Kindred Healthcare Inc. Q4 2007 Earnings Call Transcript

Kindred Healthcare Inc. (KND)

Q4 2007 Earnings Call

February 21, 2008, 4:30 pm ET

Executives

Eddie Jones - Corporate Communications

Paul Diaz - President and CEO

Rich Lechleiter - Executive VP and CFO

Analysts

Bill Bonello - Wachovia

Kevin Fischbeck - Lehman Brothers

Robert Hawkins - Stifel Nicolaus

Frank Morgan - Jefferies

Newton Juhng - BB&T Capital

James Kumpel - FBR Capital Markets

Presentation

Operator

Good day everyone and welcome to the Kindred Healthcare Conference. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Eddie Jones with Corporate Communications. Please go ahead, sir.

Eddie Jones

Good morning. Welcome to the Kindred Healthcare Fourth Quarter 2007 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 fourth quarter of 2007 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 Eddie and good morning everyone. Last night we announced our fourth quarter of operating results that came in the high end of our previously issued guidance. We also maintained our earnings guidance for fiscal 2008, and provided earnings expectations for the first quarter of 2008 as well.

During the fourth quarter we continue to make progress on our quality, customer service, human resource and business goals. We also opened a hospital in Phoenix and a replacement hospitals in Indianapolis, acquired eight nursing centers that were previously leased, and disposed the 13 under performing nursing centers that have been held for sale.

With respect to our earnings, we reported fourth quarter net income per diluted share of $0.46 from our continuing operations, which included net charges of $0.05 per diluted share mostly related to the KPS spin-off.

In our Hospital division, our same store admissions rose 2% with continuing softness in our Medicare admissions more than offset by strong growth in Medicare Advantage and other managed care and commercial insurance admissions. Our nursing centers results for the fourth quarter were strong, as we continued to demonstrate more consistent operating performance.

PeopleFirst Rehabilitation Services reported its 14 consecutive quarter of revenue growth, as we continue to expand our external customer base. And we are continuing to see the benefits of reducing our corporate overhead following the KPS spin-off.

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

Rich Lechleiter

Thanks Paul. Good morning everyone. Our consolidated revenues for the fourth quarter of 2007 totaled $1 billion. Excluding the KPS business that was spun-off earlier this, our revenues rose 7% in the fourth quarter compared to the same period a year ago. Consolidated operating income or EBITDAR, totaled $150 million in the quarter, compared to $143 million in the fourth quarter of 2006. A reconciliation of EBITDA to our consolidated results of operations is included in our fourth quarter earnings release which is available on our website www.kindredhealthcare.com.

In our Hospital division we reported revenues of $447 million in the fourth quarter, while EBITDAR for the quarter totaled $94 million. Reporting to hospital fourth quarter admissions grew 6% compared to the same quarter last year, while same-store total admissions in the quarter were up 2% compared to the fourth quarter of last year. Same store non-government admissions put on 20% compared to the fourth quarter of 2006, while Medicare same-store admissions declined 3%, probably as a result of growth in Medicare Advantage enrollment.

I would also note that we began breaking up the impact of Medicare Advantage on our hospital operations in our fourth quarter earnings release. Overall, division operating cost per patient tapered day were flat in the fourth quarter compared to a year ago, as the hospital operators continue to effectively manage cost while improving clinical outcomes.

In our nursing centre business revenues of $525 million were up 12% in the fourth quarter of 2007 compared to the same quarter last year, primarily due to favorable overall rates, quality mix improvements and new development.

Our Medicare and managed care census improved from last year's fourth quarter as we continued to invest in our operations to better care for high acuity patients. Our quality mix revenues improved to 56% of total revenues in the fourth quarter of 2007 from 54% in the same period last year. Nursing Centre EBITDA for the quarter rose to $88 million, up 23% compared to a year ago.

Our nursing center labor costs per-patient day grew 5% in the fourth quarter of 2007 compared to the same period last year, while professional liability costs in our nursing centers for the fourth quarter were down from the fourth quarter of 2006.

PeopleFirst, our Rehabilitation Division, reported revenue growth of 21% to $95 million compared to last year's fourth quarter of $79 million. EBITDAR for the quarter totaled $7 million, as we incurred additional cost transitioning a large number of new external contracts signed in the second half for the year.

While we continue to manage through a very competitive market for therapists, we're pleased with the progress we are making in growing our rehab business. We're continuing to sign new external therapy contracts, adding 44 new contracts in the fourth quarter.

