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November 2006

Teleradiology: New players, high stakes create capital opportunity


By: John C.Hayes

Night-read companies discover that daytime is the right time to expand business When investment gurus talk about radiology in the U.S., two statistics figure prominently: the annual rate of growth in the number of radiologists (1.5% to 2%) and the annual rate of growth in the number of images said radiologists must interpret (variously estimated at 6% to 12%). Not surprisingly, the talk then turns to teleradiology. Concepts such as workload balancing, market fragmentation, unused capacity, and market efficiencies fed by technological advances feed such discussions. Overall, radiology begins to look like a giant wired network where the most efficient and effective players have the opportunity to claim a larger share. Welcome to the world of the virtual reading room, in which the link between where images are generated and where they are interpreted is determined more by business patterns and Internet connections than by who is on duty when the image needs to be read. What was once a cottage industry-remote image interpretations by radiologists who were willing to work nights-has blossomed into a major part of radiology's economy. Estimates predict that up to 20% of the nation's image interpretation business-worth between $13 and $15 billion per year-could soon be provided via teleradiology. Those big figures have drawn dozens of new players to the teleradiology market in the past three to four years. This rapid influx of new companies and, just as important, investment capital, has upped the ante. Today, growth and size are often seen as keys to success. As a result, the marketplace is frequently characterized as fragmented and ripe for consolidation. "This is a market still in infancy but on a timeline determined in quarters, not years," said Justin Pettit, a vice president with DW Healthcare Partners, a private equity firm. "That's because of the demands resulting from the radiology shortage and the mandate to improve efficiency and productivity for radiology readers." Recent trends and developments include the following: - Investment capital is helping to fund the three largest teleradiology companies

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in the U.S.: NightHawk Radiology Services, Virtual Radiologic Corp., and Radlinx. NightHawk, which became a publicly traded company in February, now has a market capitalization of approximately $550 million, putting it squarely within the ranks of the nation's small cap companies. The main goal behind the scramble for investment capital is an effort to turbocharge growth through sales and IT development. - Preliminary night reads, which this year will generate in excess of $150 million in revenue, are being joined by day and subspecialty reads. One company targeting the subspecialty market, Franklin & Seidelmann, will earn enough this year to put it among the top four of the nation's teleradiology companies. The top three night-read companies are taking steps to move into the day-read market. Orthopedic imaging has helped fuel the growth of subspecialty teleradiology, as may cardiac imaging. - Barriers to entry are getting higher. When many of today's teleradiology providers started out three to four years ago, the main challenges of technology and Internet bandwidth were easily solved; services could be provided relatively smoothly on a state or regional basis. Today's largest teleradiology companies provide services to hundreds of providers in dozens of states, requiring extensive licensing and credentialing efforts. In addition, buyers are increasingly demanding Joint Commission of Accreditation of Healthcare Organization certification. Finally, technology to efficiently manage image distribution and reading processes-some providers have developed proprietary image management systems-can be a costly challenge. - Low-cost foreign competition for radiologic interpretations, a prospect raised forcefully three years ago when the Indian technology giant Wipro said it would enter the U.S. market for interpretations, has yet to seriously materialize. Wipro, which provides reads with a group of 100 Indian-trained radiologists and technologists, is providing 3D reconstructions and "collaborative interpretations" for four U.S. hospitals in the Northeast, according to Kapil Khandelwal, chief of healthcare for Wipro Life Sciences. That, however, is the same number of facilities it had three years ago. Dr. Arjun Kalyanpur, a Yale University-trained radiologist, heads another group that provides image interpretations from Bangalore, but all of the group's seven radiologists are U.S. trained and boarded. Radiology groups, once happy to unload their night-reading responsibilities, have watched warily as the growth of teleradiology has continued, particularly as the night-read companies have begun to look at daytime as the right time for business expansion. All of the teleradiology companies insist that they intend to work through established radiology practices and not compete with them for hospital or specialty service contracts, but critics maintain that growing reliance on Wall Street money will force teleradiology companies to substitute the desires of shareholders for the needs of local radiology practitioners and their referring physicians and patients.
TOP HAWKS

