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Sun Healthcare Group, Inc. (NASDAQ:SUNH)

Q1 2009 Earnings Call

April 29, 2009 1:00 pm ET

Executives

Michael Newman – General Counsel

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

L. Bryan Shaul – Chief Financial Officer

Analysts

Paxton Scott – Jefferies & Co.

Eric Gommel – Stifel Nicolaus & Company

Gary Lieberman – Wachovia

Robert Mains – Morgan, Keegan & Company, Inc.

Frank Morgan – RBC Capital Markets

Brian Siu – Sidoti & Company

Gary Taylor – Citigroup

Operator

Welcome to the Sun Healthcare Group first quarter earnings 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 first quarter earnings of Sun Healthcare Group, 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 expectations reflected in any of our 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

Thanks for joining us this morning. First quarter 2009 was the strongest quarter the company has ever had in the first quarter from both a margin and an EPS perspective. We had no normalizing items to the period, although first quarter 2008 did have $1.5 million in integration costs related to the Harborside acquisition that we normalized, so the numbers I’ll be discussing are normalized for the quarterly comparisons. We did have $900,000 in nonrecurring costs that were related to the implementation of our new clinical billing platform and a labor management system in the current quarter, and we had noted that when we issued guidance earlier this year.

Revenue increased 4% to $468.3 million. If we were to adjust for the leap year effect, revenue would have been up 5%. The effect on margins was 10 basis points. EBITDA increased 7.3% to $61.5 million with margin improvement of 40 basis points to 13.1%. EBITDA increased 10.8% to $43.1 million, with margin improvement of 60 basis points to 9.2%. Income from continuing operations increased 29.1% to $11.6 million, and our EPS of $0.26 was in line with the expectations we had when we issued 2009 guidance, and we are reconfirming our 2009 guidance.

Bryan will discuss both leverage and liquidity, and you’ll notice if you haven’t already taken a look at the press release we made great gains in our leverage and our liquidity is just in great shape, but again Bryan will go through details on that. Now, I’ll move on to the inpatient business.

At our inpatient business, Sunbridge, revenue increased 4.1% to $415.4 million. EBITDA increased 5.8% to $72.8 million with margin improvement of 30 basis points to 17.5%. EBITDA increased 7.9% to $54.7 million, with margin improvement of 50 basis points to 13.2%. Occupancy was down 80 basis points to 88.7%, but was up 20 basis points sequentially from fourth quarter of ’08. Our skill mix on skilled nursing facility beds was 30 basis points to 20.8%, and up 130 basis points sequentially. Medicare occupancy was slightly down on a quarterly comparative basis to 16.5%, but up 90 basis points from the fourth quarter. Our managed care occupancy increased 50 basis points to 4.3%, and was up 40 basis points sequentially.

Our rate growth was the strongest that we’ve seen also to date. Medicare part A rates up 9.1%, and Medicare A and B combined rate was up 10%. Our managed care rate was up 9%. The rate growth in both managed care case and Medicare case was due to really a pretty remarkable shift up in acuity. Our rehab intensity was off the charts in the quarter and has risen much more dramatically than we anticipated. Our Medicare rate was up 2.2%, which is relatively close to the expectations. We had guided to 2%, and at this point are still comfortable with that specific item in our guidance. Our skill mix as a percent of revenues on skilled nursing facility beds was up 190 basis points to 40.5%. This is the first time the company has broken through 40% of skilled mix as a percent of revenue.

Medicare was up 100 basis points, and managed care was up 90 basis points. Medicaid as a percent of revenue dropped 110 basis points to 43.7%. In terms of our RUGS numbers, our REX RUGS increased 60 basis points to 41.2%, and our rehab RUGS were up 400 basis points to 88.2%. We currently have 48 rehab recovery suites open, and in the second quarter, we’ll open another four units. We are still targeting 70 by year end, which should almost double the number of beds that we have in rehab recovery suites. Occupancy in those centers with rehab recovery suites was 88.4%, compared to 88.7% to those without. Skilled mix in those centers that have rehab recovery suites was 23.4%, compared to 19.5% in those centers without rehab recovery suites. Medicare was 17% in those with rehab recovery suites, versus 16.3 in those that didn’t have them, and managed care was at 6.4% compared to 3.2%, so twice as high in those centers that had rehab recovery suites.

