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Sun Healthcare Group, Inc. (NASDAQ:SUNH)

Q2 2008 Earnings Call Transcript

August 7, 2008 1:00 pm ET

Executives

Michael Newman – General Counsel

Rick Matros – Chairman and CEO

Bryan Shaul – EVP and CFO

Analysts

Eric Gommel – Stifel Nicolaus

Rob Mains – Morgan Keegan

Bryan Siu [ph] – Sidoti & Company

Rob Jacobi [ph] – Credit Suisse

Steve Alokati [ph] – UBS

Andrea Bici – Schroeders

Donald Hooker – UBS

Frank Morgan – Jefferies & Company

Operator

Good day, everyone, and welcome to today's Sun Healthcare Group, Inc. 2008 second quarter earnings conference. Just as a reminder, today's call is being recorded. At this time for opening remarks, I would like to turn the call over to Mr. Michael Newman, General Counsel. Please go ahead, sir.

Michael Newman

Thank you. Good morning. I hope you all have seen our press release announcing earnings of Sun Healthcare Group for the second 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 of financial performance. Although Sun Healthcare believes that the expectations reflected in any of its 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 in our report on Form 8-K filed with the SEC yesterday, a copy of which may be found on our website.

I will now turn the call over to our Chairman and CEO, Rick Matros.

Rick Matros

Hi, everyone. Thanks for joining us. I am real pleased to report another strong quarter. Let me start out with a couple of general comments. The final rule, the 3.4% increase or the rollback of the recalibration, I should say, translates to about – excuse me, we had to rollback the recalibration of the 3.3% of the market basket with an increase from 3.1% to 3.4%. That 3.4% translates to 3.3% for Sun. That 3.3% is approximately $15.3 million in revenues annually.

Another issue that affected what I will address for the quarter is the two facilities that we noted are now in discontinued operations. One facility is our Terre Haute facility which unfortunately got hit pretty bad in the floods recently in Indiana and we had to shut that facility down.

Another facility was the store that we operated in Tennessee that we leased. The lease is expiring. We chose not to renew the lease as the rates are being discussed. And so, the movement of both of those facilities into disc ops negatively affected revenues by about $4.6 million for the quarter, and then EBITDAR and EBITDA by $800,000 and $700,000 respectively.

It affected us about $0.01 for the quarter, about $0.04 for the year, despite that we exceeded consensus by $0.01. So we'd have actually exceeded by $0.02, if not for that, so we feel pretty good about our ability to mitigate that going forward.

I know there are questions about whether or not we're going to raise guidance. And essentially in our existing guidance, we assumed a 3% Medicare market basket increase effective October. So the 3.3% that we're getting is a difference of approximately $0.01 for us in the quarter. So, while today we are not prepared to update guidance or revise guidance, we are positively inclined to do so some time before we release third quarter. Essentially, we only got about one month under our belt with the two facilities gone. And even though we had a strong quarter despite that anyway, we just want to get another month under our belt. And I would totally expect that we will have an upward revision again before we release our third quarter earnings. So, we won't wait that long to do that.

In terms of the Harborside acquisition, that continues to perform as we expected it to. We had synergies of $3.2 million for the quarter. Of the $3.2 million in synergies, $1.9 million were in operations, $1.3 million related to corporate overhead, and since the closure of the acquisition, we now have $14.1 million banked in synergies today, so we're almost at the high end of our range. Right now, we fully expect to get there and ahead of schedule as well.

All the results that I will be discussing today are normalized for the $3 million in reductions to our self-insurance reserve. And most of you will recall that it's something that we do, the second and fourth quarter of every year, accretive to balance sheet and it usually has nothing to do with continuing ops, and that continues to be the case in the current quarter.

As we compare results for the second quarter of '07, the second quarter of '07 had $9 million in reductions for the self-insurance reserve, as well as about $1.5 million in one-time items related to the Harborside acquisition. And both of those normalizations are consistent with what was presented at the time in the second quarter of 2007.

The company's revenues were up $24.2 million or 5.6% to $454.2 million. EBITDAR increased $7 million, 13%, to $60.8 million. Our EBITDAR margin improved 90 basis points to 13.4%. Our EBITDA increased $9.1 million or 27.6% to $42 million. Our EBITDA margins improved 160 basis points to 9.3%. Our income from continuing operations increased $3.4 million or 44.2% with EPS growing from $0.18 to $0.25 for the quarter.