The undisputed king of the teleradiology market in the U.S. today is Dr. Paul Berger, an Idaho radiologist who is CEO and president of NightHawk Radiology Services. Berger got his start in teleradiology in 1993 with what was probably the nation's first nighthawk company, Long Beach, CA-based Memrad. That company eventually dissolved, and Berger went on to form NightHawk in 2001. The company, trading under the symbol NHWK, entered the Nasdaq exchange on Feb. 9 and in August was named to Inc. magazine's list of the 500 fastest growing

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private companies in the U.S. Radiologists based in Sydney and Zurich provide the company's reading services, a strategy that allows them to work during the day on images generated in the U.S. at night. NightHawk reported second quarter revenues of $22.9 million and anticipates 2006 revenues of $88 to $90 million. Most of that, according to Berger, comes from preliminary night reads. NightHawk has, however, begun to provide final day reads and will step up the pace of that effort by building up to four reading centers in U.S. cities that the company believes will be attractive locations for radiologists. The first such center could be established in San Francisco. The company's stock has traded as high as $27.50, but as of this writing, stocks were trading in the $19 range. As of Sept. 14, Berger owned more than 5.8 million shares. It was NightHawk's initial public offering filing last fall-and its projected 65% gross profit margin-that sparked a gold rush among those who saw opportunities in the teleradiology marketplace. More than 20 teleradiology companies exhibited at the 2005 RSNA meeting, and most of them were visited by venture capital company representatives offering investment cash. Even today, teleradiology companies report that they continue to hear from venture capital investors looking for a way into the market. For all of the interest, however, Wall Street's penetration remains limited. In addition to NightHawk, the second largest night-read company, Virtual Radiologic Corp., in August announced an initial public offering of stock and hopes to raise $75 million. Radlinx has received an investment of approximately $20 million from DW Healthcare Partners. VRC declined to comment for this article, citing Securities and Exchange Commission rules limiting company communications while the IPO is pending. But the company's filing with the SEC provides some sense of the growth that is taking place in the teleradiology market: revenues rose from $1 million in 2002 to $5.9 million in 2003, $12.9 million in 2004, and $27 million in 2005. In the first quarter of this year, revenues reached $9.7 million. The IPO filing cited a Frost & Sullivan report projecting a 15% annual increase in imaging volume to more than 500 million procedures in 2009. The VRC filing also echoed some of the risks cited in the NightHawk IPO, including price pressures in a hotly competitive marketplace. The potential for price competition is real, but whether it actually exists remains a matter of some dispute. Third-party vendors who have watched the market say they see demands for lower prices, particularly among entrepreneurial imaging center operators who are willing to shop their business. Teleradiology providers are understandably reluctant to acknowledge that price competition may be affecting their business for fear that it could increase pressure for price cuts from would-be service purchasers. Berger, in a second quarter teleconference with analysts, said declines in prices for NightHawk services were 0.8% in the first quarter of this year but only 0.4% in the second quarter. "These are modest declines, and we believe the overall declines in prices are

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flattening," he said. A competitor who asked not to be identified said that he would like to believe that. He acknowledged that some price competition has begun to take place as the marketplace has become more crowded. Eventually, he said, price competition could be reflected in salaries paid to radiologists. Morgan Stanley Equity Research, in a March 21 report initiating its coverage of NightHawk, observed that continued pricing pressure remains its chief concern for the earnings outlook. Morgan Stanley predicted continued, although not sharp, declines in prices per scan until the market reaches about $45 per scan. The firm also noted, however, that "The risk of the off-hours teleradiology business becoming commoditized is relatively low. At present customers continue to cite quality as far and away the most important criterion when choosing a teleradiology vendor."
REGULATORY FACTORS

