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Executives

Mary Ann Arico - Senior Vice President of Investor Relations and Corporate Communications

Jay F. Grinney - Chief Executive Officer, President and Director

Douglas E. Coltharp - Chief Financial Officer and Executive Vice President

John P. Whittington - Executive Vice President, General Counsel and Corporate Secretary

Mark J. Tarr - Chief Operating Officer and Executive Vice President

Analysts

Colleen Lang - Lazard Capital Markets LLC, Research Division

Ann K. Hynes - Mizuho Securities USA Inc., Research Division

Darren Lehrich - Deutsche Bank AG, Research Division

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

Frank G. Morgan - RBC Capital Markets, LLC, Research Division

Whit Mayo - Robert W. Baird & Co. Incorporated, Research Division

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

HEALTHSOUTH (HLS) Q4 2012 Earnings Call February 19, 2013 9:00 AM ET

Operator

Good morning, everyone, and welcome to HealthSouth Fourth Quarter 2012 Earnings Conference Call. [Operator Instructions] Today's conference call is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Mary Ann Arico, Chief Investor Relations Officer. Please go ahead.

Mary Ann Arico

Thank you, Maria, and good morning, everyone. Thank you for joining us today for the HealthSouth Fourth Quarter 2012 Earnings Call.

With me on the call in Birmingham today are Jay Grinney, President and Chief Executive Officer; Doug Coltharp, Executive Vice President and Chief Financial Officer; Mark Tarr, Executive Vice President and Chief Operating Officer; John Whittington, Executive Vice President, General Counsel and Corporate Secretary; Andy Price, Chief Accounting Officer; Ed Fay, Senior Vice President and Treasurer; Julie Duck, Senior Vice President of Financial Operations.

Before we begin, if you do not already have a copy, the press release, financial statements, the related 8-K filing with the SEC and the supplemental slides are available on our website at www.healthsouth.com in the Investors section.

Moving to Slide 2, the Safe Harbor, which is also set forth in greater detail on the last page of the earnings release. During the call, we will make forward-looking statements, which are subject to risks and uncertainties, many of which are beyond our control. Certain risks, uncertainties and other factors that could cause actual results to differ materially from management's projections, forecasts, estimates and expectations are discussed in the company's SEC filings, including the Form 10-K for 2012, which will be filed later today. We encourage you to read them. You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented. Statements made throughout this presentation are based on current estimates of future events and speak only as of today. The company does not undertake a duty to update or correct these forward-looking statements.

Our slide presentation and discussion on this call will be included -- will include certain non-GAAP financial measures. For such measures, reconciliation to the most directly comparable GAAP measure is available at the end of the slide presentation or at the end of the related press release, both of which are available on our website and as part of the Form 8-K filed last -- filed this morning with the SEC.

[Operator Instructions]

With that, I will turn the call over to Jay.

Jay F. Grinney

Great. Thank you, Mary Ann, and good morning to everyone participating on this morning's call. We obviously have a lot to cover this morning, so let me begin by addressing yesterday's announcement of our stock repurchase authorization. Last Friday, our Board of Directors approved an increase in the common stock repurchase authorization from $125 million to $350 million, and as we stated in the release, we intend to pursue a tender offer for our common stock for up to the full amount of this authorization, the timing and parameters of which will be dictated by market conditions. Any such tender offer will be funded with the combination of cash on hand and availability under our $600 million revolving credit facility. Even if successful at the full amount authorized, any such tender offer would modestly impact the company's leverage ratio, with the resulting ratio remaining within our target range. We believe this announcement and the contemplated tender offer is consistent with the company's strategy of deploying financial resources towards long-term shareholder value-creating opportunities.

With respect to our year-end operating results, we are very pleased to report that HealthSouth ended 2012 with another solid quarter. Demand for our services remains strong as discharges increased 5.4% compared to the fourth quarter of 2011, with same-store growth at 3%. Recently released UDS data indicates that fourth quarter discharges at non-HealthSouth facilities declined by 1.8% compared to last year's fourth quarter, suggesting our hospitals continue to gain market share.

Inpatient pricing increased 2.4% on a per discharge basis and was driven by our modest Medicare and commercial payment adjustments, higher acuity in our patient mix and a higher percentage of Medicare patients. Quarter-over-quarter, the number of neurological and stroke patients increased by approximately 18%, while the number of hip fracture and lower extremity joint replacement patients declined by approximately 2%. This is consistent with recent trends and is attributable to our focus on clinical programs and technology investments that are specifically designed to meet the needs of patients with neurological conditions.

We are very proud of the fact we currently have 86 of our hospitals designated as a stroke center of excellence by the Joint Commission. This is even more impressive when you consider that HealthSouth accounts for approximately 80% of all Joint Commission-accredited stroke centers of excellence nationwide.

Although outpatient revenues were down in the quarter compared to last year because of reduced outpatient visits resulting from the imposition of Medicare therapy caps and the closure of 2 outpatient clinics, consolidated net operating revenues were up 6.7%. A major tenet of our business model is to provide high-quality care on a disciplined, cost-effective basis. Our hospitals continued to deliver on this value proposition as we generated adjusted EBITDA of $128.6 million in the quarter compared to $122.9 million in the fourth quarter of 2011. For the year, HealthSouth's adjusted EBITDA was $505.9 million, an 8.5% increase over prior year. The company's cash flows also remain very strong. Cash provided by operating activities was $109.3 million for the quarter and $411.5 million for last year -- for the year. Last year, cash provided by operating activities was $129.5 million in the fourth quarter and $342.7 million for the full year. This strong cash flow allowed the company to continue to support maintenance CapEx needs of our hospitals while, at the same time, ramp up the implementation of our electronic clinical information system and refurbish several of our older hospitals. We believe the investment in our electronic clinical information system will further differentiate our hospitals from other post-acute providers as the health care delivery system evolves to a system characterized by enhanced clinical coordination, integration and shared patient data. Even with this planned increase in maintenance CapEx, adjusted free cash flow for the year was a very strong $268 million compared to $243.3 million in 2011.

