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Executives

Eddie Jones – President, Corporate Communications Inc.

Paul Diaz – President and CEO

Rich Lechleiter – EVP and CFO

Analysts

Paxton Scott – Jefferies & Co.

A.J. Rice – Soleil Securities

Brendan Strong – Barclays Capital

Newton Juhng – BB&T Capital Markets

Frank Morgan – RBC Capital Markets

Rob Hawkins – Stifel Nicolaus

Joanna Gajuk – Bank of America

Brian Siu – Sidoti

Ryan Halsted – Wells Fargo

Kindred Healthcare, Inc. (KND) Q3 2009 Earnings Call Transcript November 3, 2009 10:00 AM ET

Operator

Good day, everyone, and welcome to the third quarter 2009 Kindred Healthcare Incorporated conference call. Today's call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to Mr. Eddie Jones. Mr. Jones, please go ahead.

Eddie Jones

Good morning. Welcome to the Kindred Healthcare third quarter 2009 conference call. This is Eddie Jones from Corporate Communications.

Before the company's presentation, I would like to read a cautionary statement prepared by the company. This conference call includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended. Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize that actual results may differ materially from the company's expectations as a result of a variety of factors including, without limitation, those discussed later.

Such forward-looking statements are based on management's current expectations, and include known and unknown risks, uncertainties and other factors, many of which the company is unable to predict or control, that may cause the company's actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements.

The company refers you to its reports filed with the Securities and Exchange Commission, including the company's annual report on Form 10-K, the company's other reports filed periodically with the SEC, and its press release regarding the third quarter 2009 operating results, for a discussion of these forward-looking statements and other factors that could affect these forward-looking statements. Many of these factors are beyond the control of the company and its management. The company cautions investors that any forward-looking statements made by the company are not guarantees of future performance.

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

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

Mr. Diaz will begin the call.

Paul Diaz

Thanks Eddy, and good morning, everyone. Last night, we announced our third quarter results that exceeded the high end of our earnings guidance. We also reported significantly higher operating cash flows in the period as we continue to improve accounts receivable collection and better manage our balance sheet.

For the third quarter, we reported income per diluted share of $0.14 from our continuing operations compared to our earnings guidance range of breakeven to $0.05. These results were primarily driven by growth in our hospital commercial business, productivity gains, and Peoplefirst rehabilitation and improved cost controls across the organization.

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

Rich Lechleiter

Thanks, Paul and good morning, everybody. Our consolidated revenues for the third quarter of 2009 totaled $1.1 billion, an increase of 6% over last year’s third quarter. Consolidated operating income or EBITDA totaled $127 million in the quarter, up 7% from last year’s third quarter. A reconciliation of EBITDA to our consolidated results of operations is included in our third quarter earnings release, which is available on our website www.kindredhealthcare.com.

In our hospital division, we reported revenue growth of 8% to $468 million in the third quarter while EBITDA rose 21% to $79 million compared to $65 million a year ago. Last year’s hospital results were impaired somewhat by the effects of two Gulf hurricanes.

Both reported and same-store third-quarter hospital admissions rose 4% compared to the same quarter last year. Same-store non-government admissions rose 11% compared to the third quarter of 2008 and in an improvement from prior quarter’s Medicare same-store admissions increased 1%. In addition, our Medicare case mix index for the third quarter of 2009 jumped to 1.19 from 1.14 in last year’s third quarter.

Hospital operating margins for the third quarter improved to 17% from 15%, mostly attributable to easier comparisons to last year’s weak results. And finally, average hospital wage rates for the quarter grew 3% compared to last year as annualized employee turnover dropped from 23% – from 26% in last year’s third quarter.

In our nursing center business, revenues of $538 million were up 3% in the third quarter of 2009 compared to the same quarter last year, primarily due to growth in admissions and favorable overall rates, offset to some extent by shorter length of stay. For the quarter, our overall revenue quality mix of 58% was better than last year’s 57%, while we are continuing our strategy of developing our transitional care units and enhancing our clinical programs, to better care for high acuity Medicare and managed-care patients.

Nursing center EBITDA for the quarter totaled $73 million compared to last year’s $79 million, in line with our expectations. Last year’s operating income included a favorable actuarial adjustment related to professional liability costs that did not recur this year. Average wage rate growth in our nursing centers moderated to 2% in the third quarter of 2009 compared to the same period last year as our annualized employee turnover rates dropped to 40% in the third quarter of this year from 51% last year.

Peoplefirst reported revenue growth of 15% to $123 million compared to last year’s third quarter of $106 million. While revenue growth remained strong, Peoplefirst operating income growth of 47% was also driven by better cost management and productivity improvements.

New contract growth continued to be sluggish, but we are pleased with the progress we are making in same-store revenue growth and higher employee retention rates. In the third quarter of 2009, we reported annualized employee turnover of 13%, approximately the same as last year.

