HealthSouth's Corp. Q1 2008 Earnings Call Transcript

| About: HealthSouth Corporation (HLS)

HealthSouth's Corp. (NYSE:HLS)

Q1 2008 Earnings Call

May 07, 2008 8:30 ET

Executives

Jay Grinney - CEO, President

John Whittington - General Counsel

John Workman - CFO

Mark Tarr - EVP Operations

Analysts

Ann Hynes - Leerink Swann

Adam Feinstein - Lehman Brothers

David McDonald - SunTrust

Frank Morgan - Jefferies & Co

Gary Lieberman - Stanford Group

Rob Hawkins - Stifel Nicolaus

John Ransom - Raymond James

Kemp Dolliver - Cowen & Co

Miles Highsmith - Credit Suisse

Mike Scarangella - Merrill Lynch

Derrick Dagnan - Avondale Partners

David McDonald - SunTrust

Operator

Good morning, everyone, and welcome to HealthSouth's first quarter 2008 conference call. (Operator Instructions).

I would now like to turn the call over to Mr. Jay Grinney, HealthSouth's President and Chief Executive Officer. Please go ahead, sir.

Jay Grinney

Great, thank you, operator, and good morning, everyone. With me on the call today are John Workman, Chief Financial Officer, Mark Tarr, Executive Vice President of Operations, John Whittington, General Counsel, Andy Price, Senior Vice President of Accounting, Ed Fay, Senior Vice President and Treasurer, and Tyler Murphy, Senior Vice President of Investor Relations.

Ed is the newest member of our senior management team, having recently joined us from Regent's Financial Corporation, where he held several senior executive position including Senior Treasury Officer. Ed brings a tremendous amount of knowledge and expertise to our team and we are very pleased with this addition.

Before we begin, I would like to ask John Whittington to read the obligatory cautionary statements.

John Whittington

Thank you, Jay. There are a number of disclaimers, risk factors, and other cautionary statements set forth in the Form 10-Q we will be filing with the SEC later today. And in the press release we filed yesterday in connection with the filing of our Form 10-Q. We will not review these disclaimers, risk factors and other cautionary statements, but we urge you to read them and the risk factors set forth in the company's annual report on Form 10-K for the fiscal year 12-31-07 carefully.

I would, however, like to highlight the following. Some of the information provided today may include certain estimates, projections, guidance and other forward-looking information that reflect our current views with respect to future events and financial performance.

You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented today, as they are based on current expectations and general assumptions that HealthSouth believes as of the date hereof are reasonable and such forward-looking information is subject to various risks, uncertainties and other factors, many of which are beyond our control, that may cause actual results to differ materially from the views, beliefs and estimates expressed here today. All such estimates, projections, guidance and forward-looking information speak only as of the date hereof. HealthSouth undertakes no duty to publicly update or revise such forward-looking information, whether as a result of new information, future events, or otherwise.

Jay Grinney

Thank you, John. The results of the first quarter signaled a strong start to the New Year for HealthSouth, and reaffirmed that our strategic and operational agendas are yielding their intended results. Adjusted consolidated EBITDA for the quarter was $89 million, representing a 29.2% increase compared to the first quarter of 2007.

Operating earnings also increased dramatically on a quarter-over-quarter basis to $87.6 million, up from $32.6 million last year. As we have previously stated, volume growth will be an important measure of our success in 2008 and I am very pleased to report that discharges were up 2.7% quarter-over-quarter and 5.3% sequentially. This quarter-over-quarter increase was well within our guidance of 2% to 4% and indicates our investment in the team works initiative is gaining traction. As a reminder, we anticipate our volume growth will strengthen throughout the year as we implement this initiative across all of our hospitals.

At the end of the first quarter, we had 63 of our 94 hospitals utilizing the team works template, with 44 of these hospitals having been fully implemented for at least 60 days. We are confident that once all hospitals are on this enhanced sales and marketing platform, by the end of the third quarter, we will have an excellent foundation for sustained organic growth on a go-forward basis.

Our patient mix continued to be comprised of those needing specialized rehabilitative services. In the quarter, we saw significant increases in the number of patients requiring care as a result of strokes, lower extremity fractures, primarily hip fractures, non-traumatic brain injuries, spinal cord injuries, and other neurological disorders. These patients require sophisticated levels of care and are not the types of patients who can be successfully treated in lower acuity settings.

As a consequence of our focus on treating these higher acuity patients, our reliance on knee and hip replacement patients continued to decline in the quarter. In fact, lower extremity joint replacements accounted for only about 10% of our total patients, down from approximately 22% before the imposition of the 75% rule in July of 2004.

We believe this reinforces what we've been saying all along. HealthSouth will be able to grow organically by devoting our clinical expertise to that segment of the population requiring specialized rehabilitative care, and we will not be vulnerable to shifts in market share as lower acuity patients receive care in alternative settings.

Our occupancy as a percent of licensed beds remained unchanged at 66.6% quarter-over-quarter, but increased 540 basis points sequentially. The number of licensed beds increased by 90 since March of 2007, as a result of several small bed additions and the opening of two new hospitals in Fredericksburg, Virginia and Manatee, Puerto Rico.

As most of you are aware, the number of operational beds will always be less than the number of licensed beds and there are three basic reasons for this difference. At any given time, a certain number of beds will be out of service due to renovations. These beds become available again as soon as the renovations are complete. In some of our hospitals, we have converted unused rooms to other patient care uses, such as sleep labs or pain clinics, and in some instances, to non-patient care uses.

Finally, some hospitals have units that were taken out of service due to soft volumes during the phase-in of the 75% rule, and as our volumes increase in these markets, we will bring these beds back to operational status.

