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Sun Healthcare Group, Inc. (NASDAQ:SUNH)

Q4 2008 Earnings Call

March 3, 2009 1:00 pm ET

Executives

Michael Newman – Executive Vice President & General Counsel

Richard K. Matros – Chairman of the Board & Chief Executive Officer

L. Bryan Shaul – Chief Financial Officer, Executive Vice President & Principal Accounting Officer

Analysts

Ralph Giacobbe – Credit Suisse

Eric Gommel – Stifel Nicolaus & Company, Inc.

Gary Taylor – Citigroup

Robert Mains – Morgan, Keegan & Company, Inc.

[Brian Sindhu – Sidoti & Company]

Carter Dunlap – Dunlap Equity Management

Andreas Dirnagl – Stephens, Inc.

Operator

Welcome to the Sun Healthcare Group fourth quarter earnings 2008 yearend conference call. Today’s conference is being recorded. At this time I would like to turn the call over to Mr. Michael Newman, General Counsel for opening remarks.

Michael Newman

For those of you who have not seen our press release announcing earnings of Sun Healthcare Group for 2008, a copy can be obtained from our website at www.SUNH.com. I’d like to note that during this conference call certain statements may contain forward-looking information such as forecasted financial performance.

Although we believe that the expectations reflected in any of Sun’s forward-looking statements are reasonable based upon existing trends and information and our judgments as of today, actual results could differ materially from those projected or assumed based upon a number of factors including those factors set forth in our annual report on Form 10K under the heading risk factors and our other filings with the SEC.

Sun Healthcare’s future financial conditions and the results of operations as well as any forward-looking statements are subject to inherent known and unknown risks and uncertainties. We do not intend and undertake no obligation to update our forward-looking statements to reflect future events or circumstances.

During today’s call references may be made to non-GAAP financial measures. Investors are encouraged to review those non-GAAP financial measures and the reconciliation of those measures to the comparable GAAP results in our report on Form 8K filed with the SEC yesterday, a copy of which may also be found on our website.

I will now turn the call over to our Chairman and CEO Rick Matros.

Richard K. Matros

In the content of the press release I noted that our first quarter trends have been very strong. What I didn’t do was reaffirm 2009 guidance since we just put it out last month but I’ll make a point of reaffirming 2009 guidance now. We feel real good about how the company’s executing through the first two months of the year and look forward to another strong year.

Before I get in to the details on the quarter, I’d like to talk a little bit about the President’s budget and hopefully give you some rational perspective in to what’s going on. One, I would point out in the President’s budget there are four buckets of savings. The Medicare Advantage savings were about $47 billion over five years, $177 billion over 10 years. The home health cuts are $13 billion over five years and $37 billion over 10 years. The drug rebates are $8.2 billion over five years and just under $20 million over 10 years.

The bundling of Medicare payments are only $950 million, less than a billion over five years with $18 billion over 10 years. So, the bulk of the savings even if it should happen don’t even start kicking in until after 2018. So, just from that perspective alone I think we need to kind of take a look at how everybody is reacting to this.

But, some other points I would make, the bulk of the savings from bundling comes from a reduction in the readmits to hospitals within that 30 day period. One of the biggest issues we have in the sector is controlling our backdoor. That is, those unplanned readmits back to the hospital. This is a big pop for us if this should happen and it’s a real positive that I think is being overlooked in all the discussion that has happened over the last week.

While it’s fair for some people to assume that if the hospitals were in control of our payments through a bundling system that they might want to squeeze rates, it’s really a big leap at this point to assume there won’t be the appropriate checks and balances in places so that the hospitals are able to make additional profits off the back of the providers at the expense of patient care. There’s isn’t a single biggest issue in Congress right now than quality care for post acute services and nursing homes specifically.

So, I think it’s a little bit of a leap to assume that. But, the other point I’d make is even to the extent that should happen and there is some squeeze on rates, and again we’re talking about benefits that don’t start kicking in to 2013 and they’re phased in a number of years after that. We already capture a disproportionate share of market in our markets because we primarily compete with mom and pops.

In a bundling system we should be even better positioned to do that. So, even if there was some squeeze on rates the benefit we’d get from a reduction in readmits as well as gaining market share in a bundling system I think would markedly improve our upside versus the down side in that scenario. The other thing I’d point out is we really need to realistically think about whether this can even happen. I’m not sure you’re going to see the hospitals supportive of this at all.

In fact, my guess is they’ll probably lobby against it. You’re talking about in a few short years the government is going to have to do an overhaul of the Medicare system and ensure that every hospital in the country, most of which are non-profit hospitals, community based small systems have the IT in place to even handle any new system changes. So, I think it’s really a reach right now and again, even when you look in terms of the overall savings in the Obama budget, they’re pretty minuscule compared to the savings in the other three buckets.

