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Kindred Healthcare Inc. (NYSE:KND)

Q3 2008 Earnings Call Transcript

October 31, 2008, 10:00 am ET

Executives

Pat Watson - VP of Corporate Communications

Paul Diaz - President and CEO

Rich Lechleiter - EVP and CFO

Analysts

Bryan Sekino - Barclays Capital

Rob Hawkins - Stifel Nicolaus

Newton Juhng - BB&T Capital Markets

Joanna Gajuk - Banc of America

Steven Velicade - UBS

Operator

Good day, everyone, and welcome to the Kindred Healthcare Incorporated conference call. Today's conference is being recorded. At this time for opening remarks and introductions, I'd like to turn the call over to Mr. Pat Watson. Please go ahead, sir.

Pat Watson

Good morning. Welcome to the Kindred Healthcare third quarter 2008 conference call. This is Pat Watson from Corporate Communications.

Before the Company's presentation, I would like to read a cautionary statement prepared by the Company. This conference call includes forward-looking statements within the meaning of section 27A of the Securities Act of 1933 as amended, and section 21E of the Securities Exchange Act of 1934 as amended. Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize that actual results may differ materially from the Company's expectations, as a result of a variety of factors including, without limitation, those discussed later. Such forward-looking statements are based on management's current expectations, and include known and unknown risk, uncertainties and other factors, many of which the company is unable to predict or control, that may cause the company's actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements.

The company refers you to its reports filed with the Securities and Exchange Commission, including the Company's annual report on Form 10-K, the Company's other reports filed periodically with the SEC, and its press release regarding the third quarter 2008 operating results, for a discussion of these forward-looking statements and other factors that could affect these forward-looking statements. Many of these factors are beyond the control of the company and its management. The company cautions investors that any forward-looking statements made by the company are not guarantees of future performance.

The information being provided today is as of this date only, and the company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.

It is now my pleasure to introduce the speakers for today's call, Paul Diaz, President and Chief Executive Officer of Kindred; and Rich Lechleiter, Executive Vice President and Chief Financial Officer.

Mr. Diaz will begin the call.

Paul Diaz

Thanks, Pat, and good morning everyone. Last night, we announced our third quarter results that were consistent with our October 21st announcement. While the fundamentals in all of our businesses are still strong, and we see no systemic issues, our third quarter results were hampered by weakness in our Hospital Division that was exacerbated by the leverage in our capital structure.

For the third quarter, we reported income per diluted share of $0.02 from our Continuing Operations, which included $0.06 per share of net charges. While we reported solid growth in same store hospital admissions in the quarter, our length of stay declined, particularly in the commercial side of our business, resulting in fewer patient days and lower revenues than we expected. As we have seen in the past, it was difficult to flex our operating costs during low occupancy periods to completely offset this revenue decline.

On a more positive note, our Nursing Center results in the third quarter improved over last year, as we continued to demonstrate more consistent operating performance through higher census and better quality mix. Peoplefirst Rehabilitation Services also performed reasonably well in a soft operating environment, as we continued to manage through labor cost challenges.

Before commenting further on our third quarter results and our opportunities going forward, I would like to Rich to recap our operating results. Rich?

Rich Lechleiter

Thanks, Paul. Good morning, everybody. Our consolidated revenues for the third quarter of 2008 exceeded $1 billion. Excluding the spin-off of our KPS business from last summer, our revenues rose 6% in the third quarter compared to the same period last year.

Consolidated operating income, or EBITDAR, totaled $118 million in the quarter, compared to $110 million in the third quarter of 2007. A reconciliation of EBITDAR to our consolidated results of Operations is included in our third quarter Earnings Release, which is available on our website, www.kindredhealthcare.com.

In our Hospital Division, we reported revenue growth of 4% to $435 million in the third quarter, while EBITDAR of $65 million included a $6 million decline in our Louisiana and Southern Texas Operations, resulting from the Gulf hurricanes.

