Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

HealthSouth Corp. (NYSE:HLS)

Q2 2008 Earnings Call Transcript

August 6, 2008 8:30 am ET

Executives

Jay Grinney - President and CEO

John Workman - CFO

Mark Tarr - EVP of Operations

John Whittington - General Counsel

Analysts

Adam Feinstein - Lehman Brothers

Rob Hawkins - Stifel Nicolaus

Gary Lieberman - Stanford Group

David McDonald - SunTrust

Frank Morgan - Jefferies & Company

Kemp Dolliver - Cowen & Company

Miles Highsmith - Credit Suisse

Dawn Brock - J.P. Morgan

Derrick Dagnan - Avondale Partners

Operator

Good morning, everyone, and welcome to HealthSouth Second Quarter 2008 Earnings Conference Call. At this time, I would like to inform all participants that your lines will be in a listen-only mode. After the speakers’ remarks, there will be a question-and-answer period. (Operator Instructions). Today’s conference call is being recorded. Your participation implies consent to our recording of this call. If you have any objections you may disconnect at this time.

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

Jay Grinney

Thank you, Ray, and good morning everyone. With me on the call in Birmingham today are John Workman, Chief Financial Officer; Mark Tarr, Executive Vice President of Operations; John Whittington, our General Counsel; Andy Price, Senior Vice President of Accounting; Ed Fay; Senior Vice President and Treasurer, and very importantly, Mary Ann Arico, our new Senior Vice President of Investor Relations and Corporate Communications.

Mary Ann assumed her new responsibilities on August 1st, and joins us from the Mirant Corporation where she served as the Director of Investor Relations. Prior to Mirant, Mary Ann held Senior Investor Relations positions at Duke Energy and Eastman Chemical. She brings a wealth of experience to her role and we are delighted to have her as the newest member of our senior management team.

Before we begin, I’d to like John Whittington to read the cautionary statements.

John Whittington

Thank you, Jay. There are a number of disclaimers, risk factors, and other cautionary statements set forth in the Form 10-Q that we will be filing with the SEC later today, and in the press release we filed yesterday in connection with the filing of our Form 10-Q. We will not review these disclaimers, risk factors and other cautionary statements, but we urge you to read them and the risk factors set forth in the company’s annual report Form 10-Q for the quarter ended March 31, ‘08 and the annual report on Form 10-K for the fiscal year ended 12-31-07.

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

You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented today, as they are based on current expectations and general assumptions that HealthSouth believes as of the date hereof are reasonable and such forward-looking information is subject to various risks, uncertainties and other factors, many of which are beyond our control, that may cause actual results to differ materially from the views, beliefs and estimates expressed here today.

All such estimates, projections, guidance and forward-looking information speak only as of the date hereof. HealthSouth undertakes no duty to publicly update or revise such forward-looking information, whether as a result of new information, future events, or otherwise.

Jay Grinney

Great. Thank you, John. We are very pleased to report today’s results, which built off of the accomplishments of the first quarter and underscore that our strategic repositioning and operational focus are achieving, and in some cases exceeding their intended results.

Compared to the second quarter of 2007 discharges were up 5.6%. Revenues were up 5.2%. EBITDA was up 8.2% and income from continuing operations increased significantly from $4.7 million a year ago to $47.2 million this year. Another important measure of our success is our cash flow. Cash from operating activities remained strong and was $67 million for the first half of the year.

Coming into 2008 we knew that gaining market share was going to be critical to our success, especially considering the Medicare pricing rollback that went into effect on April 1st. We began preparing for this last year with the launch of our TeamWorks initiatives and have devoted significant time and effort in developing and deploying the standardized sales and marketing program across all of our hospitals.

In the first quarter TeamWorks was fully installed in 44 of our 93 hospitals, and we realized a 2.7% quarter-over-quarter increase in discharges. These results were even more impressive in light of what was occurring within the industry. According to the Q1 UDS report, there was a 3% decline in discharges in the first quarter for those units reporting on the UDS system.

In the second quarter 76 of our 93 hospitals were fully installed on TeamWorks, and we saw a 5.6% increase in discharges. As we have previously reported all of our hospitals will be fully installed by the end of the third quarter, which we believe, will drive sustained volume growth for the foreseeable future and will allow us to successfully mitigate effects of the pricing rollback.