In the first quarter, approximately 350 licensed beds were not available due to one of these factors. Based on this estimate, our operational occupancy for the first quarter was closer to 70%, or over 300 basis points greater than the licensed bed number.

With respect to our outpatient business, outpatient visits on a sequential basis were flat, signaling the stabilization of this service line. On a quarter-over-quarter basis, outpatient visits declined due to the closure of approximately 20 underperforming satellite clinics. While these satellite clinics continue to be an important adjunct to the services we provide on an inpatient basis, they are not a major contributor from a revenue or earnings perspective, and we will be diligent in ensuring that only profitable units remain open.

In addition to organic growth, we also are seeing tangible results from our development efforts. In the quarter, we filed an application for a certificate of need for a new 40-bed hospital in Ocala, Florida, and signed a contract for the purchase of land for a new 40-bed hospital in the Phoenix market. We also recently announced the signing of the definitive agreement to purchase The Rehabilitation Hospital of South Jersey. Located in Vineland, New Jersey, this 34-bed hospital will be our third New Jersey facility, and is a welcomed addition to our northeast network.

While deleveraging remains a primary objective for HealthSouth, as we indicated on February's earnings call, we believe we must balance this priority with opportunistic tuck-in acquisitions, provided they generate a superior cash return to our shareholders compared to other uses of this cash. Whenever feasible, we will acquire new businesses and lease the bricks and mortar, thereby preserving cash for deleveraging purposes. This approach, which we also will use in the development of de novo hospitals, will allow us to repay debt and grow, something that should be very attractive to long-term investors.

I'll now turn it over to John Workman, who will provide a more detailed review of the quarter.

John Workman

Thank you, Jay. First, I would like to talk about the income statement and dealing with revenues. Our inpatient revenues increased by 7.7% over last year. The items that benefited revenues were higher discharges, as Jay has commented on. There was one added business day this year, but Easter was also earlier, which we believe largely offset each other. There were two additional hospitals, but they generated limited discharges in the first quarter of '08.

Revenues also benefited from the price increase effective October 1, 2007, which will go away in the second through the fourth quarters of 2008. As Jay had mentioned, outpatient revenues were down 8.9% with 20 fewer satellites than a year ago.

Next, turning to operating expenses, and first talking about those that are hospital-related, salaries and benefits as a percent of revenue increased by 50 basis points over the same quarter a year ago. The increase reflects merit increases generally granted in the fourth quarter of 2007, as well as our investments in our employees from the items that we mentioned on our last call, namely the increased 401(k) match, instituting part-time benefits, and enhanced medical benefits without increasing the employee contribution.

Looking at the other operating expenses, and for this purpose, as I'm combining three captions, which are the ones on the income statement labeled other operating expenses, supplies and occupancy costs, all of these are generally hospital related and totaled $110.2 million, or 23.5% of revenues this quarter. A year ago, those totaled $105.6 million, or 23.8% of revenue. As a percent of revenue, this equates to a 30-basis point reduction, meaning we were largely able to offset the increase in salaries and benefits in the first quarter of 2008 and this is similar to what we have seen and what we've been approaching in trying to do in the prior quarters.

As the press release mentioned, we saw improvement in our provision for doubtful accounts, as we continue to see maturation on our billing and collection platform, which was newly installed a year ago. One reminder to you, as we look at expenses as percent of revenue, with the price rollback for the second through the fourth quarter, you should expect the percent of revenue for all these captions to go up, as we'll be losing that price increase from the revenue line.

On some other items in the income statement, general and administrative expense included $3.3 million of stock compensation expense under FAS 123(NYSE:R). Excluding the 123(R) costs, G&A expense was $24.8 million, or 5.3% of revenue. The sale of the corporate campus will help us reduce general administrative expense in the remaining quarters of 2008.

As we have said before, our goal is to get to 4.75% by the end of the year. And again, this percent was set before the price rollback was known, so it makes it a little bit more of an aggressive target, but one that we're still pushing to achieve.

Depreciation and amortization income statement includes an $11 million charge for accelerated depreciation to bring the net book value of the corporate campus down to the proceeds received in accordance with FASB statement number 144, accounting for impairment of disposal of long-lived assets.

The caption Government and Class Action is a noncash income item in the quarter and primarily relates to mark-to-market. The 5 million shares of common stock and the 8.3 million warrants, which have a $41.40 strike price that we agreed to contribute as part of the litigation settlement. We will be required to mark these shares to market and the warrants, until they are distributed along with the $230 million of cash from insurance companies to the plaintiffs. The $230 million is reflected on our balance sheet as receivable and also is part of the liability in our balance sheet under the caption Government Class Action and Related Settlements.

Professional Fees caption, primarily relate to legal fees being incurred in pursuit of derivative claims against UBS, Ernst & Young and Richard Scrushy. We still expect the amount spent on legal fees to be approximately $25 million for the full year 2008.

Next, I would like to talk about some of the items below the line of operating earnings. Interest expense was significantly below the same quarter a year ago due to lower average borrowings and a lower LIBOR rate on our floating rate debt. We incurred a $36.6 million charge on our $1.1 billion interest rate swap due to the drop in LIBOR. Since the end of the first quarter, the yield curve has gone up, which would reduce our liability. There will be cash payments, however, on the swap in 2008, which we would estimate to be between $15 million and $20 million at this time. As most of you know, most expectations for rates to rise which would reduce our liability going forward.

Turning to taxes, taxes were generally a breakeven for the quarter. Because of our refund, receivable and NOL, we do not expect to pay any significant income taxes for many years. Earnings per share from continuing operations before preferred dividends were $0.04 a share on a fully diluted basis. The government and class action benefit, basically the mark-to-market of our litigation liability and the mark-to-market items of interest rate swap were basically offset in the quarter.

