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Executives

Michael Newman - General Counsel

Rick Matros - Chairman, CEO

Bryan Shaul - CFO

Analysts

Eric Gommel - Stifel Nicolaus

Donald Hooker - UBS

Andreas Dirnagl - JPMorgan

Frank Morgan - Jefferies & Company

Rob Mains - Morgan Keegan

Ken Weakley - Credit Suisse

Ray Garson - RBS

Sun Healthcare Group Inc. (SUNH) Q1 2008 Earnings Call May 1, 2008 1:00 PM ET

Operator

Good day, everyone, and welcome to Sun Healthcare Group, Inc. 2008 first quarter earnings conference call. Today's conference is being recorded.

At this time for opening remarks and introductions I'd like to turn the call over to Mr. Michael Newman, General Counsel. Please go ahead, sir.

Michael Newman

Thank you. Good morning and welcome. I hope you all have seen our press release announcing the earnings of Sun Healthcare Group for the first quarter. If not a copy may be obtained from our website at www.sunh.com. I'd like to note that during this conference call certain statements may contain forward-looking information such as forecast to financial performance. Although Sun believes that the expectations reflected in any of it's forward-looking statements are reasonable based upon existing trends and information and our judgments as of today. Actual results could differ materially from those projected or assumed based upon a number of factors, including those factors set forth in our annual report on Form 10-K under the heading risk factors and our other filings with the SEC. Sun Healthcare's future financial condition and results of operation as well as any forward-looking statements are subject to inherent, known and unknown risks and uncertainties. We do not intend and undertake no obligation to update our forward-looking statements to reflect future events or circumstances.

During today's call references may be made to non-GAAP financial measures. Investors are encouraged to review those non-GAAP financial measures and the reconciliation of those measures to the comparable GAAP results that are report on Form 8-K filed with the SEC earlier today, a copy of which may also be found on our website. I will now turn the call over to our Chairman and CEO, Rick Matros.

Rick Matros

Thanks Mike. Hi, everyone. Thanks for joining us. I appreciate it. We had another strong quarter showing our strongest margin to-date since I've been with the company. All the results that I will present today are on a normalized pro forma basis. The good news is that for the second and third quarter of this year on a current quarter basis it won't be necessary for us to do a presentation on a pro forma basis because we own Harborside as of the second quarter of last year. So that should make these releases that much more simpler going forward.

The only normalizing item that we had for this quarter were integration costs which were $1.5 million for the quarter. As compared to the first quarter 2007 there were $6.5 million in normalizing costs in that quarter, and that was primarily comprised of Harborside bad debt expense.

So going onto the current quarter, again on a normalized pro forma basis, our revenues increased a strong 7.8% to $458.2 million. Our EBITDAR increased 27.1% to $58.5 million. Our EBITDAR margins improved 200 basis points to 12.8%. Our EBITDA increased 54.8% to $39.7 million. Our EBITDA margins improved 270 basis points to 8.7%, and income from continuing operations increased just under 45% to $9.4 million yielding an EPS of $0.21, up from $0.15 in the first quarter of 2007.

Synergies from the Harborside acquisition were $4.4 million for the quarter, and are now at $10.8 million from the date of acquisition. We expect to hit the higher end of our $12 million to $15 million estimate. So as we've been seeing in the previously reported quarters we're slightly ahead of schedule on the Harborside integration activities, and expect those to continue in a noneventful way.

I'll now move onto SunBridge, which is our Inpatients segment. And again everything here is presented on a normalized pro forma basis. Our revenues increased 7.4% to $406.8 million. EBITDAR increased 17.5% to just under $70 million. Our EBITDAR margins improved 150 basis points to 17.2%. EBITDA increased 30.5% to $51.4 million and EBITDA margins improved 220 basis points to 12.6%.

I'll now move onto some of the key stats that drive those margins. Occupancy dropped 40 basis points to 89.1% and as some of you may recall I wasn't quite pleased with where our Medicare was going in the third and fourth quarters of 2007 even though we produced strong quarters for both those time periods, and felt like we needed to be a little bit more patient relative to overall occupancies that we can keep some beds open to have more Medicare admits. And try to signal to everybody that they should expect some drop in occupancy in exchange for a stronger mix and better margins as a result of that strong mix.

And naturally what we saw happening in the first quarter, our Medicare mix in our skilled nursing facility beds was up 60 basis points to 16.6%. Our skilled mix was up 170 basis points to 20.4%, both those numbers are highs for us. Medicare as a percent of revenues in our mixed beds was up 120 basis points to 32.7% with skilled revenues up 290 basis points to 38.5%, also new highs for the company. Our Medicare Part A rates were up 7.9% to $411.37. Our Medicaid rates were up 4.3% to $165.90.

Let me make one comment on Medicaid. I've been getting a lot of questions about what's happening in certain states. I know a lot of you probably saw it. There are anticipated rate reductions in Medicaid in Florida. Our exposure in Florida is only nine facilities. We took that into account when we gave guidance.

We've got increases that were better than expected in some other states. So all in we're still comfortable with where we intended to be relative to Medicaid rate increases for 2008, and in terms of what we assumed and included in our guidance for 2008.

Our quality mix improved 270 basis points to 55.1%. Our RUGS extensive service stays, again those are the top nine RUGS categories, were up a full 200 basis points to 40.6%, and our rehab RUGS days, also very high categories, were up 110 basis points to 84.2%.

I'd like now to give you some statistics on our Rehab Recovery Suites. We had 38 opens by the end of the first quarter. We're still anticipating 50 by year end. And I'm going to provide some stats right now which compare the statistics in those centers with Rehab Recovery Suites to those centers that do not have Rehab Recovery Suites based on our SNF Beds only. Our occupancy was 89.7% compared to 88.5% in those centers that didn't have Rehab Recovery Suites, and that's an interesting statistic, we haven't been tracking this for very long.

But it speaks to, sort of the halo affect that we're seeing occur in those facilities and specifically in the ones that have Rehab Recovery Suites where we have a very distinct product that differentiates us in the local market, it creates better overall image for our nursing center in that market, and tends to help overall occupancy. And so in the case of some of these centers we're actually building Medicare mix at the same time we're building occupancy and that's an interesting phenomenon to us.