On a consolidated basis, professional liability costs for the third quarter came in slightly better than we expected and reflected some benefits from prior-year reserve adjustments. Total program costs were $13 million in the third quarter of 2009 compared to $4 million in the same quarter last year. Our latest actuarial projection for 2009 indicated our malpractice costs should approximate $50 million to $55 million compared to the 2008 aggregate cost of $33 million. In 2008, we reported favorable prior-year reserve adjustments of $38 million.

In terms of the balance sheet and overall liquidity of the company, our financial position grew stronger through the third quarter. Our operating cash flows in the quarter were $53 million, well ahead of last year’s $7 million. Compared to a year ago, our consolidated accounts receivable days were down 10% at September 30, 2009 while our cash balances at the end of the quarter totaled $45 million including $31 million of excess cash to maintain our financial flexibility.

We also reported $250 million of outstanding borrowings under our revolving credit facility at the end of September. Net of excess cash, the company’s overall leverage profile improved at September 30, 2009 compared to a year ago. In terms of adjusted leverage, assuming a capitalization of our rents at 8 times, our ratio of adjusted debt-to-EBITDA was 5.1 times, better than the 5.4 times at September 30, 2008.

For the full year, our routine capital spending should approximate $110 million to $115 million compared to $115 million in 2008. Our hospital development capital spending should approximate $45 million to $55 million compared to $50 million in 2008. As in 2008, we expect that both our routine and development capital spending in 2009 will be financed entirely through internal resources.

In yesterday’s earnings release, we raised our 2009 earnings guidance range to $1.48 to $1.53 from $1.35 to $1.45 per diluted share and announced our fourth quarter of 2009 guidance range at $0.30 to $0.35 per diluted share. We also announced our initial EPS range for 2010 at $1.20 to $1.35.

Paul?

Paul Diaz

Thanks, Rich. Let me make a few closing remarks before we take your questions. First, we are very pleased at our third quarter results and the progress we are making in what’s typically our most difficult seasonal quarter. We continue to focus looking forward on selective opportunities to grow in our cluster markets and each of our businesses and continuing to look to reduce our adjusted leverage.

As we continue to participate in the health care reform discussions in Washington, we remain focused on the opportunities in our core operation as well as our long-term strategic operating plan. And while there are significant headwinds and reimbursements in our nursing center business in the near term, we are continuing to look for ways to improve our operations in all three of our businesses and invest capital for future growth.

That concludes our formal remarks, and we’ll be glad to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from the line of Paxton Scott with Jefferies & Co. Your line is open.

Paxton Scott – Jefferies & Co.

Hey guys, very nice quarter. I was hoping if you could just provide some color on any change in the trends that you saw in the business either in the LTAC or SNIP side, kind of how it trended throughout the third quarter and if there has been any material improvement or deterioration in the fourth quarter so far. Thanks.

Paul Diaz

No. I think – particularly compared to last year, we are feeling pretty good about the underlying volume trends in both businesses. The challenge is always for this time of year the significant ramp-up that we typically get from now to our jump-off in January and you sort of look at the last four or five years and it’s fairly steep, but we are seeing pretty good volume in both businesses as we are going into November here.

I think – as Rich talked about, I think it’s very important to focus on the cost management that’s occurred over the last five or six quarters in the company as we sort of weathered LTAC rate cuts and in this quarter, began to see the pressures on the Medicaid side and the nursing center business as well.

And we are continuing to be, over the long term, excited about building out our cluster market in terms of hospital development, the projects that we still have in our pipeline, and as Rich mentioned, the selective transitional care unit development, which we think again over the long term is an opportunity for us to grow both our commercial and Medicare businesses.

Paxton Scott – Jefferies & Co.

Okay, great. And just on the guidance. I guess you effectively took down your 2009 EBITDA guidance slightly. So one, I was hoping you could just touch on that and then two, if you could just kind of give us your thoughts on both volume and pricing as you built our your guidance for 2010? Thanks.

Rich Lechleiter

Yes, Paxton. This is Rich. Good morning. I think – effectively as we think about the '09 guidance, which I think you are referring to, we effectively raised it by the amount of the out-performance in Q3 while effectively maintaining what we thought around Q4. Some of the line items may have changed a bit with respect to rents and interest and EBITDA, but overall I think our view – our implicit view around Q4 back in August was around $0.30 to $0.35.

So – not a lot of change. Just to add on to what Paul said, the announcements – I think the out-performance in Q3 was driven primarily by the hospitals. I think the nursing centers and rehab pretty much performed as expected. So that – the bounce-back, if you will, in the hospitals, particularly in light of the reimbursement cuts that took place in June, I think is fairly noteworthy.

Paul Diaz

Yes, the – the only other thing to add is that we began to see it in Q3 in the horsing home business and we'll see more of the pressure in Q4 is the Medicaid issue, both in terms of the number of states that are freezing and/or cutting Medicaid rates, as well as the negative impact of provider taxes where there isn’t a corresponding rate increase. And so we will see that pressure in the fourth quarter, we began to see a $2 million worth of that in Q3. And as we’ve talked about as it relates to our guidance going into next year, it’s a pretty stiff headwind for our nursing home guys, who are otherwise performing really well.