From an outpatient perspective, we continue to see the benefits from our decision to close approximately 20 underperforming outpatient satellite clinics last year. While reported outpatient business were down in the quarter compared to prior year, on a same-store basis, excluding these closed units, visits were actually up nine-tenths of a percent, and on a sequential basis, they were up 4.4%. This favorable trend suggests that our outpatient business has finally stabilized.

In addition to this impressive organic growth, we continue to make excellent progress with our development agenda. In April we announced the signing of a definitive agreement to purchase the 34 bed rehabilitation hospital of South Jersey located in Vineland, New Jersey. We close on this acquisition on July 31st, and are delighted with the addition of this hospital for our New Jersey network.

In June, we received a certificate need from the state of Florida to build a new 40 bed in Marion County. While this CON is being contested and is progressing through the normal appeals process, we believe the merits of this CON are very strong and look forward to a timely resolution of this matter.

In July, we achieved two development milestones. First, we announced the signing of a definitive agreement to purchase a 30 bed rehabilitation unit in Arlington, Texas, which we expect to close on today, and which will create an immediate consolidation opportunity with our Arlington hospital.

And second, we were granted a Certificate of Public Need by the Commonwealth of Virginia to build a new 40 bed hospital in Loudoun County, Virginia. In granting this Certificate of Public Need the state health commissioner cited the population growth in western Loudoun County and the enhancement of competition in that market as predicates for her decision.

These are all terrific projects that will enhance our presence in the New Jersey, Florida, Texas and Virginia markets. Our development pipeline remained strong and we expect to announce additional transactions in the second half of this year.

The biggest uncertainty we face as we entered the quarter was the impact of the Medicare pricing rollback might have on our revenues. Fortunately, with the continued emphasis on treating higher QD patients, such as stroke, hip fracture and neurological patients, coupled with solid improvement in our managed care pricing, our net patient revenue per discharge was actually up by approximately 1% in the quarter compared to the year ago.

Coupled with our ability to drive market share, this better than anticipated pricing resulted in a 5.2% increase in net operating revenues in the quarter compared to the same period in 2007.

Adjusted consolidated EBITDA came in at $85.4 million, which represents an 8.2% increase over the second quarter of 2007. In addition to solid top-line growth bad debt expense continued to improve from the standardization of our billing systems, and we were able to right size our corporate support functions following the divestitures of our non-core segments which lowered our G&A costs.

Finally, in the quarter were accelerated our deleveraging plan with the secondary offering and used a process of the proceeds from this offering to pay down debt which helped to significantly improve our earnings per share.

With that brief overview, I’ll now turn the agenda over to John Workman for a more comprehensive review of the quarter.

John Workman

Thank you, Jay. In addition to the press release we have also filed some supplemental slides on Form 8-K which will be used as we discuss our results. First starting with revenues, in our hospitals and this is reflected on slide number 3, our inpatient revenues increased by 6.5% over last year to $414.1 million, despite the Medicare pricing rollback that occurred beginning April 1st of 2008.

Discharges increased 5.6% and we had a slight up-tick in pricing of nine-tenths of a percent to $15,231 per discharge compared to year ago. We also shortened our length of stay in the quarter from a year ago to 15 days – to 14.7 days from 15 days. The higher volume provided for improved occupancy which rose to 66.4% for the second quarter compared to 64% a year ago.

In our inpatient satellites, our outpatient revenues declined 5.2% from the same quarter year ago, primarily as a result of 21 fewer outpatient satellites. On a positive note, and Jay quoted on same-store unit volume, we did see a 2.8% sequential improvement in outpatient revenues over the first quarter of 2008.

Turning next to operating expenses which are profiled on slide number 4, I first want to emphasize the Medicare pricing rollback beginning in the second quarter of 2008, as this has an impact when looking at expenses as a percent of revenues, that’s causing them to be higher due to the lower revenue base.

First, salaries and benefits proved challenging in the second quarter of 2008 as our hospitals were faced with significant discharge growth and our hospital CEOs moved quickly to provide staffing which included more expensive contract labor. As a percent of revenue salaries and benefits were 51.3% compared to 49.5% a year ago.

In addition to the inefficiencies created by the large discharge growth, the investment that we made in the benefits area, the 401(k) match, no increase in the healthcare contribution to our employees, and part-time benefits also caused the percent to increase.