Unallocated corporate overhead for the fourth quarter of 2007 reflects the cost realignments made in connection with the spin-off of KPS earlier in the year, as we continue to realize the benefits of leveraging our Information Technology infrastructure by providing IT services to PharMerica.

We continue to see improvements in our professional liability costs, based on our fourth quarter actuarial overview. Total program costs were down $8 million in the fourth quarter of 2007 compared to the same quarter last year, while our full year costs declined $16 million from fiscal 2006.

To add some further color, I want to provide some additional data around our malpractice costs. Aggregate professional liability cost was $64 million in 2005, $53 million in 2006, and $37 million in 2007. Each of the last three years included some favorable adjustments, resulting from actuarial estimate changes for prior year reserves.

For example, fiscal 2005 costs included approximately $10 million of favorable prior year adjustments. Fiscal 2006 cost included $24 million a favorable adjustments, and fiscal 2007 cost included approximately $35 million of favorable adjustments.

As we began fiscal 2008, the actuaries have projected total program costs of approximately $65 million which is been built in to our earnings guidance. This approach assumes little change to prior year reserve estimates. As a result, we expect to record approximately $16 million of malpractice costs in each quarter of 2008. As we have in the past, if the actuaries change their estimates from prior year reserve, we will reflect these changes in our formally operating results.

In terms of the balance sheet and overall liquidity of the company, our financial position at September 31 remained strong. Our cash balances at the end of the quarter totaled $33 million, and we had $275 million of outstanding borrowings under our revolving credit facility at the end of the year, in line with the estimates we made during our latest conference call.

Our operating cash flows for the year totaled $163 million, 26% ahead of last year, and substantially higher than we predicted on our last call. With respect to the 22 properties that Kindred acquired from Ventas, we sold 14 of these facilities in 2007 for an aggregate of $67 million. We continue to believe that we will meet expectations of $80 million to $90 million in aggregate sales proceeds for all the 22 properties.

In the fourth quarter of 2007, we acquired eight previously leased nursing centers, with 1,373 licensed beds that we will continue to operate. We acquired these facilities for approximately a $110 million, thereby eliminating approximately $9 million of annual rents plus escalators going forward.

In yesterday's earnings release we reaffirmed our fiscal 2008 earnings guidance range of $1.25 to a $1.35 per diluted share. We also provided for the first time our first quarter 2008 earnings guidance range of $0.22 up to $0.27 per diluted share to provide more clarity around our earnings expectations for the next quarter. The first quarter guidance assumes the higher level of malpractice cost that I discussed earlier, as well as the startup losses associated with our recently opened new hospitals.

That concludes my remarks for the quarter. Paul?

Paul Diaz

Thanks, Rich. Fiscal 2007 was a year in which we continued to reduce turnover, improve quality in clinical outcomes and grow each of our operating divisions. This is also a year where we positioned the company for future growth, and created more value for our patients, their families, our employees and our shareholders. Despite continued reimbursement pressures, particularly in our hospital business, we delivered solid operating results that were in line with the earnings guidance we provided to investors in the early part of the year.

We also completed the spin-off of our KPS institutional pharmacy business and tax free transactions for our shareholders that created the new PharMerica Corporation, a leading institutional pharmacy company. In addition, we consummated major transaction with Ventas that allowed us to dispose off 22 underperforming assets to comprise 10% of this lease portfolio.

The Ventas transaction also eliminated the out market lease provisions related to insurance requirements, facility bed management restrictions, providing the company with more operational flexibility going forward. In an effort to further enhance shareholder value, we also repurchased $50 million of our common stock in 2007, reducing our diluted share count by over 3% compared to last year's fourth quarter.

Finally, I would like to spend a few minutes talking about how we continue to position the company for future growth. First and foremost, we continue to see more opportunities to improve the working environment for our employees and a care of our patients in residence.

The link between taking care of our people and quality and profitability is never been cleared. We also seeing environment to provide better earnings visibility for Kindred shareholders as we have worked through a number of internal and external challenges and can now focus on growing our business and earnings over the next several years.

Specifically, we are excited about the opportunities to grow and continue to improve our Nursing Center and Hospital operations, the organic growth opportunities in our Rehabilitation business, and our Hospital development program.