Before Doug provides a more detailed review of the quarter and year-end results, I'd like to discuss 2013 guidance. For those with a copy of the supplemental slides that went out earlier today, I will be referring to Pages 15 and 16. Our initial guidance for 2013 adjusted EBITDA is a range of $506 million to $516 million and is predicated on the following considerations, as highlighted on Page 15. First, discharge growth of between 3% and 4%. Although we have experienced a very strong start to the quarter, as is our practice, we are taking a conservative view on full year volume growth as we begin the new year, owing to the importance of this metric as a driver of our overall operational and financial results. You'll note our 2013 discharge range is higher than the 2.5% to 3.5% range we have used in the past because it includes the acquisition of Walton Rehabilitation Hospital, which we expect to close at the end of the first quarter. 2013 revenue per discharge is expected to increase by a range of 2.3% to 2.6% before sequestration and incorporates a Medicare market basket update in the fourth quarter of 2013, reduced by the Obamacare pay-fors, and a 2% to 4% increase in our managed care pricing. These assumptions produce revenue growth before sequestration of between 4.9% and 6.2% and adjusted EBITDA growth of between $39.6 million and $49.6 million, again, before sequestration.

As shown on Page 15, the net effect of sequestration will be to reduce adjusted EBITDA by approximately $25 million, by far, the biggest headwind we will face this year. We assume the President will sign the sequester order in March, which will reduce Medicare payments made after April 1. Since the length of stay of our patients is approximately 2 weeks, we are assuming payments for patients admitted in the second half of March will be subject to this sequestration order. As depicted on Page 15, we face 2 additional headwinds in 2013: $4 million of incremental expenses related to the continued implementation of our clinical information system and approximately $5 million of additional noncontrolling interest expense related to structural changes at 2 of our joint venture hospitals, which Doug will discuss in just a moment.

Now turning to Page 16 of the supplemental slides. Our initial EPS guidance range is between $1.50 and $1.56 per share. As noted on this page, depreciation and amortization will increase by approximately $12.5 million next year, reflecting our recent investments in de novos, acquisitions and bed additions, as well as our investment in our electronic clinical information system. Page 16 also depicts nonrecurring items in 2012 and 2013. In 2012, we realized approximately $8.4 million of nonrecurring gains and incurred approximately $20.1 million of nonrecurring expenses. In 2013, we anticipate incurring approximately $5 million of professional fees primarily related to ongoing non-E&Y legacy litigation. These unusual or nonrecurring items, along with the $0.16 per share after-tax effect of sequestration, need to be considered when assessing year-over-year EPS growth.

With that, I'll now turn the agenda over to Doug, and following Doug's comments, we'll open the lines up for Q&A.

Douglas E. Coltharp

Thank you, Jay, and good morning, everyone. I'll focus my comments on Q4 2012 but also highlight certain results for the full year and elaborate on a number of the assumptions underlying our 2013 guidance. I'll be reiterating some of the ground Jay just covered in his opening comments, and I'll go into just a bit more detail.

As Jay mentioned, Q4 represented a strong finish to a strong 2012. Our revenue increased 6.7% Q4, driven by inpatient growth of 7.9%, offset by a decrease in outpatient and other revenue. The increase in inpatient revenue was driven by a 5.4% increase in discharges, 3% attributable to same-stores, and a 2.4% increase in revenue per discharge. Approximately 120 basis points of the new-store discharge growth Q4 resulted from the consolidation of St. Vincent Rehabilitation Hospital beginning in Q3 of 2012. Our discharge growth for Q4 was also favorably impacted by the timing of patient discharges from the last week of September into the first week of October. This was the offset to the negative impact to discharge growth in Q3 that we discussed during the third quarter earnings call, and it resulted in a modest decline in our Q4 length of stay.

As I stated on the Q3 call, it's difficult to quantify with precision the impact of this length-of-stay change, but with that caveat, we estimate it added approximately 100 basis points to our Q4 total discharge growth. Now as this was a timing issue, it had no impact on full year 2012 discharge growth, which was 4.6%, including 2.9% in same-store growth. The increase in revenue per discharge in Q4 '12 versus Q4 '11 was attributable to pricing adjustments from both Medicare and managed care payors; an increase in the average acuity of our patients; neurological and stroke comprised 39.2% of our discharges in Q4 '12 versus 34.3% in Q4 '11; and a higher percentage of Medicare patients, offset by the unfavorable impact of pricing related to the aforementioned timing of discharges from September into October.

The $3.2 million decline in outpatient and other revenue was impacted by the closure of 2 additional satellite clinics during Q4 '12 and the implementation of therapy caps on all hospital-based outpatient programs beginning October 1, 2012. At the end of Q4 '12, we operated 24 satellite clinics versus 26 at the end of Q4 '11. Revenue growth for full year 2012 was 6.7%, driven primarily by a 4.6% increase in discharge growth.

As anticipated, bad debt expense for Q4 '12 increased by 10 basis points to 1.3% of revenue as compared to 1.2% in Q4 '11. As we have previously discussed, this increase was attributable to the increase in medical necessity denials experienced throughout the year, as well as a slowdown in the adjudication process. We did see the rate of new denials slow in Q4.

During Q4, we continued to exhibit disciplined expense management. Expenses for the quarter did include a number of items, both favorable and unfavorable, that we expect to be non-repeating. I'll call those out as we review the components of our operating expenses.

SWB for Q4 '12 was 48.7% versus 48.5% in Q4 '11. Q4 '12 SWB was unfavorably impacted by our previously disclosed decision to pay a onetime bonus to nonmanagement employees in the fourth quarter in lieu of merit increases. You will recall this decision was made to reward our employees for a successful 2012 without permanently adding this expense to our cost structure in the face of sequestration in 2013. SWB as a percentage of revenue for Q4 '12 was also unfavorably impacted by a decrease in the benefit related to year-end Workers' Comp insurance adjustments and the costs related to the implementation of our clinical information system. These items were offset by a favorable adjustment in our group medical accrual. Netting the effect of these items would have resulted in SWB as a percentage of net revenue being essentially flat in Q4 '12 versus Q4 '11.