Our labor management continues to be extremely strong. Labor and benefits as a percent of revenues decreased 80 basis points to 51.1%, and our actual raise in benefit costs was up a modest 2.5% as we continued to roll out the new labor management system which is called SmartLinks. We would expect going into 2010 that we’ll be in an even stronger position to leverage our labor cost against our revenue growth.

Moving on to our hospice segment which is called SolAmor, our ADC in the hospice segment was 450, up from 233 in Q1 ’08. Again, this is a small business unit, but we’ve been growing it on a de novo basis, and so at this point, we are pleased with the way it’s contributing. EBITDA margin was 14.1%, up from 6.4%, and that includes startups. If you exclude our startups, our legacy margins were approximately 25% on EBITDA.

Now moving onto our rehab business, Sundance, revenues increased 21.5% to $43.7 million, driven primarily by both organic growth and new contract growth, a little heavier on the organic growth than the new contract growth. While contracts grew 33 to 451, of which 19 were non-affiliated and 14 were affiliated centers that had not previously been serviced by Sundance. Our revenue per contract was up a strong 12.6%, which has been one of our core initiatives. Our productivity was essentially flat at 70.8%, but that’s a good productivity level for us. Our labor per minute increased by a very reasonable 3.7%. EBITDA increased 33.8% to $3 million with margin growth of 60 basis points to 6.9%, and we’re starting to see real consistency here as a result of good execution on the initiatives that were established in 2008.

Our staffing business, Career Staff, as I’ve noted in the past couple of quarters, this is a business segment that is most impacted by the economy, given how much of the business is done with the hospital sector, and as a result of that we saw revenues decrease 7.5% to $27.9 million. This is primarily in the nursing per diem segment of our business which is approximately 28% of our revenue. Our allied revenue was essentially flat. Our physician services showed strong growth. Despite the volume issues that have impacted this sector during this economic downturn, our gross margin actually improved 70 basis points to 22.8% with a bill to pay spread increase of 2.6%. Our EBITDA increased slightly to $2.2 million, but margin improvement was a significant 90 basis points to 7.9%. So our management team in our staffing business continues to really excel in this environment. The revenue drop was lower than many in the sector, and to actually have a slight increase in EBITDA and a significant increase in margin improvement I think needs to commended, and we really appreciate what they have done for us.

In terms of reimbursement issues and Washington, it’s really not a whole lot different from the last call. The proposal should be out anytime now. I think we’ll see three things that could potentially affect us in the proposed rule. There’ll be a market basket increase of approximately 2.1%, and that recommended increase is lower than we would have liked to have seen. CMS with the current trends in the economic downturn, they were assuming that our costs will be lower, and so they used that to bring down the market basket. So that’s 2.1% there. We expect to see the forecast error correction again as we did last year somewhere in the 3.3% to 3.4%, and then there’ll be some discussion about RUGS refinement.

In terms of RUGS refinement, we really don’t expect anything to happen in this next fiscal year. In terms of market basket and forecast error correction, we’ll have to deal with it just as we dealt with it last year. We think that the final rule will have a better scenario for us than the proposed rule, and even the final rule won’t necessarily mean that it’s over and done with. We’ve got to wait for the budget to come out in Washington, the administration’s budget, and see how that reconciles against the CMS recommendations and then work with our friends on the Hill to have the best possibly outcome for our sector.

One thing that I would point that I think many of you are aware at this point is that it looks like the doc fix is going to 2 years, and there isn’t going to be a paperwork, so that relieves some of the pressure on us, because our working assumption all along has been that we were all going to have to contribute to the doc fix, so it looks like that will not be the case, so that should be helpful in terms of going from the proposal to the final rules, whatever the final determination is, in terms of rates for fiscal year 2010, and it doesn’t mean there aren’t other pressures. There’re going to be costs that are going to be looked at pretty hard in order to help fund healthcare reform, and we do think healthcare reform is going to happen. We’re pretty sure that long-term tail will be completed cogged out of the healthcare efforts. That said, our groups in Washington, we have developed with a third party a financing reform proposal for not just long-term care, but for the post-acute sector. We issued a press release on that a couple of weeks ago. We’ve begun introducing that on the hill, and we’re getting a pretty favorable reception, and the idea there is we want to be part of the solution. We are very cooperatively with Congress, and our hope is that by having a long-term solution on the table, it will help us negotiate through some of the short-term issues that we’re dealing with as we speak.

With that, I’ll turn it over to Bryan, and after Bryan, we’ll go to Q&A, and I would note that just to give you all something to look forward to this I think is the shortest presentation that Bryan will ever have done.