Reported third quarter hospital admissions grew 6% compared to the same quarter last year, while same store total admissions in the quarter were up 4% compared to the third quarter a year ago. Same store non-government admissions rose 12% compared to the third quarter of 2007, while Medicare same store admissions increased 1%.

As Paul indicated, overall patient days in the quarter were lower than expected, driven mostly by declines in the length of stay. As a result of lower patient volumes, hospital operating margins declined as overall division operating costs per patient day rose 7% in the third quarter of 2008 compared to a year ago.

Through the first six months of this year, operating costs per patient day rose approximately 2% compared to last year.

In our Nursing Center business, revenues of $536 million were up 5% in the third quarter of 2008, compared to the same quarter last year, primarily due to favorable overall rates and quality mix improvements. Our Medicare census in the third quarter was somewhat softer than we expected.

Our overall quality census improved from last year's third quarter, as we continue to invest in our operations to better care for higher acuity patients. Our quality mix revenues improved to 56.4% of total revenues in the third quarter of this year, from 55.8% in the same period last year.

Nursing Center EBITDAR for the quarter rose to $79 million, up 5% from last year's third quarter. Our Nursing Center labor cost per patient day grew 5% in the third quarter this year compared to the same period last year.

Peoplefirst reported revenue growth of 21% to $106 million, compared to last year's third quarter of $88 million. On a same store basis, we saw some general softness in third quarter Medicare volumes in Nursing Centers compared to our expectations.

EBITDAR for the quarter totaled $7 million, compared to $8 million in the third quarter last year. While we continue to manage through a very competitive market for therapists, we are pleased with the progress we're making in external customer growth and higher employee retention rates. So, far this year we have added 49 new contracts.

Professional liability costs for the third quarter came in better than expected. Total program costs were $5 million in the third quarter of 2008, compared to $7 million in the same quarter last year.

Our latest actuarial projection for 2008 indicated that this year's malpractice costs will approximately $35 million to $40 million, compared to last year's aggregate costs of $37 million.

In terms of the balance sheet and overall liquidity of the company, our financial position at September 30 remained strong. Our cash balances at the end of the quarter totaled $19 million, and we had $328 million of outstanding borrowings under our revolving credit facility at the end of the quarter, up from $275 million at December 31, 2007.

Our operating cash flows for the quarter were in line with our expectations. We typically experience strong operating cash flows in the fourth quarter and expect the same for this year, including the favorable settlement of approximately $65 million of Medicare receivables.

Assuming no further acquisitions over the balance of the year, we expect to close the year with approximately $60 million to $70 million in cash and $330 million to $340 million in revolving credit borrowings, allowing significant financial flexibility going forward.

This is particularly important, because we will have funded through internal sources substantially all of our expected $120 million to $125 million in routine capital spending, and $50 million to $55 million of hospital development spending in 2008.

In terms of our adjusted leverage at the end of 2008, assuming a capitalization of our leases at 8 times, we expect to be at 5.5 times EBITDAR going into 2009.

In yesterday's Earnings Release, we maintained our fourth quarter earnings guidance range of $0.35 to $0.45 per diluted share. We also provided our initial 2009 earnings guidance range of $1.30 to $1.45 per diluted share, to provide more clarity around our earnings expectations for next year.

We expect that our routine capital and organic capital spending will approximate $100 million to $110 million in 2009, while the continued investment in new hospital development should range from $50 million to $60 million. Most of this spending should be financed through internal sources.

That concludes my remarks for the quarter. Paul?

Paul Diaz

Thanks, Rich. Let me make a few observations before we take questions. First, we are continuing to focus our efforts to improve the operating results in each of our sites of service, where we have significant opportunities, particularly in our underperforming and start-up hospitals.

While we reported a challenging quarter in our Hospital Division, we are working hard to achieve more consistent operating performance across this portfolio. Our Nursing Centers continue to achieve a high level of consistency that's resulted from years of work to improve culture, engage our employees, and improve quality and customer service. And with Peoplefirst, we are focused not only on continuing top line growth but also on better throughput in terms of labor management and operating efficiencies that should result in margin improvement in this business.