Paxton Scott – Jefferies & Co.

Okay, thank you very much.

Paul Diaz

Sure.

Operator

And our next question comes from the line of A.J. Rice with Soleil Securities. Your line is open.

Paul Diaz

Good morning, A.J.

A.J. Rice – Soleil Securities

Good morning. Hello everybody. Let me just go at a couple of different things. First of all, with respect to 2010 guidance you offered last night, if you think – if I think about the guidance you offered in 2009, you are coming into this year – you are going to end up being, I guess, about $0.05 to $0.08 above what you offered guidance and we had – over the course of the year, we had a worse-than-expected Medicare outcome for the fourth quarter. I don't think anybody expected that when they started the year. LTAC reimbursement formula got adjusted midstream and we had some, I guess, deterioration in Medicaid, not maybe that much.

So obviously that original guidance has – must have had some contingencies baked into it. I guess I’m trying to think as I look at your 2010 outlook that you’ve offered, is that similarly constructed with a conservative bias that maybe includes some contingencies, how should we think about that as a starting point from your perspective?

Paul Diaz

I would take it at face value. I think that the rate headwinds on Medicare in the hospital division will – there is still an impact year-over-year as we go into Q1 of next year and Q2 on the nursing home side, our caution to you is that the Medicaid situation is very, very difficult and that is why we sort of maintained the sort of a Q4 view that we have.

And while – A.J., we certainly will work very hard to mitigate – we will not go at next year in a way that will jeopardize value creation for shareholders over the longer term, meaning that we continue to look to add nurse supervisors on the weekends in our buildings where we are seeing high volume in our nursing centers and convert LPN hours to RN hours because of the significant increase that we are seeing in acuity in our nursing center business.

And similarly, in our hospital business, the increases that we’ve had in our CMI and the ability to continue to attract commercial patients are predicated upon building a clinical model that discharge planners and physicians have confidence in.

I’ll promise you this. We will work hard to manage costs, expense, both on the corporate overhead line and exceed these numbers if possible, but I would take the guidance at face value and we’ll certainly hope to do better, but I would not assume that there is anything that we haven't disclosed to you out there that provides significant upside to the guidance at this point.

A.J. Rice – Soleil Securities

Is it – maybe it’s too early, but can you give us some flavor on the two big expense items, I guess, that tend to be swing factors? Sort of what is your assumption – underlying assumption about basic labor trends and basic general liability costs moving into next year versus this year?

Paul Diaz

Well, I think as you are seeing this year on the general liability, and Rich can add, we are not seeing the level of prior period pickup that we saw in the last few years, still very stable, slight improvement, still looking at the $50 million to $55 million line item. I mean that’s certainly an area that we’ll continue to work hard at, but I think as other companies are reporting, frequency seems to be upticking across the board for lots of different folks.

So I think that our guidance assumes a similar pattern going into next year and certainly an area that we are very focused on and hope for more opportunity, but at this point, none of the data would suggest that. With respect to cost trends, we’ll continue the process that we’ve done this year of looking to reduce contract labor, which we virtually eliminated over time, premium pay and all the other productivity gains that we’ve seen in rehab and our other two businesses.

That being said, it gets harder and harder now, many years into this process of mitigating rate cuts, to maintain quality and continue to push our folks harder. But we still have some opportunities there and certainly the labor environment is such that we think that we'll be able to mitigate some of that and that’s implicit in the guidance by continued tight cost management and you saw that in particular in the hospital division in the third quarter and our nursing center business and rehab business have also, over the last year, continued to manage costs pretty tightly.

A.J. Rice – Soleil Securities

Okay, thanks a lot.

Paul Diaz

Sure. Thank you.

Operator

And our next question comes from Brendan Strong with Barclays Capital. Your line is open.

Brendan Strong – Barclays Capital

Hey, good morning. Maybe first question will just be on guidance, I’m just curious how you are thinking about – and I know you are not providing quarterly guidance, but just – as you think about it, I mean is – this guidance – or do your results for 2010 end up being a little bit front-end loaded, meaning that you have more and more difficulty as the year goes on to offset some of the cost pressures just because you got to give some wage increases to the staff throughout the year?

Paul Diaz

Well, I mean, we give merit increases throughout the year based on first anniversary date, but I would say that generally you are correct. I mean, as the year rolls forward, the – there is a compounding impact on cost structure. We will probably see some benefit in food and energy costs, the cost of pharmaceuticals and medical supplies we hope will stay fairly moderate, but that is complicated as we continue to take more medically complex patients in both our hospitals and our nursing centers.

So that – the ancillary services outside services, radiology, lab, pharmaceutical, on a per patient day basis, will sometimes grow more than one might expect at 3% per patient day, we are taking sicker and sicker patients and obviously, we expect a corresponding revenue associated with those higher acuity patients.