L. Bryan Shaul

I’ll begin my prepared comments by updating you on our debt structure. As of March 31, 2009, we had $331.6 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. In addition, we had $173.5 million mortgage loans outstanding and $1.2 million in capitalized leases. I am pleased to report that we paid down our total long-term debt by $19.6 million during the quarter, approximately the amount we forecasted in our year-end earnings call. The $19.6 million debt reduction in the quarter brings our total debt down to $706.3 million at quarter end, 71% of which is fixed term rate debt. Our fixed term rate debt includes our $150 million of interest rate swap agreements in connection with our credit facility.

Including amortization of deferred financing costs as of March 31st, our weighted average fixed term rate on our debt is 8.37%, and our weighted average variable rate on the remainder of our debt is 4.01%. The all in weighted average rate is 7.1% down 52 basis points from the prior year quarter. Our total variable debt of $206.9 million includes $181.6 million related to our credit facility and $25.3 million related to mortgages.

Interest rates on the majority of this variable rate debt will reset on various dates prior to the end of the current quarter. Interest rate is based on LIBOR plus 200 basis points for the credit facility and LIBOR plus 300 basis points for the mortgage loans. Our fixed term mortgage loans have various rates ranging from 5.9% to 11.1%. The weighted average rate is 7.7%.

Over the next twelve months, we have approximately $8 million of debt maturities, principally related to scheduled payments on mortgage loans and the term loan. We had $65.6 million outstanding under our letter of credit facility of March 31, 2009. At the end of the quarter, we had strong available liquidity totaling $149.9 million, comprised of $99.9 million of cash and cash equivalents on the balance sheet and $50 million of available borrowing capacity under our revolving credit facility. Using March 31, 2009, EBITDA for the last twelve months normalized primarily for prior period insurance adjustments, our net debt leverage at March 31st is 3.7 to 1, fifty-two basis points better than what is required. That is based on our total debt outstanding less excess cash of $89.9 million and normalized LTM EBITDA of $167.2 million. We meet all our bank covenant requirements at March 31st.

As you are aware from our earlier discussions, we are deep into our implementation of our new clinical billing platform and labor management system. To update you on where we stand as of today, we have 37 centers operating with our new clinical billing platform and 72 centers are operating with our new labor management system. During the first quarter, we had nonrecurring cost of approximately $900,000 associated with the implementation of these systems.

Turning to our cash flow, net cash provided by operating activities was a robust $37.3 million for the quarter. That included a nonrecurring working capital reduction of $7.1 million related to converting a portion of our restricted cash held by our workers comp carrier to a letter of credit. After deducting our Capex, we generated free cash flow in the quarter of approximately $25.5 million. We still expect our free cash flow for the year to be between $48 and $53 million. Our $11.9 million of capital expenditures in the first quarter were comprised $9.4 million related to normal billing and equipment investments coupled with Capex investments of $1.8 million for our rehab recovery suites and $700 for the implantation of our new clinical billing platform and labor management system.

On March 31st, our DSO was 45 days, flat for both the sequential and year over year quarters. Our bad debt expense as a percentage of net revenues was 0.9%, substantially in line with our earlier estimates of approximately 1%. We continue to expect our bad debt expenses to run at approximately 1% in 2009. Our self insurance reserves at March 31, 2009, will be fully described in Footnote 5 of our form 10-Q which we expect to file with the SEC later today. Our corporate overhead cost as a percentage of revenues was 3.6%, in line with our expectation.

Now taking a look at our taxes for the quarter, for 2009, we have projected an effective tax rate of approximately 41%. We have previously mentioned annual limitations imposed by Internal Revenue Service Code Section 382 on our tax net operating loss or NOL carryforwards as a result of ownership changes. Due to unused section 382 limitations from prior years, the current year’s section 382 limitation, available built-in gains, and post-ownership change NOLs, there is approximately $134.9 million of NOLs which can be used to offset US taxable income in 2009. If the NOLs are not fully utilized in 2009, the remainder can be carried forward to 2010 and be added to annual limitations of $28.6 million that become available in 2010. There is another $122 million of annual limitations that become available after 2010 through 2025 bring the total available NOL carryforwards to $285.5 million. Should we experience another ownership change under section 382 rules it may be necessary to re-compute the amount and timing of certain of these NOL carryforwards.