In our Nursing Center and Hospital Divisions we see more opportunities for our service line development efforts and sales and marketing programs to continue to fill unused capacity, and really believe that our acquisition of development strategy, which is focused on our targeted cluster markets, will continue to provide opportunities to invest our operating cash flows and grow earnings.

Our continued focus on our patients, customers, and therapists puts PeopleFirst Rehabilitation in a strong market position to pursue our organic growth strategy and selective acquisitions.

And with respected to external growth, we are excited about our seven hospital development projects and the pipeline of selective acquisition opportunities we see in our Nursing Center and PeopleFirst Rehabilitation business within our targeted cluster markets.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we'll go first to Bill Bonello at Wachovia.

Bill Bonello - Wachovia

Good morning, guys. Just a couple of follow-up questions. On the Q1 guidance how that you've been impact are the losses at the new hospitals?

Rich Lechleiter

Hey, Bill good morning this is Rich. As you know we opened up some hospitals late in '06, and we opened four in 2007, and put the [India] replacement in place at the end of the year. The EBITDAR drag in Q1 is about $2 million or $3 million. And one of the things we're excited about in terms of looking forward at the end of the year particularly is the turnaround or the flip as those things start to mature and reach there potential, particularly with respect to commercial admissions and start to actually contribute to the EBITDAR growth, probably starting in the Q4.

Bill Bonello - Wachovia

Okay. And as you think about that, is that sort of turnaround time based on what prior experience with other new hospitals you've opened?

Paul Diaz

Yeah. Bill just to add a little more color. Depending on when a hospital opens, it can take 12 to 18 to 24 months before we sort of hit stride. We've opened six new hospitals in the last 14 months, and so to Rich's point, we've got a great track record performance in our hospital development over the years and we are very excited about the opportunities later this year and going into next year as these hospitals grow and stabilize. But there could be great variability which is what you see and towards the Q1 guidance in terms of how those hospitals might or might not hit stride.

Bill Bonello - Wachovia

Sure, okay. And then just a second question about Q1. The prior period adjustments that you recognized, how does that happen? I mean it sounds like you went through the year, you recognized prior period adjustments, a huge amount in 2007, then you reset the bar at Q1, how do those actually get realized? Why we sort of start over at the beginning of the year as opposed to the actuaries being able to say, well based on what we have seen over the last six months, here's how we adjust our estimate.

Rich Lechleiter

Hey Bill, let me take a shot at that. As most of you know we go through an full actuarial process using two different firms each quarter to try to deal with the issues that I think you are talking about. Let me give you an example of kind of how the numbers roll by quarter in terms of this process.

For example, in 2006, we talked about $53 million of cost that were booked, and typically what you see is more of the adjustments typically occur in the second half of the year. For example in Q1 of '06 we booked $18 million of cost. In Q2 we booked $17 million, in Q3 we booked $12 million, and in Q4 we booked $6 million.

So typically as they look out over the prior years, we tend to see more benefit in the later part of the year. Similarly in '07, we started out at $18 million in Q1, $13 million in Q2, $8 million in Q3, and actually a credit of $2 million in Q4. So again kind of a similar pattern here in terms of how this has developed at least within those two years.

So hopefully that's kind of helpful in terms of the process we go through. And we try to obviously work with the actuaries around the issue. But it's difficult since the tail on this business is several years. It is a little difficult, starting out the year they really have a good feel for the number.

Bill Bonello - Wachovia

Okay. That's very helpful. I'll hop back in the queue. Thank you.

Operator

And we'll go next to Kevin Fischbeck with Lehman Brothers.

Kevin Fischbeck - Lehman Brothers

Hi, thank you. Good morning.

Rich Lechleiter

Good morning, Kevin.

Kevin Fischbeck - Lehman Brothers

I'd like to ask you a couple of questions about the guidance. It looks like you reforming the EPS estimates but your EBITDAR estimate was down by about $3 million. Is there anything going on that explains that?

Rich Lechleiter

No, I think, good morning. I think when we do the original guidance in early November that was based on some, preliminary budget work that we were doing, we hadn’t completed so completed the processes. What you see in terms of a guidance today is a, they're fully refined operating budget for the company. So I think it's just a minor operating refinements, but really nothing significant up now.

Kevin Fischbeck - Lehman Brothers

Okay. So just to make sure I understand that from the time you provided the last guidance till today, we've had the - the Medicare Bill was passed the new LTAC proposed rules put out, and it's look like you bought one extra facility then you had originally assumed in your guidance. Are those basically all the changes that are incorporated?