Turning next to other hospital-related expenses, and these are the captions, other operating expense, supplies, occupancy and bad debt that you can find in the income statement, were a cumulative 24.3% of revenues this quarter compared to 24.5% a year ago.

General and administrative expense, excluding stock compensation cost, were 4.9% of revenues in the quarter which is a sequential improvement from the first quarter of 2008. Stock compensation cost in the second quarter was $2.7 million. While depreciation and amortization is below last year, it will increase as the announced acquisitions come on line for the balance of the year.

Next, turning to line, government class action related settlements which is a non-cash item, this primarily relates to mark-to-market the 5 million shares of common stock and the 8.3 million warrants which have a 41:40 strike price that we agreed to contribute as part of the litigation settlement. We will be required to continue to do this until the shares are ultimately distributed. Professional fees line generally relates to amounts being spent in pursuit of the derivative claims against UBS, Ernst & Young, and Richard Scrushy. As we have stated before, we expect to spend approximately $25 million this year on such costs.

Next, looking at item below operating expenses, the loss on early extinguishing of debt is the premium paid on our 10.75 bonds due 2016 that were repurchased in a pro-rata write-off or deferred financing fees on both the term loan and the bonds as those were repaid. Both of these were made possible by the equity offerings. As LIBOR increased from a level at the end of the first quarter, we had a large non-cash gain in marking our $1.1 billion interest rate swap to market. We did have a slight tax charge in the quarter, but as we said before, with our NOL and State tax refunds we do not expect to pay any significant income taxes for many years.

Next, turning to adjusted consolidated EBITDA, page 9 of the press release profiles adjusted consolidated EBITDA, which as Jay mentioned, reflects an 8.2% improvement over last year, outpacing the revenue growth of 5.2%, showing that the volume growth can overcome the negative impact of the pricing rollback. For those of you analyzing the EBITDA impact, I would remind you the third quarter is usually the lowest quarter on a seasonal basis.

Next, turning to net income and earnings per share, and this can found on slide 5, in the supplemental materials. When we discuss our net income and EPS in the quarter, we believe there are some adjustments that should be considered. These items are either non-cash or non-recurring. So, if you start with the income from continuing operations of $47.2 million in the quarter, there are adjustments for a government and class action settlement gain of $8.6 million which we believe should be excluded, the gain on the interest rate swap of $28.5 million that I have already commented along and the professional fees being spent on the derivative litigation which were in expense of 5.3. If you adjust those items, it brings adjusted income from continuing operations to $15.4 million for the quarter. A year-ago, that same comparable number would have been a $26.7 million loss. This improvement income from continuing operations is clearly very significant and well over 100%.

Next, turning to earnings per share, we want to give you two points of reference. First, on a fully diluted basis, using adjusted income from continuing operations which we have established as a long-term benchmark we have $0.17 a share of EPS which compares to $0.29 loss per share a year ago, if you ignore the impact -- the anti-dilutive impact of a loss position. Second, we know many of you look at basic EPS available to common shareholders after preferred stock dividend. On this basis, basic EPS was $0.11 a share in the second quarter compared to $0.42 a share loss a year ago, again a very significant improvement in well over 100%.

Next, I would like to talk about some items on the balance sheet, specifically long-term debt, and that is slide 6 in the supplemental materials. Our block trade transaction closed in late June 2008, and raised a $150.2 million which was primarily used to change our debt profile. We used the proceeds or intend to use the proceeds to principally pay down debt. As of this date, we have redeemed $34.6 million of 2016 notes, $25 million of that in the second quarter. The premium we paid to redeem those notes was 2.6 million. We reduced the term loan by 37.6 million. Our net revolver change, after we buyback the 10.75 notes due October 1, 2008 would be a $45.1 million reduction and will retire on October 1, 2008, 10.75 bonds for $30.3 million. That provides the expected use of the total proceeds from the FD offering. If you look at the interest savings that we would have incurred, had those items already taken place they would have been $11.6 million.

Relative to leverage, the reduction of debt will reduce our leverage ratio by approximately one-half terms. Considering the interest savings and the additional shares issued, the transaction would be accretive to EPS and is reflected in our improved 2008 guidance.

Next, if we turn to slide 7, and looking at the impact on adjusted net income of $15.4 million mentioned previously, and recognizing the higher share count, the pro-forma impact on second quarter EPS would be 8.4% accretive on a fully diluted basis which again, we have established as a long-term benchmark, a 19.6% accretive to the EPS to common shareholders on a basic basis after the preferred dividends.