I will now move on to our Inpatient segment which is SunBridge. SunBridge's revenues were up $21.8 or 5.7% to $402.9 million. EBITDAR increased $5.9 or 9.1% to $71.3 million. Our EBITDAR margins improved 50 basis points to 17.7%. Our EBITDA increased $8.1 million or 18.1% to $52.9 million, and our EBITDA margins improved 130 basis points to 13.1%.

The margins at our Inpatient segment were a little bit hampered by the starts of our hospice business. Our intent is to have our hospice segment which is called SolAmor to be a separately reported segment in the future. But, at this point in time, it's too small for us to break out. And as we've noted on prior calls, we are growing this business organically. We are opening up in new states and we're simultaneously opening up in three new states as we speak; Massachusetts, New Hampshire, and Connecticut. And two days ago, we received our Medicare certification for Massachusetts. So, all of that is good news, but as with any startup, there is a certain investment that comes before you get the ROI.

And so, in our case, if the hospice business was not embedded in the Inpatient segment, the Inpatient segment would have been 20 basis points higher in terms of its margin growth.

Occupancy in our Inpatient segment dropped 100 basis points to 88.6% very much by design and we saw the offsets with the strongest field mix to date. In our SNF Beds, skilled mix was 20.5%. Again, that is our highest to date, slightly higher than the 20.4% we saw in the first quarter of '08 which at that point was the highest. 16.5% of that 20.5% was Medicare. The skilled mix for the quarter was 140 basis points better than Q2 '07.

Skilled mix as a percent of revenue increased 290 basis points to 38.9%, of which 32.7% was Medicare. So, we are really seeing terrific execution there and it further justifies the strategy that we've been talking about for the last plus year.

Medicare A rates were up 8.2% to $415.37. Our RUGS extensive services category improved 190 basis points for the 39.3%, our rehab RUGS improved 180 basis points to 84.2%, our Medicaid rates increased 4.3% to $166.59, and Medicaid as a percent of revenues in our Inpatient segment dropped 220 basis points to 44.8%. That is our lowest reported dependency on Medicaid to date. Our managed care rates grew 8.5% to $348.75.

I would like to take a minute to give you some stats on our rehab recovery suites and we still are on target to have 50 opened by the end of 2008. Our skilled mix in those centers with rehab recovery suites was 23.7% versus 19.4% in those without. Our RUGS extensive service category was 42% versus 38.1% in those centers that did not have the rehab recovery suites.

Our rehab RUGS was 84.8% or 80 basis points better than those centers that didn't have the rehab recovery suites. And our average length of stay within our rehab recovery suite units was 26.7 days versus 33.7 days in those that didn't have the suites. So we're seeing pretty dramatic differentials between the facilities that have the rehab recovery suites and those that don't. We look forward obviously to going into 2009 with not only 50 suites but to have suites that are more mature than what we've experienced so far in 2008.

Labor was very well controlled for the quarter. Labor with benefits as a percent of revenues decreased 100 basis points to 50.8%. Actual labor and benefit costs were up 3.6% for the quarter, so a little bit less than we anticipated there. Now, let me move on to SunDance which is our contract rehabilitation business.

SunDance had very strong revenue growth that we haven't seen quite a while with this business segment. Revenues grew 14.4% to $35.6 million. EBITDA grew 11.5% to $2.7 million. We did have a drop of 20 basis points in the margin from Q2 '07 to 7.6%. That was solely a function of the fact that in Q2 '07, we had really done a great job cleaning up our receivables and have collected more than 100% of revenues. Our receivables are in very good shape at this point and we still collected close to 100%, but that accounts for the 20 basis point differential. We are actually real pleased with the progress that we continue to see in SunDance.

Productivity was very strong, improving 60 basis points to 71.7%. Labor costs were up 4.5%, so again a little bit more moderate than we have anticipated, and we're starting to see some good contract growth. We had 425 contracts this quarter versus 379 contracts in Q2 '07.

Next, I'll move on to our staffing segment, CareerStaff. CareerStaff had another good quarter. They have good quarter every quarter, it's just a great little business. Revenues grew 5.7% to $30.9 million. EBITDA grew 17.7% to $2.6 million. EBITDA margins improved 90 basis points to 8.6%, and the billed-to-paid spread which is one of the key metrics that we always focus on improved 14.2%. So we still had some flexibility in pricing despite some of the increased costs that we see associated with labor in the staffing sector.