Our continued focus on labor productivity was evidenced by Q4 '12 employee per occupied bed, or EPOB, of 3.46, which was flat with Q4 '11. Our hospital-related expenses, which includes other operating, supplies and occupancy, increased to 20.8% in Q4 '12 from 20.4% in Q4 '11 primarily as a result of the inclusion of a $2.4 million nonrecurring franchise tax recovery included in Q4 '11. In Q4 '12, continued supply chain efficiencies and leverage of occupancy cost more than offset the impact of increased clinical information system implementation cost.

G&A, which excludes stock-based compensation, improved to 4.4% of revenue in Q4 '12 from 4.6% in Q4 '11 as we gained leverage against the costs associated with our corporate office. The combination of strong revenue growth and disciplined expense management resulted in adjusted EBITDA for Q4 '12 of $128.6 million, an increase of 4.6% over Q4 '11. For the full year 2012, we generated adjusted EBITDA of $505.9 million, an increase of 8.5% over 2011.

Our 2013 guidance for adjusted EBITDA is $506 million to $516 million. Owing to the increased number of considerations factored into our 2013 guidance, we have added a 2012 to 2013 adjusted EBITDA bridge at Page 15 of the supplemental slides. Jay referred you to this slide in his comments, and I encourage you to review this slide very thoroughly. Our adjusted EBITDA guidance reflects modest growth resulting from the onset of sequestration; the continued investment in our clinical information system, with implementation scheduled for 18 of our existing hospitals in 2013; the absence of some of the favorable accrual adjustments, such as group medical, experienced in 2012; and an increase of approximately $5 million in noncontrolling interest expense due to changes in the structure of 2 of our joint venture hospitals.

With respect to the increase in noncontrolling interest, we have entered into an agreement to convert our 100% owned hospital in Jonesboro, Arkansas into a joint venture with St. Bernards Healthcare. Following the formation of the joint venture, our ownership position in this hospital will be reduced to 56%. This is a transaction we proactively pursued as it is consistent with our strategy of aligning with high-quality acute care hospitals in certain key markets. Additionally, our share of profits in one of our joint venture hospitals in Memphis, Tennessee will decrease from 70% to 50%, pursuant to a provision in the original partnership agreement, which dates back to the 1990s. There are no similar provisions in our other joint venture agreements.

Interest expense for Q4 '12 of $24.3 million was in line with our expectations and represented a modest increase over Q4 '11 resulting from our September issuance of $275 million in 5.75% senior notes maturing in 2024. As a reminder, approximately $195 million of the proceeds from this offering were used to pay down the outstanding principal balance under our revolving credit facility, and an additional approximately $65 million was used to fund an optional redemption of a portion of each of our 7.25% senior notes due 2018 and 7.75% notes due 2022.

For 2012, interest expense was $94.1 million as compared to $119.4 million for 2011. Assuming no further modifications to our capital structure, we would anticipate interest expense of approximately $98 million in 2013. Diluted EPS from continuing operations for Q4 '12 was $0.42 per share versus $0.50 per share in Q4 '11. The decline was primarily attributable to an effective tax rate of approximately 35% in Q4 '12 as compared to approximately 22% in Q4 '11. Additionally, Q4 '12 EPS was negatively impacted by an approximately $0.02 per share after-tax loss on the early extinguishment of debt related to the previously discussed optional redemption of a portion of our 2018 and 2022 senior notes.

EPS for the full year 2012 was $1.65 per share compared to $1.42 per share for 2011. EPS for 2011 included an after-tax loss of $0.25 per share on the early extinguishment of debt versus $0.03 per share in 2012. EPS for 2011 included an effective tax rate of approximately 19% as compared to approximately 38% in 2012.

The company's basic and diluted EPS were the same for 2011 and 2012. Our 2013 EPS guidance of $1.50 to $1.56 per share incorporates the aforementioned adjusted EBITDA considerations; the anticipated increase in interest expense; an increase in depreciation and amortization expense to approximately $95 million as compared to approximately $83 million in 2012, owing to our recent increases in capital expenditures; and an effective tax rate assumption of 40%.

2012 was another year of strong free cash flow generation for our company. For 2012, we generated adjusted free cash flow of $268 million, an increase of 10.2% from 2011, which, I'll remind you, had increased 34% over 2010. The increase in 2012 was accomplished in spite of an approximately $28 million increase in net working capital and planned approximately $32 million increase in maintenance capital expenditures, the net working capital increase in 2012 primarily related to the timing of payroll-related liabilities, an increase in accounts receivable stemming from the previously discussed trends in medical necessity claims denials and an increase in accounts payable due to the timing of year-end check disbursements. We expect net working capital in 2013 to increase by less than $20 million. Maintenance CapEx for 2012 was approximately $83 million. The year-over-year increase in maintenance CapEx was planned and has been previously discussed. It stemmed from the continued rollout of our clinical information system, and I'll remind you that unlike the acute care providers, we are not subsidized by the government for this investment under the HITECH program, and from a number of significant hospital refurbishment programs. We will continue with these investments in 2013 and anticipate maintenance CapEx in a range of $80 million to $90 million.

With respect to discretionary capital expenditures in 2013 and as indicated on Slide 19, we anticipate increased opportunities to convert a number of our leased hospitals into owned facilities. This relates primarily to the timing of lease terminations and purchase options embedded in certain of our real estate lease. The decision to exercise a purchase option is typically driven by economic and/or control considerations. The estimated range on Slide 19 is based on 5 of our hospitals on which the purchase option is in play during 2013. As reflected in the breadth of this range, the timing, magnitude and ultimate outcome of these negotiations is difficult to predict.

I'll conclude with a quick review of our year-end balance sheet. We ended 2012 with debt of $1.254 billion, roughly flat with the end of 2011. Our leverage ratio at the end of 2012 was approximately 2.5x as compared to 2.7x at the end of 2011. Net of cash and cash equivalents, our year-end 2012 leverage ratio was approximately 2.2x. We ended 2012 with no borrowings under our $600 million revolving credit facility and with approximately $133 million of cash and cash equivalents. We have no debt maturities of any consequence until Q3 of 2012, when our revolver is set to mature.