Because as I stated earlier in the call we have been exercising some patience with some of our operators to keep some beds open, even if it means some decline in overall occupancy in order to build Medicare. So we'll be tracking this pretty carefully and looking for opportunities within our portfolio to build overall occupancy and Medicare mix. But for the time being because this is all relatively new, our focus is still going to be on that business which pushes our margins the most. And if we have to sacrifice, as I said, a little bit of occupancy to get there, we'll continue to do so.

Our Medicare mix in the facilities that had Rehab Recovery Suites was 160 basis points higher than those that don't have those suites at 17.8%. Our skilled mix was 370 basis points higher at 23.2%, and again that's 23.2% compares to the 20.4% that I noted the company had on a consolidated basis.

So everything that we're doing relative to these Rehab Recovery Suites is proving to be the right strategy, and I'm beginning to become more pleased with our execution as time goes on. I think earlier on although we benefited from the Rehab Recovery Suites, a lot of that was sort of if you build it there, we'll come. And I don't think any of us felt like we were executing as well as we need to execute and we're still not there. But our execution is getting better on those and as a result our numbers are getting better.

The RUGS extensive service case mix in those centers that had Rehab Recovery Suites were 720 basis points higher at 45.7%. Rehab days were 220 basis points higher at 85.8%. Again, pretty significant differences in those facilities with that specialized product.

On the labor side, we continue to do a real fine job controlling our labor costs, and despite the shortages that we all have to deal with, our labor as a percent of revenues was down 90 basis points for the quarter to 40.3% while our actual operating salaries including agency labor was up 5%. And again, that's all due to the strong top line growth that we have offsetting that 5% pure wage growth that we see occurring on an operating level.

With that, I'll now move onto our other two primary business segments. And I'll first talk about CareerStaff, our staffing company which once again had a very strong quarter, and I don't think it's anything less than a strong quarter for probably the past three years now. Our revenues increased 13.6% to $30.2 million. Our EBITDA increased 37.5% to $2.1 million. Our EBITDA margins improved 120 basis points to 7% and our billed to paid spread, an important indicator of where our business is headed from a margin perspective improved 16.6%.

So again, all things look good for our staffing business. We're still continuing to build the Physicians Services segment which is at this point still several million dollars in revenue but growing at a pretty heavy clip considering that we're just starting it from scratch and not doing any acquisitions along those lines.

Now, I'll move onto SunDance, our contract rehab business. As everybody knows, we've struggled with that business on and off over the past couple years. We restructured our contracts. We put a new IT system in place and we feel like we're starting to get some traction out, so I'm cautiously optimistic. And I stress the word cautiously optimistic that we've perhaps turned the corner here with a couple of good consecutive quarters.

Our revenue increased 16.3% to $36 million. Our gross margin improved 32.7% to 18.1%. Our EBITDA increased 45% to $2.3 million. Our EBITDAR margins improved 130 basis points to 6.3%. Our productivity improved 20 basis points to 70.9%. So we've been pretty regularly above 70% in productivity now which in no small part has to do with the new IT system, where prior to that we tended to be in the 67% to 68%, 68.5% range on productivity.

Our revenue per minute increased 6% and our labor per minute increased 5.4%. Now while that's a little bit higher than the wage inflation we see in the Inpatient business, it's actually lower than what we've seen the past number of quarters in the Rehab business, but that shouldn't imply to anybody that the labor shortage, the therapists is getting any better.

I think we're doing a little better job from a recruitment and retention perspective, but still have a long way to go. So I wouldn't be surprised to see that labor pop up again going forward, it's just a tough market for therapists. We had 418 contracts in the quarter up from 390 contracts in the first quarter of 2007.

A couple of other comments that I want to make, one along the reimbursement lines I already made a comment on Medicaid. Let me talk about Medicare. First, obviously, I feel and I have had a lot of conversations with a lot of you folks that are on the call that the reaction to the reimbursement uncertainties in Washington is really over blown. I think -- obviously they're going to have to be paid for the physician, for the physician fix and everybody's going to have to chip in something.

But to assume that we're going to take a $20 to $25 rate hit on Medicare, which is what's been baked into the stock with everybody assuming worse case scenario, and again a worse case scenario being a market basket freeze and the full implementation of the CMS forecasting error correction I think is very farfetched, and would hope that people would respond to that with a little bit more reason going forward. So again, we expect that we'll have to chip in like everybody else will. But I don't think worse case scenario is even close to what's currently, what's currently baked into the stock.

Other item that I want to note, before I turn it over to Bryan, is as many of you saw we issued a press release this morning. We filed a $200 million shelf registration. That shelf registration is consistent with our past behavior. It's a smart thing to do. Most companies do it on a routine basis. It doesn't mean that we have anything going on as you all know.

We've talked about taking a break from doing deals. But when you put a shelf in place to the extent that at some point in time in the future you are looking at some growth opportunities, it expedites matters with the SEC. And it's as simple as that.

In terms of why we issued the press release today, frankly I wanted to do it so that if there were any questions about it to the extent that I can, given the limitations imposed upon me by the SEC, I can answer any questions. And secondly, frankly the first time we posted a shelf registration we had a great reaction, the last time we did it we had a negative reaction, so it's a little bit difficult to predict. But given how ridiculously low our stock is trading at, didn't really think it would make a difference anyway.

So we just thought we'd get it out there and make sure we preserved our optionality for future purposes. And with that, I will turn it over to Bryan Shaul, our CFO. When Bryan's concluded then we'll take questions. Thanks.

Bryan Shaul

Thank you, Rick. I'll start with the recap of our debt. As March of 31st 2008 we had $349 million outstanding under our credit facility. We have no balances outstanding under the revolver. In general, the interest rate on the credit facility is LIBOR plus 200 basis points. We had $200 million outstanding under our 9-1/8% senior subordinated notes at March 31st.