As a result of the NOL carryforwards available in 2009, we expect cash payments for income taxes to be in the range of $10 to 12 million in 2009, primarily for AMT and state income taxes. Actual cash payments in the first quarter were $920,000. The realization our deferred tax assets is dependent upon the generation of taxable income during the periods in which the deduction of credits can be utilized. The valuation allowance of $34.3 million as of March 31, 2009, relates primarily to state net operating loss carryforwards and other deferred tax assets for which realization is uncertain.

That concludes my prepared remarks. Rick will now sum up the call

Richard K. Matros

Why don’t we move on to Q&A?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Paxton Scott – Jefferies and Company.

Paxton Scott – Jefferies & Co.

My first question relates to the Medicare rate growth that you been seeing over the past few quarters which excluding the market basket has been anywhere between 4-7%. So my question is how sustainable is this acuity driven rate growth level, and if not sustainable, where do you see it ultimately settling out?

Richard K. Matros

I actually do think it’s sustainable. We weren’t expecting as large an increase from a therapy intensity perspective that we saw this quarter, but we do think it’s sustainable, and much of it has to do with the maturity and better execution in our rehab recoveries. As we continue to open more of those, I think that you’ll see the numbers continuing to be impressive. We’ve got between 1000 and 1100 rehab recovery suites beds now. We’ll have approximately 1800 by year end. That’s a huge increase, and that said, I’d also note that we’re seeing gains in our centers that don’t have rehab recovery suites as well. We’re just not seeing them at the same level because you wouldn’t really expect to, so there’s no reason for us to think that that rate growth won’t be sustainable, and it certainly helps in the context of thinking about what happens in the market basket. Our Medicare rates were up $38 this year, and I understand it’s a fear-driven market. The sky was falling last year, and the sky is falling this year, but we’re going to have decent growth again next year because of what’s happening on the acuity side, even though we may take something of a hit on the market basket, and I think that’s what people don’t keep in perspective and really should keep in perspective, and that’s not even to talk about the managed care growth that we’re seeing, and again even though the rates aren’t as high as the Medicare rates, they’re still good rates, and it’s obviously better than Medicaid or private, and that rate growth is acuity driven as well and has been matching our Medicare rate growth.

Paxton Scott – Jefferies & Co.

Staying on the same topic of Medicare reimbursement, I was wondering if you could provide your thoughts on last night’s release of the Senate Finance Committee’s proposal to improve patient care and reduce healthcare cost, and specially the discussion of value-based purchasing and what impact of any do you see that having on your business?

Richard K. Matros

We’re already expecting that to happen. There’s been a pretty big push on the part of Congress to hold the nursing home staff more accountable for quality, and we really embrace that. One of the other components which came out of the Senate on that paper last night was the transparency act, and we’ve been working for last year plus with both COBRA actually on the senate side and [inaudible] on the house side to work out legislation in a way that creates a win-win for both us and for the Hill. We feel good about the level of cooperation there. On the quality side, our sector has taken up the responsibility to put together a quality initiative that can be a standard for the sector and is acceptable to Congress. In addition to that, we’ve been extremely supportive of the advance in Excellence Campaign which has had widespread support from a number of groups, and they’ll be releasing a report on nursing home quality that we haven’t seen yet, but we feel will be extremely positive and probably more positive than any report that’s been issued to date, so we really welcome that. We view that as really the solution to a lot of the issues that we’re talking about, both in terms of helping us on reimbursement discussions and putting our case forward that we are part of the solution, that we’re not just a lower cost provider, but we’re the low-cost quality provider, and I think the quality metric improvement that we’ve seen in our sector over the past couple of years while acuity has been rising is testament to that. We feel good about that. One of the things I should note for us kind of in line with what you’re talking about is our state and federal survey results for the first quarter of this year at the same time our acuity intense degree was at its highest were the best the company has ever experienced. So, we’re for that. There are already states on the Medicaid side that have pay for performance—Oklahoma, Georgia, and a number of other states are considering it, and we do well in those scenarios, so we’re fine with it.

Paxton Scott – Jefferies & Co.

As far as your plans for free cash flow, obviously in the first quarter you paid a good bit of debt, is there anything in the acquisition environment that is starting to pick up, or what are your thoughts for uses of free cash flow going forward?