Excluding the depreciation charge for the corporate campus and professional fees related to the pursuit of derivative proceeds, EPS would have been $0.20 per share for the quarter from continuing operations before the preferred dividends. We typically look at the earnings per share, excluding the preferred dividend, but using all of the shares on an as-converted basis when we talk about it on a fully diluted basis.

But just to walk you through the math, because I know there's some confusion on the EPS, our income from continuing operations, net income, was $3.9 million. We had a $36.4 million gain on the Government class action line, which we would say is nonrecurring. The interest rate swap at $36.6 million charge, again, which we would back out, professional fees, which will go away once the derivative suit is settled at 3.6, and lastly we had the depreciation catch-up on the sale of the corporate campus, which was $11 million. If you total those on a normalized basis, that would be $18.7 million divided by the $92.3 million of fully diluted shares, would equate to $0.20 per share.

Next, turning to adjusted consolidated EBITDA, which is proceed filed on Page 8 of the press release, as Jay mentioned, at $89 million, this is a 29.2% better than the $68.9 million reported a year ago. Last year still had the general and administrative expense for all four divisions. Even if G&A were normalized for last year, we would still have a strong increase in the double-digit range.

For those of you trying to annualize the first quarter of 2008, I would remind you that we had the price increase in the first quarter, but that that price increase will go away in the second through the fourth quarters. However, we do expect discharge volumes to continue to improve, as TeamWorks is rolled out, which would help us alleviate some of the loss from the pricing rollback.

Next, dealing with some items on the balance sheet, long-term debt, long-term debt was $2.0506 billion at the end of the first quarter of 2008, and included $90 million drawn on our revolver. Since the end of the first quarter, our revolver has been reduced by $60 million, with the largest reduction attributed to the corporate campus proceeds. There will likely be some additional borrowing on a revolver in the second quarter from the current $30 million level due to the timing of our interest payments. We did buy $5 million of 10.75 bonds in the quarter and capital expenditures for the quarter $8.7 million, represented maintenance expenditures.

As to non-operating cash flows outstanding, the tax recovery reflected on our balance sheet of $48.7 million is expected in 2009, though we are attempting to collect it as soon as possible.

Derivative proceeds from the litigation, for which we are spending legal fees against UBS, Ernst & Young and Richard Scrushy, we're not providing guidance, but that is a source of funds. We are not providing guidance as to the amount or the exact timing of those proceeds.

Next, turning to cash flow, looking at cash flow for the quarter, adjusted consolidated EBITDA was $89 million. Cash interest payments were $46 million, and CapEx at $9 million. This left $34 million available, of available cash in the quarter. This calculation is intended to be reflective of the ongoing potential of the company, as we have excluded cost to professional fees that are being spent on derivative proceeds and it also excludes the preferred dividends, which would have been $6.5 million in the quarter.

As our press release states, we are using our available cash flow to reduce debt, but we'll also use some funds for disciplined acquisitions in our core IRF business. As a reminder, the acquisition of a hospital or a consolidation creates immediate cash flow on our investment, much like purchasing a bond.

As a reminder, we have NOLs, or future deductions in excess of $2.5 billion, that will shelter future federal taxable income. There occasionally have been comments about section 382 of Internal Revenue Code, which would limit the losses we could take each year. This has little risk to us and one, we are short of the 50% threshold today; and two, even if we cross the threshold through some event in the future, we would still be able to shelter approximately $100 million per year of taxable income at a minimum.

One other point, the convertible preferred, which did increase the percentage and was issued back in March of '06 will be three years old in March of '09 and it will lower the overall percentage.

Finally, last comment relative to guidance, we did reaffirm guidance. I just want to emphasize the cash flow implications. From a cash flow perspective and dealing with the annualization of amounts in the first quarter, starting with adjusted consolidated EBITDA, at the midpoint of our guidance, $328 million, if you annualize the cash interest expense, that would be 184, which is probably a little bit higher than it should be in future quarters, because of borrowings on the revolver and the fact that our floating rate bonds will have a reset LIBOR as we progress throughout the year.

Backing off that number, and then backing off maintenance CapEx at an annualized $36 million in the first quarter times four leaves available cash for deleveraging development of over $108 million. On a per share, and again, we use fully diluted shares, because we believe that's the most indicative long-term view of the company, this equates to over $1 per share, even considering the swap payments that will be made.

So with that, I'll turn it back over to Jay.

Jay Grinney

Great. Thank you, John. Before we open it up for questions, I would like to comment on 2008 guidance. Clearly we are very pleased with the start to the new year and while we don't have full visibility on the impact of the pricing rollback, we do believe, as John mentioned, that our continued growth in the higher acuity case mix groups, or CMGs, will allow us to achieve the higher end of the EBITDA and EPS ranges previously provided.

In conclusion, I believe the results of our first quarter provide continued evidence that our strategies are working. Discharges are up, net operating revenues are up, earnings are up. We're generating strong operating cash flow. We're taking down our debt, and we're adding to our portfolio of hospitals. We are pleased with these results and we'll remain focused to ensure continued success throughout the remainder of 2008 and beyond.

With that, operator, we'll begin the Q&A. But in order to give us as many people as possible a chance to ask questions, we will need to limit each person to one primary question and one follow-up question. So if you have more than one, please prioritize them. We'll try to respond to as many as we can and go through the queue as often as we can in order to answer all of your questions. Operator, could we open up the lines, please?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is coming from Ann Hynes of Leerink Swann.

Ann Hynes - Leerink Swann

Good morning.

Jay Grinney

Good morning, Ann.

Ann Hynes

So thanks for that explanation on the EPS because I think there was a lot of confusion. So just to go back to it, your $0.20, is that comparable apples-to-apples to your $0.30 to $0.38 guidance, using the fully diluted shares. I think some people are using basic shares, some people are using dilutive shares, but so I guess everyone's on the same basis. It's that $0.20 is on fully diluted, you're excluding the preferred -- I guess that includes the preferred in the share counts.