Before I turn the call over to Bryan Shaul, our CFO, and after Bryan, then we'll go to Q&A, is one of the matters that I wanted to address in. There was an article that came out in The Wall Street Journal that got posted on Yahoo Finance, and the only reason I'm mentioning it is because it's the first thing you see when you pull our stock up and it mentions us in it. Basically, it's an article that talks about patient dumping by nursing homes and no allusion to us in that regard and we never engaged in that, but the issue that I have with the article and the integrity of the reporter and (inaudible) from the Wall Street Journal is he talked on and on about patient dumping and cites examples with some facilities and it quotes one of the analysts about – some of those in the nursing home sector that are focusing on the short-term rehab patients and then talks about Sun Health focusing on the short-term rehab patients, and the differential in rates that we see between Medicare and Medicaid. But the way we are sort of strategically placed after he talks about patient dumping implies there's a link there. So, I just want to point that out that, from our perspective, it's just a very badly written article that shows a real lack of integrity. And in terms of patient dumping, it's certainly something that this company has never engaged in nor would ever engage in.

So, with that, I'll turn the call over to Bryan Shaul.

Bryan Shaul

Thank you, Rick. I'll begin my prepared remarks by updating you on our debt structure. As of June 30, 2008 we had $348.1 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 have $200 million outstanding under our 9.125% senior subordinated notes at June 30.

After giving effect to the impact of our $150 million interest rates swap agreements which includes $50 million of the interest rates swap entered into on July 24, we have approximately 69% of our total debt of $730.1 million with fixed term rates. Including amortization of deferred financing cost as of June 30, our weighted average fixed term rate on our debt is 8.37%. Our weighted average variable rate on the remainder of our debt is 5.29%. The all-in weighted average is 7.41%, down 21 basis points from the previous quarter.

We have $50 million outstanding under our letter of credit facility at June 30, 2008. At the end of the quarter, we had available liquidity of $118.4 million comprised of $68.4 million of cash and cash equivalents on the balance sheet and $50 million of available borrowing capacity under our revolving credit facility.

Using June 30, 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 June 30 is 4.4 to 1. That is based on total debt outstanding of $730.1 million, less excess cash of $58.4 million and normalized LTM EBITDA of $152 million. We comfortably meet all our bank covenant requirements at June 30, 2008.

Before I turn to our cash flows, I'd like to highlight certain events related to our discontinued operations. As Rick discussed earlier in the call, we experienced a flood in our Terre Haute, Indiana facility in early June. As a result of the flood damage to our center, we recorded a $1.8 million impairment charge in the quarter and reclassified the Terre Haute center to discontinued operations.

Also during the quarter, we elected not to renew the lease on our Hillside center at Kingsport, Tennessee and accordingly have reclassified this center to discontinued operations. The combined quarterly impact of the re-class of our Hillside and Terre Haute centers to discontinued operations on the previously reported 2007 second quarter was $4.6 million decrease in revenue and a $700,000 decrease in EBITDA. There was a $4.7 million decrease in revenue and a $600,000 decrease in EBITDA impact on the previously reported first quarter in 2008.

On July 1, 2008, we receive $9.5 million in cash proceeds from the sale of two standalone hospitals. The sale was recorded in the second quarter and resulted in a pretax loss of $2.7 million to discontinued operations.

Now, turning to cash flow, for the quarter, we reported $18.1 million in GAAP cash flow provided by operations. Our operating cash flows were derived from our $9.7 million of net income combined with $24.7 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, we used $16.3 million in cash flow. Our DSO for the quarter was 45 days, sequentially flat as compared to our first quarter of 2008. Cash used for investing activities during the first quarter totalled $10.8 million. Our investing activities for the quarter principally related to our capital expenditures which totalled $10.2 million. We also paid cash of $700,000 as part of the total purchase price of $5.9 million to acquire two of our lease centers in New Mexico, thereby increasing the owned portion of our portfolio to approximately 40%.

Our capital expenditures in the second quarter 2008 were principally related to improvements to our Inpatient centers including the build-outs of rehab recovery suites and IT system enhancements. We anticipate total capital expenditures for the year to be in the range of $40 million to $45 million.

Net cash used for financing activities in the quarter totalled $1.8 million. Our principal payments for the quarter totalled $22.1 million, which includes ongoing mortgage and capital lease payments as well as the refinancing of an existing $20 million mortgage note associated with five of our centers. Cash from long-term debt borrowings increased $20.3 million due to the mortgage refinancing of these five centers.