Including the impact of our $100 million interest rate swap agreement we have approximately 65% of our total debt of $726.3 million with fixed term rate. Including the amortization of deferred financing cost, as of March 31st our weighted average fixed term rate on our debt is 8.55% and our weighted average variable rate on the remainder of our debt is 5.89%. The all in weighted average is 7.62% down 50 basis points from the previous quarter. During the first quarter we reset the interest on $194.5 million of our variable rate debt. The average rate prior to this reset was 1.7% and after the reset it was 4.86%. Another $54.4 million with an average rate of 6.93% was reset in April at 4.92%.

We had $61 million outstanding under our letter of credit facility at March 31st, 2008. At the end of the quarter we had available liquidity of $112.9 million comprised of $62.9 million of cash and cash equivalent on the balance sheet and $50 million of available borrowing capacity under our revolving credit facility.

Using March 31st, 2008 EBITDA for the last 12 months normalized primarily for prior period insurance adjustments, the prior AR settlement adjustment and certain adjustments related to the Harborside acquisition, our leverage at March 31st is 4.6 to 1. That is based on total debt outstanding of $726.3 million, less excess cash of $52.9 million and normalized LTM EBITDA of $145.6 million. Normalized LTM EBITDA excludes the full impact we expect to realize related to the Moffie and the NHP transactions. If those adjustments were included in the calculations, our leverage would be 4.5 to 1. We comfortably meet all our bank covenant requirements at March 31st, 2008.

Sequentially our DSO for the quarter if up one day as compared to fourth quarter 2007 due to an increase in our Medicare reimbursable bad debt receivables and the increase sequential revenues quarter-over-quarter. Medicare reimbursable bad debt receivables are seasonal in nature as they accumulate during the fourth, first and second quarters and are then collected through Medicare in the third quarter. Accordingly the one day increase in DSO is not indicative of an adverse trend.

Now turning to cash. For the quarter we reported $12.8 million in GAAP cash flow provided by operations as compared with $1.6 million of cash provided by operations in the prior year's first quarter. Our operating cash flows were derived from our $8.6 million of net income combined with $15.4 million of adjustments to net income for non-cash items such as depreciation, amortization, our bad debt provision and changes in net deferred tax assets.

Changes to our net working capital used $11.2 million in cash flow. Cash used for investing activities during the first quarter totaled $2.4 million. Our investing activities for the quarter principally related to our capital expenditures which totaled $5.9 million. We received cash of $3.8 million in conjunction with our sale of our minority interest in a regional pharmacy joint venture during the quarter.

Our capital expenditures in the first quarter 2008 were principally related to improvements to our Inpatient centers, including the build-outs of Rehab Recovery Suite units and management information system enhancements. We still anticipate total capital expenditures for the year to be in the range of $45 million to $50 million. Net cash used for financing activities in the quarter totaled $3.3 million. Our principal payments for the quarter, including capital lease payments totaled $3.1 million.

Now, we go to my favorite topic, taxes. For 2008 we have projected an effective tax rate of approximately 40%. We have previously mentioned annual limitations imposed by Internal Revenue Code section 382 on our tax net operating loss or NOL carry forwards as a result of ownership changes. These annual limitations consist of $10.3 million on Sun's and Peak's NOL carry forwards, and $14.6 million on Harborside's NOL carry forwards. If they are not fully utilized in any one year they can be carried forward to the next year.

As a result of unused section 382 limitations from prior years, the current year section 382 annual limitations available building gains and post ownership change NOLs, there is approximately $107 million of NOLs which can be used to offset US taxable income in 2008. This is significantly higher than the available NOLs that I have previously discussed and is driven by the detailed analysis that we did at the end of the fourth quarter and the addition of Harborside's NOLs to the mix.

As a result we expect cash payments for income taxes to be in the range of $7 million to $8 million in 2008 primarily for AMT and state income taxes. Actual cash payments for the first quarter were $703,000. Assuming we hit targets in 2008 I would expect that there will be at least $70 million of NOLs which will be available but will offset US taxable income in 2009.

From a balance sheet perspective, we believe that it is still necessary to have a valuation allowance and a portion of our net deferred tax asset. However, if we determine that significant positive evidence exists in future periods to enable us to reverse part or all of the variation allowance of $132.9 million as of March 31, 2008 than a portion of such reversal, up to $55.9 million, would increase capital in excess of par value and a portion, up to $77 million, would reduce the provision for income taxes. Positive evidence includes future sources of taxable income and tax planning strategies.

We continue to make progress in reducing our corporate overhead costs as a percent of revenue. For the quarter ended March 31st, 2008 our normalized corporate overhead cost as a percent of revenue was 3.5%, down 140 basis points as it compared to 4.9% a year ago.

Our self-insurance reserves at March 31st, 2008 are fully described in footnote 8 of our Form 10-Q which was filed earlier this morning. The programs are running well and there is nothing unusual to report, so I won't bother you with the details.

During this quarter, we identified $1.5 million of non-recurring Harborside integration costs principally related to clinical systems integration costs and severance costs. $1 million of these costs are in SunBridge operating G&A and $500,000 are in corporate G&A.

We have several attractive purchase options on properties that we lease. We are evaluating each of the options and in context of future returns to the company and our goal to continue to delever our debt. That concludes my prepared remarks. Rick will now sum up the call.

Rick Matros

Thanks, Bryan. And for those of you that have to try and interpret it the way I do, the NOL things of good news. So with that, we'll take some questions.

Questions-and-Answers Session

Operator

(Operator Instructions) We'll take our first question from Eric Gommel with Stifel Nicolaus.

Eric Gommel - Stifel Nicolaus

Good afternoon.

Rick Matros

Hey, Eric.

Eric Gommel - Stifel Nicolaus

How you're doing? Just on guidance, you're still comfortable with your current guidance?

Rick Matros

Yes.

Eric Gommel - Stifel Nicolaus

Okay. And then, just a couple questions on operations. How has sort of the rising I guess food costs and utilities impacted bottom lines. You actually reported better margins than we expected. I'm just curious your thoughts there.

Rick Matros

At this point it really hasn't affected us at all. We've got pretty strong contracts in place through a group purchasing organization for all of our food and don't expect that to have any material change. It's obviously a little bit more difficult to predict on the fuel side but we don't have a whole lot of folks out in the field in the context of all of our employees that are driving all that much in terms of impacting our fuel costs.