Rich, you want to add anything?

Rich Lechleiter

Yes, just in terms of the quarterization [ph], which I think was part of your question, I think the Q guidance that’s there is kind of consistent with the range of $1.20 to $1.35 and typically and we would expect this to occur next year. Q1 is a very strong quarter for us seasonally, Q2 a little bit weaker and certainly the most difficult period is Q3, followed by kind of an upswing as Paul talked about earlier.

So I think the trend – the quarterly trend that you saw in '09 would likely continue into ’10 in terms of seasonal variation by quarter.

Brendan Strong – Barclays Capital

Okay. And then how are guys thinking about a rebound in the economy? I’m just curious like how would – anything at all kind of plays out not – not necessarily when the economy rebounds, but when it starts to come back, I mean, I’m thinking you are going to see more pressure on the wage side, but you hopefully will be looking forward to better increases on the Medicaid side as well. So I’m just curious, how do you see that playing out? Is there a period where it hurts you a little bit more in the beginning and then you make it up later?

Paul Diaz

Yes, that’s a good observation. I mean, in fact, because of the way the tax revenues tend to follow – and federal tax revenues too, we have sort of this late swing and you are also correct that as it begins to swing, we will be more and more challenged to be an employer of choice.

That being said, we have viewed the silver lining in this environment has been to really double down on our team, our staff, a service excellence program that we rolled out this summer that I think has built even more brand within the company in terms of our engagement of our folks and their commitment to our customers. We think that that will have a lasting impact as we come out of the recession in terms of peoples’ commitment to the organization turnover and retention rates and that we can hold on to much of these productivity gains.

More importantly, there are prerequisites to growing volumes and continuing to take more commercial and medically complex patients in our nursing centers and our hospitals as we come out of this. And thinking longer term are the essential elements that we will need to participate in a world that is likely to see care being delivered in a much more integrated fashion, payments moving to episodic type payments and so we are continuing to trying to build a foundation of people and systems and assets that we can be successful as we look two, three, four years out as hopefully the economy rebounds and we get better pricing.

The next year or two certainly will be challenging in terms of pricing and it will require us to be steadfast in our cost management, continuing to collect receivables so that we can redeploy capital for the longer term and continue to push on differentiating the service and growing volumes in each of our cluster markets.

So that is the strategy as we see it playing out over the next two or three years.

Brendan Strong – Barclays Capital

Okay, thanks.

Paul Diaz

Thank you.

Operator

And our next question comes from Newton Juhng with BB&T Capital Markets. Your line is open.

Newton Juhng – BB&T Capital Markets

Thank you very much. I was wondering about the status of the Melbourne, Florida hospital and I think that’s scheduled to be opened sometime this quarter and if it’s still on track.

Paul Diaz

Yes, I was just down there a few weeks ago. We got the rest of our certification and so like our very successful opening in West Palm, that hospital is ready to rock.

Newton Juhng – BB&T Capital Markets

Okay, Paul. Rich, one of the comments you made was just regarding the new contract growth on the Peoplefirst side being a little bit sluggish at this point. And I was just kind of curious as to what initiatives you guys have in place to try and stimulate that.

Paul Diaz

Well, we are actually starting to see that pick up a little bit, Newton. We have made some changes in the team and we are – part of what we realized, and we talked about this in the last couple of quarters, was that we had built and grown the external business quite a bit over the last three years, but we needed to pause and make sure we were executing for all of our customers in terms of their goals, both clinically and financially.

So we’ve caught up – I think you’ve seen in the numbers, productivity gains and revenue gains based on executing better on the business that we have, both internally and externally. We signed a 16-facility chain here recently in the last 45 days and we are starting to see the pipeline improve and we do think that as we approach RUGs IV and again an environment where rehab is going to be so important or continue to be important in the future that we can show that Peoplefirst is uniquely positioned or certainly as well positioned as others to be an asset to our nursing home and hospital customers.

I’d also note that we’ve signed a few additional hospital clients and we brought on someone to help us grow our – the hospital rehab contract business and we are starting to get a little traction there as well.

Newton Juhng – BB&T Capital Markets

Great. Thanks for the color, Paul. Just one last question and you may have had a little bit of comment around this, but I was just looking for a little bit more. On – I guess, this one is steered towards Rich. In terms of the AR days outstanding, how do you expect that to trend going forward? Obviously, you had a very successful year in terms of cash collection and so on and I’m just kind of curious as to what you are looking at going forward in terms of trend.

Rich Lechleiter

That’s a good question. I think most of the progress we’ve made this year is really on the hospital side of the business in the non-government, primarily managed care and commercial insurance. That’s really the progress that’s been made in lowering the overall accounts receivable base. The nursing center business has been fairly stable and rehab as well.