And now, operator, I believe we're ready to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Colleen Lang of Lazard Capital Markets.

Colleen Lang - Lazard Capital Markets LLC, Research Division

Jay, just quickly, we've seen fairly steady increases in stroke and neuro cases as a percent of your total discharges. Do you guys have an expectation of where you think these cases could go over time?

Jay F. Grinney

I wouldn't say that there is an expectation in terms of a specific targeted percent of the total patient volume. I mean, as we all know, the incidence of strokes continues to go up. And as the population continues to age and we see that baby boom cohort moving into the 65-plus category, we do expect that there will be a continued demand for the kinds of services that we provide. But no, we haven't said that we're going to be tapped out or maxed out at any certain percent.

Colleen Lang - Lazard Capital Markets LLC, Research Division

Okay, great. And can you talk quickly about the acquisition environment and what you're seeing in the marketplace of late? Are you seeing any increases in the number of freestanding IRFs looking to sell given the uncertainty in D.C.? And also, what are you seeing from the acute care guys in terms of what they want to do with their IRF units?

Jay F. Grinney

Yes. First of all, there aren't a lot of freestanding inpatient rehabilitation hospitals. Those that are out there and are unaffiliated, we're certainly in touch with and have expressed our interest in talking with them. I think that, that will be maybe slower to move. What we have seen is the openness of the acute care hospitals with rehab units to discussing some kind of transaction involving those units, be it a complete monetization, where they just -- because of reimbursement pressures or cost pressures that they're under, they're just making the decision to get out of that business. Other instances, they're looking to joint venture that. Oftentimes, with the idea that we might come in and take the unit that is currently inside the hospital and joint venture that and build a new freestanding hospital, that would give them additional capacity on an acute care side. So we certainly are seeing that. And frankly, the pipeline for de novos is still very attractive. I think you probably saw that we're looking at a couple of opportunities out in California. That's a slower go because of the OSHPD process. But overall, we feel very good about the runway of growth in inpatient rehabilitation, and we're seeing it across both the de novos, the acquisitions and the joint venture avenues.

Operator

Our next question comes from the line of Ann Hynes of Mizuho Securities.

Ann K. Hynes - Mizuho Securities USA Inc., Research Division

I just want to focus on your EBITDA guidance. So the $25 million sequestration impact you have in guidance, it appears to me there's really no cost offset assumption in there, and I know that you instituted a merit rate increase freeze, which equates to about $16.5 million in savings. So is that just buffer room for you guys just in case something else negative comes down on the Medicare front, or how should we view kind of any cost savings you have in guidance to offset the sequestration?

Douglas E. Coltharp

Ann, it's Doug. I think you're absolutely right. Because it's a pricing cut and not a volume reduction, there really aren't any immediately accessible cost reductions that go along with that. The action that we did take with regard to the bonus in lieu of merit in Q4 is factored into some of those other bars. And what we're showing with the $25 million is the gross impact of sequestration.

Ann K. Hynes - Mizuho Securities USA Inc., Research Division

All right. So your guidance probably has some buffer room with that $16.5 million. Is that the way to look at it?

Douglas E. Coltharp

I'm sorry, say that again.

Ann K. Hynes - Mizuho Securities USA Inc., Research Division

I guess the $16.5 million, will that be incremental costs that you don't have to incur this year? So is that incorporated in guidance?

Douglas E. Coltharp

The merit structure that we are carrying moving into 2013 is embedded in our EBITDA guidance range.

Ann K. Hynes - Mizuho Securities USA Inc., Research Division

All right. And just to follow up on Colleen's question on the competition, I know there was a lot of not-for-profit hospitals who lowered bed capacity back in 2008, when you had the Medicare freeze. Do you and not-for-profits tend to be reactionary? So if you don't -- do you expect to see any unit growth given the sequestration or at least bed declines in your peers going forward? Have you heard anything in the marketplace?

Jay F. Grinney

Not really. I think that the overarching concern among most of the acute care hospitals, and that's going to be disproportionately weighted to the not-for-profit since they represent 80% to 85% of all hospitals nationwide, the overarching concern is with reimbursement going forward. And there's the secondary concern of 2014 and '15, will they have the capacity to accommodate any new patients that might be coming to them through Obamacare. Did that get at your question, Ann?

Operator

And your next question comes from Darren Lehrich of Deutsche Bank.

Darren Lehrich - Deutsche Bank AG, Research Division

I wanted to just ask a question around the buyback. Obviously, a nice announcement to get here. Jay, I know in talking to investors over time, you've thought about the buyback as something more opportunistic. I think I've heard you describe it as potential shock absorber in the face of bad news. But it sounds like you're thinking about a little bit differently, obviously, increasing it. So I guess I just want to flesh out a little bit more about the decision and how we should be interpreting this.

Jay F. Grinney

Well, I think I'll leave it to you on how you want to interpret it, but I certainly would agree that our thinking has changed. Previously, we saw that primarily, as a kind of a stopgap, we're clearly being a lot more aggressive looking at all of the levers that we can pull to bring value to our shareholders. I mean, if you think about where we were back in 2008, $300 million of EBITDA, and we just posted $506 million. We were generating maybe $7 million of free cash flow, and we just posted $268 million of free cash flow. We had a leverage ratio of 4.5x. We're now down 2.5x. And our price is still the same. So clearly, there are other ways that we can bring value to the shareholders that potentially -- or I should say, previously, we have not accessed. And looking at share buybacks in a more aggressive way is certainly part of that. And there are other things that we're going to be looking at as time goes on. That's -- we started this year -- one of the first equity conferences that we participated in, we made it pretty clear that we feel very good about the underlying performance of our company even in the face of sequestration, even in the face of additional risks that may come forward out of Washington, but that we are also then going to start looking at other means of bringing value, long-term value to our shareholders. And so this would be an example of that.