As we have discussed in prior earnings calls, we evaluate the adequacy of self-insurance reserves on a quarterly basis. And on a semi-annual basis in the second and fourth quarters, we performed detailed actuarial analysis to support our management evaluations.

As a result of the most recent management evaluations, which included an outside actuarial review, we determined that our prior year self-insurance reserve for our workers' comp and GLPL programs were overstated on a pretax basis by a net $3 million, with $2.7 million related to our prior period's continuing operations, and $300,000 related to prior period's discontinued operations.

Our total self-insured reserves at June 30, 2008 of $55 million included general and professional liability reserves of $83.1 million, workers' compensation reserves of $64.8 million, and employee group health insurance reserves of $7.1 million.

As of June 30, 2008, $70 million of the total workers' comp liability and $4.2 million of the total GLPL were collateralized by either restricted cash or letters of credit.

Taking a look at our 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 carryforwards as a result of ownership changes. These annual limitations consist of $10.3 million on Sun's and Peak's NOL carryforwards and $14.6 million on Harborside's NOL carry forwards.

If they were not fully utilized in any one year, they can be carried forward to the next year. Due to unused section 382 limitations from prior years, the current year's section 382 annual limitation 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.

As a result, we expect cash payments before income taxes to be in the range of $7 million to $8 million for 2008 primarily for A&P and state income taxes. Actual cash payments for the second quarter were $1.1 million.

Assuming we hit our targets in 2008, we expect that there will be at least $70 million of NOLs which will be available to offset US taxable income in 2009.

From a balance sheet perspective, we believe that it is still necessary to have evaluation allowance on a portion of our net deferred tax assets. However, if we determine that sufficient positive evidence exists in future periods to enable us to reverse part or all of the evaluation allowance of $132.9 million as of June 30, 2008, then 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.

From a corporate overhead perspective, I have a couple of things to share with you. I am pleased with our progress in our IT initiative involving the implementation of an electronic clinical record system which will also feed into and enhance our billing revenue system. We signed contracts with third party IT vendors in the quarter which served to further advance our progress on this important initiative.

I am also pleased with our continued progress in reducing our corporate overhead costs as a percent of revenue. For the quarter ended June 30, 2008, our normalized corporate overhead costs as a percent of revenue was 3.6%, down 30 basis points as compared to the same quarter prior year.

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

Rick Matros

Thanks, Bryan. He had more to say than I did. That's pretty good. Why don't we turn it over to question-and-answer right now?

Question-and-Answer Session

Operator

(Operator instructions) We'll go first to Eric Gommel of Stifel Nicolaus.

Eric Gommel – Stifel Nicolaus

Good afternoon. Just a couple of questions. There was a lag in the physician fix bill getting passed, and I'm curious if that had any impact on your therapy business from a therapy cap perspective, did you have to do anything with managing the therapist's time and such given that there was a short period there where the cap was actually in place?

Rick Matros

No, not at all, we assume that it was business as usual. We had a very high level of confidence that it was just going to be a timing issue, once this would be retroacted. So, we had massive amounts of communication both to our Inpatient-affiliated business and to the non-affiliated costumers that they were getting full service and we didn't want any gaps whatsoever.

Eric Gommel – Stifel Nicolaus

And the final rule from – the SNF final rule that came out last week was I think a surprise, in the sense that they ended up rolling back this downward revision in the RUGS, and I'm curious what you think the impact might be on maybe the potential that they do something in 2010 to RUGS, or does that increase any risk that there could be changes further out for the SNFs?

Rick Matros

I can appreciate you guys always looking to the downside. There's no connection whatsoever. I think we were all surprised that we got a complete rollback. As you know, I've been saying all along that we would get at least a partial rollback. We had unbelievable support from a lot of our friends in the Senate and the House in terms of their discussions with the White House in that regard. But we're going to have an election in November and this is going to be a whole new ballgame next year. The guys that are there today aren't going to be the guys that are there next year. What happened this time has no – there is no overhang to [ph] what happened this time into whatever the annual battle is next year. I mean, every year we have a battle over something.

Eric Gommel – Stifel Nicolaus

Okay, great. Thanks.

Operator

We'll go to next to Rob Mains of Morgan Keegan.