Richard K. Matros

Primary uses of free cash at this point would be to fund CapEx, and we’ll make the normal set of debt payments, but I don’t think we’ll see any additional debt payments beyond what we’re required to make this year. In terms of acquisitions, we’re still not seeing anything or any real activity, although we’re starting to hear whispers that we should start seeing some activity soon, and if that’s the case, we’re certainly going to be interested. We have always been inquisitive. I think the gating issue for us is that anything we look at is going to need to be very compelling because we don’t want to disrupt what is a very inexpensive capital structure currently for just a small deal that’s going to be mildly helpful to us. That’s really going to be the gating for us, really looking at something that’s compelling to us.

Operator

Your next question comes from the line of Eric Gommel – Stifel Nicolaus & Company.

Eric Gommel – Stifel Nicolaus & Company

Looking at maybe from the other part of the equation, your rate growth was up pretty significantly. Patient days in Medicare on a year over year look somewhat flat, and I noticed last year it kind of tailed off, and I think there were some issues later in the last year from a patient days perspective, but if I was thinking about how 2009 plays out from a Medicare patient day perspective, do you see that number—that 15% number—moving a lot or how do you look at that?

Richard K. Matros

It’s a good point. In the fourth quarter, we were flat year over year on Medicare days, and we’re slightly down in the first quarter year over year, and there aren’t any data points out there that would indicate to us it’s a result of anything necessarily happening in the acute hospitals. There are a couple of pockets in the country here or there where there is an uptick in observation days on the part of acute hospitals, but I think some of this for us is just internal with the level of intensity increasing a lot more dramatically than we anticipated with our patients, our operators. I think we’re a little bit more selective in terms of their admission criteria, so they can accommodate the higher intensity patients, so our effort right now is to make sure that we’ve got our arms around that and that we start seeing Medicare occupancy growth again. One of the things that’s going to be a big focus for us on that is length of stay and seeing what we can do to impact that better there to help increase our occupancy. So we’re mindful of it. We’re not really concerned about it, but we’re mindful of it.

Eric Gommel – Stifel Nicolaus & Company

To assume it just stays flat maybe for this year would be you think a good conservative way to look at it?

Richard K. Matros

I think that’s conservative. I think our expectation is that we’ll probably see similar numbers on a year over year basis in the second quarter as we did in the first quarter, but I would like to think that we’ll see improvement in the third and fourth quarter this year on a year over year basis.

Eric Gommel – Stifel Nicolaus & Company

On managed care, now that has actually showed some pretty good improvement on a year over year basis. The same question again, managed care seems to be an opportunity, do you see that also improving on a year over year basis?

Richard K. Matros

Yes, I do, and really for different reasons. I think managed care is kind of a different animal from an operating perspective and from a contractual perspective and a little bit more complex, and I think our operators shied away from it early on. I think everybody is getting a lot more comfortable on the company in terms of more aggressively going after managed care. We’re still not where we need to be from an infrastructure perspective, in terms of handling the managed care business as well as we would like to, so as we get better with that, we think that number is going to continue to grow, we also don’t see any evidence at this point that we’re gaining managed care at the expense of Medicare. We think the Medicare issue is a separate issue.

Operator

Your next question comes from the line of Gary Lieberman – Wachovia.

Gary Lieberman – Wachovia

Question for you just in terms of the number on the pace of the additions of the rehab recovery suites. I guess back at the end of ’08, you had 47 units open. You’re saying now that you have 48, so just to reconcile to make sure the numbers are right, it looks like you added one in the first quarter, and you said that’s picking up to about 4 in the second quarter. Is there anything that has caused the addition of the rehab suites to be slower than you anticipated or did you expect it all to be more kind of back-end weighted in 2009, or is it a deliberate slowdown? Can you just talk a little bit more about what’s going on?

Richard K. Matros

It was meant to be more backend weighted. There are a couple of things—one, it was backend weighted last year, so from an execution perspective we want to make sure that we’re executing appropriately with all the new ones that came on board the third and fourth quarter last year because it was heavier in the third quarter and fourth quarter because that’s going to help really fuel out growth into and help the overall growth in the first quarter, and will do the same for us in the second quarter. It’s really an execution thing and spreading it out a little bit, but the other issue is we might have been able to have a couple more open in the first quarter, but you just get hung up with construction permit and all that sort of stuff, the licensing, and OSHPD in California, so some of that stuff that goes on, and any delay we’ve had in rehab recovery suites opening has specifically been a result of bureaucratic issues like that.

Gary Lieberman – Wachovia

If those numbers are right, one in the first quarter, four in the second quarter, and then maybe 8 or 9 in each of the third and the fourth quarter, is that the right way to think about it?