Next, turning to cash flow, as the press release states and as Jay mentioned, we had $67 million generated by the operating activities for the first six months. If we turn to available cash flow, for the second quarter, starting with adjusted consolidated EBITDA of $85.4 million, our cash to interest payments were $41.8 million in the quarter, capital expenditures in the quarter were $10 million. That leaves available cash of $33.6 million. We believe this is indicative of the run rate of cash flow. It does exclude professional fees and the preferred dividend. As we have indicated, we expect to use our available cash flow for paying down debt and tuck-in acquisitions as well as for any capital monies on de novos to create a platform for future earnings growth, and you can tell based on Jay’s comments that we are making obviously progress in that direction.

We will generally looking to lease the real estate that we may initially build some of the hospitals and look to flip them via a sale and lease-back transaction so as to continue with our capital light approach.

We have talked about the $2.5 billion of NOLs, our future deductions that will shelter future Federal taxable income, the block trade equity transaction was done in a fashion and was small enough to allow us to protect those NOLs.

With that, I will turn it back over to Jay.

Jay Grinney

Great. Thank you, John. I would now like to briefly address our revised guidance for 2008, a summary of which can be found on page 4 of our earnings release. We now expect discharges to grow in the 4% to 5% range, as we have realized the positive results of TeamWorks in all of our hospitals. We are extremely pleased with this initiative and believe that it will provide sustained volume growth for the foreseeable future. To reflect these higher volumes, we have increased our net operating revenue range accordingly. As John mentioned, the significant increase in the number of patients we are treating has created some temporary staffing inefficiencies which we are addressing. The extent to which these inefficiencies can be successfully mitigated in the third quarter will determine our ability to potentially exceed the high end of the adjusted consolidated EBITDA range.

Finally, the positive impact from the deleveraging which occurred as a result of our equity offering is evidenced in our revised earnings per share guidance. The as reported diluted earnings per share range has been increased to $0.15 to $0.20 per share, while the adjusted diluted EPS is projected to be between $0.50 and $0.55 a share.

Before we respond to questions, I would like to conclude by reiterating that we are very pleased with these results, which we believe validates the strategies we have put in place. By posting another solid quarter, we have confirmed our ability to drive market share and top-line growth, sufficient to mitigate the Medicare pricing rollback. We have executed and accelerated deleveraging plan that is creating immediate positive results, and we have continued to expand a portfolio of assets to discipline development transactions.

In short, we are continuing to deliver on our promise of building long-term value for our shareholders. With our strategic and operational models demonstrate near potential we have decided to host an Investor Day this fall to coincide with our third quarter earnings release. By having this meeting in early November, we anticipate having three positive quarters from which to elaborate our story. We are working to firm up the date and location and Marianne will be communicating these to you as soon as possible.

With that operator, please open the lines for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Adam Feinstein from Lehman Brothers. Please go ahead.

Adam Feinstein - Lehman Brothers

Okay. Thank you. Good morning, everyone.

Jay Grinney

Good morning, Adam.

Adam Feinstein - Lehman Brothers

Very strong quarter. Just, I guess, couple of questions, let me just start just to talk about volumes, maybe if you could talk about the different specialties in patient mix since just to have an understanding in terms of what kind of patients you guys were bringing in during the quarter, and then, at the same time you have mentioned the industry data being pretty weak for a Q1. Just curious about your thoughts, they are in terms of how you are thinking about the industry volume growth in terms of just the market share, it seems like you guys are gaining, so just if you could just comment on just the mix for the quarter, as well as just the industry trends, and then I have a quick follow-up question?

Jay Grinney

Sure. With respect to the mix, as we mentioned in our first quarter call, there are about six conditions that represent about three quarters of our patients. And there is stroke, there is debility and other disabling impairments, there are hip fractures, there are neurological patients that we treat. There are -- there is a category called Other Ortho which is primarily conditions related to the spine, spinal stenosis, back and spinal fractures and so on. And then of course, the lower extremity joint replacements which are the knee and hip replacements. If you look at those six, the relative mix for most of those has not changed much year-over-year, nor has it changed sequentially. So, the majority of our patients are stroke patients. The second largest category would be the debility and other disabling impairments. Hip fractures would then round out the top three.