Rob Mains – Morgan Keegan

Yes. Good morning. Interesting comment on your part about the second quarter margins and Inpatient could have been better. So, I think they were kinda record highs, weren't they?

Rick Matros

Yes. They were record highs.

Rob Mains – Morgan Keegan

Okay.

Rick Matros

Unfortunately, we can't treat the hospice business as a separate segment and we are going to be investing in it and growing in it. So, it was too small prior to this to have any impact at all. They had a slight impact this quarter so I thought I should point it out.

Rob Mains – Morgan Keegan

Right. Also, the margin on the rehab business also is pretty high. Could you remind us a little bit seasonally what we should be expecting in terms of the patterns for those margins?

Rick Matros

Yes. I think on a sequential basis, you'll see for the Inpatient business, slightly lower occupancy, you'll see a lower mix. But on year-over-year basis, we still expect mix improvement. I think what we will see in the third quarter is similar to what we saw in the first and second quarters, which is we'll have a year-over-year drop-off in overall occupancy but a nice improvement is mix. So we expect that to continue in the third quarter but sequentially, clearly it will slowdown.

On the rehab business, same kind of thing, sequentially we'll have a drop-off in RUGS. We're not going to see 14% growth in the third quarter on a year-over-year basis. But, we will have I think a nice comparative – with nice comparative metrics in the third quarter of ‘08 versus the third quarter of ‘07 that we had business as well. And then I will say the same thing for career staff. All these businesses have some seasonality to them, and obviously that's reflected in everybody's estimates out there, but we think we're going to have a nice quarterly comparison.

Rob Mains – Morgan Keegan

And then, the business bounces back some in Q4, right?

Rick Matros

Yes. Q4, you got a lot of strength going into those last few months. Your equity starts picking up again and then our mix starts growing again and we're still playing around with occupancy a little bit as I've been talking to you guys about and we actually – we've gone back for two years and looked at every quarter in terms of where our occupancy, our mix is and the effect on both EBITDA and the EBITDAR margins. And the correlation is really strong despite the drop-off in occupancy or the gains that we're seeing on mix and the subsequent growth in margin. Very much the opposite of what we saw in the third and fourth quarter last year, where occupancy was really strong but the mix wasn't improving as quickly as we would have liked to. So, we are still playing around with it a little bit, but yes, I would expect in a sequential basis field mix to improve in the fourth quarter over third quarter.

Rob Mains – Morgan Keegan

Okay. One question on the rehab, kind of turn the last one around, did you see in the two weeks before we got the physician fix any reluctance on the part of Part B patients to order a therapy and kind of hoarding their hours?

Rick Matros

No. Maybe there might have been a tiny bit in assisted living, but our assisted living business within SunDance is a pretty small component. So, if there was any, it wasn't enough to move the needle.

Rob Mains – Morgan Keegan

And then, given the margin performance that you had in the quarter, could you talk – I know you've not given out '09 guidance at this point, but certainly you're feeling about where margins can go in Sun?

Rick Matros

I think our margins have been pretty strong obviously, the growth in part because [ph] it's synergy. Next year, we are not going to have synergies but I kind of stick by with what I've been saying and that is we still expect to see at least 100 patient point margin growth in the EBIDA line and more in the EBITDAR line without synergies in '09 versus '08. The $15.3 million obviously helps because we'd like to think that we can maintain that 7% to 8% Medicare rate growth and without that 3.3%, obviously it wouldn't have happened but that translates to a little bit over $0.20.

We feel really good about what we see in our EPS growth in '09 over '08 and still feel, as I've been saying, that while we have taken this hiatus from doing deals that we got a long runway ahead of us. And it would be nice if we can find kind of a nice deal to do next year. But we've got plenty of organic growth ahead of us to get us through 2009 and 2010. That will be opportunistic but we don't have to worry about it. We don't have to feel pressured into doing something in order to exact growth out of the company.

Rob Mains – Morgan Keegan

And then one deal-related question, what's your appetite generally speaking about buying other people's operations versus buying your own real estate?

Rick Matros

I think as deals start coming up and we really haven't seen very much activity this year at all, so there hasn't been a whole lot to look at, we are still going to focus on – if we can find a regional chain with 20, 30 buildings, that is ideal for us because we can kind of suck it up pretty easily into our size. But we will definitely focus on deals that have more owned properties than leased properties.

Rob Mains – Morgan Keegan

Okay. Speaking specifically of your own properties, if opportunity were to rise –?