Richard K. Matros

Yes, that’s correct. We’ll also be expanding a few as well, and we’ll also be knocking a few of the smaller ones out that were put in place early on when we first got started that really shouldn’t be rehab recovery suites.

Gary Lieberman – Wachovia

If it’s possible, could you give a little bit more color in terms of what’s been going right, what has the staff been doing that’s been allowing them to see the kind of growth that you have in the high acuity RUGS?

Richard K. Matros

There are a couple of things. In the rehab recovery suites, we improved our infrastructure last year and consolidated the rollout of the rehab recovery suites under our leadership position, and that’s really helped standardize how we’re executing on the rehab recovery suites and better coordinated both the construction and the operation of clinical and business development interplay among those things on a day to day basis, so there was a concerted effort there just to provide more support so that we can execute on a more predictable basis. The other thing that’s helped not just in the rehab recovery suites but overall in the company in terms of what we’re seeing with the high acuity patients and the improvement there both on quality metrics, on an internal basis, and the external metrics that we have with state and federal health department surveys is we rolled out a new clinical system, not from an IT perspective, it was primarily manual, but we rolled out a new clinical system last year that was really the result of an intensive effort to look at the best clinical aspects of what Sun was doing and the clinical aspects of what Harborside was doing, and it took a while to get through that last year, and we had some bumps in the road particularly in the second and third quarter as we rolled that out as you typically would expect when you’re making a major change to infrastructure in a company, and we really started to see some improvement in the fourth quarter and even more improvement in the first quarter. So I think all of that has helped us, and then finally the third piece on the business development side is that we’ve gotten a lot more sophisticated from a data perspective. We now have a database built in every one of our local markets that gives us a lot more information on our local markets so we’re able to build those into the local strategic plan and make sure that execution happens, and we jiggered our whole business development infrastructure really at the end of 2007. So 2008, similar to clinical, was really a transition time for us. We had new people in place, we got new programs in place, some policies in place and got that data built up, and that data really wasn’t completely done until sometime in the fourth quarter.

Operator

Your next question comes from the line of Robert Mains – Morgan, Keegan & Company.

Robert Mains – Morgan, Keegan & Company

I lost the signal for a minute, so if you already talked about this, Rick, I can get the transcript. Did you talk about state Medicaid rates already?

Richard K. Matros

No. I just mentioned it briefly in the opening remarks that our rates were up about 2.2% in the first quarter, so the 2% that we guided to when we issued 2009 guidance is a number that at this point we’re still comfortable with.

Robert Mains – Morgan, Keegan & Company

We’re in April, and a lot of states start their year in July. Any of your more significant states do you have a fixed sum where you’re going to be coming in?

Richard K. Matros

Nothing new on any of the states. Rates come our in July and August, and we really don’t start getting a decent picture of what’s happening at the state level until end of May.

Robert Mains – Morgan, Keegan & Company

When you talk about some of the acuity increases you’ve had on the Sundance side of the business, give a sense as to where you are there. The acuity being driven higher, how is that getting driven higher? Who is initiating that move?

Richard K. Matros

On the Sundance side, it’s almost a similar story to what I talked about on the Sunbridge side where what went through is clinical infrastructure improvements and business development and the like last year, and I just want to remind everybody at this juncture that once we did the Harborside acquisition, 2007 and a portion of 2008 were really devoted very much to integration activities, and we had talked after we did that acquisition that we were really entering the first phase of fine-tuning for the company, and that’s really a lot of what you see happening now as a result of all the initiatives in 2008. 2008 was really the first full year that we really focused fine-tuning the company, reinvesting in infrastructure, and trying to sort of take the existing platform to the next level, so in terms of Sundance, similarly we made leadership changes at the end of 2007, we readdressed how we were operating within the model, a lot of the focus on the Sundance side is on the non-affiliated piece where the nonaffiliated contracts are primarily with mom and pops who aren’t as knowledgeable and sophisticated in terms of dealing with the high acuity patient, and so there has been a real effort on the part of Sundance to provide that additional value to the nonaffiliated contracts from an educational perspective, so that we help those mom and pops execute better from a rehab perspective. That’s really helped the numbers a lot, and then similarly for the cultural change that we envisioned as we changed leadership and made other infrastructure changes in Sundance has benefited us on the affiliated side as well. So it’s no silver bullets up, it’s not anything sexy, it’s just the basics, just doing better at blocking and tackling and accepting what we’re doing good and what we learned doing good and helping our customers deal with that better.