And whether vendors try to pass on higher costs to us because of their increased fuel costs, which would be the greater concern, I think from our perspective there are enough vendors for us to choose from within our GPO that we can apply some good leverage there because we obviously give these guys a big book of business, so at this point we don't have that much of a concern about it, Eric.

Eric Gommel - Stifel Nicolaus

Yes, and I was thinking more on the energy side, just utility bills and that sort of thing for your --.

Rick Matros

They've gone up but not to the point where it's hurt us. The rest of our operating initiatives have been more than adequate to compensate for any inflation there.

Eric Gommel - Stifel Nicolaus

Okay. And then, in your guidance I just want to be clear about what you've embedded in there for Medicare changes or potential changes because you did spend some time discussing that. What kind of Medicare rate growth expectation do you have embedded in your guidance?

Rick Matros

We assumed a 3% market basket increase on October 1st, and we assumed overall Medicaid rate growth of 3% for calendar year 2008. Now, let's assume for a second that we don't get the full market basket increase. At this point it's way too early for us to even think about amending our guidance because it really becomes a 2009 issue. It's only a one quarter issue for 2008 and I don't want to presuppose that anything less than 3% would cause us at this early date to restate guidance.

I also believe that what everybody's got baked in terms of their concerns is not going to be a reality. And so, I think that not only is it too early to even consider doing something like that with the momentum that we have relative to all the initiatives in terms of building the level of our acuity and opening our Rehab Recovery Suites.

We can mitigate some of that. If you look at our Medicare rate growth two quarters in a row now of over $30, even if we had to take some hit, you're still showing some very nice accretion on rate growth which translation to the margin. And that's what I think people seem to be missing in this kind of irrational reaction to what's going on. Having been in the business for as long as I've been in it, this kind of noise is around the nursing home more often than not, but I've really never seen this kind of reaction.

Eric Gommel - Stifel Nicolaus

Great, thank you.

Operator

Thank you. We'll go next to Donald Hooker with UBS.

Donald Hooker - UBS

Great, thanks for taking my question. Good afternoon.

Rick Matros

I don't think I had an option, did I, Don?

Donald Hooker - UBS

I don't know. So in terms of your rate increase going back to that earlier question, Besides the anything from the government, do you have like a target in your mind in which you'd like to see in terms of rate increases? Because obviously there's been a consistent growth in your rate beyond the market basket, like you mentioned. Is there a target you think we should think about?

Rick Matros

Well, there isn't a target in terms of rate. I think that the 7% to 8% rate growth that we've seen is still a target that we'd like to achieve. Obviously, if we have some minor, which is what we would expect, reductions then you're still looking at 6% to 7% and maybe better than that because we're going to go from having 38 Rehab Recovery Suites to 50 Rehab Recovery Suites. And that's was the point I was trying to drive home in terms of comparing the stats within our Rehab Recovery Suites to the other facilities. It really helps to drive that margin. So at this point I'm not willing to say that we're looking at anything different than kind of consistent 7% or so rate growth on the Medicare side.

Donald Hooker - UBS

Okay.

Rick Matros

The other point I would make there is the other thing that we're seeing as a result of all these initiatives is that the market basket as a percentage of our total rate growth is half of what it was two years ago. And that goes to the point that I made relative to our ability to mitigate what happens there, and that's not to make light of the market basket. I don't want to have any cut obviously. But this industry has never been in a position before this, ever, to do anything to really materially mitigate what happens on rates, and now we've got some ability to do that. And that's an important distinction relative to where this industry sits today versus where it sat for its entire history prior to January 2006.

Donald Hooker - UBS

Okay. And then, in terms of these Rehab Recovery Suites in the past you mentioned that the -- I think in last quarter it seemed like the average length of stay was pretty high in these Rehab Recovery units. Did you give that statistic? I didn't think you did?

Rick Matros

No, we haven't seen it move down much. It's still 30, 31 days. And I would expect that it will start coming down. One of the things that we're trying to do and we're just not ready to discuss it yet in terms of providing data, is we've got so many units opening at any given time that when you look at our 38 units they're all at different stages of maturity. And so we're trying to do some sensitivity analysis much like you would do in a retail business when you open up a new store. When do you stop calling it a new store and you start calling it a same-store.

So we're going to see what we can do about carving up our stats there and picking a point in time where we can look at those units and say they are now mature and looking at those stats, versus having those stats affected by the new units that are opening. So that will give us a better picture of say that in terms of average length of stay in the units that have been open 15 months, the average length of stay is shorter than in those units that have been open for three months. But we're still drilling down to try to come up with all that data.

The other point I'd make there in terms of average length of stay is those units are still being driven primarily by Medicare although we have much stronger managed care there than we do in the rest of the business. I think as managed care continues to grow, and the age of the patient in those units continues to decrease, then that will bring average length of stay down. Right now the average age of the patient in those units is a few years younger than our typical patient but it's not material.

Donald Hooker - UBS

Okay, I'll ask one more and let others ask. On a very different topic. In the past you had rolled out and been focusing on dementia. I didn't know if that sort of view kind of refocused elsewhere, or are you still rolling out new units there? Do you have a bed count for that kind of business?

Rick Matros

No, we're not. What we're doing there is we have 51 units.

Donald Hooker - UBS

Okay.

Rick Matros

And the average unit size is about 35 beds. The reason that we're not rolling out new units isn't just because we're focused more on the Rehab Recovery Suites, but there are a couple of issues. One, between Sun legacy business and the Peak acquisition and the Harborside acquisition everybody sort of had a different approach to the product that was provided in those Alzheimer's units. So we're trying to standardize it and rather than opening up new units, we're really going back and revisiting our program completely so we have a standardized product across all those 51 units that we're proud of and that have consistency from facility to facility, that's one issue.

The second issue is we actually have a couple of facilities that may have an Alzheimer's unit and a Rehab Recovery Suite, but we need to do a lot more analytical work on our end to see how we want to position our facilities in those markets. Do we not want to have a facility with the Rehab Recovery Suite if the facility already has an Alzheimer's unit, or does the market tend itself to have both? So we want to make sure that the left hand sort of knows what the right hand is doing and have a more holistic approach to our business development function as we do that analysis. So I think we have enough work to do to standardize our product in the Alzheimer's units without considering opening more now and then that will give us more time to do greater analysis.