Darren Lehrich - Deutsche Bank AG, Research Division

Yes, makes sense. And if I could just follow up for Doug. We've seen you bring more real estate on the balance sheet in owned fashion. We get the question sometimes just about the REITs and their cost of capital. Are you, at all, considering anything different with all the owned real estate that you have, and is there potentially a way to monetize that differently?

Douglas E. Coltharp

There are a lot of different ways that we could monetize the value of the real estate. None of those, as we've explored them, are at all attractive to us, including any kind of significant sale-leaseback with REITs. The REITs do have a very favorable cost of capital. They use that to the benefit of their shareholders. And the proposals that we have seen had been unwilling to share that with our shareholders and our constituents, you see. We also think that as we continue to face some reimbursement uncertainty, and although, as Jay mentioned, we feel very, very good about our current operating position and our ability to navigate on any event of uncertainty, that our position is further strengthened by not being subject to automatic escalators in leases. And frankly, if you look at the price at which we've been able to access long-term debt capital in the unsecured markets, and lease exposure is debt capital, we don't see any kind of arbitrage opportunity that exists between our cost of incremental funds and that which could be provided to the REIT community. So that's a rather long-winded answer of saying we haven't found anything attractive in any of those alternatives, but we're certainly aware that they're out there.

Jay F. Grinney

And Darren, I just want to reiterate, there are alternatives, but we have looked at them and they are not appealing to us under any circumstance. You get a onetime pop and that's it. But you basically -- you've sold the company on an installment plan, and particularly in light of what's changing in the marketplace, losing control of one's assets, I think, really handicaps providers in today's environment. I mean, you look at what Kindred is doing, I mean, they're having to walk away from hundreds of millions of dollars of revenue and tens of millions of dollars of EBITDA because of the fact that they're hamstrung with those onerous leases from Ventas. So why would we want to jump into the that kind of situation? I mean, if -- we get this question a lot, but it's something that we've looked at. It makes no sense to us, and we have absolutely no interest in attempting to monetize the value and then cripple the company going forward. That just does not seem to us to make sense from a long-term perspective.

Operator

Our next question comes from the line of Sheryl Skolnick of CRT Capital Group.

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

First, Jay and Doug, I can't thank you enough for making that very firm statement about the REIT option because I not only agree with you, but I think it's important that we know exactly where you stand and put that issue to bed. But my question is around the question of capital and capital deployment, and I realize that you may soon be subject to tender offer rules and may not -- maybe currently and can't talk about it. But you do have options. You clearly have laid out a capital spending plan to sustain the growth of the company and have lots of opportunities to do that. You've got lots of flexibility. It is the cash flow story that folks thought it would be. It's substantially different than when all this started, 10 years ago next month, by the way. So I'm looking at this decision to return capital to shareholders, and I'm curious if you can share with us what your thinking was around some of the key issues here. First of all, if you buy back stock, then obviously, it affects the liquidity, but it's not an essentially liquid situation anyway. So help us to think through what your thought was on that to the extent that it might be a price you have to pay, okay. And then the second question is as you think about it, why a repurchase versus a dividend? Why a tender versus an open market transaction?

Jay F. Grinney

Let me try to answer the first question. And when we looked at the buyback and made the decision, recommended it to the board and got the authorization to move forward, quite frankly, it was really a matter of where is the best opportunity to invest our cash and the resources that we have. I mean, we've got plenty of opportunities to build new hospitals, acquire inpatient rehabilitation facilities, merge them with us. We have plenty of opportunities to continue to add beds, but we're still going to have a lot of cash leftover. And we felt that there's no better investment than our company. And so we felt that the stock buyback really made the most sense from a financial return perspective simply because we know this company and we know what the future potential is, and therefore, we made the decision to invest in what we think is the best investment out there for us. In terms of the other alternatives that we looked at, it is fair to say that we have evaluated a broad range. We felt that, again, going why a buyback and not a dividend, we felt that the opportunity to buy at this time made sense to us and to buy back, again, something that we know very well and have a lot of confidence in. And I think that it's fair to say, and we certainly signaled this back in January, it's fair to say we will continue to look at a wide range of value-creating opportunities. We haven't made any decisions, but we're certainly going to be constantly looking at that, again, to your point, Sheryl, because we're generating such strong cash flows. So this is not a won-and-done kind of situation. This is really sort of having the company embark on a new strategy that complements the other strategies that we've been putting in place over the last several years. First, it was to delever and to focus on operations to build a company that was -- that could grow. We did that and generated a lot of free cash flow, allowed us to be able to invest in really game-changing investments like our electronic clinical information system, like new hospitals and new markets. And now, again, because of the success that we've had, we're able to explore other value-creating avenues, and we will continue to do that going forward.

Douglas E. Coltharp

I think, Sheryl -- this is Doug. Just to then get to the issue of why did we express a preference to potentially execute this increased authorization via tender offer as opposed to another mechanism like an open market repurchase. First of all, we have ruled out those other modes of execution. But the preference for a tender offer really owes back to something that you identified in your question, and that's the liquidity in the stock. The magnitude of the increased authorization that we're attempting to undertake here really dictates moving more towards a tender because the average daily trading volume of the stock is roughly 0.5 million shares, and if we were to try to put ourselves in that Safe Harbor regarding both 10b-5 and 10b-18 applications, it would take a very long time for us to execute under this program. And while that might carry the advantage of some kind of dollar cost averaging, we do believe it would be creating somewhat artificial trading within the stock.

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

Yes, and I don't disagree with that, actually. At least this way, you're actually -- if your intent is to return the capital to shareholder, you might as well actually put the capital in their hands. And I appreciate that very much. And can you just -- I can't really relate it to this -- oh, I guess I can. Can you just update us on the status of E&Y and General Medicine, please?

Jay F. Grinney

Yes, I'm going to ask John Whittington, our General Counsel, to answer.