Robert Mains – Morgan, Keegan & Company

What’s your sense of the growth potential on the nonaffiliated side in terms of competitive environment, your ability to recruit and retain, and the number of nursing homes out there that you could derive reasonable revenues from?

Richard K. Matros

Our turnover in Sundance is down to single digits, so they’ve done a remarkable job there at retaining therapists, and we’re still doing a nice job recruiting, so on the sale side, we’re going to continue to be a little bit more aggressive than we had been the last couple of years on the sale side. I don’t want to say that we’re going to continue to have 20% revenue growth year over year, but it should be double digit revenue growth on Sundance. I still do not think that we’re going to break into double digit margins on EBITDA, but we should be able to sustain higher single digit margins.

Robert Mains – Morgan, Keegan & Company

What’s the therapist marketplace now, is it still pretty tight?

Richard K. Matros

Yes, it’s tight, and it’s not going to get any better. I think what’s helped us is that I think our reputation has really continued to improve, and I think we’ve done some tweaks to our benefits and things like that, and I think that’s created a nice environment for our therapists. We rolled out a whole new IT system in our therapy subsidiary, and that’s made life a lot easier for our therapists. This has also made it easier for us to execute. We have much better data, we’ve got much better tools in place. We can react to everything that’s happening operationally on a real-time basis much more effectively than we were under the old system that we had, so I think all those things have contributed. It’s kind of like anything else. You’ve just got to figure out ways to separate yourself from the guy next door, so you’ve got a better working environment for that therapist, and so far that’s really helped us out a lot.

Operator

(Operator Instructions). Your next question comes from the line of Frank Morgan – RBC Capital Markets.

Frank Morgan – RBC Capital Markets

I wanted to ask about thinking ahead to the days of RUGS refinements and recalibration of the whole RUGS waiting system towards these non-therapy ancillary areas, the medically complex patients, I’m wondering when that day comes, how do you think about adjusting your strategy particularly on these rehab recovery units? Is that something that has to be altered or changed, or is that something you can continue to implement, and in terms of just refocusing the company to looking at new growth opportunities, how long does it really take a clinical standpoint to retool to be able to focus after areas like medically complex patients?

Richard K. Matros

We’re actually preparing for that now. Even though we call our units rehab recovery suites, the focus is to rehabilitate patients and get them home into a lower level of care. It doesn’t mean they’re just hips and knees, and so part of our focus these last several months is to expand the array of clinical products that we can provide within our rehab recovery suites, so even if there is RUGS refinement in fiscal 2012, by that point we should have a number of different programs rolled out that don’t just sort of go after, if you will, the low-hanging fruits—that’s the knees. As we look across the spectrum of our centers, we take almost every conceivable patient possible right now across all of our centers. What we haven’t done is say, okay, we do a really good job in these two centers with these kinds of patients, and now let’s take that and let’s formalize that into a product that we can train more of our centers on. We can standardize the protocol for it. We’ll have it on our internet, so all of our affiliates have access to it and then we can more formally roll out these programs. So it’s not like we’re having to reinvent the wheel and think about having to take care of patients that we have no experience with. We have experience with a lot of these patients now. We just haven’t packaged it if you will and addressed it in a standardized way that meets our own internal quality standards that we can sort of give a sign-off to more facilities to roll out these different kind of programs, and that of course would be in conjunction with an acceptance in the local market so we have a better understanding which we do not with our databases of what the needs are in those markets so we can tailor the programs to the needs of those markets and what those condition groups are looking for in those specific markets.

Frank Morgan – RBC Capital Markets

Earlier you made a comment about the growth in your managed care business and how you felt like your infrastructure was maybe not quite in place. Could you elaborate on that and tell us exactly what it is and what kind of infrastructure do you need to really accommodate the managed care population?

Richard K. Matros

Essentially our managed care growth has happened really on a decentralized basis to a large extent. So in terms of having a better corporate infrastructure to set standards from a contract negotiating perspective to standardizing the kind of metrics that we want to look at and how we’re negotiating those rates on a patient specific basis. That’s the kind of thing that we have to do, so we just really have to centralize things more and determine from a resource perspective what we need to add if anything at the corporate level to kind of head that initiative up similar to what we did with the rehab recovery suites.