Rich Lechleiter

Yeah. Let me speak to the reimbursement changes that have occurred. It's a good question, as most of you know the SCHIP Extension Act that was signed into law in December, they provide some relief to the LTAC in the near-term, particularly the suspension of the limited payments for a very short stay patients. That clearly has a positive effect for the company in terms of our guidance that we have put out in November, probably to the two the tune of $8 million to $10 million of additional reimbursement in the hospital business in 2008 compared to our previous view. So that clearly was in right direction.

In terms of the proposed rule that recently was issued and that is still in a proposed stage that will affect July 1, to make a long story shorter, is an effective rate increase of about 1.9% for LTAC hospitals beginning July 1. That compares to our view, our previous view of around a 3% increase. So that's a negative, if you will, to the budget or to our review around the precious guidance. Is the net-net effect of those two items primarily pretty much offset each other on the full fiscal basis?

You also asked about some of the changes in rents and other capital costs. We acquired an additional facility that we had previously released that accounted for some of the movement. And the other thing that's of note is that interest rates are starting to move downward. Our credit facility is LIBOR based, and within the last 60 days there has been some pretty good movement in terms of downward rates there.

So we've refined our thoughts around the interest costs accordingly.

Kevin Fischbeck - Lehman Brothers

Okay, great. And then as far as the seasonality your guidance goes it sounds like the malpractice expense bump up has explained most of the drop off, but that kind of implies that the rest of the year is a little stronger than I might have thought, and then you touched on the hospital start-up losses. Is there anything else that kind of makes you feel a little better about the numbers getting stronger as the year goes on?

Paul Diaz

Look, Kevin. I think that we are just trying to be more thoughtful about managing our expectations around the quarter, as we did in this past year, and as we learned particularly in the third quarter. And we feel really good about the underlying business trends, our quality metrics that supports the malpractice improvement, the admissions trends, our operators focus on quality and managing payroll cost, and it is exactly as we've laid out. It is the phenomenon of the sequential projected malpractice cost and the variability of the potential performance around our new hospital starts, that produces the first quarter estimates that we've given you in terms of try to manage our expectations around the first quarter.

Kevin Fischbeck - Lehman Brothers

Okay. And then as far as the malpractice expense goes, what's been driving that improvement as you have seen in the last couple of years. Is it fewer claims; is it reduction in cost per claim?

Paul Diaz

It is really a three-prong approach that we've worked on very hard, since we exited Florida and Texas. First and foremost, it's been quality and both in response to the incentives in the RUG system to take shorter stay and more medically complex patients, we've stacked up our facilities, we've made the physical plant improvement, we've improved the physician component, and that has resulted, particularly in terms of serious deficiencies, significant drops over the last, four years of the severe deficiencies in our facilities and that translates into fewer malpractice claims in our nursing centers.

We've also been very proactive in our risk management efforts, and we have nurse, paralegal folks, our risk management specialist that use an event reporting system and are very proactive in our hospitals and nursing home intervening with families, working with staffs around incidence as they arise.

And we've also made considerable efforts in our claims management processes and claims administration processes in reducing the turn around for claims that can effect actuarial outcomes. And we've had a very successful alternative dispute resolutions program that has really helped managed patient and family expectations around incidences and just creating a better customer environment.

So, all of those things have come together although last few years and continue to come together in terms of both the outcome on the malpractice line and the outcome along the growth in occupancies and quality mix, they are very related. So it's still an opportunity for us on both of those line items.

Kevin Fischbeck - Lehman Brothers

Okay, great. And then last question. Do you have any comments on the recent CMS disclosures that they plan to implement some of their revenue forms outlined in the first Bush budget any thoughts from the impact there?

Paul Diaz

Yeah. Let me speak to that for a second. First we don't have anything specific to react to. But again let me just comment on it from a policy perspective. I think that we at Kindred and many of our peers have work very hard really over the last six or seven years to invest in our facilities in terms of plans, staffing, the division component to meet the needs of these patients.

And the policy as it was designed in new nine categories, and the reason we have seen a growth of the number of patients in those categories is the policy that I believe that Congress and CMS has articulated that we want to move patients at a short-term acute care hospital at LTAC and in patients rehab facilities to less restrictive, less costly setting where clinically appropriate.