Just as challenging is the prospect of regulatory changes that could upset the delicate economic balance that makes teleradiology a profitable proposition. Teleradiology providers typically avoid billing insurers or Medicare, instead charging physicians or facilities directly on a volume or per-image basis. This allows them to skip the costly and time-consuming process of collecting the professional fee for image interpretations, something that can add up to 20% to the cost of an interpretation. But payments to physicians are covered by a complex web of state and federal laws and regulations, changes in which could limit the ability of teleradiology companies to avoid the billing hassles that hospitals or radiology practices face. "If our arrangements with our affiliated radiologists or our customers are found to violate state laws prohibiting the practice of medicine by general business corporations or fee-splitting, our business, financial condition, and ability to operate in those states could be adversely affected," VRC stated in the risk factors section of its IPO filing. The company also sees risks associated with the enforcement of federal and state anti-kickback laws and with changes in federal or state self-referral regulations. Similar caveats are found in the NightHawk IPO filing. In fact, the Centers for Medicare and Medicaid Services in August asked for comments on adding new restrictions to existing rules for reassignment of Medicare physician fees as part of an effort to crack down on self-referral abuses. Currently, the rules are fairly broad, a situation that has enabled direct billing of physicians and facilities by teleradiology firms. As proposed, the restrictions would probably not have much effect on preliminary night reads, which make up the bulk of teleradiology in the U.S., said healthcare attorney W. Kenneth Davis Jr., a partner in Katten Muchin Rosenman in Chicago. But they could hinder the provision of final day reads, considered by the top three night-read companies to be a source of growth and the model used by subspecialty teleradiology providers. In its announcement, CMS also asked for comments on the idea of exempting

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diagnostic radiology from added restrictions on physician fee reassignment. Although comments were due in October, it is not yet clear whether or when CMS would propose new rules for physician fee reassignment. Setting aside major changes in the price, regulatory, or fee environment, the lead players in the teleradiology marketplace see tremendous opportunities for future growth. NightHawk's Berger, in the July 26 analyst conference, placed the size of the U.S. night-read market at $750 million and said that current market penetration is approximately 40% to 50%. Berger also estimates the day-read market at $14 billion. Others say the figures put forth by Berger may be too low. Mark Bakken, president of Radlinx, the nation's third largest teleradiology company, said adding in weekend and holiday call could bring the figure for preliminary reads to $1 billion to $1.4 billion. That's a far cry from where teleradiology was just a few years ago. Bakken, whose experience in teleradiology dates to 1998 when he cofounded U.S. Radiology Partners, said that in 2000, only one or two companies were operational and teleradiology was a running joke at the RSNA meeting. "A year later, there was one more, and then three or four more. In 2004, teleradiology was all the buzz, and in 2005, there were investment guys all over us," he said. "There has also been a fallout of the little guys. Once you could do teleradiology along analog lines, and nobody knew what credentialing meant. In those days, you could get into the business with just you, a buddy, and another guy. Now it takes hundreds of thousands of dollars, JCAHO approval, call centers, and credentialing and licensure departments." Although Berger says the off-hours market can continue to grow at 11% per year, consistent with the overall growth in imaging procedures, many others say the night-read market is already getting crowded. "You can't do it the way you used to," Bakken said. "In the early days, we never ran into each other." Dr. Maheep Goyal founded NightHawk Pros two years ago, and he has seen significant changes over that short period. "When I first started, people were looking for help. Now they are shopping for price or better quality or better service," said Goyal, whose company employs the equivalent of 3.5 radiologists. "We're getting few calls from people who have never had service." Partly in response to the tighter competition for night reads, the big players are now increasingly emphasizing their ability to perform day reads. Both the NightHawk and the VRC IPO filings mention day and specialty reads as a future direction. Today, most of the companies in the teleradiology field advertise themselves as providing 24/7 365-day-a-year reads, even if they are primarily a night-read company. "Online radiology has huge room to grow," Bakken said. "Our fastest growing segment by far is daytime coverage. Six months ago, it was 10% days and 90% nights. Now it's 70% days and 30% nights. The market is switching to where the