So I think – we are down 10% year-over-year, which I think is a pretty phenomenal track record, particularly given our revenues are up 6% or 7%. I don't expect to repeat that next year and we’ll have a very significant operating cash flow year this year, certainly in excess of our expectations, but that – operating cash flow is all things being equal, particularly given the guidance, we will be lower next year. But again, still pretty – at a level which we are going to fund a substantial portion of a higher CapEx number next year. So we are excited about that.

Newton Juhng – BB&T Capital Markets

Great. Thanks for the – that color there, Rich.

Operator

And our next question comes from the line of Frank Morgan with RBC Capital Markets. Your line is open.

Paul Diaz

Good morning, Frank.

Frank Morgan – RBC Capital Markets

Good morning. I was hoping you could comment a little bit about the opportunity to grow your net Medicare rate increase because of acuity. I mean, clearly you’ve got the market basket cut, but still – I’m just curious, what’s your thoughts about how much you can really drive your overall net Medicare rate growth in light of the fact that it seems like you are going to be accelerating your CapEx for these transitional care units on that side of the business.

Paul Diaz

Well, we’ve had great success in terms of case management in both divisions and we certainly – particularly on the commercial side in both our hospitals and nursing and rehab centers think that there is more opportunity there. And we continue not only to look to expand our transitional care centers and transitional care units, but expand the clinical program offerings there, offering more cardio and pulmonary rehabs as well as complex wound care in addition to the more traditional ortho, hips and knees, and stroke recovery programs.

But in terms of ADLs and RUGs mix on the nursing home side, we are reaching a point of more maturity there in terms of where we have taken the distribution of facilities, where we are comfortable from a quality and compliance standpoint. So I would moderate – one thinking a little bit, Frank, if we think that we are going to lay out and maintain case management that same kind of trajectory and growth, given the maturity of our Medicare business.

On the hospital side, probably some improvement. I mean, we continue to get better there, but similarly, I wouldn't get – I’d be careful in one’s modeling to forecast out too much case mix improvement in the nursing centers or the hospital on the Medicare side. The commercial side, I’m a little bit more optimistic about, because we still have a lot of education to do in many markets about the value proposition of our LTACs and nursing and rehab centers to commercial players. So that’s an area where I do think we have more opportunity.

Frank Morgan – RBC Capital Markets

Okay, thanks. And any color on – from a Washington standpoint, legislative standpoint on the – getting extensions to the Medicare Modernization Extension Act and any other thoughts that you are hearing out of Washington? Thanks.

Paul Diaz

Sure. As you can imagine, we maintain directly and through our associations a high level of engagement with policymakers both in the House and the Senate and with CMS in terms of the various policy issues that are being looked at, both inside and outside the context of health care reform and certainly going into maybe a conference committee process here in the next few weeks. We will continue to advocate for an extension of MMSEA, which we think is a good policy, it allows CMS and the industry to work together on developing better certification criteria for LTACs.

And with respect to the nursing center business, we certainly understand the need for everyone to participate in the context of reform, but we are concerned about the level of pay-fors, particularly in the House bill and continue to try to help people understand the significant deterioration that’s happened on the Medicaid side as people think about Medicare rates and the subsidization there.

But it’s – it is really very early to predict any outcomes at this point on any of that, but we still stay very much engaged in this process, which will probably go into early next year, I’m guessing.

Frank Morgan – RBC Capital Markets

Thank you.

Paul Diaz

Thank you.

Operator

And our next question comes from Rob Hawkins with Stifel Nicolaus. Your line is open.

Rob Hawkins – Stifel Nicolaus

Hi, good morning.

Paul Diaz

Hi Rob.

Rich Lechleiter

Good morning.

Rob Hawkins – Stifel Nicolaus

Hey. A lot of my questions have been asked. Just – can you remind me – again, the new bed initiatives that have gone in here 2009 and then kind of what you guys are – again are doing in 2010 and how the – early – how the 2008 vintage or 2009 vintage, what kind of a impact can we point to that maybe we can try to extrapolate a little bit into 2010? It looks like there might be some upside related to this, I’m just guessing.

And then kind of along those lines too, are there any kind of updates related to the M&A environment? I know obviously you got the moratorium and there is a few things going on in the LTAC rule, but I’d also like to maybe know a little bit more about kind of nursing homes.

Paul Diaz

Well, we continue to find selective opportunities in the LTAC business, even within the context of the moratorium. And as we expected, some of the regional players including some that is – that have projects in the development pipeline are having problems financing them. And so – we’ve got one opportunity that we are – we hope to close on here soon where an LTAC provider just wasn't able to see a project through. And so – as we talked about several years ago, we do see and continue to see an opportunity to consolidate market share in our cluster market with selective LTAC opportunities. We still have several projects in the pipeline.

You are seeing some of the backfill today as against the rate cuts in the LTAC being the performance of the newly opened hospitals in the last 24 months. And as we said – so we are filling the rate pressure well there. Similarly, in our nursing rehab centers, we are seeing good success, particularly in the markets that we are in with our transitional care units and transitional care centers, which are facilities that have really almost entirely moved to short stay, where we had a transitional care unit and like the Greens that we’ve talked about in Ohio where now we are up to 80 – 85 short stay patients.