And I thinks its very important, and we obviously have more work to do with CMS and Congress in engaging in this, but we need to be careful not to be in the silos as we look at this, and look at the benefits to the overall post acute space, meaning how has the RUG system positively impacted length of stay, short-term acute care hospitals. How has it continued to move patients who are clinically appropriate for SNF care out of LTAC and out of IRFs? And I think we have to make sure that the discussion isn’t so silod and broader in terms of what's - how is the RUG system working within the post acute policy goals that CMS and Congress has and we think it is.

And so we are very pleased both in terms of our clinical outcomes, as we are seeing the efficacy of our programs in terms of short-term stay and medically complex patients both in terms of clinical outcomes and costs effectiveness, and you'd see that in the growth of our Medicare Advantage business as well, where those payers are seeing the opportunity to use our transitional care units as an alternative to further days on an STAC or an IRF or an LTAC. So, we've been engaged in that broader policy discussion with CMS here over the last few months.

Kevin Fischbeck - Lehman Brothers

Okay, great. Thanks.

Operator

And we will go next to Robert Hawkins at Stifel Nicolaus

Robert Hawkins - Stifel Nicolaus

Good morning.

Rich Lechleiter

Good morning, Rob.

Robert Hawkins - Stifel Nicolaus

How are you? I got a couple of questions, and I think I understand the guidance issues and the malpractice piece. I appreciate your comments on that and kind of following up, I know there are some question just now were asked about rates and kind of where you see that I understand your arguments there. But obviously with the New York Times article, are you seeing anymore regulatory actions at the state level from state surveyors, regulators or things like that, tightening or deficiencies. I know you've done a lot towards quality but becoming more stringent and looking a lot more carefully because of the heightened political environment.

Paul Diaz

There is no question, Rob that we have seen over the last 24 months a heightened state surveyor environment, and I think if you look at the national statistics in terms of average deficiencies and substandard care deficiencies and serious deficiencies that you have seen. Those numbers trickle up, and I think the industry need to continue to demonstrate the progress we were making within our quality first and advancing excellence initiatives in terms of -- within the context of that continuing to make progress.

Now for Kindred, I will tell you that we've continued to make a significant progress as compared to both national numbers and other benchmarks. So, as I alluded to earlier, we believe that, that is directly connected to our further opportunities in the malpractice line and our ability to improve our quality mix.

But I think it is fair to say that we need to continue to demonstrate more clearly and in a more transparent way our value proposition, whether it's in terms of, post acute, the demonstration projects and where the patients are best served and in terms of transparency and accountability around quality, and how that is looked at by CMS and other. And there is a clearly ongoing discussion in Congress and CMS about that and I think we need to engaged further in that in a data driven way.

Robert Hawkins - Stifel Nicolaus

Okay. And then wanted to see if I can update on your market cluster strategy. You guys were opening or roughly getting start with three to four markets, you've got some deals in your development pipeline, how does all that tie together right now and where is that heading. I mean because you saw there is a lot more opportunities in just a three or four markets want to try to understand, what to expect in terms of that progress over the next couple of years?

Paul Diaz

Yeah. We are very excited about that. I think you get only different things in different markets but, as we look it our cluster market strategy, certainly one big component of is what's a more rational strategic way to allocate capital and make investment decisions. And so as we look at growth in our rehab and hospitals and nursing home businesses. We clearly have a strong preference to where does it add to our cluster market strategy.

And the cluster market strategy in it's absence really has a three -pronged, had really three prong. So is this sort of the revenue opportunity. Opportunities to capture, cross referrals opportunities to be more visible to hospital discharge planners, to payers, to physicians. And we're seeing in Indianapolis, in Las Vegas, and different markets where we've been piloting some of our collaborative marketing the programs and leveraging our clinical liaisons such that it is clearly helping and we're seeing those numbers.

Secondly, and I would say this is just as important in my view is the opportunity to share clinical programs to advance our service line, development efforts or sub-acute programs or TCUs, and to share this clinical competencies of our hospitals, so there are nursing homes who can continue to take more medically complex and short-term patients. That's a big part of it for us. It's also incredibly helpful in terms of our HR challenges and progress.

I mean he you has the best nurses and the best therapist and the best physicians, is going to be best physician in the post acute space. And clearly we think our cluster market strategy is important in that regard.

And then thirdly, from everything from having our hospitals do lab services to how we purchase landscaping, to how we are using out side dialysis and other services in many markets combined business office operations. There are cost efficiencies and how we try to manage down nurse agency cost which we have successfully down in our nursing home and hospital business.