The lower extremity joint replacements, the knee and hip replacement procedures actually is fairly steady in that10-11, may be 12% range down from 22% before the 75% rule. So our mix is remaining fairly stable and it is reflective of the patients who really need a high level impatient rehabilitative care and it’s precisely where we built our program, invested our technology to meet that demand particularly in an aging population.

With respect to the industry I believe that the weak showing in the first quarter is a reflection of a couple of thing. One, the fact that most of our competitors are departments of or units within an acute care hospital, and as most of you know are going to be focusing on matters like how do they deal with the influx of bad debt coming into the emergency room, where do we put the capital to get into an open heart program or enhance the oncology program. Rehabilitation oftentimes is a secondary or even less consideration for those hospitals. So we have put our emphasis, we’ve put our focus on rehabilitation and I think that that has allowed us to continue to take market share. The other thing, and we’ve talked about this on previous calls, we have never been that reliant on the knee and hip replacements.

As we said many of our competitors were. They built their programs around their orthopedic business. And with the 75% rule and with the fact that many nursing homes are trying to get into that business and to provide that lower acuity care I think the competitors who didn’t have the sophisticated programs, didn’t have the expertise, hadn’t made the investment that we have, were going to be vulnerable those competitive threats.

Adam Feinstein - Lehman Brothers

Okay, and just one quick follow-up question, thanks for the detailed response. Just want to get your thoughts on the Medicare reg that came out the other day, they raised the [outlier] threshold, just curious how you guys think about the impact from that and was there anything else within the reg that you’re focused on?

Jay Grinney

We did have a chance to look at it and our assessment is that it’s really going to be neutral to potentially slightly positive. As you know the intent was to try to create something that would have been as neutral as possible. We see no down side in the final reg and in fact there may be, there are a lot of moving parts in that but I think net/net it is worse case it’s neutral, best case it is slightly positive for us.

Adam Feinstein - Lehman Brothers

Okay, great, thank you very much.

Jay Grinney

You’re welcome.

Operator

Thank you. Our next question comes from Rob Hawkins of Stifel Nicolaus. Please go ahead.

Rob Hawkins - Stifel Nicolaus

Good morning.

Jay Grinney

Good morning Rob, how are you?

Rob Hawkins - Stifel Nicolaus

Fine, thanks. Nice quarter guys.

Jay Grinney

Thank you.

Rob Hawkins - Stifel Nicolaus

Can we talk a little bit about TeamWorks first? I mean I understand the concept. I just want to know a little more detail about how often are you guys visit visiting, is it physiatrists, neurologists, what kind of level of detail, what kind of follow up are you seeing? And then, with some of the earlier facilities that you brought on in the program, is there kind of an early curve where they seem to get a lot of referrals and it peaks out. I just want to understand a little bit more about how that’s all going?

Jay Grinney

I want to take the second part first and I am going ask Mark Tarr, who is our Executive Vice President of Operations, to give a little more color commentary on the details of of TeamWorks. In terms of early curve, no, we are not seeing that. This is a very successful program that is allowing us to reach out even further than we have historically to new markets, to new referral sources and we are not seeing any indication that those that are on the program for a longer period of time are starting to see a trailing off of their ability to bring patients in. And again, I think it’s important for us all to remember that there is no real magic to the sales and marketing.

The ultimate magic is performed at the hospitals, by the therapists, the care that’s provided by the nurses, the quality that we provide, that’s what really differentiates us, the investment that we’ve made in our rehabilitative technologies, the fact that we have clinical pathways that are proven to be effective, those are the things that really ultimately bring the patients in, engender the trust from the physicians and brings the patient and the family members back should they need the care on a go-forward basis.

So, no, we are seeing good results. I don’t think we would have increased our volume guidance had we been concerned about any kind of trailing off. And as I said, we feel pretty good about where we were in the first half, feel pretty good about the volumes as we enter now the third quarter and we feel pretty good overall about this initiative. Mark, you want to

John Whittington

Before Mark -- one comment just to add to what Jay said is that the whole project, Rob, was built with sustainability in mind. And so, when we built the project we were very focused on not a project that would just occur and then go away but would be sustainable and that’s the way its developed.

Jay Grinney

And in fact we just launched that aspect of the roll out. I mean, we are already in sustainability phase for those hospitals that were early in the implementation.