So as Rich talked about, one of the things that investors I think should take note of, over the last several years we have in a very disciplined way invested capital in LTAC, in our nursing centers, and we have used that to deliver high-teen IRRs on the invested capital. You see that happening this year and we see further opportunities to generate operating cash flows here and again redeploy that into selective projects in our cluster markets.

We are going to build, for example, a new freestanding nursing transitional care center in Indianapolis, a – one of our high performing cluster markets. We’ve expanded in Las Vegas; we are looking at a new project in Seattle.

So we’ve got several places where we think that a good return characteristics solidify our market position, quite frankly elevate our market position because new projects have a tendency to have a halo effect in terms of how physicians and payers see the quality of your services and that tends to benefit – we build a new LTAC like we did in the Indianapolis, that’s had a halo effect on our nursing and rehab centers. It has raised everybody’s profile and gained to see further opportunities to do that.

Rob Hawkins – Stifel Nicolaus

Okay, great. Good color, specifics – I know you are increasing cash flow. You got a sense of how many beds maybe new that are going to be brought in or transitioned out versus I think about a – ?

Paul Diaz

Well, I think early next year we’ll lay that out.

Rob Hawkins – Stifel Nicolaus

Okay, fair enough. Fair enough.

Paul Diaz

For you and particularly at the Investor Day. That’s the place where we kind of go through the pipeline and go through specific projects and characteristics there. But very much – even with the different changes in pricing and stuff, we are still seeing really good return characteristics on a risk-adjusted basis for the selective LTACs that we are doing. And we do a lot of front-end work before we build an LTAC and we’ve hit – we are hitting better than 500 – a lot better on those.

And the same thing, over the last year or two, our science around our transitional care centers and transitional care units have improved as well. So as we look at those further investments next year, we have even a higher confidence level on the flow through.

Rob Hawkins – Stifel Nicolaus

Okay. And then another one, this is a little bit of a curve ball – new rules over this weekend. It looks like they are granting greater clinical freedom to nurse practitioners, PAs, that’s been a tremendous opportunity to help reduce returns to hospitals. I know in nursing homes you involved and I know you guys have used them in different shifts and stuff. Can you maybe go over – I mean, I wonder you guys are aware of it and do you have a sense of kind of what that might mean across a different business line? Is this another opportunity maybe to expand Peoplefirst? Are there other ways that might kind of either help productivity or raise the acuity?

Paul Diaz

Yes, I mean, I would say that you touched upon something we've been talking a lot about. As we look at our strategic plan and our pyramid, we talk about the top end of the pyramid is the portfolio strategy that we just discussed and cluster markets and investing assets in those cluster markets both on the LTAC side and nursing side.

In the core, those things that enable us to take more medically complex patients, more commercial and Medicare patients and prepare us for a more integrated world are things like case management, care management coordinators, the – our physician competencies and relationships and physician centers and clinical nurse specialists, as well as our information technology.

And we are giving great thought to notwithstanding the pricing headwinds that over the longer term, those are areas that we will likely see – would be seeing further investment. Physician services, managed care, which we made a – we brought in terms of a vertical structure supporting our nursing centers and rehab centers and our hospitals, we are looking at new strategies in terms of marketing, which is different than sales as well as physician services and information technology that would enable us to, on a differential way, participate in episodic payments and bundle payments and those things and in the mean time, help manage formularies, lab utilization, RUGs costs, et cetera.

So those enablers and physicians being a big part of it is something that we hope to be talking more about next year. We – and others are doing this too, certainly see the role of clinical nurse specialists and nurse practitioners and using different models, bonding further with physicians and including hiring more hospitalists, because we are doing that is something integral to our future.

Rob Hawkins – Stifel Nicolaus

Okay. And this is kind of all to be laid out kind of at the Investor Day or it’s still too early for this one?

Paul Diaz

Yes and I think next year as we move past health care reform and past public plans and all of that, I think the public dialog will focus a lot more on the ability of the health care delivery system to move to more episodic payments, pay-for performance around re-hospitalizations and so notwithstanding all the focus on blocking and tackling right now and watching our cost per patient day like hawks, we are trying to keep an eye towards that future of being able to be successful and ultimately, we are not going to cost cut our way through the next few years.

We need to grow revenue, we need to grow commercial business and the mix of patients and we are only going to do that through more physician services, a better product, more transparent clinical outcomes, and a differentiating customer experience.

Rob Hawkins – Stifel Nicolaus

Thanks for the color. I appreciate it.

Paul Diaz

You’re welcome. Thank you.

Operator

And the next question comes from the line of Kevin Fischbeck with Bank of America. Your line is open.

Joanna Gajuk – Bank of America

Thank you. Good morning. Actually this is Joanna Gajuk for Kevin. I just want to have a little bit more color on the Medicare and Medicaid rate cuts you highlighted. Maybe there is a way for you to quantify the headwinds for each of these for next year, what the Medicare cuts you are looking at and how much Medicaid cuts you are looking at next year?