Finally, we expect to end the year with a stronger balance sheet and better operating cash flows, positioning the company well going into 2009.

That concludes our formal remarks and we're glad to take your questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) And we'll take our first question from Bryan Sekino of Barclays Capital.

Bryan Sekino - Barclays Capital

Hi, good morning many this is actually Bryan Sekino on behalf of Adam Feinstein.

Paul Diaz

Good morning.

Bryan Sekino - Barclays Capital

Good morning. I just wanted to ask you a bit of question as you look at your occupancy, it was kind of up year-over-year and we see your admissions increase, but just kind of wanted to think about where you would have expected it to be in the LTAC division of (inaudible) kind of where you had expected it at the end of Q2?

Paul Diaz

Really, if you look at the days, the length of stay declined both in Medicare, but particularly in the commercial side really affected our revenues and affected our length of stay. During a period of typically low occupancy anyway, our third quarter, which we've talked a lot to investors about, this drop of length of stay sort of caused a double whammy for us. And we see that length of stay, and we've seen over many years the length of stay bounce around a little bit, depending on the mix of patients we'll get. In this third quarter, again, in a period of seasonally low census, we sort of had that double whammy with that drop in length of stay.

Bryan Sekino - Barclays Capital

Okay. So like -- so you saw your LOS come down. Now, when you talk about that double whammy, are you talking about acuity as well?

Paul Diaz

No, the acuity does bounce around as well. What I'm talking about that is that we -- we've not really seen a sort of this kind of drop in length of stay, particularly in the commercial business, happen in the third quarter, and so that resulted in the much lower days than on an average daily census that we expect.

Bryan Sekino - Barclays Capital

Okay.

Paul Diaz

And again, nothing systemic here. I think that's the important point. We've talked about over the years that we see our length of stay and the mix of patients, there is volatility in that when one looks over the 12-month, 18-month period. This was somewhat unexpected in seeing this length of stay drop during the third quarter as well.

Bryan Sekino - Barclays Capital

Okay.

Rich Lechleiter

Let me add, this is Rich. Let me add just one thing to that. I think, as we think about the quarter, in any event, I think Paul's right. I think, you know, as we said in our comments, it's difficult to flex some of these costs in the hospital business when you have an average -- the average capacity in our building is 50 or 60 beds. It is more difficult to flex in periods in which the overall census goes down. And I think, again, the lower than expected days in a period in which it's tough to flex anyway on the cost side, it really kind of exacerbated the issue in terms of margin pressure on the hospitals in the quarter.

Bryan Sekino - Barclays Capital

Okay. And then, back to the question about, I guess your revenue per patient day, now, you mentioned the acuity didn't really go down but we did see a bit of a decline in revenue per patient day in the commercial business. Can you give us some comments on that?

Rich Lechleiter

Yes, I think if you look back historically, and that's one of the reasons we put out the quarterly data in the form we do, I think you're going to see that bounce around from quarter to quarter. I think generally our view on an annual basis is that we ought to see pricing somewhere in the 1% to 3% range in terms of aggregate per patient day, mostly on the commercial side.

But again, as we're -- it's a little tough to predict that from quarter to quarter, as we're growing that part of the business more rapidly than the others. As we indicated, the same store growth in admissions for non-government in this quarter was 12% over a year ago, so that growth can tend to make that rate jump around a bit.

Bryan Sekino - Barclays Capital

Got you. Got you. And then, one more question and I'll jump back into the queue. You talked about as -- it's difficult to flex on your labor costs in the quarter, so we saw, I guess, SG&A come up a bit. Can you tell us about how you expect that to change going forward?

Paul Diaz

Well, you know, again, you have a higher percentage of fixed costs on this lower average daily census. And we've also seen in our hospital and our nursing home business cost pressures in terms of labor, medical supplies, ancillaries, et cetera, partly as a consequence of taking higher acuity patients and growing our managed care business. We are very focused on how we can better manage those costs, both in the near term and going into next year, and it's something that we're confident we can do a better job of -- and we're going to need to do a better job of, because clearly we still have a lot of opportunity to grow our managed care business, both in our nursing home and hospital business. So, we're going to need to improve that, the management of the ancillaries and med supplies around those patients.