We can talk about this a little more in Q&A if you desire to do so but for now I’ll get on to the quarter. All results for the quarter are normalized for the company’s deferred tax asset which Bryan will talk about in more detail, our prior period insurance reserves and the gain on the sale of the property. The fourth quarter of 2007 is normalized as well for comparative purposes. The normalizing schedules can be found at the back of the press release.

For the quarter, revenues grew 5.5% to $467 million. EBITDAR increased 13% to $61.6 million. EBITDAR margins were up 90 basis points to 13.2%. EBITDA grew 19.7% to $43.3 million. Our EBTIDA margins improved 110 basis points to 9.3% and income from continuing operations grew just in the 37% to $11.4 million.

For the full year 2008 our revenues grew 6.1% to $1.824. EBITDAR increased 14.3% to $236.7 million. Our EBITDAR margins improved 100 basis points to 13%. Our EBITDA increased 25.8% to $163 million. Our EBTIDA margins improved 140 basis points to 8.9% and income from continuing ops grew 37.7% to $40.8 million.

I’ll now move on to Sun Ridge, our inpatient segment which is our core business as you know. For the quarter in patient revenues grew 5.3% to $414.2 million. EBITDAR increased 9.1% to $72 million. EBITDAR margins improved 60 basis points to 17.4%. EBTIDA increased 12.7% to $54 million. EBITDA margins improved 80 basis points to 13%. Our rehab RUGS increased 310 basis points to 88% as a percent of total Medicare days and our REX days as a percent of total Medicare days grew 260 basis points to 42.1% which I believe is a new high for us.

Our occupancy was down 110 basis points to 88.5% allowing our skill mix to grow pretty dramatically. Our skilled mix as a percent of SNF days grew 100 basis points to 19.5%. From a days perspective that was due to the growth in managed care. Our skilled revenues though as a percent of SNF days increased 250 basis points to 38.6% of which 80 basis points was Medicare growth and 170 basis points was managed care.

Part A Medicare rate was up 8.1% to $446.09. Our managed care rate was up 10.9% to $363.95 almost entirely due to increased security. Our Medicaid rate was up 3.2% to $168.79 and as a result of the increased skilled mix our Medicaid as a percent of inpatient revenues decreased 190 basis points to 45%.

Our rehab recovery suites we had 47 units at yearend, we now have 50. We expect to have approximately 70 by yearend. The skills mix in our rehab recovery suite centers was 21.8%, 340 basis points higher than those centers without rehab recovery suites. Our Medicare rates in those centers with rehab recovery suites was $17 higher than in those centers without rehab recovery suites. Our rehab RUGS was 360 basis points higher in those centers that had rehab recovery suites at 90.1%. Our REX days were 700 basis points higher in those centers with rehab recovery suites at 47%.

Our average length of stay was relatively stable at 28 days in the rehab recovery suit units and 33 days in those centers without rehab recovery suits. Over the course of last year we built a new infrastructure for our business development function that included developing a data base for data in every market that we currently operate a center in. We also executed on a whole new sales and training program, all of which we would hope would benefit us in 2009.

We started to see that benefit in the fourth quarter of 2008. Total new admissions for the quarter were up 7%. Those centers that were at that point trained on our new sales program were up 12% while those not yet trained were up 3%. So, we expect to see good things from that and maybe show the ability to continue to grow skills mix without as much of a drop in overall occupancy. Our labor and benefits which have always been managed exceedingly well grew a modest 2.9% and as a percent of revenues we had 51.5%, 120 basis points lower than the fourth quarter 2007.

With that I’ll move on to our hospice segment. Our hospice business is called SolAmor. I typically haven’t commented on this because it’s a pretty small business in the scope of things. It still is with a $25 million run rate but it is starting to contribute to EBITDA so I thought I’d start sharing some of the stats for that business segment on these calls. Our ADC was 448 at yearend. Our EBITDA margin was approximately 10% contributing $600,000 in the quarter.

The 10% was actually a little bit misleading because almost half of our offices are startups. Our legacy offices had EBITDA of approximately 25%. So, we’re looking forward to the growth of that business. Unfortunately, in the absence of acquisition activity it’s going to be slow growth because we’re doing it on a de novo basis but at least it’s starting to contribute to earnings albeit at a relatively low level.

Next, I’ll move on to our rehab segment which is SunDance. Revenues were up 22.5% to $40.6 million. Gross margins improved 40 basis points to 17%. Our productivity improved 100 basis points to 70.9% and revenue per minute was up 4.4%. Our labor rate [inaudible] increased a moderate 4.3%. So, while our labor costs are moving up at a higher rate than throughout the rest of the company, 4.3% was still relatively moderate.