So there are - and that all mean different things in different markets over the next five years, as we've come together as a company around this cluster markets stretch.

Robert Hawkins - Stifel Nicolaus

So is it three now and how many you expect kind of at the end year and the next year or how should we will be thinking about it.

Paul Diaz

Now let me clear it. A lot of that's three-pronged. You are going to have service line development, HR, clinical program efforts rolled out in this year and next year, maybe in 10 markets. You may have to collaborative marketing stuff rolled out in another two or three markets. There are certain conditions present to doing different things in different markets. So, just try to be a little clear. Current market strategy will need different things in different markets. As we figure out which were the best practices that can be standardized across the portfolio.

Robert Hawkins - Stifel Nicolaus

Okay. And just a final question on -- a quick on the share count in the guidance. You finished the year at 38.4 million shares, on a weighted average basis for fourth quarter, and you're guiding for 39 million shares next year. And I know that was kind of the original guidance right around the time you were setting up the repurchase program. You still have 50 million of capability going into next year for repurchases. How should I be thinking about the 39 reconciled with 38 and maybe future options? Where do they all that kind of shake out?

Rich Lechleiter

Yeah, this is Rich. Well on that point, well first of all we are assuming a higher share price, so there is more dilution in the option. That's a one point. We typically have an annual grant of equity to senior management which is built in to the guidance, those are really the two primary factors that may bump your roll number up by as much as a 0.5 million shares.

Paul Diaz

And the second part of the question, Rob, we are committed to our share repurchase program, and as we've done over the last several years, we'll continue to be opportunistic. But we are constantly looking at that versus a skilled nursing facility acquisition opportunity in our cluster markets in terms of what creates the most value for shareholders. But we are committed to doing that and affecting that this year. so…

Robert Hawkins - Stifel Nicolaus

All right. Thank you.

Paul Diaz

Thank you.

Operator

(Operator Instructions) Next to Frank Morgan at Jefferies.

Frank Morgan - Jefferies

Good morning, a couple of questions. First on the hospital side, can you talk a little bit more about the dynamic of the shift from traditional fee for service Medicare over to Medicare Advantage? From a profitability standpoint is this better or worse business, and really how far do you think this shift can go based on what you see out there in your patient population today? What kind a penetration rate do you think you can ultimately see from that Medicare Advantage side.

And then you mentioned this in your prepared remarks, but could you go back through on the rehab side of the business a little more detail about this notion of the external contract transitioning in the second half of the year and what the cost where there and where we think margins will ultimately stabilize at on that. Thanks.

Paul Diaz

Sure. We will first on the Medicare Advantage side. The pricing will vary by market. And we have sort of the same, supply-demand negotiations that the short-term acute-care hospitals have often in terms of competitors and those things. But I'd say overall Frank that, pricing will continue to approximate and move and regress to the Medicare fee-for-service type pricing in the Medicare Advantage business.

But it does vary greatly by market, and we use pricing power when we can, when we can demonstrate to folks that, really that the reason we're being so successful there both in our nursing home and LTAC business is that those case managers realized how much it's costing them for their patient to stay in a short-term acute care hospital, ICU. They realized how much it costs for that patient to stay in the patient rehab facility when they are otherwise stable and they can get the same approximately three hours of rehab services, the same intensity of nursing services and physician over sight in one of our transitional care units.

So it is our challenge and opportunity to continue to demonstrate that value proposition across our portfolio and Kathy our new VP for Managed Care is really elevating our gain, the quality of our discussions within our company and our capabilities. We are excited about that.

At the same time as we've talked about previously, investor should be sensitive to the AR pressure there because we don't get paid as quickly as we do in fee for service Medicare, and that pricing in some markets will be more challenging. But our view is we need to swim in that tide not against that tide, and continue to demonstrate the value that we can create, and I think that's a lesson for the folks in the policy realm as well.

If you look at what we're doing in the hospital side, what we're doing in our nursing home side, and the value we're creating for those Managed Care payers that would argue for maintaining stable reimbursement for LTAC and SNFs going forward as well. And then we have to do a better job of connecting those dots for policy makers.

On the rehab business, we continue to be very excited about how that business will mature this year and going into '09. We have good experience that as contract matures and get to their full potential, the margins in those contracts and we've been working hard and have been successful in meeting customer expectations around staffing, around productivity, and we only have a handheld technology that is improving productivity. So the underlying benchmarks are crucial to us. Retention, turnover, productivity, pricing, are all in place and we see the drop through opportunity and we expect you'll see more of it in Q1 and certainly into Q2 and Q3 of this year.