Mark Tarr

Hey, Rob, it’s Mark. The program is very comprehensive. It’s helped us look at not only our processes for which we bring the patients in, it helps us take a look at the overall staffing levels that we need to have in our marketing team for any given market, it’s helped us on our training, our sales training. Many of our liaisons are more clinical in nature and they weren’t salespeople in general so we had to go back in and help support them on their sales training skills. It has helped us in being quicker to respond in the marketplace and get the answers back to the physicians and discharge planners on when we can and can’t accept a patient. So, It’s more than just the ability to go out and call on physiatrists, as Jay alluded to earlier, a lot of our patient mix is now coming from neurologically impaired patients. So we are focusing not only on physiatrists, but also neurologist, internal medicine, hospitals that are out there in the acute care hospital. So, it’s a pretty comprehensive program that we think will help us for the long term.

Jay Grinney

And before we take the next question, the only other thing I would remind everyone is that all the patients coming into rehabilitation hospital have to meet medical necessity and the admissions criteria are reviewed at the local level by the fiscal intermediaries, it is a much, much more rigorous admissions process and criteria driven process than, say, the acute care hospital where it’s really left to the attending physician to make that decision and there may be some pure review within the hospital but there isn’t that oversight and scrutiny on those admission that our rehabilitation hospitals have. So, the patient that we see need to care, the patient that we see are getting that care and we are really pleased with the results.

Rob Hawkins - Stifel Nicolaus

Should I be thinking about this the way I think about, I don’t mean to sound -- is a drug rep calling on the physicians like detail people talking to the doctors mostly, was a still pretty focused on hospital case management and discharge planners.

Jay Grinney

It’s really both. It’s all of the above and actually some of my best friends are detailed drug reps so no offence taken. But this is really a comprehensive effort to streamline the process of deciding and determining which patients need the care, reaching out to as many of the individuals in a profession who have contact with potential patients, some times that is going into nursing homes and sometimes that’s going to home health agencies, sometimes that is going to physician’s offices, often time it is working with case managers in acute care hospitals. So, it’s a pretty comprehensive effort and I think a lot of that, a lot of the new aspects really are what I just talked about, going away beyond just, going to the acute care hospital, talk to the case manager, and try to bring the patient in and provide the care. We may have to go to the next question and then get back in line and perhaps we can get you at the end.

Operator

Thank you. Our next question comes from Gary Lieberman of the Stanford Group. Please go ahead.

Gary Lieberman - Stanford Group

Thanks, good morning.

Jay Grinney

Good morning Guys.

Gary Lieberman - Stanford Group

It looks like you had pretty good progress on the doubtful accounts. Could you maybe give us some more detail there? Is it better collection of data that the software helps it to or is it a better qualification for patients coverage that they might not have otherwise got.

John Workman

Yes, Gary basically if you recall the company had billing platforms and had multiple billing platforms and it was late in 2006 that we completed putting all the inpatient rehabilitation hospitals on one common platform, and so we were in the installation phase if you will for most of 2006, and as with any new installation you have some kind of sort out period which occurred in part of 2007. And as we got into 2007, we become more proficient with the system itself which allowed us to focus on, so better billing accuracy if you will, and stronger collection efforts and the other thing I would tell that we did is we put the receivables as part of the bonus calculation in all the regions, also in terms of cash flow. So, we also have more of a focus on getting the cash in and what we watch very closely is clearly the cash collections based on billings and we are doing very well in that category. So, it’s a combination of the new system gaining efficiencies as we learn the functionality of the new system that helps us to operate better, and focus of everybody of making certain that we collect the cash.

Jay Grinney

And the only thing that I might add and I know that you are very aware of this but there may be some out there who still don’t see that there is a pretty significant difference between acute care hospitals and specialty hospitals such as ours. When we don’t have emergency rooms we don’t have the bad debt that are associated with the uninsured coming in, the vast majority of our patients are covered with Medicare. We have got may be what 15%, 18% of the business that is managed care, so we are very different from acute care hospitals and very unique in many ways, but one very pronounced way is we do not have the bad debt exposure that acute care hospitals had, that’s why you see our bed debt in the 1.5 to 1.7% in net revenue range and being pretty consistent.

Gary Lieberman - Stanford Group

It sounds like the collections are potentially much better on the front end on the co- payer deductible side or is it on the back end?

John Workman

It’s both actually. I mean it’s across the board.