Our EBITDA increased $400,000 to $2.1 million and margins dropped to 5.2%. This was primarily due to a bad debt reversal that we had in the fourth quarter of ’07 of about $600,000 and we’ve increased infrastructure cost primarily to generate and support new contracts and we’re seeing the results of that on the top line with 22.5% revenue growth that we had in the top line for the fourth quarter is the greatest growth that we’ve had in a number of years in this business segment.

We added 29 new contracts and that’s primarily what drove a lot of that growth. And, we expect that as that new business matures the EBITDA margins look to continue to improve as well and a little bit worth the additional investment in the infrastructure even though that compressed margins in the short term. That said, for the full year 2008, our margins were up 40 basis points at SunDance at 5.6%.

Then finally before turning it over to Bryan I’ll move on to CareerStaff, our staffing business. The staffing business as most of you know that cover that sector has been the hardest hit by the economy with so much of the revenues depending on the hospitals and the hospitals are obviously hurting pretty badly right now. Our revenue was down 2% to $29.2 million a relatively modest decrease in this sector but you’ll recall that we typically have double digit revenue growth in this particular segment.

That said, the management team did a terrific job as they always did leveraging its G&A to generate strong EBITDA results. The EBITDA was up 14.5% with $3 million with margins up 150 basis points to 10.3%. Our bill to pay spread improved 6.6% which drove gross margins of 80 basis points to 22.9%. We continue to expect that this segment will be the hardest hit due to the economy. We really don’t see really much economic impact in the rest of the portfolio other than in Medicaid rates which we’ve talked about before.

We’re hopeful that with CareerStaff that we’ll have relatively flat performance or close to it in 2009 over 2008 and I think if we can manage to have relatively flat performance on a year-over-year basis that will be a big win given what that sector is going through. But again, this is a very small contributor to the overall portfolio so even as it suffers somewhat from the economy, it was already assumed in the guidance and shouldn’t impact us to any severe degree in terms of we expect from an earnings or company margin perspective.

With that I’ll turn it over to Bryan.

L. Bryan Shaul

I’ll begin my prepared comments by updating you on our debt structure. As of December 31, 2008 we had $346.4 million outstanding under our credit facility. We currently have no balances outstanding under our revolver. We had $200 million outstanding under our 9 1/8% senior subordinated notes at December 31st. After giving effect to the impact of our $150 million interest rate swap agreements we have approximately 69% of our total debt of $725.8 million.

With fixed term rates including amortization of deferred financing costs as of December 31st, our weighted average fixed term rate on our debt is 8.38% and our weighted average variable rate on the remainder of our debt is 4.72%. The all in weighted average rate is 7.24% down 24 basis points sequentially. Our total variable debt of $225.3 million includes $196.4 million related to our credit facility and $28.9 million related to mortgages.

Interest rates on the a majority of this variable rate debt will reset on various dates prior to the end of the current quarter. Interest is based on LIBOR plus 200 basis points for the credit facility and LIBOR plus 200 basis points for the mortgage loans. Through the end of 2009 we have approximately $12 million of scheduled debt maturities principally related to secured mortgage loans and term loan payments.

In addition, we are required to repay a portion of our term loans in the first quarter of 2009 based on our excess cash flow generated in 2008 as defined in our credit agreement. The required payment is approximately $6 million. We also expect to make an additional $5 million voluntary payment in the first quarter. Accordingly, we expect to pay down our debt by over $20 million in the first quarter of 2009.

We had $57.9 million outstanding under our letter of credit facility at December 31, 2008. At the end of the quarter we had available liquidity of $142.2 million comprised of $92.2 million of cash and cash equivalents on the balance sheet and $50 million of available borrowing capacity under our revolving credit facility. Using December 31, 2008 EBITDA for the last 12 months, normalized primarily for prior period insurance adjustments and certain adjustments related to the Harborside acquisition, our leverage at December 31st is 3.9 to 1. That is based on total debt outstanding of $725.8 million less excess cash of $82.2 million and normalized LTM EBTIDA of $163 million.

We comfortably meet all of our bank covenant requirements at December 31, 2008. With respect to 2009 our leverage covenants dropped 75 basis points in the first quarter so the maximum total leverage ratio moves from 5 to 1 at yearend to 4.25 to 1 at the end of the first quarter 2009. As you see we are already more than 30 basis points below the required ratio and we expect to improve on that with the release of our first quarter 2009 results.