John Workman

It includes the preferred in the share counts.

Ann Hynes - Leerink Swann

Share counts, okay.

John Workman

And that is the apples-to-apples, and we did the $0.30 to $0.38 a share, we did fully diluted. We did fully diluted because as you look in the out years, we think that's the most appropriate determination. It does get a little bit complicated in quarters in which you have a loss.

Ann Hynes - Leerink Swann

Loss, yeah.

John Workman

Ultimately on a reported basis, you can have abnormal impact, if you look at reported numbers and start to normalize between primary shares and fully diluted, so everything that we've given is on a fully diluted basis, but to your point, it is $0.20 on a full fully diluted basis, and that compares to the $0.30 to $0.38 for the year.

Ann Hynes -Leerink Swann

Okay.

John Workman

We'll continue to try to make it uncomplicated but not having it.

Ann Hynes - Leerink Swann

No, it's helpful. I think everyone on the first call is using different assumptions, so it gets confusing.

John Workman

No, I think that's a great question, and we do hope that everyone will understand that explanation and then we'll be able to, as you said, look at things on a consistent basis. Okay. Next question?

Operator

Our next question is coming from Adam Feinstein of Lehman Brothers.

Adam Feinstein - Lehman Brothers

Okay, thank you.

Jay Grinney

Good morning.

Adam Feinstein - Lehman Brothers

Good morning. Just maybe just get you to comment on the recent proposed reg that came out, CMSA a couple weeks ago, looked like there was something major in there, but there were some minor changes around outlier payments and just some changes in the relative weights for the CMGs. Just curious in terms of your initial read? Thank you.

Jay Grinney

First question. As the CMS had indicated, the attempt was to make this budget-neutral, and as we evaluate these changes against our operating base, we find that to be basically the case. The outlier issue is going to be de minimus for us. We look at that and we've calculated that to be about a $250,000 issue. So I mean it's not even a rounding error. And I think that that reinforces the notion that we are treating patients that need inpatient rehabilitative care and that we're treating them in a timeframe that is appropriate for their needs.

So overall, Adam, this is going to be a neutral event, if the proposed regs come out in final form. To your point, you're right, really no surprises, and even on the CMG re-weighting, that might be a little bit positive for us, but, again, at this point, we're essentially looking at this as a nonevent.

Adam Feinstein - Lehman Brothers

Okay. And then if I could just follow up here with a follow-up question. Just with the -- you talked a little bit about mix earlier on in other call. Could you just provide some more details. You had said that within the higher acuity areas, you saw higher growth,but just curious if you can just give us some metric or some what you think about your mix of business for the quarter? Thank you.

Jay Grinney

We have most of our patients are going to be stroke patients. As you know, we've put a primary focus on treating stroke patients. We think that we have the right clinical protocols. We think that we have the advanced technology that allows us to differentiate ourselves from our competitor from a quality and from an outcome standpoint.

So we've put a big focus on stroke. The next largest would be the, the hip fractures. Again, that's a very important service line, as the patient population gets older and as we see more falls and more hip fractures, again, we think this is a very important service for us and one that we have provided a lot of clinical protocols around and treatment modalities to ensure that those patients get in and out very quickly.

And then we have replacement of knees and hips would be probably our next category, but that's again, at 10% and then the balance would be in spinal cord injuries and other orthopedic cases.

Adam Feinstein - Lehman Brothers

Okay. Thank you very much.

Jay Grinney

Does that help?

Adam Feinstein - Lehman Brothers

Yes, thank you.

Jay Grinney

Okay, next question.

Operator

Our next question is coming from David McDonald of SunTrust.

David McDonald - SunTrust

Good morning, guys.

Jay Grinney

Good morning.

David McDonald - SunTrust

Jay, kind of a two-part question on the discharges. I'm wondering, one, if you run back through the TeamWorks implementation numbers, I didn't catch all of those. And I was wondering if you could also give color around January. Did you guys see any lumpiness as you got into January just as your hospitals were kind of moving from playing defense with the 75% rule to kind of playing more offense in terms of picking up discharges? Just some color around that, and then I have one follow-up.

Jay Grinney

Sure. On the numbers, we have 94 hospitals. Three of those hospitals had the TeamWorks implemented in them, but we use 60 days as sort of our internal measure for determining full implementation. In other words, we roll it out. It's fully installed. We then provide 60 days for it to be fully integrated into the operations of that hospital. So one metric is how many hospitals have been touched, and then the second would be how many are fully implemented. So we had 63 of our 94 hospitals were at some form of implementation and then 44 of those 63 were on at least 60 days or greater. So that clarify that.

In terms of January, yeah, there was probably a little bit of a slow start and to your point, and we mentioned this when we were on the call, going from defense to offense did require a mindset change. However, we are very, very encouraged by the results in the first quarter, from a discharge growth standpoint. We're encouraged by the continued results into April and as we compare our hospitals, those who are on and those who are not on the TeamWorks, we remain absolutely convinced that this was an excellent investment and we'll continue to see great results from this on a go-forward basis.

So, yeah, there was a little bit of lumpiness. Some of it was just coming out of the holiday season as we traditionally do, but the balance of the quarter, as you saw, was very strong.

David McDonald - SunTrust

Thank you.

Jay Grinney

You're welcome. Okay.

Operator

Our next question is coming from Frank Morgan of Jefferies & Co.

Jay Grinney

Good morning, Frank.