Rick Matros

In terms of our own properties, we are going to be exercising the purchase options that are available this year. Bryan had mentioned we have about – we are at about 40% own properties now. Once we exercise the options available for us this year, we will be closer to 45%, and then we've got a few after that. But on a same store basis, we are not going to move that number up appreciably. That number is going to change appreciably only for acquisitions.

Rob Mains – Morgan Keegan

Okay, very good. Thanks a lot.

Operator

Bryan Siu [ph] from Sidoti & Company has our next question.

Bryan Siu – Sidoti & Company

Good morning. A quick question about leases. You mentioned that one of the centers that you had shut down was due to unfavorable lease terms, I was wondering if you are sort of seeing that going forward as a trend or that is just a one-off?

Rick Matros

It's a one off. We've got long term leases in almost all of our buildings. This is a one-off with an independent landlord and we were fully prepared to negotiate a reasonable rate increase to reflect our market conditions, and he just wanted more, so it's just a one off. No trends at all.

Bryan Siu – Sidoti & Company

In terms of facility ownership, do you set any kind of target as to what you would like to see in terms of the consolidated portfolio?

Rick Matros

No, it's really not possible to set an ultimate target. It's possible to set a target given the options that we have within our existing portfolio to exercise. Fortunately in our case, every one of those options were negotiated at a point in time that makes them very attractive now. And so, it's an easy decision for us. So, we look at it, we can say with this next tranche of options that we have a bill to exercise on the leased properties, it can get us to 45%. But when we look at our portfolio and the opportunities we have within it on a same store basis, we're not going to get above 50%. So, you can't really set a target above that. You can set a goal to exceed that, but that goal has to be achieved then through acquisition.

Bryan Siu – Sidoti & Company

Okay.

Rick Matros

But I don't want to box myself in by not looking at a good deal because 30% of the buildings were leased. But we are careful in that regard in terms of goal setting and boxing us in.

Bryan Siu – Sidoti & Company

If you can quantify it somehow or you give a ballpark figure of that, what would you say like at this point in time constitutes a favorable or unfavorable lease, or does it depend on the area?

Rick Matros

It really depends on the area because we are in so many different communities. It depends on the area. But, I really can't – there is no way really to ballpark. And in our case, our leases are so long term where we've got options that are already baked into or to the extent of leases that are kind of not relevant to us anyway.

Bryan Siu – Sidoti & Company

Just switching gears, this is probably beating a dead horse, but in terms of food and utilities, if you could quantify percentage-wise how that comes out in your operating expenses this year versus last?

Rick Matros

Yes. We have seen some increase. It's really been relatively flat. Our food costs as a percent of revenue vary on a month-to-month basis around 2.2% to 2.3% of revenues. It's approximately a $35 million, $36 million spend. I don't have the percentage of utility costs as the percent revenue at my fingertips right now. But actually, I may have it in a second, but that's been relatively flat. Have you got that, Bryan?

Bryan Shaul

Yes. It's running around 2.8% now and is fluctuating.

Rick Matros

Utilities is running about 2.8%, give or take 20 basis points.

Bryan Siu – Sidoti & Company

Okay. Are you undergoing any initiatives to control that or do you not feel it as an issue at all?

Rick Matros

Well, we are talking to some of the utility players to see if we can lock in some rates. And then generally speaking, we're part of a very large GPO. So, all the vendors that we have including our food vendor doesn't just negotiate with sort of our 24,000 beds, but 10 times that.

Bryan Siu – Sidoti & Company

Okay.

Rick Matros

So it gives us a lot of clout. And most of the players in the GPO are the companies that are part of the alliance for quality nursing home care based on DC. But, there are couple of players who are in our specific sectors that are in the GPO such as SunRise.

Bryan Siu – Sidoti & Company

Okay, thank you.

Operator

From Credit Suisse, we go to Rob Jacobi [ph].

Rob Jacobi – Credit Suisse

Great, thanks. I just wanted to go back to guidance just to clarify – clearly, you are not changing guidance today. It seems like you have maybe a more positive bias to the current guidance range and at the same time, you're absorbing the $0.04 from those facilities that are now in discontinued ops. Is that a fair way to look at it?

Rick Matros

Yes, we do have a positive bias. We've only got one month to close financials since those facilities went into disc ops. So I just want to get another month or so under my belt that's all.

Rob Jacobi – Credit Suisse

Okay, and then just in terms to clarifying for '09, you said you still expect 100 bips of margin improvement?