Frank Morgan – RBC Capital Markets

One final question for Bryan, and I’ll hop off here. I was just curious with regard to the guidance for the year, what did it really contemplate in terms of, I think you got some swaps you said that were rolling off or some debt that’s getting refinanced, refresh my memory—I think it was swaps or rolling out here I think in this quarter—can you tell me what is embedded in your guidance with regard to what happens once those swaps roll off?

L. Bryan Shaul

The swaps are not rolling off. They go into 2010, and the interest rate that was contemplated was about 7.7%, so we’re underneath that right now.

Frank Morgan – RBC Capital Markets

I must have missed something—rolling off or repricing.

L. Bryan Shaul

We repriced depending upon what the reset is. We reprice to LIBOR every 3 or 6 months. We’ve got some of it layered in on 3 months and some of it on 6 months, and when it comes due, we reprice. We just repriced a bit of it, and I think LIBOR was something like 1.09, and so we’re just over 3 on that. We’ve got that layered across so that we don’t have one bullet hitting us.

Operator

Your next question comes from the line of Brian Siu – Sidoti & Company.

Brian Siu – Sidoti & Company

I just wanted to backtrack to the healthcare reserve funds and their proposed cuts. I know that’s not due till 2015, but when do you expect to actually hear the next data point regarding that, and what do you think the potential implications are?

Richard K. Matros

Are you talking about the bundling specifically?

Brian Siu – Sidoti & Company

Yes.

Richard K. Matros

I still find it hard to believe it’s going to happen. It didn’t take much for them to say, okay, now it’s 2015 instead of 2012, which means most of the savings don’t start kicking in until 2020 or 2021. I don’t know if all this will be under the same situation at that point in time. I just think it’s going to be a really difficult endeavor to pull off because if you think about the majority of hospitals in this country being community based, non-profit, and the IT and sophistication from an infrastructure perspective that’s going to be required to manage that, it’s seems pretty daunting to me. That said, I still believe what we talked about on the last call which is while it’s reasonable to expect to some pressure on us from a pricing perspective, we really should see an increase in occupancy and specifically an increase in skill mix in that scenario because there is going to be even a greater incentive to push patients down to us. There is going to be an incentive to decrease unnecessary hospitalizations which is very beneficial to us because it’s an issue that we really have to deal with and do better job of dealing with and that is controlling our back door, and then finally if you look at our local markets and you can see that in terms of the results that we’ve been showing relative to the skill mix and what number we have with rehab recovery suites or whatever the other guys call them that this has always been a mom and pop environment, and that’s primarily who we deal with, and in an environment we’re bundling could exist, I think that we’re going to be in a much better position as a larger provider, particularly with the IT systems that we have in place and we’re putting in place right now to deal with that as opposed to some of the mom and pops. I just do not believe they’re going to have the sophistication and the wherewithal to take advantage of that the way we’re going to be able to take advantage of it, so I think the competitive advantage in that scenario will be even greater than the competitive advantage we experience today.

Brian Siu – Sidoti & Company

Do you expect to hear any update anytime soon?

Richard K. Matros

Who knows?

Operator

Your next question comes from the line of Gary Taylor – Citigroup.

Gary Taylor – Citigroup

Most of my questions have been answered except one. Is there any extra color on just Ohio Medicaid? I know a lot of states were in flux, but that was one that had some very specific proposals out that have kind of moderating it appears, but what’s your latest take on Ohio?

Richard K. Matros

Nothing new there. I think some of the talk was about the tax going up without seeing anything on the rate side, but I think we’re looking at having our rates pretty close to flat in Ohio, so nothing has really changed. It hasn’t gotten any worse there, and that’s as of this last week.

Gary Taylor – Citigroup

That’s the July outlook?

Richard K. Matros

That’s the July outlook, and that was envisioned when we put our guidance out.

Operator

We have no further questions at this time. Mr. Rick Maltros, I’ll turn the call back over to you.

Richard K. Matros

I appreciate everybody joining the call today. Bryan and I as always will be available to both respond by email and by phone, and again as we look forward to the next few months, hopefully everybody will keep things in perspective when the proposal will come out because as always we see significant changes by the final rule comes out and by the time there’s any legislative action, so I’d focus on keeping that in perspective, and I’d also focus on the fact that we have really strong rate growth outside of what happens on the pricing side, and that really is what needs to be considered as people think about what we can do in 2010 regards to what happens on October 1, 2009. With that, have a good day!

Operator

Ladies and gentlemen, that does conclude today’s conference. We thank you for your participation.

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Source: Sun Healthcare Group, Inc., Q1 2009 Earnings Call Transcript
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