Donald Hooker - UBS

Okay. That's fair. I'll jump off. Thanks for your comments.

Rick Matros

Yes, thanks Don, nice talking to you.

Operator

Thank you. We'll take our next question from Andreas Dirnagl with JPMorgan.

Andreas Dirnagl - JPMorgan

Yes, good morning. Bryan, maybe we could talk just about some of the synergies that you've been seeing. In terms of your commentary being at the higher end of the range, have you been seeing the synergies just coming in earlier than you expected, or are you actually seeing sort of a larger absolute amount? And have you given any thought to maybe raising the amount of synergies that you think you can obtain?

Bryan Shaul

Yes. I think we've said 12 to 15 and we said we're comfortable at the high end of that. We're seeing the synergies, if you looked at what we anticipated initially, we're seeing them come in just as we anticipated them. The initial ones were related to the overhead in the corporate offices, cutting out the people and the office costs, and then it moved to purchasing and some revenue opportunities that we have. You get the clinical roll out. You've got the accounts receivable coming on down the road. So we're very comfortable with where we're at.

And I think you also get into the question once you get those synergies in and it starts operating as a unit, we continue to focus on improvements. So we've gotten most of the corporate synergies in but we haven't stopped focusing on improving our corporate cost structure.

Rick Matros

I want to clarify one thing on Don Hooker's question on average length of stay. The facilities that have Rehab Recovery Suites, the average length of stay is 31, but if we just look at the units themselves, the average length of stay itself is 28. So we are seeing some downward movement here as we would expect.

Andreas Dirnagl - JPMorgan

Okay. And, excuse me. Bryan, I should know this or I should be able to look it up, but can you just remind us, what sort of things have you used your shelf registrations for in the past?

Bryan Shaul

We have the equity offerings that came out in December of 2006.

Rick Matros

And December 2005.

Bryan Shaul

2005.

Rick Matros

But both of those equity offerings were in the context of acquisitions. They weren't done just for the sake of doing them.

Andreas Dirnagl - JPMorgan

Right. And then, Rick, finally you sort of gave some good color on your thoughts of when it comes to reimbursement updates and in terms of market basket for Medicare. You really didn't mention anything about the concern that the market may or may not have around CMS just looking at the whole high acuity RUGS categories. Can you maybe give some color on that, whether you think that's a possibility?

Rick Matros

Yes, I'm not sure if you're referring to the STRIVE project which will be completed next year, that's the time and motion study where they're going to be looking at RUGS across the board. But that's intended by CMS to be budget neutral.

Andreas Dirnagl - JPMorgan

And then, but also I was actually referring to [Herb Kune's] comments to BNA in February, where he said that they were seeing utilization of those high intensity or higher RUG categories being larger than they thought.

Rick Matros

Yes, those comments were specific to this forecasting error correction.

Andreas Dirnagl - JPMorgan

Okay, great. Thanks.

Rick Matros

It was just specific to that and it wasn't specific to anything more than that. So in other words, from their perspective there was a forecasting error correction back in 2003 that gave us a nice rate pop. Herb has specifically stated we are not targeting you guys at all. It's just that things have gone up a little more than we thought that they would when we implemented the new RUGS category. So this is simply just a forecasting error correction. Our position as an industry is that that's a myopic view of the world. But the fact of the matter is that we have saved the government a lot of money on the Medicare side because of the shift in acuity from IRS and short-term acute hospitals to nursing homes.

And that's what we're trying to present in terms of the data that, that they should be aware of anyway. But that we're trying to get in front to them and get in front of elected officials on the Hill that CMSs intention is working. Between the nine year RUGS categories, the 75% rule or the 60% rule, whatever you want to now call it, the impact on L pack reimbursement is it's all achieving the desired effect. And to look at any one segment of the post-acute factor by itself is really not taken into consideration the whole and I think that's purely a function of the budgetary pressures in Washington.

Andreas Dirnagl - JPMorgan

Great, that's exactly the sort of color I was want.

Rick Matros

Yes, the other point I'd make there, is remember, I think people are focused on the fact that CMS can make these cuts, administratively. Well, the polls rules probably going to come out this afternoon, it's going to look like everybody expects it to look. There's not going to be anything different there, from what we understand and it doesn't mean that that's what the final rules going to look like after the 60 day commentary. Nor does that mean that's what anything's going to look like at the end of the day because even though CMS may or may not be able to make certain kinds of cuts administratively, it doesn't mean that there wouldn't be legislative action to prevent them from doing so.

Andreas Dirnagl - JPMorgan

Thank you.

Operator

(Operator Instructions) We'll go next to Frank Morgan with Jefferies & Company.

Frank Morgan - Jefferies & Company

Going back to the question about just how long or how you can drive, continue to drive Medicare rate growth as a result of acuity shift. What do you really see as the remaining market potential for adding these Rehab Recovery units out there in your markets?

And when you look across your portfolio is it more skewed toward the Harborside portfolio or the legacy Sun portfolio, where do you really see the biggest opportunity and how much more of a run do you think we can get on just the whole notion of a driving rate growth through acuity shift? Thanks.

Rick Matros

I think we can get a pretty nice run going forward. Let me break it down a couple of ways. We have 213 facilities. Of the 213 facilities, 190 of those facilities are nursing centers. Of those 190 nursing centers about a third or so of those are rural and we would probably tend not to open Rehab Recovery Suites in rural communities because there are less options anyway, and you may already get that business. It doesn't mean that isn't a possibility, but generally speaking. So that leaves you with an awful lot of centers that have the potential for Rehab Recovery Suites.

That said, if we have 50 at the end of the year could I see us getting to 70, yes, absolutely I could see us getting to 70. Could I see us getting to 100, I don't know. We need some more time on that, we'll see. Certainly, I think we can get above 70. And I don't want to give a range here that doesn't matter to people. So it's between 70 to 120. But I think that there's a lot of runway still ahead of us.