In 2008 we generated free cash flow of approximately $45.3 million for the year based on net cash provided by operating activities of $87.8 million less our capital expenditures for the year of $42.5 million. At December 31, 2008 our DSO was 45 days, up one day both from the sequential and year-over-year quarters. For the fourth quarter of 2008 our bad debt expense as a percentage of net revenues was 1% up 30 basis points from the sequential quarter and up 40 basis points from the year-over-year quarter on a normalized basis. Our recent increase in bad debt expense is the result of the weakened economy which in turn has slowed our cash collection. As a result we would expect to run at approximately 1% in 2009.

Now, taking a look at our taxes; before I walk everyone through our 2008 taxes, let me just take a minute to review last year’s 2007 key tax events with you. Recall that late 2007 we maintained a full valuation allowance on our net deferred tax assets principally as a result of our earlier tax loss years. During the fourth quarter of 2007 we reevaluated the need to continue maintaining a full valuation allowance as required by FAS 109.

By considering all items of positive evidence such as future sources of taxable income and tax planning strategies and negative evidence such as the history of operating and taxable losses. As a result last year in our 2007 fourth quarter we reduced our valuation allowance by $77.8 million of which $28.8 million impacted the provision for income taxes.

Now, turning to the most recent year 2008, using our budget for 2009 and projections for future years and considering all other items of positive and negative evidence, we determined that it is more likely than not that a significant portion of our net deferred tax assets as of December 31, 2008 will be realized in future periods. Accordingly, we reduced our valuation allowance by an additional $112.5 million in the fourth quarter of 2008.

The realization of our net deferred tax assets is dependent upon achieving our projections of future taxable income and failure to do so would result in an increase in the valuation allowance in the future periods. Any future increase in the valuation allowance would result in additional tax expense. $40.8 million of the $112.5 million reduction in our valuation allowance related to the valuation allowance established in fresh start accounting and increased capital in excess of par value.

$1.2 million related to the valuation allowance established in purchase accounting and decreased goodwill and the remaining $70.5 million reduced our provision for income taxes. In addition to the $70.5 million our 2008 provision for income taxes was further reduced by $3.5 million related to equity compensation deductions and the reduction in our unrecognized tax benefits thereby bringing our total provision reduction to $74 million.

Our 2008 yearend income tax statement on an as reported basis reflects a benefit for income taxes of $47.3 million. This $47.3 million overall tax benefit includes the benefit of the $74 million provision reduction I just discussed which is offset by a provision of $26.7 million related to consolidated pre-tax income. Our effective tax rate for 2008 is approximately 40%.

For 2009 we have projected an effective tax rate of approximately 41%. Because of NOL carry forwards our cash tax rate should be significantly less than 41%. We expect cash payments for income taxes to be in the range of $10 to $12 million in 2009. We believe that it is still necessary to have a valuation allowance on a portion of our net deferred tax assets however, if we determine that sufficient positive evidence exists in future periods to enable us to reverse part of all of the remaining valuation allowance of $34.3 million as of December 31, 2008 then such reversal would reduce the provision for income taxes.

As we have discussed in prior earnings calls, we evaluate the adequacy of our self insurance reserves on a quarterly basis. Furthermore, on a semiannual basis in the second and fourth quarter we perform detailed actuarial analysis to support our management evaluation. As a result of the most recent analysis we had reviewed by an independent actuary, we determined that our prior year self insurance reserves for our GL PL programs were understated on a pre-tax basis by a net $4.3 million with $3.6 million related to our prior periods continuing operations and $700,000 related to prior periods discontinued operations.

During the second half of 2008 we focused on settling old and new claims quicker. To accomplish this our risk management team performed an in depth review of all the GL PL claims outstanding. Where appropriate settlements were made, in other cases reserves were adjusted. Increased efforts were made to close new claims that were without merit as soon as possible. This increased settlement activity while beneficial in the long run adversely impacts our actuarial analysis because of the impact on prior periods development trends.

No changes were made to prior year’s workers’ comp reserves in the fourth quarter. We expect GL PL and workers’ comp expenses in 2009 to be in line with 2008 expenses. As of December 31, 2008 $70.3 million of the total workers’ comp liability and $4.2 million of the total GL PL were collateralized by either restricted cash or letters of credit.

We had previously mentioned our new clinical and billing platform and labor management system. We began the roll out of these new systems with our first beta site for the clinical billing platform in the third quarter and started to ramp up the rollout of both systems in the fourth quarter. As of the end of 2008 we had nine centers operating with our new clinical billing platform and 15 centers operating with our new labor management system. During the fourth quarter we had non-recurring costs of $800,000 associated with the implementation of these systems.

Finally, for 2008 our normalized corporate overhead costs as a percentage of revenue was 3.4% down 40 basis points as compared to the pro forma 2007 year. That concludes my prepared remarks.

Richard K. Matros

Why don’t we turn it over to Q&A now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ralph Giacobbe – Credit Suisse.