John P. Whittington

Thank you, Jay. On Ernst & Young, we have filed in substance an appeal. It is pending here in Alabama, in the Jefferson County Circuit Court. A scheduling order has been entered. And based on the scheduling order, we would expect to have a hearing sometime in March and maybe a ruling on the appeal in the April time frame. With respect to General Medicine, that litigation is also pending here in Jefferson County. We have filed a motion to dismiss the case. It is actually set for hearing tomorrow afternoon, and we'll give you a report on that at the appropriate time. Our view continues to be that the judgment and settlement agreement between General Medicine and Horizon is collusive and fraudulent and should not be admitted into evidence, and that's what we'll be arguing tomorrow before the circuit court here in Jefferson County.

Operator

Our next question comes from the line of Frank Morgan of RBC Capital Markets.

Frank G. Morgan - RBC Capital Markets, LLC, Research Division

I'll ask this question because it hasn't been asked in a while, but since you're talking about opportunities with JVs and acquisitions and de novos and what to do with this excess cash, have you thought about or evaluated opportunities outside of the core rehab business lately? In the past, you talked about other post-acute lines. I'm just curious if you've come back to that and thought about that again lately, or is that just kind of off the table and just purely focused on either more IRFs or buybacks?

Jay F. Grinney

No, we certainly are looking at other post-acute services. To be very candid, right now, as we look around to those other services, there are enough risks inherent in virtually every other post-acute segment that would really make them unattractive on a current basis. The runway is very robust for inpatient rehabilitation. It's a business we know. We believe we do a pretty good job at it. There are still, obviously, some risks coming out of Washington, D.C. That deck has not been cleared. So you think about any of the other segments, and it's pretty easy to come up with a list of headwinds that are specific to those sectors. Having said that, Frank, we're always looking at what makes sense. We do believe that on a much longer-term basis, and this is not a 2013 or even '14 or maybe even '15 kind of time frame, but certainly, over time, to the extent that the industry migrates to a risk-sharing, accountable care bundled kind of environment, we do believe that in that kind of new world order, that the silos that limit the kinds of patients that can be treated in Medicare-designated facility-based post-acute settings will start to go away. They'll become unnecessary. And so that then creates an opportunity for us in the 4 walls of what we now call an inpatient rehabilitation hospital to treat patients that otherwise might be going to other facility-based post-acute providers. In that new world order, we think it would be attractive if we could then supplement that facility-based post-acute care with home-based post-acute care. And we certainly would be looking to do that through acquisitions, most likely -- in fact, I can't imagine -- I don't know of any public company, home-care company that has the kind of market synergies that we would be looking for. So what we would want to do is we'd want to look at regional players, get a couple of those that are high-quality, learn a little bit more about home care, build the infrastructure, just as we did on the rehab side. But that's a long, long-term view. And I always hesitate to answer questions like that, even when they're asked about what is the long-term view, because your sense of long term may be different than mine. But this is certainly looking at it over a 10-year horizon, not a 10-month or a 2-year horizon. So that's kind of our thinking. And frankly, there still needs to be more clarity out of Washington with respect to, A, overall Medicare changes; and then B, sector-specific changes that we all know about, be it a re-basing of the payment system, patient criteria in LTACs, home care having a co-pay added. I mean, there's a lot of risks out there. Buying in or getting into those risks today makes no sense when we have such a very attractive sector that we do very well in and where there's a lot of near-term growth.

Frank G. Morgan - RBC Capital Markets, LLC, Research Division

Okay. I kind of thought you'd answer that way, but I just hadn't heard you comment on it in a while. One other, just in terms of your -- given how well you're doing with your business, the leverage coming down, have you really reevaluated your tolerance for leverage? I mean, would you consider taking leverage back up, seeing that you've operated higher levels in the past and certainly did it very successfully then? And it seems like you're in much better shape today, and the cash flow is much higher. Is there any possibility you might even reassess what your leverage target levels are? And I'll hop off.

Jay F. Grinney

I think we signaled to some degree that we are doing that beginning, again, at the start of this year, when we attended the JPMorgan Equity Conference, and that was in our business outlook slide. We made a subtle but important change in the way that we talk about our leverage target. And there, we expressed our willingness to go 2x, 3x or higher if we were presented with compelling shareholder value-creating opportunities. So currently, if you look at the composition of the debt markets right now and also of our balance sheet, it suggests that the capacity is there to take on a bit more leverage. We're going to be prudent about how we do that. As we have always talked about, when we think about leverage, we're not thinking just about absolute levels of leverage because that is certainly an important measure. But looking at the form of that leverage is equally as important. And in addition to the fact that we're currently at a very low level of leverage, particularly as you compare us versus the other health care providers out there, you look at the structure of our debt capital, and with no maturities facing us prior to the third quarter of 2017, and that maturity being a completely unfunded $600 million revolving credit facility, those things factored into our decision to pursue the increased authorization.

Operator

Our next question comes from the line of Whit Mayo of Robert Baird.

Whit Mayo - Robert W. Baird & Co. Incorporated, Research Division

Doug, you talked in your prepared comments about the denial rates slowing but bad debt maybe up a little, which really doesn't look like to me on the P&L. But maybe just remind us if you've gotten a change in your macro fiscal intermediary, and if so, what's the experience then?

Douglas E. Coltharp

That is pending but has not taken place yet. So our largest intermediary continues to be Cahaba. We have had more proactive discussions with Cahaba beginning in the fourth quarter of this year, and we're optimistic that those discussions are bearing some fruits as we did see the number of incremental denials slow in the fourth quarter.

Jay F. Grinney

And with the -- this is Jay. The transition from the current structure to one where every single one of our hospitals will be assigned to the MAC that gets the wins, the MAC contract for that particular geography, it's my understanding that won't be finalized until sometime in 2015. I could be wrong. And I think I'm right. And it's at that point that we will then move those hospitals that are currently serviced by Cahaba, and there are 70 some of those. Any of them that are outside of the Cahaba MAC, and there are quite a few of them, would then go to a variety of different MAC. But it'll be a while until we see that happening. We've declared that, and we've let CMS know, but it's just the way the process has been structured. We don't have that ability to move ours out of Cahaba until all of the MAC contracts have been executed.