Bryan Sekino - Barclays Capital

Okay. Thanks for taking my questions.

Pat Watson

Sure.

Operator

And we'll take our next question from Rob Hawkins with Stifel Nicolaus.

Rob Hawkins - Stifel Nicolaus

Good morning, guys.

Paul Diaz

Good morning, Rob.

Rich Lechleiter

Good morning.

Rob Hawkins - Stifel Nicolaus

I guess one place, maybe kind of following on Bryan's question, and I understand kind of as you get to a drop in census you have a par level of folks that you have to kind of have in there, and it becomes more like a fixed cost than a variable cost, but a lot of the work that you guys have done with turnover, kind of go looking back the last couple quarters, it doesn't seem like you're quite still getting the leverage in your labor, and the year-over-year costs seem to be going up 5% ish, 4% to 5%, when I was kind of expecting with the turnover as great as it's been, why aren't we seeing that kind of more 100 basis points or a little bit better than what most folks are experiencing?

Paul Diaz

That's a great question, Rob, and I think it's a little bit different story in the first half of the year than, quite frankly, in the quarter.

Rob Hawkins - Stifel Nicolaus

Sure.

Paul Diaz

Part of it is, exacerbated by the volumes in the quarter. And we still think that's a source of opportunity. I tell you, one of the things that happened in the Hospital Division in the third quarter was we've been very focused on reducing contract labor, and unproductive hours were up somewhat. Now that should benefit us in Q4 and going into next year, as we were doing orientation and training for new nurses, with the hopes and expectation to reduce and we're seeing, you know, we're seeing that. But it's bad timing to be doing that unproductive orientation and training, with the right goal of reducing contract labor in the third quarter.

But that should prove a benefit for us in terms of reducing contract labor and having that staff as we're in Q4 and going into next year. We could have done better in this regard. It was less, as we peeled the onion back, less in terms of nursing hours on the floors. We flexed pretty well there but it is very hard to flex your laboratory, your radiology departments, your business offices, where we've made some significant changes over the year to mitigate the LTAC rate cuts of the prior years, to flex further when you're down 12,500 days.

Rob Hawkins - Stifel Nicolaus

Okay. Can we spend a little bit of time with the guidance? I got a little bit of color last night. Can you talk a little bit about how you're building guidance and maybe where you guys think a normalized growth rate, knowing that you're going to kind of bounce in the second and third quarter around, but maybe where that I guess trajectory growth line is going for you guys on, I guess, on an EPS and a revenue basis?

Paul Diaz

Let me go through a couple of points in that regard. This preliminary guidance is based on kind of where we are in our budget process, which is fairly well along, and we've made a lot of progress internally in advancing that. But we'll put the finishing touches on over the next couple of months.

One of the things that affects our view is, where we are in terms of volume and jump-off, as we said here in October and think about where we're going to be on January 1st, the lower base of volume and mix going into the fourth quarter, and as we talked about in our previous announcement, you know, September was softer than expected, that affected our third quarter results, we typically get a bigger bounce both in our hospitals and nursing homes in September.

We are starting to see here in the back half of October things picking up. But we still have a lower base, as we think about the jump-off in mix and volume for January 1st. So, that affects this preliminary view. We've still got an opportunity, depending on when flu seasons hit and those kind of things, to make more progress there.

The second thing is the rate pressures and probably a little more cautious view around Medicaid rates in the Nursing Home division, we are large operator in Massachusetts where a freeze is proposed in Medicaid rates. We have some other states where, given the state budget situation, and you saw the Republican governors yesterday asking for more help from the Federal Government in terms of the Medicaid rate pressures, we expect to see the states that we have now and probably more states have concern about the market basket increases in those states.

Similarly, in our Hospital Division, we have a somewhat more cautious view around the commercial rates, although, we continue to grow our commercial business and our Medicare Advantage business, the pricing there as we've previously talked about is probably going to be more in the 2% to 3% range.