Ralph Giacobbe – Credit Suisse

Can you maybe help us a little bit more in terms of timing around visibility on the Medicare side if at all possible? You know when do you think we’ll get more info and maybe any update you’ve had on discussions either pre or post budget with sort of your people in Washington?

Richard K. Matros

We’ll get some visibility when the proposed rule comes out but I’m not even sure about the exact timing on that because there’s still a leadership void in CMS. So, that kind of remains to be seen. We’re not hearing anything new or actually anything specific out of Washington and I spent two days on the hill not that long ago with leadership from both the Senate and the House and frankly, we’re not even being talked about so that’s a good thing.

That said I think if they are going to be focused on a permanent position fix as I think I said to you all individually I think we’re all going to have to chip in to that. So, even though obviously we would put forth our argument against it I can see us taken some reduction in the market basket but I wouldn’t foresee it being anything draconian. So, that’s pretty much how I felt last year and nothing has really changed this year.

We’re continuing to hear mix signals on what, if anything, [Strive] is going to show but we are consistently hearing that it is going to be revenue neutral if in fact it even comes out so nothing negative there. I think that’s pretty much where it is at right now.

Ralph Giacobbe – Credit Suisse

Then any more maybe on the Medicaid side since you last gave guidance, I know it was only a month ago but any updated thoughts would be helpful if there are any.

Richard K. Matros

A little bit updated. When we forecast the 2% that was what we knew as of the day before we released guidance internally based on state budget deficits we could see things getting worse in certain states in the absence of any release from FMAP and one third of the states that we thought could get worse we’ve already heard from that FMAP is going to be helpful and things aren’t going to get any worse. That [inaudible] was just passed so that’s pretty quick feedback.

We haven’t heard from all our states yet but again, we’ve heard from about a third of them and the news has been good. That doesn’t mean that rates will do better than the 2% but at this point it still looks like that could be worse case and we haven’t gotten any negative news from any states beyond what we already knew.

Ralph Giacobbe – Credit Suisse

One more if I could here, can you maybe just remind us how much of the business is Medicare Advantage and maybe ho it’s priced and any concerns around that just given cuts to that program?

Richard K. Matros

Almost all of our managed care is Medicare Advantage. So, when you look at our managed care as a percent of revenue so for the quarter all in 3.5% of our revenue was managed care on SNF beds only it was just under 4% so that’s all Medicare Advantage. But, that said most of our contracts have several levels in the rates and one of the reasons we’ve been able to affect such nice increases in rate growth is because we continue to get better at handling the high acuity patients so we get the higher end of those levels.

Really, what it comes downs down with the managed care providers, Level IV is the highest level you can get reimbursed at. It’s a negotiation between whether that particular patient should be assessed as a Level IV or Level III. That’s kind of the discussion if you will that goes on, on every admit.

To the extent that Medicare Advantage, we know that it will be cut we see ourselves really as part of the solution there. They’ve got to get people out of the hospitals and they’re going to have to get them out even more quickly than they have before and we can handle those patients and we’re more than happy to take even more of them because as you see with our skilledness even though on a patient day perspective most of the growth came from managed care, they’re all replacing Medicaid patients. We’re much better equipped to handle those contract negotiations than most of the smaller operators than we deal with in our markets.

That’s not to say that they won’t try to squeeze us some on rates but I don’t think it’s going to be significant because in any given market there aren’t that many willing takers they have. So, they’re going to need to maintain good relationships with those of us that are equipped to take care of higher acuity patients.

Operator

Your next question comes from Eric Gommel – Stifel Nicolaus & Company, Inc.

Eric Gommel – Stifel Nicolaus & Company, Inc.

Just a quick question on the liability insurance reserve adjustment, does that come out of the inpatient line or is that out of the corporate line?

L. Bryan Shaul

It’s primarily the inpatient line. It’s distributed throughout the organization but the majority of it runs through the impatient because that’s where the risks are.

Richard K. Matros

The other point I would make there is this was a conscious effort on our part to settle sooner and more quickly because we’ve got the ability to do that even though we know from a reserve perspective for out-of-period ops it would be a short term negative. It’s a long term positive and it doesn’t affect our run rate on a current ops basis.

Eric Gommel – Stifel Nicolaus & Company, Inc.

Just kind of building on the last question, if I’m looking at sort of the managed care rate growth in 2008, it’s pretty healthy and I want to sort of frame it for ’09, what are your thoughts on a realistic outlook for rate growth for managed care?

Richard K. Matros

I think prior to the fourth quarter our managed care rate growth was pretty much in line with our Medicare rate growth. This quarter our stripped it and I wouldn’t expect us to maintain double digit rate growth but to think that we’ll be in the high single digits I think is a realistic expectation. I think we’ve been able to consistently do that. The fourth quarter was a lot stronger but I think high single digits is reasonable to assume and certainly built in to our guidance expectation.