Frank Morgan - Jefferies & Co

Good morning. Hey, a follow-up on this volume question and the ramp up. I was just curious if you could give us a little more granularity. How did volume look across the first quarter, as it ramped up? And then any color that you can give us so far on maybe how the April month has gone specifically, and then -- so that's my volume question.

The other is a pricing question, which is do you have a case mix index for rehab facilities? Are some equivalent acuity measure is there such a thing? And then if so, what would those numbers be and how quickly do you think you can drive that acuity higher to perhaps offset the payment freeze? Thanks.

Jay Grinney

I'll take them in reversal. Yes, we do have case mix indices and our CMI traditionally has been in the 1.26, 1.28, occasionally get up to 1.3. And as we look to the volume building strategies, we're going to continue to drive the higher acuity, stroke, spinal cord, hip replacement types of patients into our hospitals, again, because we think we've got the services and the capabilities to provide a superior level of care. I wouldn't use that, Frank, as a measure, though, of the, strong corollary to our ability to overcome the pricing rollback. We think, that the CMI is going to stay in that 1.28, 1.30 range.

So it really kind of goes back to your first question, which is on the volume, and the volume was pretty consistent throughout the quarter. February was a very strong month. We saw good results in March, and as I mentioned a minute ago, we're very, very pleased with what we're seeing coming into the beginning of the second quarter.

So, you know, I don't want to get too far out ahead of ourselves here, but we are very pleased with our volume building initiatives. As we said consistently, that was going to be a real important measure of our success, not only in 2008 and beyond, but it's certainly what we've seen has allowed us to not only reaffirm guidance, but I think it's very important to emphasize that as you look at the EBITDA range that we provided, and the EPS range that we provided, we're directing everybody to be looking at the higher end of those ranges, and we would not be, we wouldn't be directing you there unless we he felt pretty good about the volume opportunities that are there for the balance of the year.

Frank Morgan - Jefferies & Co

Okay, thanks.

Operator

Thank you. Our next question is coming from Gary Lieberman of Stanford Group.

Gary Lieberman - Stanford Group

Thanks, good morning.

Jay Grinney

Good morning, Gary.

Gary Lieberman - Stanford Group

I don't think you gave it. Could you give the number of how much you spent on TeamWorks in the quarter and if you're still sort of on track to the $8 million number you had referenced before?

John Workman

This is John. We're still on track for the $8 million for the year. It is a little heavier weighted. Obviously as you heard Jay talk about, we should be done by the third quarter, so you can just take it proportionally through the three quarters, a little bit heavier first and second, so I think it's kind of a 3-3-2 kind scenario is the best way to look at it.

Gary Lieberman - Stanford Group

Okay, great. And then in the press release, you talked about strong outpatient pricing, is that simply a function of the Medicare increases, or is there a commercial component that you owe some of the strength in the pricing?

John Workman

I think part of that is just a function that on a comparable basis we were losing, we were dropping off some of the weaker units. There has been some good commercial pricing, but, our outpatient business we see that really as more of an adjunct to the inpatient core business. And, we're pleased with the strengthening and the pricing there, but it's really we're not seeing huge shifts in the commercial. We're not seeing, obviously, huge increases on the Medicare side either.Gary Lieberman - Stanford Group

Thank you.

John Workman

Okay.

Operator

Our next question is coming from Rob Hawkins of Stifel Nicolaus.

Jay Grinney

Good morning, Rob.

Rob Hawkins - Stifel Nicolaus

Hi, good morning. I got to get to my question here.

Jay Grinney

Okay.

Rob Hawkins - Stifel Nicolaus

Let me ask you about surgeries, I understand the knees and hips number is now down to kind of 10%. We've seen lower hospital inpatient and outpatient surgeries. We're also seeing -- seems to be a lot more medical management now, we're seeing a shift of about one out of five Medicare patients to Medicare managed care. How much of this is playing into your referral base and to what you guys are seeing in terms of being able to get an admission on, do you have any sense of that right now, what you're hearing from either docs or the hospitals?

Jay Grinney

I'm not sure I fully understand the question, but if the question is are we some sensitivity to the knee and hip replacement volume as a result of medical management versus surgical intervention, if that's the question, we're really not seeing a lot of that. And as I mentioned, we're really only taking the knees and hips that require a two-week stay in a rehabilitative hospital. And they tent to be the medically complex patient. They tend to be overweight. Maybe they don't have the, meet the obesity criteria for a qualifying condition, but they tend to be overweight, maybe they are diabetic, hypertensive, and so they are not in a position to be able to rehabilitate themselves following the surgery. But we haven't really seen an impact from the medical intervention versus the surgical intervention in volumes.

Rob Hawkins - Stifel Nicolaus

That was part of what I was intending. I'm sorry I didn't probably word it correctly. The other part of that, how does that maybe play into your new emphasis in neurology, either with medical management, where you're seeing these guys try to put folks on more drugs to maybe try to prevent strokes, or try to put off or put these smaller outpatient procedures, to try to prevent major surgeries related to neurological cases?

Jay Grinney

I'm going to ask Mark Tarr, who is our executive vice president of operations to respond to that. He's a lot closer to that. But I will tell you in general we are not seeing that impact, and frankly, as you know, with the aging of the population, which is one of the major positive demographic positives for our business, as the population gets older, there is an increasing incidence of strokes and other neurological disorders.

Mark Tarr

Hey, Rob, it's Mark. The major impact on our hospitals just been, we've been trying to for the past several years now, as we've ramped up to take care of a higher neurological base, a higher acuity patient. We brought on a different skill set on some of our attending and consulting physician staff. We've backfilled in on clinical education and clinical techniques with our, both our therapists and nursing staff. In some cases, we've added additional equipment that we did not previously have and we are so dependent upon an orthopedic case load.

So I don't think what you would described has been a huge impact on our hospitals, but we have made the necessary adjustments in all of our hospitals to better accommodate and treat a higher acuity patient, of which the stroke population is certainly fall into.