The cost pressures, we've already talked about. Again, we clearly believe we can manage that better, but we have had in the labor line, the food, medical supplies, ancillaries, increased cost pressure as the years unfolded. Again, we expect to manage that better in Q4 and a lot of focus going into next year.

And then lastly, is a longer view around reaching stabilization of our new hospitals, and reaching full potential in our underperforming hospitals. And this is also the source of the greatest opportunity in this guidance next year.

So, we've got hospitals in Cleveland, in Pittsburgh, Philadelphia and Richmond, that have a lot of upside and we are intently focused on. We've got a new hospital that opened in August in West Palm Beach that we are excited about. We've got our new hospital in Indianapolis south that's actually performing quite well, as is our new hospital in Phoenix.

And next year, and you guys will see this in our revised investor presentation next week, we've got one more hospital expecting to open later in the year in Melbourne, Florida. So, not a lot of new starts next year, but the ability to get these new hospitals and some of our underperforming hospitals, to full potential. It hasn't moved as quickly as we would like and there's great intense focus on that inside the company right now.

Rob Hawkins - Stifel Nicolaus

All right. Thanks. I'll jump back in the queue.

Paul Diaz

Thanks.

Operator

And we'll take our next question from Newton Juhng of BB&T Capital Markets.

Newton Juhng - BB&T Capital Markets

Hi, good morning, everyone. I did have a quick question about the receivables. Rich, I was wondering, if you could just give us a little more detail as to -- it was a little bit higher than we were expecting here in the quarter, and just what the components of that were?

Rich Lechleiter

Yes, good morning. Most of the increase that we typically see in Q3, and we saw again this year, is related to Medicare, primarily between the two largest divisions. And typically what you see, and again, referenced to our earlier comments, the collection, kind of the lump sum collection, a lot of those monies should occur in Q4. Part of it’s already occurred in October, and the rest of it will be wrapped up in December. So, in aggregate we’ll bring that down by $65 million on the Medicare side alone in the fourth quarter. So, we should see some very strong operating cash flows in Q4 around that.

Newton Juhng - BB&T Capital Markets

Okay. So good to see that coming back down in the fourth quarter. Can I also get a quick take on the routine cap spending. It looks like you’re looking for it to come down year-over-year, and I was just wondering if you could give us a little detail as to what you’re cutting back on, on that front?

Paul Diaz

Well, as we’ve talked about this before, that we’ve made a significant amount of investments in our nursing center business, in our transitional care units. After several years of sort of working on basic things and improving, replacing all our beds, for example, with state-of-the-art beds and mattresses, all that’s benefiting us on the workers’ comp line, and in-house acquired pressure [shores] and the quality of the asset to take care of higher acuity patients.

But, as we’ve talked about, you’re seeing us finish the hospital development program, and you’re seeing our ability now to reduce the CapEx spend, because a lot of the transitional care unit investments have happened. And so, you will see next year and the year after greater free cash flow, which is consistent with the comments we’ve made over the last year.

Newton Juhng - BB&T Capital Markets

Okay, Paul. Then just lastly, I know I’ve asked this question of you guys before, but in terms of the outlook and what you guys have put out at this point. How should we be looking at your current footprint of hospitals? And is there any more that might be at risk for potential consolidation or removal at this point?

Paul Diaz

No, I mean, we’ve scrubbed this pretty hard over the years. And again, when we’re operating 312 facilities, we are constantly looking at the opportunity to improve performance, and add and subtract where we have non-strategic assets and are not in the market for where we think we’ve got the greatest opportunity. But, that pruning of the portfolio has for the most part been completed. And so, we don’t really have anything else right now that we’re focused on from a divestiture standpoint.

The focus right now is getting to full potential at every one of our nursing centers and nursing and rehab centers, and the hospitals that we have today, and the ones under development, and improving the performance of the new hospitals that – starts that we’ll have in 2009 and 2010.

Newton Juhng - BB&T Capital Markets

Okay. Thanks for the comments, Paul.