Paul Diaz

Well, we’ve talked about this before as others have. I mean, essentially on the nursing home side, you are looking at a minus 1.2% in terms of Medicare rates when you look at the forecast there and the market basket. And on Medicaid, we are at a zero to 1% and that’s still quite volatile because state budgets are still bouncing around. So it is – as compared to the pricing environment that we have had of sort of 3% or 4%, it makes for very stiff headwind going into next year.

Joanna Gajuk – Bank of America

I guess. And then on this topic, are there any particular states that you are – have your eye on?

Paul Diaz

Not 40 of them. Yes, certainly the – the states where we have a larger presence, California, Massachusetts, North Carolina, Indiana, these are states that because of the amount – the number of facilities we have in those states with the Medicaid issues we get a great deal of focus, I would say that we are – the diversification though that we have is helpful in that not any one state is going to tip this over one way or the other.

And we do hope that policymakers, as we into next year, see the significant challenge that we have here of maintaining quality and access in the context of the kinds of reimbursement cuts that we are proposing and I do think that federal policymakers are coming to understand that the stimulus dollars have not made their way too to maintaining provider rates and that’s something that we hope to get more attention from federal policymakers going into next year.

Joanna Gajuk – Bank of America

Okay. So you mentioned that you expect Medicaid to be zero to up 1%. Is that right?

Paul Diaz

Correct.

Joanna Gajuk – Bank of America

Also then, would it be states that you think you will cut rate cuts?

Paul Diaz

Yes, net of provider taxes, there are some states where – but it’s – we would be happy go through state by state or talk about it with you offline, but it varies greatly. And you have to sort of factor in the provider tax piece of it and just a heads-up on the nursing home side, as you think about $1 million of managed expenses next year, we are looking at about $12 million of additional provider taxes that come through the expense line year-over-year. That’s a pretty big number in that nursing center business.

Joanna Gajuk – Bank of America

Right. And then in the press release, you mentioned some of the things you could do to mitigate the rate cuts, but would you be willing to give us more color on that?

Paul Diaz

No, I mean – I don't think we got any specifics other than continuing to look at wages, benefits, overhead in a way that it doesn’t jeopardize our mission or our ability to be successful longer term. And we’ve had a really good history here over many, many years of managing costs and you see that in the first nine months of this year without jeopardizing patient care ratios at the bed side.

We are not talking about lowering our staffing, our standards at the bed side. That is mission-critical for the longer term. We will look to manage contract labor, overtimes, premium pay, wage rate growth, and manage benefit cost in a way that still retains employees, which is important – is critically important, but at the same time is fiscally responsible.

So sort of across the board, we manage the per patient day expenses and ancillary very tightly and we’ll continue to try to do that next year and again, we’ll be helped a little bit by food and energy costs, but it is still very tough given the increased acuity of patients that we are seeing and their needs to maintain quality and fiscal responsibility in the context of these rate pressures.

So – I hope that’s helpful.

Joanna Gajuk – Bank of America

Yes, that’s very helpful. And just quickly on another topic on transitional care units, it looks like you have kind of ramped up your CapEx spending on TCUs, but then given the pressures you also mentioned about the new reimbursement system. Does it make sense to wait maybe until you see how it plays out before you spend the CapEx?

Paul Diaz

Those who sit in the boat and wait, die. We have to have a longer-term view of how we can create value for shareholders and again, given the success over the last year and sort of the imperative of growing through these pricing pressures, I don't think we can afford to sit back and wait when we have clear, low-risk ways of high-teen returns to do. And it’s defensive as well as offensive.

So I don't hesitate at all, given the nearly $100 million of debt that we’ve reduced. I mean, we – it is going to be a tough year, maybe a tough two years, but we have a great deal of confidence that we have a clinical model both in our LTACs and our nursing and rehab centers that is broadening and will continue to be a source of growth over the longer term and create earnings growth for shareholders.

Joanna Gajuk – Bank of America

Great, thank you. And just very quickly, can you just remind us how many sites have TCUs and how many you might think could accommodate them overall?

Paul Diaz

Well, we’ll go through the specific numbers, but it’s roughly around 82, 84 transitional care centers and primary transitional care units as we think about the next year or two and the – there are others certainly longer term, but over the next – in terms of where we are today in over the next 18 to 24 months, that’s kind of where are at, 82 to 84 centers.

Joanna Gajuk – Bank of America

Okay, I see. And then maybe, is there any data you can give us in terms of how you compare sites with TCUs and those without the TCUs but occupancy or skill mix?

Paul Diaz

We – if you go back to our investor presentation that we gave back in the spring, you’ll see a fair amount of detail there and we’ll certainly revisit with you that – those projects. But I think if you get online and go to our investor presentation, you are going to see four of five slides that really lay out – and I know Kevin has looked at them, what our TCU model looks like and again, the return characteristics aren’t as good as they were last year certainly, but they’re still good and I guess that’s the point. Notwithstanding the rate pressures, we still see a good return on invested capital on a risk-adjusted basis in these units.