Rob Hawkins - Stifel Nicolaus

Thanks, I'll jump in the queue. Thank you.

Jay Grinney

Thanks Rob. Next question?

Operator

Our next question is coming from John Ransom of Raymond James and Associates.

John Ransom - Raymond James

Hi. Good morning.

Jay Grinney

Good morning, John.

John Ransom - Raymond James

Just a question about couple questions about cash flow. First of all, when you talk about the $108 million for the year, I think that's the right number, I guess you're excluding the preferred dividend and the expenditures on professional fees, as well as state taxes, so would that 108, in terms of cash available to shareholders, would that be more like $50 million, or am I missing something in that calculation?

Jay Grinney

What we're trying to do, John, is give an indication of what the cash flow characteristics of the company look like, and that's why we do it on a fully diluted number of shares, and that's why we exclude the preferred dividends.

John Ransom - Raymond James

Okay.

Jay Grinney

Professional fees, we look at as nonrecurring costs. Obviously, we wouldn't also count the derivative proceeds when they come in as a available source of cash going forward. So what we're trying to get is what is the operating cash characteristics of the company and equate that in a per share basis, and looking out for the longer term, that's why we excluded the preferred dividends, but use fully diluted shares.

John Ransom - Raymond James

Okay.

John Workman

On the professional fees, we do see that as a 2008 expense and…

John Ransom - Raymond James

Maybe a little in '09.

John Workman

Maybe a little in '09 but,

John Ransom - Raymond James

Depending on when, we would

Jay Grinney

Yeah, John, whenever we get this settled, right, John?

John Workman

Right, and we expect to go to trial on UBS in early January, mid-January of 2009. There is a trial date. Discovery is due to be completed at the end of June of this year, so we're moving forward to a trial date and the conclusion of this litigation.

Jay Grinney

Which is very good for us because as you -- I think everybody knows, up until recently, this whole derivative action was sort of a, an event that would occur at some point in the future and there wasn't a lot of certainty around that. Now, with the trial date, January 26th, it does start to put that into better focus.

John Ransom - Raymond James

Well, at the rate at which UBS is writing off bad mortgages, I guess sooner better than later.

Jay Grinney

Well and to that point, one could argue that it would be in their best interest to try to get this settled in 2008. I suspect that a lot of banks will be very happy when 2008 is in their rear view mirror.

John Ransom - Raymond James

Sure.

Jay Grinney

We're certainly going to be encouraging a settlement, but we feel very, very confident of the position and our argument. So if it needs to go to trial, we will be very happy to make arrangements at the top level of hotel here in Birmingham and invite all of our friends into Birmingham for the trial.

John Ransom - Raymond James

Well, I would buy tickets to the Scrushy trial for sure. The other question I had, looking at the cash flow year-to-date, it looks like all of the net deleveraging has occurred really from the sale of the campus. So I was just trying to balance the $40 million in operating cash flow and the $60 million you got from the sale of the campus to the net deleveraging and the free cash flow, could you just help me with that a little bit? And I'll drop off. Thanks.

Jay Grinney

I mean so we generated $41.8 million of cash flow from operations. Obviously out of that we did pay some professional fees and some preferred dividends, but to your question on the deleveraging, we did have $60 million of cash on the balance sheet. We did reduce the revolver in April. We do get a little build in working capital in the first quarter.

John Ransom - Raymond James

Okay.

Jay Grinney

Because with revenues being up 7.7%, typically our first quarter's going to build some working capital so you don't see as much of the working capital flow through as you start to get into the later quarters, it comes rolling in.

John Ransom - Raymond James

And I was looking at net debt, so the buildup in the cash and the change in debt. It looked like net debt got reduced by $60 million and you got about $60 million from the sale, so it looks like--

John Workman

No, we got $43.5 million on the sale. We did not get $60 million for the sale.

John Ransom - Raymond James

I'm sorry, okay. Wrong number.

John Workman

If you look AR went up about $15 million, $20 million from year end.

John Ransom - Raymond James

Got you. Okay, thank you.

John Workman

You bet.

Jay Grinney

Okay, next question?

Operator

Our next question is coming from Kemp Dolliver of Cowen and Company.

Kemp Dolliver - Cowen & Co

Hi.

Jay Grinney

Good morning, Kemp.

Kemp Dolliver - Cowen & Co

First question is, there are several projects that you had outstanding that are essentially going through CON battles of one form or another. Do you have any update you could give on those?

Jay Grinney

Nothing to report except that they are proceeding on course and we still remain pretty positive that we're going to be successful in securing those certificates of need. And one other things that made the Vineland hospital an attractive acquisition for us was because it was a hospital in a CON state. So there was a certain value that we felt not only in adding the third hospital in New Jersey, but also getting one in a certificate of need state.

Kemp Dolliver - Cowen & Co

That's great. Second question is I think in certain markets, you have got competitors planning to open facilities. In some cases they may be near you. Other cases, not. But besides TeamWorks, what are the actions you take to head off the impact of new capacity?

Jay Grinney

Well, in some of those markets, the capacity is coming on and, as you said, they are either planned or they have been announced, but in many of those markets, we haven't seen anything yet. We do believe that our positioning as a specialized provider of inpatient rehabilitative care, will always differentiate ourselves from, say, nursing homes or lower acuity settings that simply can't take the kinds of patients that we're treating and within two weeks get them back out and living independent life.

The evidence just isn't there, and as I've said many times before, how many of us on this call would, if our parent or loved one had a stroke, and they were being discharged from an acute care hospital, how many of us would voluntarily put those patients, or that loved one in the nursing home if they had the opportunity to put that loved one in a rehabilitative hospital.