Paul Diaz

Sure. Thank you.

Operator

(Operator Instructions). We’ll go next to Kevin Fischbeck with Banc of America.

Paul Diaz

Good morning, Kevin.

Joanna Gajuk - Banc of America

Good morning. Actually, this is Joanna Gajuk for Kevin Fischbeck. So, I just want to ask a little bit more about the 2009 guidance in terms of, does the guidance assume for the commercial length of stay, what do you assume for commercial length of stay? Do you assume that it comes back to normal or does it stay at the same levels? And also, do you foresee any swing factors that affect your guidance for next year?

Paul Diaz

You know, as I mentioned before, we see the length of stay both managed care, Medicare Advantage, commercial and Medicare fee-for-service bounce around from time to time, depending on the types of patients that we’re getting. So, in the short term, we don’t think that there is any systemic issue, nor as we thought about in and working on our budgets and guidance for next year, do we see any sort of permanent impairment. But again, that will bounce around from time to time.

I think over the longer term, good case management, improvements in medical technology and practice patterns, and working with our managed care partners, our goal is to get people home faster. That is being offset with a much higher acuity in our commercial business. I mean, one of the things that is offsetting over the longer trends is that if you look at the case mix index of our commercial business and our Medicare Advantage, it’s much higher than our Medicare fee-for-service business.

So, there are factors moving length of stay in a number of different ways. And again, that can have a different effect in different months, depending on the mix of patients that we get.

Joanna Gajuk - Banc of America

Okay. And then you mentioned more malpractice expense this quarter, but what does your guidance include for ‘09?

Paul Diaz

For what expense?

Joanna Gajuk - Banc of America

For malpractice expense.

Rich Lechleiter

Malpractice. We have targeted $60 million to $70 million for next year’s malpractice cost.

Joanna Gajuk - Banc of America

Okay. That’s great. And then also you mentioned implementing those [out-backs] that were -- that are having some issues, because I think last quarter, right, you were talking about experiencing a drag from some of those newly opened [out-backs] . So, can you give us more color in terms of how they did this quarter and what you think is going to happen next year? And also how you think those out-backs that might open next year how they would do next year?

Paul Diaz

Yes, we did, and again, we did talk about that in Q2 and just sort of mentioned a couple of those again. Our new hospitals in Cleveland and Pittsburgh, Philadelphia and Richmond have been a drag. And while we have -- we see opportunity there and we expect to see better performance in Q4 and Q1, they are still behind our expectations. And again, the Indianapolis south hospital, the Phoenix, Arizona hospital are off to good starts. Similarly, we expect our hospital in West Palm Beach that opened in August to have a good start and better start than our hospital in Cleveland, for example.

Next year, in terms of -- and you’ll see, again, in our revised investor presentation some more specifics around this. So, you can drill down on it, the hospital in Melbourne is not expected to open until October of ‘09 and our other hospitals -- our other hospitals under development aren’t expected to open until 2010.

So, we don’t really have new starts, per se, that are affecting our view of 2009. But it is taking us longer to get to full potential in the hospitals that we have. And some of the hospitals in markets where we have seen greater pressure in the commercial business, our action plans there have taken longer to take root. And so, we’ve got more opportunity there as well and we expect that to play itself out over the next few quarters.

Joanna Gajuk - Banc of America

Okay, great. That’s very helpful. And also you mentioned the freeze in Medicaid rate in Massachusetts. So, can you talk more about other top states and how you see Medicaid?

Paul Diaz

Yes. There are -- I think there are approximately four or five states right now that are proposing rate freezes in the Medicaid rate. I don’t have that list with me right now. But Massachusetts being one of them where we have a very large presence. Now, again, we’ve done a really good job in our nursing home division of improving our quality mix. We see further opportunity in doing that, and we’ve managed costs there very consistently. But, it is difficult to continue to grow EBITDAR when you’re not getting those market basket adjustments on the Medicaid program.