Gary Lieberman - Stanford Group

Okay, great. And then one quick follow-up, is there some sort of metric you could give us on the contract labor, I guess on FTE metric or some other metric they would help us quantify sort of the increase you saw on the contract labor in the quarter, and it’s sounded like it came down by the end of the quarter, so may be a corresponding metric to where it came down by the end of the quarter.

John Workman

What we do as we track it by dollars and we have seen a slight decrease in that in the at the end of the quarter. What we saw in the quarter it was very solid volume growth in the first two months, the third month was a little bit softer, so we are brining on individuals new employees, train them, orienting them. We have individuals who are taking vacations so there is some of that inefficiency that was in June. Now we are seeing volumes rebounding nicely in July and coming in to August. The goal is to reduce the contract labor stand, and we don’t brake that out, we don’t look at that, we are not going to start providing that granularity, but we are looking at the dollars and we are brining that down as quickly as we can. We are actually seeing some good progress in July, but the real test is going to be once we get through the summer months, and we start seeing September, October, November, and we are able to replace the contract labor with full time employees. We feel like we are going to be in pretty good shape.

Gary Lieberman - Stanford Group

Thanks a lot.

Operator

Thank you. Our next question comes from David McDonald with SunTrust. Please go ahead.

David McDonald - SunTrust

Hey, guys congratulations. John, I was wondering can you just run, I apologize I missed it, but can you just run through the available cash flow calculation again in the quarter?

John Workman

Sure. We started with the adjusted consolidated EBITDA for the $84.5 million. Cash interest payments were $41.8 million, and our CapEx in the quarter both the second quarter we were characterized all of the CapEx is maintenance CapEx was $10 million. So that left us 33.6 again that exclude clearly the cash spend on professional fees and the prepared dividend.

David McDonald - SunTrust

X those items that’s a fairly good run rate number to think about?

John Workman

It is. I think if you look at that and look at the first half you will see that we are about -- if you combine the first and second quarters you are going to see in that $60 to $70 million range, so I think that is a fairly decent run rate.

David McDonald - SunTrust

Okay. And then just the only other question I had guys as I was wondering if you could give us any incremental update as there is one on the derivative losses and kind of where that whole processes and kind of where we think it’s going over the next couple of quarters?

Jay Grinney

Yes. I’m going to ask John Whittington, our General Counsel, to answer that so that I don’t say anything that I will get in trouble for.

John Whittington

Thank you Jay for doing that. The UBS litigation is a jury trial, it’s set for jury trial here in Birmingham in late January of next year. We expect that to go forward and try the case. The E&Y matter is an arbitration. We are in the process of selecting the panel and I would expect that arbitration to occur in the late spring probably April or May of next year. We’ve completed discovery and are just getting ready for the trials.

David McDonald - SunTrust

Okay. Thanks very much.

Operator

Thank you. Our next question comes from Frank Morgan of Jefferies & Co. Please go ahead.

Frank Morgan - Jefferies & Company

Good morning. On the volume growth, can you talk a little bit about how much of the volume growth was attributable to may be a ramp up in noncompliant cases? First question, and then could also give a little bit color on where you saw the most strength, was it on the Medicare side versus the managed care side?

Jay Grinney

Sure. In terms of the -- our overall compliance level we have set a target of being 100 to 150 basis points above the threshold. So between 61 and 61.5 is the level that we want to be at from an internal perspective. And I think that’s pretty close to where we have been and so we feel pretty good about the compliance level. And in terms of the volume increases it’s been an appropriate mix of both compliant and noncompliant. As we said before the number of stroke patients compliant, hip replacement compliant, debility compliant, neurological compliant all of those represent the top conditions that we treat, and so we feel pretty good that we are getting a good mixture of both the compliant and noncompliant. And frankly with the local coverage termination and the medical necessity decisions that are being made the ability to get the noncompliant patient in is only predicted on is there a compelling medical necessity.

So if you have noncompliant patient that doesn’t mean they don’t need the care just that means that they don’t meet an arbitrary criteria as part of the 50% rule. In terms of the growth is it more managed care or is it more Medicare, we have actually seeing pretty consistent pattern in our overall mix of Medicare and managed care. So we haven’t seen a big shift in those two buckets.

Frank Morgan - Jefferies & Company

Did you see a sequential growth in the single joints, knees or hips?

Jay Grinney

In the single joints there was a slight increase sequentially, but it wasn’t very significant. It was less than a 100 basis points. It was pretty small and still below where it was in the second quarter of last year.