Rick Matros

Correct

Rob Jacobi – Credit Suisse

Okay. And then, maybe can you talk about the referral network and whether you think there's still that low hanging fruit from discharge planners that still maybe generally you referred it to the higher cost settings or you think – how do you think that sort of played out at this point?

Rick Matros

I don't know that it has played out, but let me clarify a couple of things. Only about half of our centers are in the same market radius as either an L pack or an IRS. There are a lot less IRS than L pack in our nursing homes. So there's a limited number of markets out there where you are competing directly anyway. And so, most of the markets, the discharge clients and physician groups don't even have that option where we exist. That said, I don't think that we're finished with it yet primarily because we're not at the point where we sort of look ourselves in the mirror and think that we are executing real well from a business development perspective. So even though we are real pleased with kind of how far we've come particularly with the development, the rehab recovery suites and skilled mix overall, we can get a lot better at it. So, I think that there is some room for improvement on a same store basis. Generally in the portfolio and then obviously as we open more rehab recovery suites, that adds a little bit more muscle to that movement. And I do think that for sophisticated referral sources that are used for high-end settings, having those rehab recovery suites helps bolster the image of nursing centers in their minds.

Rob Jacobi – Credit Suisse

Okay. And then on the acquisition side, it sounded like you said you haven't missed sort of too much at this point. I guess do you think the better Medicare rate either changed the pool of availability out there or the pricing for acquisitions at all?

Rick Matros

It's a little bit hard to tell, because I think the lack of activities has been the result of both the uncertainty about reimbursement and the credit markets. So now that there's a lot less uncertainty about reimbursement, I don't know how much – because the credit markets haven't recovered yet, how much that is still going to impact deal flow, because we really – even in deals that we've seen, haven't gotten consummated. So, it's a little bit hard to tell. For us, it's beneficial because we don't want to do anything yet anyway, although we do continue to be very active looking for hospice acquisitions, but the regional players just aren't ready to do deals now, and so anything that we think may happen is going to be really small. But at least it would allow us to get into a state more quickly without incurring some of the startup costs that happen with a de novo hospice business.

Rob Jacobi – Credit Suisse

And then just one last one. In terms of Medicaid, any changes to expectations among any of the states or anything that we should be aware of sort of in the back half of the year or into next year?

Rick Matros

No, certainly not in the back half of the year, because in almost all cases, Medicaid rates comes out in July and August.

Rob Jacobi – Credit Suisse

Alright

Rick Matros

So, and we don't expect anything different than we have – than we've already seen. And so I think we're pleased that we have the 4% rather than the 3% that we've anticipated. But we're assuming in the projections that we're developing for 2009 in our budget process, we're assuming a stable Medicaid environment.

Rob Jacobi – Credit Suisse

Great, thank you.

Operator

Steve Alokati [ph] from UBS has our next question.

Steve Alokati – UBS

Actually I was going to ask the Medicaid question, but you just answered it. So, thanks.

Rick Matros

Okay.

Operator

(Operator instructions) From Schroeders, we'll go to Andrea Bici.

Andrea Bici – Schroeders

Hi, what was you cash flow from operations?

Rick Matros

Say again Andrea?

Andrea Bici – Schroeders

Cash flows from operations?

Bryan Shaul

$18 million.

Andrea Bici – Schroeders

$18 million. Okay, thanks.

Rick Matros

Thanks Andrea.

Operator

We'll go next to Donald Hooker of UBS.

Donald Hooker – UBS

Great, good afternoon.

Rick Matros

Hey Donald, long time.

Donald Hooker – UBS

Yes. With regards to everyone was talking about, thinking about what you're going to do with your balance sheet down the road, like with regards to the funding side, the debt side, where do you think – where should we think about that going, what debt level would you be comfortable making – to start re-levering up?

Rick Matros

Well, we're comfortable with where we are right now. I mean we're way ahead of schedule. When we did the financing for the Harborside deal, we were at 6.1 debt to EBITDA. Now were 4.4, so we are way ahead of schedule and well on our way to our goal of 3.5 times and we'll be months ahead of schedule on that. So we were – it's funny how it kind of goes because that was the one downside that everybody pointed out on the Harborside deal that we levered up to do it, when in reality we were healthier as a result of that deal than we were before.