So, it’s somewhat giving us a more cautious view of next year. And we think that’s appropriate, given that there still may be other states that are working through their state budget pressures that may look to curtail reimbursement for nursing homes as well. So, we’ll see how that plays out and we’ll see how the federal intervention plays out in the context after next Tuesday. But, I think that is prudent for us to have a cautious view around that, given the economic backdrop and the pressure state budgets are under right now.

Joanna Gajuk - Banc of America

Great. Thank you. That’s very helpful. And then also In terms of the lease renegotiation that happened last year with Ventas, I guess as part of those renegotiations you were able to remove 900 beds from your nursing homes. So, can you talk about where you are in that process and whether any of the refurbished units have opened yet, and any indication on how they might be doing?

Paul Diaz

Yes. We are continuing to make good progress there in the development of our transitional care units. And quite frankly, some of those have been so successful that our facilities, some of our facilities are becoming transitional care centers, where the majority of the beds are now focused on our short-term rehab and medically complex patients. So that's proceeding rather well. I think everyone saw some softness in Q3 in terms of Medicare census. You know, we saw that in our rehab business as well. But as we kind of come into the peak season here, you know, we expect to have a lot more traction in Q4 and going into next year in terms of that program and the benefits of that program.

Joanna Gajuk - Banc of America

Okay. Great. And then also, yes, I guess in the press release there was something you mentioned about additional opportunities to improve operations in each division? So can you walk us through where some of the bigger opportunities are, and are those related more to cost-cutting or top line?

Paul Diaz

In the hospitals, as we've talked about, we've got a lot of opportunity to reach full potential and get the return on invested capital in our new hospitals, and the hospitals we have in the portfolio right now. We know how to do that. We have had some facilities that have had market changes, and we needed to react to those. And the better cost management and the better flexing of cost to the average daily census is something we can do a better job of. But as I said earlier, the third quarter was less about flexing labor to the staffing and more about just the structural challenge you have there on a lower census and a lower length of stay. So we are excited and think that as -- you know, with all of the hospitals that we have built and are building, we're still confident that they're in the right markets and there's a good demand and high demand for LTAC services.

In our Nursing Home division we still see opportunities in the continued progress of our quality initiatives, and how that is impacting the malpractice line, how that is impacting workers' comp, and that continues to be a good story for us and the growth of our Medicare Advantage, Medicare business, and quality mix improvement in our Nursing Centers.

And Peoplefirst Rehabilitation, we're continuing to grow our contract business there and there's a great deal of focus improving the margins in our non-affiliated business through better management of contract labor, productivity gains through the implementation of our handheld technologies and better cost management. So we've got margin improvement opportunity there going into next year, and that's reflected in the guidance opportunity, albeit some of the challenges around Medicaid rates, etcetera.

Joanna Gajuk - Banc of America

Okay. And just a quick one about the acquisition environment. You know, do you see anything for both [Smith] and LTAC? And when you thing about those three divisions, where do you think you will be most active on the acquisition front?

Paul Diaz

We'll continue, as we have been, you know, looking at opportunities in our cluster markets to add high-quality skilled nursing facilities that complement, and where we think we can take our high acuity program and our managed care relationships and get good returns for investors. Less likely to see acquisitions in the LTAC space. We're very focused on was we have and the opportunities we have in our LTAC portfolio. And we'll be opportunistic in terms of things in the rehab area as well. But right now, we're very focused on the opportunity within this portfolio and within the businesses that we have. That is where most of our attention, the vast majority of our attention is focused right now.

Joanna Gajuk - Banc of America

Great. Thank you. That's very helpful. Just a quick one. I know maybe it's too early, but in terms of any thoughts about Medicare rates for [Smith] and LTAC for 2010?

Paul Diaz

You're absolutely right. It's very early. That will be a better conversation once we get a new Congress in here and the new Administration. So more to talk about that probably after Q4. But why don't we let somebody else in the queue now?

Joanna Gajuk - Banc of America

Okay. Great. Thank you very much.

Paul Diaz

Thank you.

Operator

And we'll go next to Steven [Velicade] of UBS.