Eric Gommel – Stifel Nicolaus & Company, Inc.

That’s the rate side then looking at the volume side in your opinion what’s a realistic sort of mix? I mean how do you move patient day and mix? How much do you think is a reasonable move that you can make in a year relative to some of your long term strategic growth targets? How should we think about that? I think this quarter we were surprised by the move in the managed care side, Medicare was kind of flat, how should we frame that?

Richard K. Matros

I think between a mix of the two I think to expect 100 basis point growth year-over-year is a reasonable expectation to have. The mix is a little bit harder to predict. I think you’ll see us focusing a little bit more on building the Medicare mix at the same time we’re building the managed care mix. I think some of it is a function of and the reason it’s a bit unpredictable is because when we acquired Harborside even though Harborside was primarily in the Northeast except for Florida that does a lot of managed care, Harborside basically ignored the managed care component of the business except for their Florida portfolio.

So, we’ve really focused on that and focused on it across the portfolio and now we’ve only got two states where we’ve got low single digit growth in our managed care rates. We had two or three states that were even higher than the average but generally speaking we’re seeing our managed care growth on a patient base perspective in the 5% to 7% range in an awful lot of our states.

I don’t know if it will continue to grow at that pace because I think a lot of it was the enhanced focus we put on it this past year but my guess is if we’re looking at 100 basis points in skill mix growth on a continuing basis, a little bit more of it should come from managed care than Medicare. But, the main thing for us is to make sure that in either case or in both cases it comes in place of Medicaid patients.

Operator

Your next question comes from Gary Taylor – Citigroup.

Gary Taylor – Citigroup

On the insurance, when will be your next kind of full actuarial review having gone through this process?

L. Bryan Shaul

The second quarter. The adjustments have still been sizeable enough and it’s really helped us in terms of cleaning up the balance sheet from all the old stuff that we’re still going to do it twice a year instead of just doing it yearend. We’ll reevaluate it I think at the end of 2009 to see if we need to do it every six months as we’re going in to 2010.

Gary Taylor – Citigroup

What percent of your patient population has signed an arbitration agreement?

Richard K. Matros

About 40%.

Gary Taylor – Citigroup

Is that a number that’s still going high?

Richard K. Matros

Yes, it’s going higher. One of the things about our agreements which should make it more palatable because obviously we’re going to be dealing with arbitration legislation is our agreements are not mandatory and we allow our patients to rescind them within 30 days. So, as a result of that you’re not going to get obviously as high a number. But, it’s not unreasonable to think that the 40% could exceed 60%.

Gary Taylor – Citigroup

Any update on Medicaid in Ohio? I know that right around your guidance they had been contemplating both a new tax and/or potentially a cut? Was that one of the one third of the states that you’ve heard anything from or is it still kind of out there?

Richard K. Matros

We don’t know. At this point the government is moving directly to a price basis, somebody is recommending that an increasing the provider tax. But, the reason that we can’t get a fix on a number is that we don’t know with the relationship is going to be to new rates and the provider tax itself. That said, the impact to us and we’ve got 19 buildings, the impact to us for the year is – actually, it’s a pretty small number, it’s less than a $1 million number.

Gary Taylor – Citigroup

Under what scenario?

Richard K. Matros

Under a scenario where a disproportionate share of the change goes to tax and not to price.

Gary Taylor – Citigroup

Two other quick ones, I guess I’m looking at the Medicare Part A rate a little differently than the other question, I’m just looking sequentially up 5.4, how much of that is kind of geographic mix of how your October sequential rate came through versus mix on that number?

Richard K. Matros

It’s really negligible. We’ve seen the same pace of growth pretty much every quarter in all of our regions. We’ve got about 25% of the portfolio that is relatively rural or would be rural by definition.

Gary Taylor – Citigroup

My question is how much of that is kind of pure rate about the 3% Medicare update that’s because of the geographic mix? So, of that 5.4 sequential how much is rate versus acuity?

Richard K. Matros

On a sequential basis it’s about 2%.

Gary Taylor – Citigroup

The acuity piece?

Richard K. Matros

Yes.

Gary Taylor – Citigroup

My last question, to the extent you feel like you can answer publically and I appreciate the color on the bundling but this is something that we can go back in to the early and mid 90s and see has been kicked around and fully vetted and looked at and struggled with because some of the obvious implementation challenges. Even last fall because of the perceived implementation challenges [Med Pack] had only recommended a pilot be conducted and now it’s just fully scored on out as savings. Why do you think they did that? Is the obvious answer they wanted to score a few savings?