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real mother lode is." For the night-read companies, that switch creates an opportunity to build on existing contracts, filling in when demand goes up, or when a staff radiologist is ill or on vacation. Teleradiology service compares favorably with the cost of hiring a locum tenens, Bakken said. But for the night-read companies, the day-read market has proved more difficult to master than the preliminary nighttime read business. Night preliminary reads can be performed fairly quickly and released with a short report; they are far less time consuming than those for which a full read is required. Also, night radiologists performing a preliminary read can usually assume a radiologist will go over the image again and issue a full signed report in the morning. This can speed up the night reading and reporting process considerably. Goyal says he has heard of night radiologists kicking out 50 or 60 studies in an hour. Indeed, the Morgan Stanley report estimates that NightHawk radiologists will perform 31,900 reads per FTE in 2006 compared with a median of 12,100 per FTE for all of radiology. "You may have a renal cyst or a liver cyst that a radiologist will really have to concentrate on in the morning, and the night reader doesn't have to worry about it," Goyal said. Pricing is another issue. Goyal said he's heard of teleradiology companies collecting $60 to $65 for final reads, but the time commitment is 50% higher. His typical preliminary report is not more than three or four lines. Final reports are never less than 10 to 15 lines. According to Bakken, full reads are priced by modality. Garden-variety MR studies often fall into the $80 range and sometimes higher. Complicating pricing are issues of how payments are billed and collected. Typically, teleradiology companies that prepare final reports sign them and collect from the radiology group or facility for which they performed the service. That group or facility then bills the insurer or Medicare under the signing radiologist's name, collecting more for the interpretation than the teleradiology company charged. An additional complication in Medicare billing is geographic variation in practice costs, according to Thomas Greeson, a partner in the healthcare group of Reed Smith LLP in Falls Church, VA. Practice costs differ by location, and Medicare payments reflect this. To ensure correct practice costs in the payments, CMS requires that the bill for the final read be submitted to the carrier in the jurisdiction where the interpretation was performed. There is an exception for independent diagnostic testing facilities, which can specify where the interpretation was performed and leave the practice cost adjustment up to the carriers.
SUBSPECIALTY NICHE

A key to the night-read business has been the ability, through technology, to aggregate small segments of the operation that would be otherwise uneconomical

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to serve through onsite or call-in staffing. Most hospitals, for example, don't generate enough business to justify an onsite radiologist at night. Using that same logic, a number of companies have aggregated specialty radiology reads. Probably the biggest player in that segment is Cleveland-based Franklin & Seidelmann. Formed in 2001, the company has grown steadily. It now claims 140 customers in 30 states and annual revenues of $15 to $20 million, according to president Scott Seidelmann, enough to make it the nation's fourth largest teleradiology company. It employs about 30 radiologists. Unlike the night-read companies, Franklin & Seidelmann focuses exclusively on high-end reads; 80% to 85% are MRI studies, and most of the rest are CT, Seidelmann said. Seventy percent of its customers are imaging centers or specialty practices, with orthopedics and neurology heading the list. Franklin & Seidelmann's pitch to its customers, and to the radiologists it hires, is the power of aggregated subspecialty expertise. "We're aggregating client volumes all around the country," Seidelmann said. "The challenge for other facilities is that they don't build enough volume to develop expertise." Using teleradiology, he said, it is possible to bring the expertise of a $600,000 neuroradiologist to a small hospital that otherwise couldn't afford it. "We can tell our radiologists, 'You are the best in your field. You can focus and read only the cases you want to read. And you can live wherever you want, work wherever you want,'" he said. Among those benefiting from the power of aggregated expertise is Dr. Javier Beltran, chair of radiology at Maimonides Medical Center in Brooklyn. Beltran joined Franklin & Seidelmann three years ago and reads on his off-hours. He took the position because he was not seeing enough MR cases to instruct his residents and fellows. The private musculoskeletal work provides a wealth of case studies and also access to high-level experts elsewhere in the country, he said. Recently, for example, Beltran was researching denervation atrophy of muscles in the foot. It is the type of pathology an academic or private radiologist might see once or twice a month. Beltran sent out a request on the Franklin & Seidelmann network and received 25 cases in a week. Identifying the fifth largest teleradiology company is difficult because revenue figures for the smaller players are usually not disclosed. But at least two sources (Morgan Stanley and a survey by HC Pro) suggest that slot may belong to Templeton Readings. Formed in 2002 by Dr. Phil Templeton, president and CEO, the company has what is undoubtedly the largest panel of radiologists, 150, almost all of them part-time, and perhaps also the broadest reach in terms of service, offering preliminary night reads, day reads, subspecialty reads, and reads for the VA and the military. The company also has a different business approach. Trading on his 10 years of work as professor and chair of radiology at the University of Maryland, Templeton has built an extensive database of radiologists who can be linked to clients with a specific radiology need.