Frank Morgan - Jefferies

But was there something specific that in terms of just margins in the quarter, that were, you were elaborating in the prepared remarks about the transition of external contracts is what I've got written down as there.

Paul Diaz

It's just simple fact that it takes 90 to 120 days to stabilize new contracts. You don’t make money in the early months because you are staffing up, you're making a lot of investment in training. So the new contract rehab business doesn’t become profitable until a 120, 150 days out.

Frank Morgan - Jefferies

Okay, that makes sense. And then one final one going back to the MA discussion, I take it since its obviously becoming material enough on the hospital side that you break it out as a separate line item in your operating stats, but how is that same penetration looking over on the nursing home side of the business so far.

Rich Lechleiter

Well, obviously, I am [marked] for you; I am looking at John here, who does all his work for us. We are going to have more hopefully in the first quarter about down on the nursing home side as well, because there has been good movement there, and we are developing better skill sets around managing the care of those patients and managing the pharmacy and rehab cost of those patients which is critical as well. So, we will have more to talk about that as well as the management changes in nursing home business when we announced first quarter results.

Frank Morgan - Jefferies

Okay. Thank you.

Rich Lechleiter

Sure.

Operator

And we will go next to Newton Juhng at BB&T Capital.

Newton Juhng - BB&T Capital

Gentlemen, actually all my questions have been answered, so I'll move back into queue. Thank you.

Paul Diaz

Thank you

Operator

(Operator Instructions). Next to James Kumpel at FBR Capital Markets.

James Kumpel - FBR Capital Markets

Hey, good morning guys. I just wanted to revisit the whole actuarial assessment of patient liabilities, and I was curious if and when your actuarial advisors would recognized that you've made permanent in roads to result in just lower quarterly accrual?

Rich Lechleiter

Hey, Jim it's Rich good morning.

James Kumpel - FBR Capital Markets

Hey Rich.

Rich Lechleiter

I think you asked a question, and I think we've had a pretty collaborative process with the actuaries over the last several years when we do meet with them each in that regard, and then particularly around the things Paul talked about around clinical quality and the improvements we've made; their survey results and etcetera.

So I think they are tied into and knowledgeable about the things that Paul talked about risk management and operational quality, as they think about, setting reserve levels around malpractice. At the same time there is still volatility in the marketplace. I mean I am not - while we've made great strides to improve this picture, I don’t want to give anybody the impression that there is not still volatility and activity around this topic in the marketplace and it does vary from state-to-state and year-to-year and we've seen some of that and I am sure you have as well.

So I think there is some level of, I don't want to use the word resistance, but I think some of conservatism that the actuaries are going to retain around the volatility of the marketplace. That perhaps covers their view a bit of Kindred.

James Kumpel - FBR Capital Markets

Okay.

Paul Diaz

Joe, now we just add from an operator's perspective. Yes, this is hard right. You get excited, you want to keep driving the behavior that we've been driving and we benefited from and the operators see that and we're really transparent inside the company about we, for example are AHCA quality award winners, which we have a 105 of them now. And we are quite proud of that, that which is a Malcolm Baldrige type quality process. Those facilities in our portfolio have 40% fewer clients than the facilities in our portfolio that happens to have won that award.

So we talk about those kinds of things in order to get further commitment in the company to our quality processes. And at the same time, we have to maintain the intellectual consistency around this process with our actuaries. And that's really what drags us, is the consistency of this quarterly review process and the thoroughness that is involved there, and our operators are at the table there.

So, we share the frustration to some extent, but we need to maintain the discipline around this process, and I think that that will continue to bode well for shareholders over the long-term.

James Kumpel - FBR Capital Markets

But generally speaking, do you think that because of the conservatism at the beginning of the year which tends to be ameliorated over the course of the year resulting in better than expected patient liability cost over the course of the year. That, that might have the effect of creating sort of a seasonal lift over the course of the - over the year in terms of earnings trajectory which has not historically been the case for you guys.

Rich Lechleiter

I think given the long tail of the business, it's hard to project the current year cost. Every company is in that position. We give ourselves and we do our shareholders a decent service by at least from starting out the year, providing some view point that we are not going to come back to shareholders and say, well we think this view is going the other way and instead of having some potential upside here, we've got some down side. So, I've been having gone through this before several times.