A couple of other dynamics here to consider is we're really completely changing our business development function with the leadership change that occurred towards the end of the fourth quarter. Nursing home marketing historically has been pretty antiquated. You bring coffee mugs and candy to the discharge planners and that sort of thing, and everything is based on relationships. And we're not a sector that's really had a data driven analytical approach to building business. So in other words, in a local market we want everyone in our facilities to be able to say these are our three primary referral sources. These are the top five discharges. Out of those referral sources, these are the physician groups that drive those discharges and this is where our facility sits in terms of its ability to meet the clinical needs of those referral sources and their top five discharges.

That's the kind of data that we're starting to drill down on for the first time which is going to not only help execution of existing Rehab Recovery Suites but better help us target additional facilities to open Rehab Recovery Suites. But in some ways just as important, help all those facilities that we don't have Rehab Recovery Suites in because we are still building Medicare business there as well. So we're really taking a much stronger approach. I think there have only been a couple of companies in the business that have really done a good job from an execution perspective on business development. Most companies in the sector unit sort of have taken the same old kind of nursing home approach.

The other point I'd make is people will ask, if all of you guys are going after these patients, how can you continue to build it? Well, the answer is not all of us are. There are very few markets that we are in the same competing target market as the other bigger players in the sector. There are peers from a capital market perspective. At the local market, we're primarily competing with mom-and-pop, and they tend not to go after this kind of patient because the patient is more sophisticated. It requires more infrastructure. It requires more sophisticated systems. And that's not to say that there are very good mom-and-pops out there that don't do it, but that's more the exception than the rule.

Frank Morgan - Jefferies & Company

Okay. So you're adding more of these units, but if you look at the ability to grow organically the units that you've organically grow the volume at these units, 30 some odd units that you've already gotten open. Where do you feel like you are in terms of your ability to max that out? I guess that comes back to your point about same-store, kind of a same-store analysis. But how much kind of organic pent up demand do you think you've got in the markets where you already operate these units? And then secondly, your comment about length of stay declining over time as these units mature, is that because you're taking care of a higher acuity short stay patient, or tell me a little bit more about what's driving that thing? Thanks.

Rick Matros

On the latter question, it's because we're taking a higher acuity short-stay patient. So the average length of stay should drop. But I also think that the age of that patient is going to be dropping as well. And right now that the average age of that patient is 76 for us as opposed to about 80 outside of those facilities that have those centers. And we're really targeting a broader demographic. We're targeting the 65 plus Medicare bracket, not just the 85 plus, and we're targeting younger managed care patients. We haven't made a whole lot of progress there, yet.

So that also goes to your question about kind of how much more capacity or opportunity do we have to grow that. I don't know what kind of what inning we're in. We're certainly not in the sixth or seventh inning. We're probably out of the second or third. So maybe we're kind of halfway there but we still have, we think quite a bit more runway to go. Just from these fourth quarter to the first quarter of 2008 our skilled mix in those 38 facilities improved by close to 200 basis points.

Frank Morgan - Jefferies & Company

Okay. One final question for Bryan. I don't want to leave him out. Any release of (inaudible) results from prior periods in the quarter? Thanks.

Bryan Shaul

No, there're not.

Frank Morgan - Jefferies & Company

Okay, thanks.

Operator

Thank you. Next we'll take Rob Mains with Morgan Keegan.

Rob Mains - Morgan Keegan

Hi, good morning, guys.

Rick Matros

Hey, Rob.

Rob Mains - Morgan Keegan

Just a couple quick number things. SunDance internally generated revenues were up about 10% sequentially but you didn't have any growth in contracts. Is that indicative of you doing more with your own nursing homes or is that kind of like noise?

Rick Matros

Yes, it's really kind of more noise. I think we'll see a little bit more contract growth where we added a couple of folks to the sales force. So we're going to be a little bit more assertive there but still trying to be very selective given some of what has happened historically. But the growth was really just a combination of both the affiliated and the nonaffiliated business. Although, I think it's fair to say it's more on the affiliated side than the nonaffiliated side.

Rob Mains - Morgan Keegan

Right, okay. And then you mentioned --.

Rick Matros

I'm sorry. The other item was where over the course of the latter part of the year we were transitioning the Kentucky facilities which had a third party contract through Harborside over to SunDance.

Rob Mains - Morgan Keegan

Okay, all right. So you had full quarter's benefit.

Rick Matros

Yes and that's about 20 buildings.

Rob Mains - Morgan Keegan

Okay, good enough. You mentioned the rehab now at 60% rule. I have heard from some of the operators there that they're seeing higher census because they can keep more to the hips and knees. Obviously, you're not seeing any kind of big census pressures. Can you remind us how many or kind of like what percentage of your nursing homes are in the same market as a rehab hospital?

Rick Matros

I can tell you if I look at a combination of rehab hospitals and LTACs, it's probably about 40% of our buildings. But we need to do a better job identifying the rehab hospitals from the LTACs from these acute hospitals that have transitional care units because that's where we're getting a lot of those patients from also. So they come directly to us instead of going to say a rehab hospital to begin with. So we've to do a better job accumulating that data which we're in the process of doing.

Rob Mains - Morgan Keegan

Okay.

Rick Matros

But I'd say at least the combination of the LTAC and the rehab hospital is about 40%.

Rob Mains - Morgan Keegan

All right, but is it safe to say that you're not seeing any sort of turning off of the spigot of hip and knee patients?

Rick Matros

No, because the fact that the rule is frozen at 60%, we're not losing any business. We are continuing to get the same business we've been getting all along. So we're not seeing any decline there at all. We'll just have to get the additional pop that we would have gotten if the rule went from 60% to75%. But to the extent that we're still able to get, and I think we still as an industry have a shot at this, still able to get the equal payments for the hip replacement, knee replacement and hip fractures, that's probably more meaningful to us if we can get that done than the other 15% anyway.

Rob Mains - Morgan Keegan

Right. Good enough. If I look at the Medicare per diem, up 7.9%, you got a 3.3% market basket. Kind of rule of thumb then that says about 4.6% of its acuity, but that's about 40% rate, 60% acuity. Is there a similar type of breakdown that you can give us for the managed care commercial business? What are base rate growth there?

Rick Matros

The rate growth there was actually pretty strong and we were at $316 and change in the first quarter of 2007, we're now at $343. But that's less a function of changes in contracts or rate increases from the managed care providers than it is related to the fact that we're taking higher acuity patients than the managed care providers.