Richard K. Matros

Yes, I think they wanted to score savings and I think there were people in the administration that really believe that’s the right way to go. I think that the savings are so minimal at least until you hit 2018, assuming they hit that time frame and the contracts and all the other savings their looking for in healthcare reform that would be difficult in the execution on this and the push back that I would expect to see on the part of the hospital association I just don’t see it.

Gary Taylor – Citigroup

It can be a priority.

Richard K. Matros

Right. You pick your battles right and for a battle that’s going to affect less than $1 billion in savings over five years even if you hit your timeframe, do you pick that battle?

Operator

Your next question comes from Robert Mains – Morgan, Keegan & Company, Inc.

Robert Mains – Morgan, Keegan & Company, Inc.

The increase acuity, kind of Gary’s question about your sequential increase in rates, there wasn’t anything going on in the fourth quarter that makes you think you can’t hold on to those Medicare rates that your realized correct?

Richard K. Matros

Right. In fact, what we felt really good about in the fourth quarter and I think this is a result of the new sales program that I had mentioned earlier, we typically see a downturn between Thanksgiving and New Year’s Day. That’s just a seasonal thing we see it every year. The holidays, doctors are on vacations, people are trying to stay out of hospitals and the downturn that we experienced in that six week period this year was half of what we experienced last year.

So, we felt real good about that and so the normal bump that we get after the first of January we got but we got off a better base. Now, it’s only two months in to the year but still we’re two months in to the year and we feel good with all the trends we’re seeing.

Robert Mains – Morgan, Keegan & Company, Inc.

Medicare Advantage plan are not subject to the 72 hour rule, is that correct?

Richard K. Matros

That’s correct but they tend to honor it.

Robert Mains – Morgan, Keegan & Company, Inc.

You were talking about what might happen if they’ve got more pressures and more of a desire to move patients out earlier, is that where you think you might see some movement or is it going to be a four day patient becoming a three day patient?

Richard K. Matros

I don’t know. Because they honor it but they don’t have to honor it that’s a way for them to save costs obviously which would be huge for us. It’s hard to say at this point but that’s certainly an option for them particularly since their not bound by it.

Robert Mains – Morgan, Keegan & Company, Inc.

Bryan, the small increase you’re talking about in bad debt, are those receivables building from patients or third party nursing homes?

L. Bryan Shaul

It’s not a building of receivables, it’s a slowing of cash collection. We use the balance sheet so if it moves in to another bucket which we tend to collect down the road. Our cash collections have been strong in the first two months so we’re just seeing it kind of drift in to the buckets.

Richard K. Matros

Rob, the other point I would make is number one it is patients and the other point I would make is that we I think have the lowest bad debt as a percent on our income statement even in fact, if you go back to the guys that had been public and now are private. So, maintaining the .7% or .8% is challenging. If we can keep it at 1% that’s still I think far and above better than our peers.

Robert Mains – Morgan, Keegan & Company, Inc.

Then last question was free cash generation has been pretty good. You’ve been able to fund some internal projects and pay down some debt. Any external investments that you’re looking at? I know in the past you talked about hospice as an opportunity potentially or do you think that you’ll keep it internal?

Richard K. Matros

Well, we’re not seeing any opportunities right now. There were a bunch of small hospice opportunities that we had been seeing when we picked up the deal in New Jersey, we’re not even seeing small ones anymore. So, I think if an opportunity comes up for us to do something particularly in hospice with a relatively small amount of cash, we’d like to do that because CMS doesn’t want to issue new hospice licenses at this point so you’re going to want to buy them and expand that way.

Operator

Your next question comes from [Brian Sindhu – Sidoti & Company].

[Brian Sindhu – Sidoti & Company]

Just a few questions, most of mine have been answered already, I was wondering if there’s any change in your thoughts on RRS build outs beyond 2009? [Inaudible] as a percent of the portfolio, a raw number?

Richard K. Matros

No. We had anticipated opening about 15 this year, we expanded that to 20 and we want to be aggressive as possible on that. You look at the numbers there and obviously the top line numbers are a lot stronger on our RRS’. Plus, we are beginning to expand our clinical product line as well so we’ll have a broader sort of diagnosis that we can go after for our RRS’ as well and not be as dominated by kind of the low hanging fruit, the hips, the knees and stroke. We really want to go with the full steam ahead.

That is infrastructure, I think we’ve improved our processes there, we’ve got a senior officer that is overseeing the build out and execution of those rehab recovery suites. We’re going back to every rehab recovery suite that’s been in existence in our portfolio back to 2005 and reassessing them. In some cases we’re not going to [inaudible] out because they were put in really early on when none of us really knew what we were doing and don’t really make any sense but we have others that we are going to expand.

So, from our perspective we want to put as many in as we can execute on and that’s really the key here. We’d love to do 30 but we think we can do 20 and execute on 20 really well. But, we’re also going to be expecting an improvement to our existing rehab recovery units.