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Competitors call the approach "reselling," but Templeton says that label is unfair. "For each client (he estimates there are 140), I can find a discrete number of radiologists who match their particular need," Templeton said. "Reseller is not accurate. Customized radiology is more accurate. I will specifically seek out certain specialists for certain things, linking people by state license and by specialty." A midtier group of firms operating both nationally and regionally exists beyond these big five companies. Major players in this market space include U.S. Radiology On Call, NightShift Radiology, and Stat Rad. U.S. Radiology On Call was formed in 2000 and is based in Los Angeles. It has 18 full-time and four part-time radiologists and is licensed in all 50 states, according to Ian Seidel, director of marketing and sales. Currently, U.S. Radiology On-Call gets about 80% of its business from preliminary night reads, but interest in day reads is growing rapidly. "Five years from now, it will be 50-50. Our plate will be full 24 hours a day," Seidel said. NightShift Radiology, founded in 2001, has 18 radiologists and is based in the San Francisco Bay Area. It was cofounded by Dr. Eric Trefelner, a radiologist (and columnist for Diagnostic Imaging). NightShift is licensed in 26 states and remains largely focused on night reads. Stat Rad, based in San Diego, was founded in 1995 as an outgrowth of a radiology practice. Today it remains a cooperatively owned radiology practice, but with a night and teleradiology focus. Its 18 radiologists serve only hospitals in California. "We've found that the best radiologists don't want to get credentialed at 25 facilities and have 15 state licenses," said Dr. Doug Bates, chief executive officer. Instead, Stat Rad hopes to build interest by radiology groups in other states in something approaching a national radiology cooperative. Part of that plan includes developing its own software products for image management, workflow, quality assurance tracking, and radiologist productivity.
CAPITAL INFLUENCE

Like most of the other teleradiology companies, Stat Rad has met with venture capital providers. But the company bills itself as "radiologist-centered" and tends to be highly critical of equity-funded companies such as NightHawk. A statement on the Stat Rad Web site notes that, "There is a growing perception of risk on the part of radiology groups, who fear the loss of autonomy as corporate entities enter the field of teleradiology. Within publicly traded firms, radiology becomes a commodity and profits are the focus. In an attempt to boost profits, will corporate giants sacrifice quality and industry incomes, or will prices be gouged? Will large public teleradiology companies seek to take your practice's daytime business or contract with other medical specialties? The benefits of outsourcing night coverage must be weighed against the long-term costs of inviting a competitor into your hospital or imaging center."

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That sentiment is not uncommon among other teleradiology providers. "We have no intention of going to venture capital," Seidel said. "We don't want to have stockholders to answer to. We want the clinical side of our service to be the main focus. Being a publicly traded company, your stockholders have expectations of growing profit on a quarterly basis, and that may not happen. It may compromise things to require profit after profit, quarter after quarter." Berger has heard the arguments but indicates he is not convinced. "We were asked on numerous occasions why we were going public. I'm always concerned that this will sound disingenuous, but I have a really good feeling that we're helping to improve the quality of medical care," he said. The firm is interested in a wide range of opportunities that exist to improve healthcare, according to Berger. "Telemedicine and teleradiology are booming. We want to be involved in those sorts of things, and one way to do that is through access to the capital market," he said. While public investment has the potential to modify the way the company does business, NightHawk has made a strong commitment not to let it, Berger said. "If we do the right thing for patients and radiologists, our shareholders will be comfortable," he said. During a recent trip to Washington, DC, for example, one legislator offered to link Berger up with a CEO at a large hospital chain, he said. "He was very surprised when I said I would not be interested," Berger said. "I would be more than happy to meet with the radiologists who work with that chain, but we are not about to discuss in any way, shape, or form displacing radiologists." Mr. Hayes is editor of Diagnostic Imaging.

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