and there are other factors,” Helsper says. “So, if you meet all those criteria, it truly can be an operating expense as opposed to a capital expense. Then it doesn’t fall into the same guidelines as capital, and we can do more creative things around that. … So, you have to be very careful and work with your finance accountants. As I tell people, the decision between a capital lease or an operating lease and an outright purchase is not made at a local level.”

Leasing has other accounting advantages. After considering start-up costs and slow revenue periods, lease payments may be planned to match the estimated monthly revenue that will be derived from the new equipment.

Pay-per-Use and Beyond

Flexible, short-term, carefully crafted leases and 0% financing are two methods to beat the risk of obsolescence. Some institutions also are looking to pay-per-use leasing, where an institution will negotiate a price-per-image with a minimum and maximum number of “clicks.” The advantage is that the institution will have cutting-edge technology and be able to pay as it goes—assuming payor reimbursements are timely.

However, pay-per-use agreements tend to be very complicated and have other financial risks. Although the finance company retains ownership and the obsolescence risk, the institution is analyzing throughput and estimating the number of times the equipment will be utilized. If it is used less frequently than expected, the institution still must pay for the prenegotiated minimum clicks. On the other hand, if there are more clicks than the negotiated ceiling, the institution must pay a penalty premium.

“We haven’t seen a large market demand for that type of thing because of the risk premiums involved,” says Rob Kulis, general manager of outpatient imaging centers for GE Healthcare, Chicago. “It’s one of those ideas that’s often talked about, but when you get down the path and you present a 60-month fair market value lease, they go for the lower payment.”

One area where pay-per-click may make more sense is with information technology (IT) products, such as PACS. Due to the fact that they are software-driven, IT systems like PACS are quite vulnerable to obsolescence and can cost more than a piece of advanced technology. Every upgrade requires more personnel training, larger computers for storage, more memory, and more backup systems, not to mention more confusion.

Addressing this problem, many PACS companies offer pay-per-use terms. Ford says that Philips’ iSite line of PACS (formerly Stentor) is essentially outsourcing for a PACS. “Obviously, [the contract] needs to be carefully crafted with good understanding of the volume of use by the customer and the throughput,” he explains. In addition, as with CT or MRI pay-per-click leases, minimums and maximums may be worked into the pricing.

However, Ford says that besides addressing obsolescence risk, pay-per-use’s “attraction to customers is that it enables them to focus on health care rather than having to deal with complicated computer technologies.” It also has the potential to save on IT human resources, computer storage costs, and repairs.

Another trend that finance people are seeing due to the DRA is the strategic alliance between hospitals and outpatient centers.

According to James Sadowski, health care financial services marketing program manager for GE Healthcare Financial Services, Chicago, “Because the return on equity and the availability of outstanding returns for imaging centers have been compressed due to reduced reimbursements, outpatient centers are much more open to the strategic alignments with the local hospitals. Likewise, I think we’re seeing local hospitals reaching out to strategic physician groups in order to extend their reach geographically and to extend their continuum of care.” Besides sharing in financial rewards, both entities also benefit by sharing in the costs of updating technology with high obsolescence risk.

For more information about obsolescence strategies—specifically for MRI, but that also could apply to CT—read “Strategic MRI Management” in the November 2002 issue of Axis Imaging News.

On the other hand, entities must be cautious when making alliances, steering away from any suggestion of self-referral. A recent report in Axis Imaging News’ e-newsletter, ADVISOR, describes an Illinois lawsuit targeting 11 MRI companies claiming that their equipment lease arrangements are an elaborate cover-up for kickback payments to referring physicians.¹ Also, this month’s “The Last Word” addresses this very topic.

The risk of obsolescence does not appear to be declining in the near future, especially for CT, MRI, and PACS hardware and software. The good news is that this rapid turnaround environment makes OEMs and leasing companies more competitive.

Tor Valenza is a staff writer for  Axis Imaging News. For more information, contact .

Reference

1. Axis Imaging News’  ADVISOR. Other states may follow Illinois in per-use leasing crackdown. January 30, 2007. Accessed February 15, 2007.