So we don't want to lever up to that extent again. But we're real comfortable where we are right now. And it depends on the deal, if you do the right kind of deal from a synergistic perspective that allows you to deleverage relatively quickly, you may not have a problem going to 5.2 times or 5 times, because you can see a way to getting back to that 3.5 times.

But on the other hand, you don't want to do a deal that's going to lever you up when you really don't have the kind of bankable synergies that we knew we had with Harborside and Peak before. So you really have to look at it from that perspective. But I don't think we want to lever back up to where we were when we did the Harborside deal, just because the credit markets are in a different place and debt is a lot more expensive. That was one of the advantageous things at that point in time, and one of the reasons that we were so comfortable in being where were from a leverage perspective, because the debt was so cheap that we used to finance the deal. It makes all the difference in the world.

Donald Hooker – UBS

Got you. And just a detail question, I don't know if you mentioned your goals to get the 50 rehab recovery suites by the end of the year, did you mention where you were actually at the end of the quarter?

Rick Matros

Yes, we're at 38, we had planned on opening two units in the second quarter. The bulk of the new units opened in the third and fourth quarter. We had planned on opening up two units in the second quarter and they are just about done, there was just timing issues getting approval on construction issues.

Donald Hooker – UBS

Got you. In the economics there, I think you mentioned in the past about the – correct me if I remember wrong, but it's about 100 basis points difference in margin between the rehab and the non-rehab?

Rick Matros

We've actually seen that move up to about 150 basis points.

Donald Hooker – UBS

Okay, great. Well, I'll jump off, thanks for the comments.

Operator

(Operator instructions) We'll go next to Frank Morgan of Jefferies & Company.

Frank Morgan – Jefferies & Company

Good afternoon.

Rick Matros

Hi Frank.

Frank Morgan – Jefferies & Company

Hi, question here just to clarify, the guidance that you'll update, will that be just for the remainder of 2008 or will it also include 2009?

Rick Matros

It will be for 2008, we're not going to do 2009 until later on. We base our annual guidance on our budget and it wouldn't be great to put guidance after 2009 in the next couple of months and then actually ask our operators to believe that they have implemented their budgets.

Frank Morgan – Jefferies & Company

Secondly, going back looking at your discussions about increasing the margins 100 basis points year over year from 2008 to 2009, how much of that would you attribute to basically just having a full year's impact of the synergies? Because clearly this year has been sort of a ramp up in that, but how much of the 100 basis point year over year increase would you say is attributable to just a full year impact of having the synergies in there for the full year, and what were the other sources that go with that?

Rick Matros

I'm not sure that we attribute a whole lot to having the full year impact. I think that, and we look at ourselves with or without synergies internally. We think it's a pretty pure basis point improvement in 2009 over 2008 that's primarily driven by mix shift and to a lesser extent hopefully further efficiencies on the infrastructure side.

Frank Morgan – Jefferies & Company

How much of the mix shift is predicated on having units opening in 2009 or in most of that accomplished by having these 50 units online for the full year effect in 2009?

Rick Matros

It's primarily from the full year effect of, because let's say by the end of 2009, we will be at 65 or so. I think because most of our units, the remaining 12 units for this year will be opening up in the third and fourth quarter, we'll be spending a lot of time early in the year fine-tuning those. And so, the units that will be opened by the end of 2009 will probably be a little bit heavily weighted towards the backend. So it's primarily the 50. Plus the other thing I should note is that, we're going back and taking a look at some of rehab recovery suites that were opened up really early on where I think the approach probably wasn't as analytical as it is today. We've got some units out there that don't perform as well as we'd like. We've got some units out there that we think aren't sized appropriately. And so part of it we are going to be focused on doing is not just opening up new units, but going back and revisiting some existing units and maybe setting some capital on that and tweaking some.

Frank Morgan – Jefferies & Company

Okay, thanks.

Operator

And it appears we have no further questions at this time. I will turn the conference back over to Rick Matros for any closing remarks.

Rick Matros

Thanks very much. I appreciate everybody's time today. As always, Bryan and I are available to any additional conversations that you want to have. And I know that Brian and I have like everybody [ph] would be pretty busy getting back out the conference season again and doing marketing trips. So we look forward to seeing a lot of you fact to face on the road. And again, we're real pleased with the quarter. Once I stop tripping over my tongue, so I can articulate it. But again, please give us a buzz if you've got any additional questions and we'll look forward to talking to you and seeing you on the road. Thanks.

Operator

And that concludes today's conference. We thank you all for joining us.

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