And that, that kind of decision-making gets played out over and over and over again. So having a new nursing home open up is not something that we are concerned about. We certainly look at any competitive threat seriously, but we see ourselves as being quite different. As I said before, we don't feel we're vulnerable to the lower acuity patient market share shift to the nursing homes. And I think the evidence is there, that we continue to grow in the higher acuity patients that simply can't be treated in those lower acuity settings.

Kemp Dolliver - Cowen & Co

And I would echo, competition isn't something new, every business in the United States has competition and we've been facing competition for years and continuing to grow share and we will continue to address that as we move forward.

Jay Grinney

One other things that we do believe differentiates ourselves frankly is the quality of our employees. The staff, they are highly trained, they are professional, they are committed to their patients, and you are not going to see a lot of highly qualified therapists wanting to move from a rehabilitative hospital where they are providing a minimum of three hours of care per day to a nursing home environment. You just -- you don't see that. Even if there is a salary differential, you just don't see that migration.

So, yeah, there's some new competitors coming into some of our markets. It is interesting to see how many of them are just announced versus actually occurring, but, we don't feel that that poses any meaningful threat to us. Operator?

Operator

Thank you. Our next question is coming from Miles Highsmith of Credit Suisse.

Miles Highsmith - Credit Suisse

Hi, guys. Couple questions on a broader scale. Just curious now, a little bit of relief from a legislative standpoint, and on the regulatory side LTACs what you're feeling is there with your 6 LTACs and the potential to grow those?

And then secondly, I'm sorry, I actually just hopped off, so I apologize, this was just asked and answered, just let me know, but I'm curious specifically about in recent years building out the rehab extensive services and specifically around that product offering, if there are maybe some examples that you can give us about, for a similar patient, how you differentiate yourself with the IRF versus some of those rehab extensive service offerings? Thanks.

Jay Grinney

Yeah, and in fact, we just finished answering that second question, and the way we differentiate ourselves is in the clinical protocols that are established to help the patients get back into an independent life-style, and the requirement that we have for patients coming in is not just us. Any rehabilitative provider is that the patient must be able to tolerate at least three hours of therapy per day. And there is no such requirement in a nursing home. So a patient can come into a nursing home and, maybe they get a half an hour, maybe they get nothing, maybe they just languish in the bed, because the services aren't there, the resources aren't there.

In our hospitals, we have very highly trained professional therapists who bring those patients and provide the care at least on a 3-hour per day basis. Then if you look at the average length of stay in our hospitals is maybe 14, 15 days. Average length of stay in a nursing home is, 25, 30 days. So there's a big difference between the level of care. There's a big difference between the outcomes and there's a big difference in the length of stay that they have to, or that they actually have to incur during each setting. So that's the first part, second part of the question.

Repeat the first part. I'm sorry. LTACs yeah. I still think that the LTAC is a very important part of the healthcare continuum. The three-year reprieve that the industry received I think was certainly very positive. The moratorium makes it pretty hard to develop new, and so it gets back to if we were going to grow that segment, how would we do that? And we, clearly, with the moratorium can't go out and build them, so we would have to buy them. And in today's environment, we would prefer to put our free cash flow to deleveraging and then opportunistic acquisitions of IRFs, because that's our core business.

Longer-term, I think that that's a business that will be very attractive for us. But we've made it pretty clear. We've said this before. We'll say this again. For the next two years, '08 and '09, our focus is going to be deleveraging and building our IRF platform. We think that makes the most sense and then we believe that by doing that in 2010 and beyond, we'll have a balance sheet that will allow us to pursue other complimentary services in the post-acute pace space and to be able to do that on a more aggressive platform and perhaps a larger platform, but we're not going to do that until we can get our balance sheet to the point that that type of acquisition would make sense and we would be able to finance it and we would be able to do that in a reasonable way.

So I still think LTAs are important. I think they have been beat up pretty badly. I worry about what's going to happen once the three-year moratorium and the reprieve is over. I don't know if the cases are being built in Washington to come after them, but it is something that we are going to continue to monitor, but in the near-term, our focus is going to be on our rehabilitation hospitals. Operator?

Operator

Thanks you. Our next question is from Mike Scarangella of Merrill Lynch.

Jay Grinney

Good morning Mike.

Mike Scarangella - Merrill Lynch

Hi. Thanks. Good morning guys. Questions for your, I understand, I know in the past you've had some trouble with the fiscal intermediaries. My understanding is that CMS has awarded some contracts to these so-called recovery audit contractors and I would like to know, first of all, do have I that right, and secondly, what do you think that means to your business and your ability to get paid from Medicare?

Jay Grinney

Well, I don't think it's going to have any impact on our ability to get paid. The so-called rack audits are designed to come in and determine if there's been any over billing, and we feel, first of all, we haven't seen much of an impact at all. We do know that there -- I guess it was last year, there was a lot of controversy, because the rack audit process that was in place was very favorable to the auditors and very unfavorable, in fact, very unfair, to the providers, and we were very pleased to see that CMS responded to an industry-wide outcry about the heavy handedness and the one-sided nature, sort of the guilty until proven innocent approach. And CMS, to its credit, took those criticisms very seriously and have changed the procedures and the methodology that the rack auditors are allowed to go in and do their study.

So, one, the process has not been one that has hit us. Two, it's certainly been changed since last year, and we think that the process is more fair. But most importantly, we feel very good about our coding. We feel very good about the way in which we're billing for our services. We're certainly training our people about this, educating them about the rack audit process and what's involved, and so we, we feel that we're very ready for that if they, if someone should come knocking at our door, we're very ready to come in and we don't think that there's going to be any exposure there.