I think we are better served starting out the year in somewhat of a conservative fashion. With the understanding operationally that if we continue to execute on the thing Paul talked about, there may in fact be some good news here. But I don’t think it's good for us and it's good for the shareholders to necessarily jump out in front of this [thing].

James Kumpel - FBR Capital Markets

Okay. As it relates to Mike Embler, can you talk about the circumstances of his resignation from the Board and who you are looking at as a potential replacement?

Paul Diaz

Those are going to be tough shoes to fill. Michael has been one of the best Board members' I've ever had the pleasure of working with. A smart investor who really kind of gets it in terms of the length between quality and profitability, and has been a rock in terms of all the progress we've made since the bankruptcy, and he will be missed dearly.

He's got broader responsibilities within his funds and really needed to pay more attention to those other responsibilities, and so we'll greatly miss him. I think there are a number of skill sets that we need on our Board to continue to grow our company and position us for the future, and certainly replacing Michael's financial acumen will be one of those things, to have a smart shareholder view point on the Board is important. I kind of think of myself that ways, because I think like a shareholder most days.

But Michael certainly does and so we'll look to make sure we have that view on the Board. But there are other skills that I think we would benefit from the Managed Care area, in government relations, in public relations, in and sales and marketing, HR information technologies. So we've had a great Board and a lot of skills around the table, but we'll continue to look at the diversity opportunities and other things in terms of rounding out the Board in the context of Michael's stepping down.

James Kumpel - FBR Capital Markets

I guess the last question for us would be, the margins or at least looks like the EBITDAR margins on the rehab businesses, it's been on that client throughout 2007 and you talked optimistically about the increase in revenues and I was curious if you could give a sort of sense of where you think an appropriate margin recovery would be in 2008 and beyond once you sort of transitioned and start to get some efficiencies.

Paul Diaz

We clearly grew - this business is really starting to mature. It's only a couple of years old, and in the same way that we successfully grew our pharmacy business. We've got a good track record in growing these ancillary businesses. I really think that we should be doing $9 million to $10 million of EBITDAR in this business, and certainly the nine level is kind of where I think this thing will stabilize at. And pricing for therapist is the big challenge there, but I would say that we should be able to get to $9 million of EBITDAR and growth from there.

James Kumpel - FBR Capital Markets

Great. Okay. Well, thanks very much.

Rich Lechleiter

Thank you, Jim.

Operator

And next to Frank Morgan of Jefferies.

Frank Morgan - Jefferies

I have one follow-up question in the insurance market. There are clearly a lot of company-specific initiatives that you can implement frequency of claims and what not. But Rich, how would you characterize just the greater market in general of med mal? Is the market softer, is pricing better in general. What's kind of a macro environment for that med mal pricing that you're seeing out there as you shop for business. Thanks.

Rich Lechleiter

There is kind of two folding are there, Frank. One is and Paul all alluded to this earlier the Ventas transaction that we did last summer nearly opened up an opportunity for Kindred to re-bid and re-prices its external insurance costs around med mal. We had some restrictions in the lease that pretty much limited the universe of companies that we could talk to about excess coverages that we maintain with unrelated insurance careers.

We just recently completed that pricing, and I'll tell you that, that environment first of all for us was a broader environment from which to works so we got better pricing there simply because we were talking more careers.

But I would tell you more broadly that on the insurance front, particularly in long-term care, the limits are coming down and pricing is getting better and it's a pretty dramatic improvement in terms of those metrics compared to three or four years ago. But at the same time, I would tell you there really aren’t any aggregate caps in the market place that - we haven’t had aggregate caps since 2002, nobody is willing to go to that level yet. But the market has completely gotten better.

Frank Morgan - Jefferies

How would allocate the expense, the 60 some odd million dollar number you are talking about between the hospital side and the nursing home side?

Rich Lechleiter

It's roughly two-thirds to the nursing home side and a third to the hospitals.

Frank Morgan - Jefferies

Okay. Thanks.

Paul Diaz

Thanks [Mike].

Operator

And we are standing by with no further questions. At this time, I'd like to turn the conference back for any closing or additional comments.

Paul Diaz

Great. Well I thank you all for participating this morning. We really feel good about our results for '07. We are excited about '08. We are off to a good start, and we look forward to being back with you again after first quarter results continuing our progress from there. Thank you.

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