Whit Mayo - Robert W. Baird & Co. Incorporated, Research Division

Understood. But I guess the point is that it hasn't gotten any worse with Cahaba, and it appears to be improving.

Jay F. Grinney

I think it's gotten better.

Whit Mayo - Robert W. Baird & Co. Incorporated, Research Division

Yes, okay, great. And maybe one last one, Jay. Maybe just a general update on your IT initiative and how pleased you are now and any surprises or benefits that you've been able to see you put your finger on. And do you think that this strategy, in any way, is assisting in some of your market share gains?

Jay F. Grinney

I'll answer the first part, and then I'm going to ask Mark to address the implementation success. I think what is has done is it makes us a little more attractive in the processes that are run when a unit or a hospital is looking to be sold or joint-ventured. I know for example that at Walton Rehabilitation Hospital over in Augusta, the fact that we had a clinical information system that we were installing, we were told, differentiated us pretty dramatically from the others who showed up in the process.

Mark J. Tarr

Yes, Whit, the rollout has gotten extremely well, extremely smooth up to this point. We're now implemented in 13 hospitals. Next month, we'll roll it out to an additional 5 hospitals for a total of 18. And it's gone real well. We're able to interface with the lab and radiology systems that are out there, working particularly close with our partners and referring hospitals. So we're very pleased with it up to this point. I think in terms of isolating benefits that it's bringing to us, it's still a little early to tell. But we're confident that overall, the system is going to work well for us.

Operator

Our next question comes from the line of Gary Lieberman of Wells Fargo.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

With regards to the tender, would you expect it to be a Dutch tender, or is there some other format that you guys are considering?

Douglas E. Coltharp

And again, our announcement was not that we are launching a tender offer. Our announcement was that we have increased the common share authorization and that we intend to pursue them, which means we are currently evaluating our opportunities, and within that evaluation, if we choose to launch a tender, we will then make a determination whether or not a fixed price or a Dutch option best suits our needs.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Okay, great. That's very helpful. And then in terms of the facilities that you are considering purchasing, do you think the fact that you're the operator gives you any kind of advantage in the purchase of the facility? And also, would you consider purchasing facilities that you don't currently operate today?

Douglas E. Coltharp

So our presence as not only the operator but the most efficient operator in the business is a bit of a double-edged sword because virtually, all of the purchase options are subject to a fair market value determination of the price. And that is typically resolved by HealthSouth as the tenant going out and getting one appraisal and then the landlord going to get another appraisal, where almost all instances, we tend to look at the value of the real estate if HealthSouth were not the operator, whether another IRF were in there or another party. And obviously, in most of these cases, the value of the underlying real estate is towards the low end. The landlord is not surprised when you look at it on an income basis and assume that everybody would operate it just the way that HealthSouth does. And you know if try to compare us with the peers that very few companies are able to achieve that level of efficiency. So it creates some tension in the process. In terms of purchasing or moving to another facility, that really gets to another core issue that is embedded in this decision about pursuing the buyout of leased options, and that's where's the control of the CON vested? Is it a CON state at all? If it is not a CON state, then it certainly makes it a lot easier for us to consider moving to another piece of property in the same market. And in some cases, we'll choose to do that such as in Ludlow, Massachusetts because we had an old facility and wanted to move to a slightly better location. But I'd say in the vast majority of the situations we're dealing with, our preference would be to not disrupt the existing hospital and to try to stay in the existing location. And the negotiation that goes on over this period of time is not only about trying to reconcile to what a fair market value is, but frequently, that opens up the door to discuss renewing the lease on terms that are more market, more favorable from our perspective.

Operator

Our next question comes from the line of A.J. Rice of UBS.

Albert J. Rice - UBS Investment Bank, Research Division

You guys mentioned a couple of times in your prepared remarks that part of the benefit on pricing in revenues was the higher acuity year-to-year. Do you have any metrics on that, either case mix or something else, that would tell us to what extent that helps you in the quarter and year?

Jay F. Grinney

Our case mix index is approximately 1.35, so that's a little bit higher than what we've seen in the past, and that certainly is a contributor. And if you recall, A.J., say, 5 years ago, we were closer to 1.30, 1.31.

Douglas E. Coltharp

That CMI is going to be tied to those 2 significant categories that we talked about, which is stroke and the neurological. And then you may recall that in our prepared remarks, we did state that those 2 categories were up nearly 500 basis points in Q4 '12 versus Q4 '11. The specific percentages of those 2 combined, 39.2% in Q4 '12 versus 34.3% Q4 '11.

Albert J. Rice - UBS Investment Bank, Research Division

Okay, that's helpful. And then my other question will be around the D&A. That was sort of a point where I know that's noncash, below the operating income, but there was some variance relative to what we're looking at. Can you just flesh out a little bit more why the increase year-to-year in the guidance? And then specifically around the investment in the IT, are you -- the way you amortize that, can you just give -- remind us of that, maybe?

Douglas E. Coltharp

There's no doubt that we said that we would look for D&A to be more in the $95 million range next year. I don't think you're going to see the same kind of year-over-year increase in subsequent years beyond 2013. But here's a number of things. One is the rollout of the clinical information system. And recognizing that although we believe that system is going to be in place for a long time and have a very long and sustainable benefit, that the nature of the assets means that it gets written off over a shorter period of time, then do our investments in our typical fixed asset if you're talking about a 7-year life on the capitalized portion of the CIS investment. We've also had an increase in the refurbishment expenses, and those tend to be with shorter-lived assets. And then if you couple that with the increased activity we've had under the de novos, all of that is kind of culminating in what appears to be a significant step-up between 2012 and 2013. But again, I would expect that beyond 2013, the rate of increase -- the slope of that increase, if you will, will be substantially flatter.