Steven Velicade - UBS

Hi, thanks. Not to beat this to death, but I guess I'm just curious, what would specifically drive down LTAC length of stay and just the commercial book of business in a given quarter? Is it just luck of the draw or are commercial payers somehow playing a role in this? Or is it just Kindred operation managers trying to manage patient flow around the 50% rule and just basically mismanaging it? What's really happening here that could make it happen in just a given quarter, just in a commercial book?

Paul Diaz

It's a very good question. We don't manage patients at the front door to short stays or normal stays or high cost [outlies]. Our job, and you see that when you kind of look at this over multiple quarters, is to take very sick patients out of short-term acute care hospitals, through the similarity process, get them home and medically manage them, and they fall out where they fall out.

Now, good case management and working with the case managers of the commercial payers means that we're going to try to get people home and that will affect length of stay. But this quarter was really more about the mix of the patients that we were seeing, and what was happening in the short term acute care ICUs, and that can greatly impact us from one market to another. So I mean, I don't think it's a luck of the draw. I mean, you know, it is that in the quarter, we saw this length of stay exacerbate the results, given the leverage, you know, in the operating model in our hospitals, that length of stay exacerbated what is normally just a low census base. And the percentage of cost that's fixed goes up.

Steven Velicade - UBS

Okay. But just to be clear, then it doesn't sound like that commercial payers are somehow playing a role in this, either through coverage, policy changes that might have taken place mid-year?

Paul Diaz

Not…

Steven Velicade - UBS

My understanding it's illegal for payers to be involved in trying to persuade physicians, etcetera, but it sounds like there's nothing going on along those lines. I wonder if you could confirm that one way or the other?

Paul Diaz

I'm sorry. I'll try to be clear. No, there is no difference between the case management that was happening with our commercial payers in Q1, where you saw the opposite view of this leverage, than how they were case managing patients in Q3. Our case managers working with the case managers of Aetna or United or Humana. So nothing different. Everybody works towards what's clinically best appropriate, and how we can get patients better and get them home. That's how we approach this, and the mix of patients that we can get on any given day can affect that length of stay.

Steven Velicade - UBS

Okay. Thanks.

Paul Diaz

Sure.

Operator

And we have a follow-up question from Rob Hawkins with Stifel Nicolaus.

Rob Hawkins - Stifel Nicolaus

Hey, thanks. I want to see if maybe I could get a little bit of an update on the marketing strategy. You guys have been changing your interfacing with doctors and so forth and kind of -- and it seems to be working very well the last few quarters, and you've been getting a lot of success there. I'm trying to reconcile that with the guidance and kind of what's happened during this quarter. Are you finding marketing is effective? Is it filling hospitals faster? What's maybe changed here?

Paul Diaz

No, Rob, I don't think anything's changed. We still have more opportunity in this regard. As we've talked with you and others, as we think about sort of the longer-term multiple-year horizon, you know, we think whether it's commercial payers or government payers, we're going to have a pricing environment for the next few years that's sort of probably be, if things go well, in the 2% to 3% range. So we are intently focused on growing volume and on stable length of stay, and that means growing average daily census, and the ability to cover greater fixed costs on that growth of average daily census. And I think if you kind of look at the year-to-date, that's working and we need to do more of that. It didn't come together in the third quarter.

Rob Hawkins - Stifel Nicolaus

Okay. Fair enough. Thanks, I'll jump back.

Paul Diaz

Sure. Thank you.

Operator

And gentlemen, we have no further questions at this time. Mr. Diaz, I'll turn the call back over to you for any additional or closing remarks, sir.

Paul Diaz

Well, thank you. Again, as we've chatted about, some things did not play out as expected in the quarter, but we do see more opportunities to execute better going into the rest of this quarter and going into next year, and we commit to everyone that we will be very diligent in that regard, and look forward to talking with you again after the fourth quarter. Thank you.

Operator

And that does conclude today's conference call. Thank you for your participation. You may disconnect at this time.

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Source: Kindred Healthcare Inc., Q3 2008 Earnings Call Transcript
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