Our managed care contracts tend to have several levels and the negotiating you do with those guys is, you're going to admit a patient and you say I think it's a level 4 patient and they say we think it's a level 3 patient, which is lower reimbursement, and that's kind of where your battle comes. And sometimes you win and sometimes you loose in that battle. But on an overall basis, we've had a big enough push to take higher acuity patients from the managed care providers that we're getting reimbursed on more patients than we used to at the higher levels in those contracts.

Rob Mains - Morgan Keegan

Okay. Is it safe to say that most of the realized per diem you're saying is acuity?

Rick Matros

Yes.

Rob Mains - Morgan Keegan

Okay. And then last question, do you know whether the revenues per patient day growth and Medicare and managed care, how it compares company overall versus RRSs?

Rick Matros

Yes, the Medicare rate and the RRSs is about $2.50 higher than our consolidated rate. But if we were to compare just to the rates in the non-Rehab Recovery Suite facilities, it's about a $4 difference. So in other words, our Medicare rate on a consolidated basis was $411 and change and the centers that have Rehab Recovery Suites its $414 and the centers that don't have Rehab Recovery Suites it's about $410.

Rob Mains - Morgan Keegan

Okay. And is the rate of growth year-over-year comparable?

Rick Matros

Yes.

Rob Mains - Morgan Keegan

Okay. That's all I had. Thanks.

Operator

(Operator Instructions) We'll go next to Ken Weakley with Credit Suisse.

Ken Weakley - Credit Suisse

Thanks and good morning everyone. I guess question number one, Rick you had mentioned better execution in the Rehab Recovery Suites. I was just curious if you could give us a couple of examples of maybe where execution wasn't quite where you wanted it to be and what steps that have to happen to get you there? And just give us some sense of the dynamics of improving that business. Not to say that you where dollar on it, just that you were giving us a sense that there's always work to be done.

Rick Matros

Sure. Well, I think the first set of tranch units we opened were the obvious ones. They were facilities that were already sort of doing great on Medicare to begin with.

Ken Weakley - Credit Suisse

Okay.

Rick Matros

So they were obvious choices, but shouldn't necessarily making the best choices, but they were obvious choices. And so when we took those facilities and created these units that were much more attractive then the numbers moved up even more. So that was more if you build it, they will come, as opposed to us really doing kind of what I said earlier where we looked at everyone of those centers, we looked at their markets both in terms of their primary referral sources, their tertiary referral sources, identified the key position groups, identified the key discharges and then took a look at our clinical product and said do we match up and can we meet those needs? That really wasn't happening.

So I think it says something about the product that when you put something in place that makes it more attractive to that younger short-term patient to go to a nursing home, you just naturally are going to have better numbers. So that was really our conclusion that we were doing better but it was really despite the lack of analysis and that's really what's changing right now. And so we're trying to generate a lot more analysis on a specific market basis and then there's got to be a lot of training that has to occur from corporate down to the field so that the local business development people we have out in the field understand how to utilize that data.

And you can't just do it once and sort of forget about it because those markets change all the time. So that analysis has to be sort of an ongoing process. You may have a dominate product one year and there may some shift in the market that's going to cause you to have a different product a year later. And that's really what we were missing. So now it's easier said than done. Because we have to be able to generate that data out of the company in order to provide the field the tools they need.

So for example, in the second quarter of last year which I think was the first quarter we started providing any data on the Rehab Recovery Suites, we had to go into every building and pull that data manually, it was pretty brutal. By the third quarter all that was automate. So from an IT perspective it's sort of one step at a time in terms of getting the data and with our new Senior VP of Business Development, or relatively new, at this point in time the needs that she has relative to the data that she is looking for are really what we're trying to meet right now to execute better. Does that answer your question?

Ken Weakley - Credit Suisse

Yes it does, thank you. Question number two. You had briefly touched on the potential for I guess just lobbying or inducing some legislative process to deal effectively with CMS should they come out with a proposal that doesn't make a lot of economic sense.

Can you walk us through what steps have already taken place in that regard? And then further what actual steps, which I don't know if this is not the right way to discuss this, but just to give us the sense of what has to happen here on out for you to convince CMS that your view of the world is correct?

Rick Matros

Well, it may not be just a function of convincing CMS.

Ken Weakley - Credit Suisse

No, that's my point. I know you have to convince some people in Congress.

Rick Matros

Right. So we're doing a number of things. Obviously, we have a very active lobbying effort where we've gotten some great support from Congress most recently this morning with letters being written to CMS advising against any potential cuts even within the proposed rule. So we're continuing to try to garnish support on the Hill to oppose any cuts. At the same time we're providing data to demonstrate that if you look at the post acute sector as opposed to just the SNF sector, you see that there are savings that are meaningful to the government as a result of the changes that have occurred over the past couple of years in terms of CMS policy.

I think another critical point is, that we make, is that CMS shouldn't do anything to undermine their stated objective which is to reduce costs by moving patients to a lowest cost setting possible. Their stated goal is to have a uniform patient assessment tool which would be great for us. Have a single sort of post acute reimbursement system. And so therefore, they shouldn't do anything that would desensitize us from continuing to move in that direction.

Then of course, the other very important component here and both in terms of what we talk to CMS about and what we talk to the Hill about is quality. And we know that Senator Grassley. For example, is a huge, huge proponent of having better quality nursing homes, and we're right there with him and we try to proactively find initiatives that will improve quality, and cutting rates to any significant degree will completely undermine that.

And we believe that that really has some resonance on the Hill maybe more so than CMS, because CMS I think tends to look at things just more technically. So that's where we try to garnish support from the Hill. Mean it BBA '97 isn't too far from everybody's minds.

And so no one wants to do anything to really disrupt us. We don't believe based on the feedback that we've gotten. And that's why I have some comfort level that while we all may have to chip in something to for this position fix, particularly because we don't know whether the White House is going to be less rigid relative to any Medicare advantage cuts.

Ken Weakley - Credit Suisse

Okay.

Rick Matros

But again what we're hearing is that we're not targeted but everybody has to chip in a little bit of something.