Operator

Our next question comes from the line of Kevin Fischbeck of Bank of America Merrill Lynch.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

So I just want to follow up on the commentary around, I guess, your outlook on what's going on in D.C. because I don't -- you assume sequestration cut in 2013, but I guess there is this idea that the sequester might be sort of -- that Congress will try to find another way and replace the sequester with something else instead. So what is your view in terms of positioning of the industry IRFs in D.C., and what are the topics out there that are being discussed in terms of potential offsets for the sequester, how you view the positioning of IRFs there?

Jay F. Grinney

First of all, we are not hearing a lot about that sequestration for health care providers is going to be pushed back or not implemented. It's hard to know, frankly, what will happen in Washington, but we're planning on sequestration or that order being signed because we're not picking up anything that would suggest that there's movement to strike a grand bargain or to come up with an alternative plan. Because remember, the sequestration is there to help reduce the budget deficit and to limit the amount of increase in the national debt. And without that sequestration, the deficit becomes larger, the debt ceiling becomes more problematic. So it's nice to talk about avoiding sequestration and helping the middle class in doing that but the reality is that Washington is going to have to come to grips with the fact that we've got a huge deficit. It's growing. And we've got a debt ceiling that is going to be breached again here in the not-too-distant future. So those can't be avoided, and there are going to have to be some very tough decisions. Everybody's going to have to tighten their belts a little bit, and we're assuming that, that will occur through sequestration for health care providers.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Yes, but that was my point, that even if the sequester stays the same but then Congress will have to address the next debt ceiling, what is your view in terms of the industry being addressed for changes to reimbursement, additional, on top of sequestration?

Jay F. Grinney

Yes. We're not hearing anything that would suggest that inpatient rehabilitation is at any disproportionate risk to anybody else. I mean, I think everybody is expecting that when the President finally issues his fiscal year '14 budget, that there will be the same provisions in there, the 75% rule and the site neutral and no market basket update, but those have been around since September of 2011. They have not been acted on because there's no momentum. There's no advocate for that outside of the political machine in the White House. So we don't see any disproportionate risk for inpatient rehabilitation providers. We do, of course, believe that there's always going to be some risk for all providers that we will be asked to do more from a rate perspective. I think that would be more short-term in nature. If Congress ever does get together and works with the President and finds a way to come up with a grand bargain, if you will, everything we're hearing suggests that the grand bargain would include major structural changes and not just going in and tinkering with this sector or that sector or going after across-the-board cuts. So we certainly -- and I spend a lot of time up there. We've got a full-time person who lives in D.C., who's on the hill constantly, and we're not hearing anything that would concern us that inpatient rehabilitation facilities and hospitals are at a disproportionate risk to other providers.

Operator

Our next question comes from Sheryl Skolnick of CRT Capital Group.

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

I'm curious about a couple of more detailed questions. One of the axioms, I guess, about your market positioning of your hospitals, I thought, had been that it was better not to align with any one provider, yet it looks like some of your more interesting opportunities to reposition and, perhaps, breathe new life into a fully utilized facility or less-than-fully-utilized facility may be to joint venture with some local partners. So I'm wondering if you can talk about the conditions under which it makes sense to align with a local partner and when it doesn't. That will be question number one. Also related to hospitals, how many more in line to be refurbished and how many have you done? And then the third question related to the hospitals is have you seen any indication to date, whether it be in your piloting or your rollout, of positive or negative implications of the clinical information system on productivity and workflow and quality?

Jay F. Grinney

All right. In terms of the market conditions for joint venturing, typically, it would be in those situations where it's a relatively small market. There are few providers in that market, and aligning with an acute care hospital is really sort of an investment in the future, if you will, and in anticipation of the market evolving to one of risk-sharing or some level of integration. Typically, what we'll do is we will align ourselves in those kinds of situations with our largest provider, largest single referral source. So it's kind of a natural in terms of when we do that. And keep in mind, we have 1/3 of our hospitals that already are in some kind of joint venture arrangement with a large provider. We've got them with academic medical centers like UVA, Vanderbilt, Barnes-Jewish, St. Louis. We have it with acute care systems, not necessarily academic medical centers. So it's very market-specific, but we're certainly flexible and open to doing that. In terms of the number of hospitals that we've refurbished and those that are on the docket for refurbishment in the future, I'm going to ask Mark to answer that.

Mark J. Tarr

Yes. Sheryl, we first put in what we call our refresh program 4 or 5 years ago, and the whole goal was to go in and address hospitals that were, in terms of having the most need for major renovations, cosmetic and otherwise. We typically do nurses' stations. We touch all the patient rooms with wallcoverings, flooring, major corridors. And in some cases, on some of the more major hospital renovations we've had, we go back in and take care of bathrooms in each one of our patient rooms. But we've touched or completed, I think, somewhere between 10 and 12 of our hospitals, I would say, on an ongoing basis. You could expect us to do 2 to 4 hospitals a year. And in some means, as our hospitals continue to age, we'll have to continue to reinvest in our hospitals on a go-forward basis.

Jay F. Grinney

And then on the implications on the electronic clinical information system on productivity, we really haven't seen any impact there yet. And frankly, when we rolled it out and even when we sold it to the board, we didn't sell it on the notion that it was going to save us salary wages and benefit dollars. What we did was we said it would free up our clinicians to spend more time with the patient, and that still is the primary objective. What we hope to do over time is to see that translate into improved patient satisfaction, improved outcomes, and we're confident that we're going to get that. We're seeing some early benefit of that in the hospitals where we have installed the clinical information system. Certainly, from an integration standpoint, with physicians and making sure that the documentation is there, those are all some of the benefits that we know are there. Whether or not they're going to translate into fewer litigation expenses and so on down the road, I think that's just going to play itself out over the next several years.

Operator

At this time, there are no further questions. I would like to turn the floor back over to Mary Ann Arico for any closing remarks.

Mary Ann Arico

As a reminder, we will be filing the updated Investor Reference Book next week. The 10-K will be filed later today. If you have any additional questions, we'll be available later today. Please call me at (205) 969-6175. Thank you.

Jay F. Grinney

Thanks, everyone.

Operator

Thank you. This concludes today's HealthSouth Fourth Quarter 2012 Earnings Conference Call. You may disconnect at this time.

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