Mike Scarangella - Merrill Lynch

All right. Great, thanks. And just a quick follow-up, you talked a lot about the balance sheet and getting leverage down. In the past, you've also talked about potentially trying to redo or restructure your balance sheet in kind of the current market environment. What do you think your options are? Is there any thought going into replacing any parts of the capital structure at this point?

John Workman

Well, as you well know, the markets are not subject to a lot of refinancing. I think the good news about our debt structure is we really have no refinancing risk and, we've got several years before we have to address that. So we hope between now and then, the credit markets improved and we have some opportunities. But we're continuing to use our available cash flow, combination to delever the company. We have bought bonds back when they have been opportunistic, but as you well know, they have traded up to higher levels at this point in time. And we will continue just to delever the company and we are expecting some proceeds from the derivative litigation, which we think will be the next big nonoperating source of cash in addition to the -- I think approximately $50 million of tax refund we have yet to come in. So we don't see any dramatic changes in terms of any refinancings, or even attempting to do that in these choppy markets.

Mike Scarangella - Merrill Lynch

Thanks, guys.

Jay Grinney

Okay. Operator, I think we'll take two more questions. We're running a little bit over, but we would like to get as many questions answered as we can so we'll take two more.

Operator

Thank you. Our next question is coming from Derrick Dagnan of Avondale Partners.

Derrick Dagnan - Avondale Partners

Good morning. Thanks for taking my question. I wanted to get on the labor side. Jay, you mentioned the efforts you took in increasing wages and benefits for your employees, and I was wondering if you feel now that you're on par in your local markets with your competitors, from a wage and benefit standpoint?

Jay Grinney

Yes. In fact, I think that in some of our markets, the benefit package that we provide has been very helpful in recruitment efforts and has been -- it's hit on our objective of reducing our turnover. So, yes, we do feel that we are in a competitive position in our markets. And the increases from a compensation standpoint we are first merit increases and that's sort of the -- what we do every year. And then we did have some selective range adjustments in some select markets, but we certainly were not behind in all markets.

There were a couple that we will admit we probably did fall behind in, but we do believe that we are at a competitive level, both from a compensation and from a benefits perspective, and we are encouraged by the trends that we're seeing in the first quarter with respect to retention, ability to recruit, and reducing our turnover.

Mike Scarangella - Merrill Lynch

Okay, and related follow-up is just looking at the full-time equivalent count, looks like it's down about 140 employees year-over-year. And I was just wondering, with the growth in your volume and revenue on the inpatient side, should we expect that to tick up here with employee retention and do you need to go out and find some new hires to really drive this growth?

Jay Grinney

We will need new hires to continue to grow, but again, we've been very pleased and it was a strategic decision we made back in the fall to enhance the benefits and to ensure that we had compensation structures that were competitive.

So clearly our growth is going to be dependent on bringing new patients, new employees on. As you know, though, that first new patient that comes in, you don't have to add a lot of additional staff. You can do that on the margin, but over time, yeah, as the volumes grow, we will see an increase in the number of our employees. We are going to be evaluating and putting under the TeamWorks umbrella our whole human resource utilization area later this year to determine if there are best practices. I suspect that there are, throughout the company that will allow us to show improvement in that area, but they are the business. Our therapists and our nurses really are the back bone of this company.

And I know that some see that as just sort of a line item, a cost line item, and we see it as an investment, an investment to be managed, no doubt, but an investment nonetheless. And without our employees, we wouldn't be the great company that we are, and we owe a lot to them and we'll continue to make the right kind of investment and I think that we'll be able to continue to recruit and retain the best and the brightest to come to work HealthSouth.

Mike Scarangella -Merrill Lynch

Okay, very good. Thanks a lot and have a great day.

Jay Grinney

Okay. Thanks question, operator?

Operator

Thank you. Our next question comes from David McDonald of SunTrust.

David McDonald - SunTrust

Hey, guys, Jay, just one follow-up, on the pricing side, I know you guys talked about I think a 3% to 5% range on the managed care business. Can you give us some sense as what you're seeing is kind of in that range, high end, low end, and just general overview of the managed care side on IRF business?

Jay Grinney

No, no real changes there, David. We're still seeing the 3% to 5%. Clearly we are pushing our folks to get the high end or north of that 5%, but 3% to 5% I think is the right range for you to be using as you model out in your model the company, because I think that is going to be an area that we continue to focus on. We do think that we have some leverage because we are a specialized provider. We don't want to abuse that, so 3% to 5% we think is in the right zone.

David McDonald - SunTrust

And you think that's sustainable for the next couple of years, Jay?

Jay Grinney

Yeah, we do. We really do.

David McDonald - SunTrust

Okay, thanks very much.

John Workman

David, on the Medicare pricing, to remind everybody that the price rollback is effective April 1st, and for those of you working on models for that, we would tell you the best indication is to look at our third quarter of '07 revenue per discharge, which was $15,521 for discharge, but then also divided by the length of stay. The length of stay for the third quarter is 15.4, which puts you at about $1010 per patient day, compared to the first quarter of '08, where that the discharge number was $15,951, we have improved the length of stay to 15.2 and we're looking at $1049 on the Medicare part. So as you're thinking about pricing, that's probably an appropriate guideline, if you will, to look at Medicare pricing in the year in the quarters in which the rollback occurs.

David McDonald - SunTrust

So, again, that would be putting it at the 1010.

John Workman

Right.

David McDonald - SunTrust

Per day.

John Workman

Per day.

David McDonald - SunTrust

Thanks, guys.

Jay Grinney

All right, operator that will conclude the call. I want to thank everyone for dialing in today. I think we had an excellent start to the year, and we look forward to reporting on second quarter in a couple months. Thanks, everyone.

Operator

Thank you. This does conclude today's HealthSouth's first quarter 2008 Earnings Call. You may now disconnect, and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!