Ken Weakley - Credit Suisse

Okay. And my last question I guess related to your comments earlier you mentioned the excessive volatility in the stock, which is obviously true. And I guess from my perspective as an analyst it's clearly a function of the market's contention or belief that a large portion of your future earnings power, whatever that might be, is directly tied to the issue at risk today of course the high-end RUGS.

So maybe, I don't know if there's a way to ask this intelligently, if you look at your earnings power, assuming the pricing of Medicare won't directly bare on your ability to switch on to Medicaid into more and more interesting or more interesting patient mix but obviously the profitability of that switch is what's at risk here.

So is there any way to walk us through maybe a range where the profitability of this company might be maybe just on an EBITDA margin basis in various scenarios for pricing within the high-end RUGS? Is there anyway to do that intelligently?

Rick Matros

Well, number one, I would still tend to think that any changes in the RUGS category as a result of the forecasting error correction would be across all 53 categories.

Ken Weakley - Credit Suisse

Okay.

Rick Matros

Not the nine and I think that is, that is their intent. The dollars are the same for CMS. But obviously if you take the dollars out of the nine there's the disproportionate hit for the larger companies that are focused on that than there is for the smaller companies. But I don't think that that's the intent here. I think even under the worst case scenario we're not going to see EPS deterioration here. Because if you look at our rate growth, even if you assumed that worse case scenario we're still going to have accretion in our Medicare rates.

Ken Weakley - Credit Suisse

Right.

Rick Matros

We'll have a lot less of it. But in terms of getting down to a margin perspective, obviously, our margins improved by 200 - 270 basis points looking at EBITDAR and EBITDA at this point and a significant for us, it's not significant, but it's a big piece of that was obviously due to the synergies. And what we've been telling everybody is that we're comfortable post synergies on a go forward basis even taking into consideration some reduction in Medicare that we can improve our margins 100 basis points a year. Okay. Okay. Very helpful. Thank you.

Operator

Thank you. We'll take our next question from [Ray Garson] with RBS.

Ray Garson - RBS

Thanks. I just wanted to follow-up on a comment Bryan made with respect to some purchase options you guys have on some of your facilities. I was hoping you could maybe just give us a little bit more perspective for how big, or how many facilities are involved, timing and any sort of I guess prenegotiated cap rates?

Bryan Shaul

A couple of things on the facility. One is we've always talked about the exercising the option on the Clipper facilities and we can purchase that and have an opportunity to purchase and finance it through the end of this year and that's nine facilities.

We have several other facilities that we are looking at right now, without going into specific details, that we're evaluating the purchase option and the leases and the use of cash and considering that in how it benefits going forward, as I said, versus our goal to continue to reduce the leverage.

Rick Matros

Let me make a couple of other points. First of all, non of these are open under negotiations. These were purchase options that were set in place a long time ago and so they're all very attractive. Number two, on the Clipper properties. As you know, we already show about $50 million in debt on the balance sheet even though its nonrecourse debt and we never really get credit for that. In terms of exercising the Clipper options you're talking about another $6 million, $7 million on top of that, so it's just not material.

And so what we're balancing here is the longer-term benefit of being more attractive by having a higher percentage of owned facilities with any impact on leverage. The purchase options on these properties, and we have around 14 in total, are so attractive that we don't see it having much of an impact on leverage at all.

In fact, we still think we'll be able to delever at the same time we exercise most of those purchase options. So that's what we're taking into consideration. We're looking at enhancing the long-term value of the company, not diluting EPS, not increasing leverage and fortunately we're able to look at all those things in a very concrete fashion, because those purchased options have already been set from a price perspective.

Ray Garson - RBS

Okay and do you have kind of an average cap rate with respect to those?

Rick Matros

They're really, they're kind of all over the board but they're more in line with traditional nursing home cap rates of 12% plus.

Ray Garson - RBS

Okay, great. And then I guess I just wanted to make sure I heard Bryan right on the new I guess kind of disclosure around cash taxes. Did you said as a result of all this, you now expect FY'08 cash taxes to run around was it $7 million to $8 million?

Bryan Shaul

That's correct. It's primarily the state tax, the income taxes because we don't have the same NOL position, each state is different. So we will be paying state income taxes and we will be paying an AMT which is probably in the neighborhood of $1.3 million give or take on our federal return.

Rick Matros

Did we cover your question? Okay.

Operator

Thank you. And that does conclude today's question-and-answer portion. At this time, I'd like to turn the program back over to Mr. Matros for any additional or closing comments.

Rick Matros

Thanks, again I appreciate all your time today. I know the Q&A went a little bit longer than usual. Hopefully, you'll take things into perspective. We had a pretty nice stock price as of the middle of February and since then we released good year end earnings, good guidance and I think a good first quarter and to no avail it seems like. So hopefully everybody will hang in and we'll get through this. But we really feel good about-- continue to feel good about our prospects going forward.

We continue to believe that the break that we said we were going to take from doing deals, post-Harborside, certainly deals of any significant nature is really benefiting us as it allows us to really focus on improving the strength of the platform generally with all the various initiatives that we have finishing out the integration activities, so that as we become acquisitive again at some later date we have a stronger base to do so. Fortunately for us, because the credit markets have been as bad as they've been, there really hasn't been much deal activity of note. And so while we're taking this sort of hiatus, we're really not missing any opportunities, which is advantageous for us.

We'd still like to grow the Hospice business through acquisitions, it's very small still. We're licensed in Connecticut now. We just recently got licensed in Massachusetts. So we're now licensed in five states. But it's a slow haul and we're just doing it organically.

And there's really not that much out there. Providers are just a part, one sells at this particular point in time, whether it's got to do with the credit markets or not, is speculative. But that's an area that we continue to try to look for some opportunities even if they're really small, and all those opportunities do is just get us into the state that we don't already exist.

It's a lot easier to get a Hospice business going that way than it is to go through the whole licenser application process, which can take up to nine months. So we'll continue in those efforts. And again thanks for your time and give Bryan or I a call with any follow-up questions you have, and we'll talk to you soon. Thanks.

Operator

That does conclude today's call. You may disconnect your lines at this time

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Source: Sun Healthcare Group Inc. Q1 2008 Earnings Call
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