Joanna Gajuk – Bank of America

Great. Thank you very much.

Paul Diaz

Thank you.

Operator

And our next question comes from Brian Siu with Sidoti. Your line is open.

Brian Siu – Sidoti

Hi, thanks for taking the question. I think most of them have been answered. But jumped on the call later. I was wondering if you could give us a quick refresher on RUGs IV and any steps you plan on taking out of the implementation.

Paul Diaz

Well, we – I think the first goal is to keep everybody focused on the basic value proposition that we see operating within both RUGs III and RUGs IV for Medicare as well as Medicare advantage and other commercial patients. And that means both our nursing centers and Peoplefirst rehab continuing to recruit, retain the best therapists in the marketplace, support them and create the best clinical outcome because ultimately if you lose sight on that, you are not going to be successful in any change in payment system.

We certainly have a great deal of training to do. We probably have about $3 million worth of training in the budget in the guidance that we talked about. So one of the other things embedded in the 2010 guidance is the learning and the transition and the preparation for moving to the new MDS 3.0 system and potentially moving to the RUGs IV payment system in Q4.

So the focus is continuing to recruit therapists, train therapists, working with our nursing and our case managers in terms of maintaining the intensity of service and the quality of outcomes that we’ve had and to not lose focus on that. And whether it’s been therapy caps or when we move to RUGs III, we’ve been pretty successful in keeping people focused on that as these changes have played out and that’s really the strategy going into next year, is to maintain a focus on this transition – system transition.

At the same time, we are maintaining focus on functional improvements of our rehab patients and productivity gains of our therapists using our handheld technologies and other things.

Brian Siu – Sidoti

Okay. And then – I mean, do you anticipate sort of October 1st [ph], you are ready to go or do you think it will – can you give us a sense of the timing?

Paul Diaz

No, I must say I’ve got a lot of work to do to get ready for October 1st and as we’ve said in the release, as we think – as you all think about the guidance of 2010, there is a lot of work, a lot of training, a lot of system changes that need to happen and there is certainly variability in outcome that could happen in the context of RUGs IV because we do not yet have the data coming out of the new MDS 3.0 system that would give us high visibility on what RUGs IV looks like, which patients fall into which category.

And this is precisely the argument that we are trying to educate policymakers about is that moving forward with both the MDS 3.0 data collection system and the movement to RUGs IV, a new payment system based upon that new data collection systems, simultaneously could have unintended consequences for patients and access and payments in what is intended to be a budget-neutral program.

So we are going to work over the course of the year to increase as much visibility about that and there are new technical manuals coming out and we are thinking about how to map and do the crosswalk from the MDS 3.0 to RUGs IV. And hopefully, over the next couple of quarters we’ll be able to talk more about it, but we are clearly trying to prepare for that, but don't have a tremendous amount of visibility yet because the data is not there to give it to us.

Brian Siu – Sidoti

Okay, fair enough. Thank you.

Paul Diaz

Thank you.

Operator

(Operator Instructions). Our next question comes from Gary Lieberman with Wells Fargo. Your line is open.

Ryan Halsted – Wells Fargo

Thank you. This is Ryan Halsted in for Gary. Just one question. I was wondering if you could give some commentary on potential impact from the change to concurrent therapy in the fourth quarter next year.

Paul Diaz

It’s sort of similar. We continue to work through the concurrent therapy component of the final rule in RUGs IV. We have a high level of confidence that we know how we are delivering therapy services and that we are following clinical protocols in terms of the appropriate use of growth – of group and concurrent therapy. And so as we work through the course of the year, ultimately how we manage through that like RUGs IV is something that we’ll be able to speak tomorrow as we move closer to that implementation date.

But really not much more offer to you at this point in terms of that, but a lot of work and energy is going towards that as we speak and as we prepare for 10/1 [ph] of next year. Keep in mind that we want to maintain our level of focus today on the quality and the intensity of services that we are providing to Medicare beneficiaries and commercial patients and we don't want to see any disruptions in service levels.

Ryan Halsted – Wells Fargo

Okay, great. Thank you.

Paul Diaz

Sure.

Operator

And this concludes our question-and-session for today. I now turn the call back over to Mr. Diaz for any closing remarks.

Paul Diaz

Great. Rich and I thank you for your participation today. We are obviously pleased with another good, solid quarter of operations and the team is continuing to work hard and we are awfully proud of everybody’s maintaining focus in terms of quality, service and financial outcomes as well. So we’ll try to maintain that level of balance and energy going into the fourth quarter and into what clearly looks like a challenging 2010 but one where we continue to see opportunities as we look to 2011, 2012, et cetera.

So thank you all for your participation today.

Operator

This concludes our conference call for today. Thank you for your participation.

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