[Brian Sindhu – Sidoti & Company]

Just one more I guess, in terms of – and I know it’s a small portion of the portfolio but in terms of your AL portfolio are you seeing any softness in occupancy there?

Richard K. Matros

No. None.

Operator

Your next question comes from Carter Dunlap – Dunlap Equity Management.

Carter Dunlap – Dunlap Equity Management

You mentioned the new training and the impact it had on admits of three versus 12, maybe I missed it, how far through the network is that? And also, does that have any impact on acuity?

Richard K. Matros

As of the end of January through I think all but six centers of that network. So, basically it’s through the entire network and yes, it does impact acuity because the difference in acuity between those facilities that have gone in skill mix increase and those facilities that have gone through the training versus those that didn’t go through the training that’s 300 basis higher. So, it’s not as big a differential as new admits overall but we’re still seeing a pop.

Operator

Your next question comes from Andreas Dirnagl – Stephens, Inc.

Andreas Dirnagl – Stephens, Inc.

Most of my questions have been answered but I did want to follow up, just as you were doing your review of the RRS, and looking back over time is there anything in terms of some idea that maybe the RRS you did were sort of the really low hanging fruit and therefore they had a lot of upside and as you go forward and build them out you’re still going to get some upside but perhaps just not as much? Or, are you still seeing the same amount of upside in terms of the differences in acuity and occupancy in the facility?

Richard K. Matros

We’re still seeing the same upside, the difference in performance in the units is based on a couple of things, one the size of the unit itself, secondly when they were put in place where they put in place the right way? In other words were they placed in the right place within the center so that it was segregated from the rest of the nursing center, was it sized right to begin with?

Then the other piece of it was operational execution where we have a number of services that we want to see offered in our RRS that we view as non-negotiable and some of our centers have strayed from some of the non-negotiable which was part of the reason that we put a senior officer in charge to make sure everybody adheres to it. So, for example, we expect all of our units to have concierge services and we had well meaning centers that wanted to beat their budgets and they felt like they could save in that staffing position they save on that staffing position.

But I think now they are adhering to the non-negotiables and now we’ve got enough time under our belt that they actually see the upside that’s created by adhering to the model as it’s meant to be adhered to.

Andreas Dirnagl – Stephens, Inc.

Final question, in terms of the overall portfolio the potential for RRS, I mean I realize we’re probably a fair distance away from this but is there any estimate that you have in your mind to say, “Well we could build this out in 70% of the portfolio.” I mean, clearly it’s not applicable to every single facility you have?

Richard K. Matros

I’d say that out of the 185 or so nursing centers about 25% of those are rural and most of those probably won’t lend themselves to RRS so does that mean we can get 120 in place? I’m not ready to say that yet. Do I think we can do 100? Yes, I think we can do 100 but the question is how much further up we can go after that.

Operator

There are no other questions in queue. At this time I would like to turn the call back over to Mr. Rick Matros for any closing remarks or comments.

Richard K. Matros

I want to thank you for your time. I know it’s been frustrating for all of us, we’re shareholders too obviously and it seems like good performance in this market doesn’t matter. But, we do feel good about where we are. We had four quarters in 2008 where we met or exceed expectations every quarter. We had the best year the company has ever had. We’ve got good guidance out there and good trends to start the year and from a reimbursement perspective when you talk about market basket and things like that, this is an every year kind of event.

We go through it every year, we fight it every year, we have our wins and sometimes the wins aren’t complete. But, we’ve had a lot of stability I think in this business for a long time and if we get tweaked we get tweaked, we still have some nice growth ahead of us anyway. But, I think the most important thing to note here is we are viewed as part of the solution in Congress and that’s a critical place for us to be at. The fact that we weren’t even noted in the President’s budget where certainly home health was I think is important as well.

Again, I know it’s the guess the opposite of irrational exuberance but we look forward to another good year. We’ll do the battles on the hill like we always do and I’ll continue my involvement in DC. I’m there every month, I’m chairing the alliance this year so I’ll be even more involved than I have been in terms of having direct meetings with leadership on the hill. And, we’ve found that our access has been terrific up there. We’ve gotten a lot of time, personal attention from everybody from Nancy Pelosi, to Harry Reid, to Henry Waxman and a host of others that are in leadership positions and we would expect that to continue.

With that, if you all have any other things to discuss Bryan and I are always available by email or phone and we’ll be responsive to you. Have a good day.

Operator

This concludes today’s Sun Healthcare Group Incorporated conference call. Thank you for joining us and have a wonderful day.

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Source: Sun Healthcare Group, Inc. Q4 2008 Earnings Call Transcript
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