Frank Morgan - Jefferies & Company

I got you.

Jay Grinney

Substantially below last year.

Frank Morgan - Jefferies & Company

In terms of your volume guidance for the year now the 4 to 5% range, clearly after a good second quarter, did I understand you correctly the seasonally you would expect the third to be the softest? So when we talk again next quarter and you show volume should we continue to expect to see volume at this level or should it drop down a little bit, and make pick back up to higher level in the fourth to net you out of this 4 to 5% range?

John Workman

What we were talking about is normal seasonality play, Frank, is the third quarter from an earning stand point typically a softer quarter, but obviously we are going to be comparing the same season as a same season.

Frank Morgan - Jefferies & Company

All right.

John Workman

So it should be the third quarter last year was our softer quarter and we expect the third quarter this quarter and historically is, but it will be comparison and should be an appropriate comparison barring massive hurricanes and different thing that could disrupt the business little bit.

Frank Morgan - Jefferies & Company

Okay. Thanks.

Operator

Thank you. Our next question comes from Kemp Dolliver of Cowen & Company. Please go ahead.

Kemp Dolliver - Cowen & Company

Hi. Thanks and good morning. Just quickly over the course of the balance of ‘08 and then into ‘09, could you just quickly run through what’s likely to come, what new development projects will come on line beyond the once you mentioned in the prepared comments?

Jay Grinney

As far as the additional development initiatives, I think it would be inappropriate for us to comment on the specific nature. I think that what I’d like to do is I’d like to bring you back to the guidance that we have provided in the past, which is that we’d like to bring on three acquisitions per year, and be able to launch five de novos each year. And when we say launch that means get the certificate of need, have it free and clear, and be able to break ground. And so that’s really our goal is to try to bring eight new projects on each year, and in some cases obviously with the de novos is really not bringing them on as much as launching. And I think that our view is that we are by doing in that manner and putting more of the focus on to de novos. Number one, we are able to control our destiny of little bit better. Number two, we are building the growth platform for the out years. Number three, we are preserving cash by doing it and as John has mentioned sort of capital like manner, so that we can use our free cash flow to pay down our debt. And that’s, that plan, that five de novos, three acquisitions, averaging that each year is still pretty good plant.

Clearly, we had some good success this year. We do anticipate that there will be additional announcement that we will be able to make. I think most of those are going to be in the de novo area or joint venture arena, but we feel pretty good about the pipeline. And as a rule of thumb, Kemp, if you take the four that were announced clearly, Vineland is an acquisition, on acquisitions we expect to see earnings right away. So you would put that category in Vineland and Arlington, that should be starting to see some earnings in later ‘08 into ‘09. And good way to think about de novos is probably going to be an earnings contributed about two years after we announced it. So if you look at Ocala and Loudoun we would kind of expect those to come on line from a earnings stand point, may be not the beginning of the year but during 2010.

Kemp Dolliver - Cowen & Company

Thanks. And just one follow-up question, John, depreciation was down year-over-year to $18 million from $20 million. What accounted for that?

John Workman

Well, part of it is as you recall we took a large catch-up adjustment in the first quarter for the corporate campus. So when we sold the corporate campus. So you are going to get some fall off and then it’s just some the natural retirement of some buildings but with some added CapEx and the acquisitions I think will you see depreciation, amortization start to come back in the second half of the year.

Kemp Dolliver - Cowen & Company

That’s great. Thank you.

Operator

Thank you. (Operator Instructions). Our next question comes from Miles Highsmith of Credit Suisse. Please go ahead.

Miles Highsmith - Credit Suisse

Hey, good morning, guys.

Jay Grinney

Hi, Miles.

Miles Highsmith - Credit Suisse

Sorry if I missed this. I think I heard you mention the target for the compliance would be at 61% to 61.5%. Where are you guys right now?

Jay Grinney

We’re right at the top ends of that, we are actually a little bit above that on our internal methodology which is a much more rigorous methodology than you’ve heard us use the term presumptive which is what the fiscal intermediaries use as they analyze IRS for compliance. But we are actually a little bit higher than that target at this point.

John Workman

And remember, Miles, that calculation is made on a hospital basis. So sometimes it’s a little misleading when you look at the great averaging because we have some hospitals that are running at a very high compliant rate that are part of that mix. So -- and clearly we may be looking at bed expansions in those opportunities if they are running a high compliant rate and a high occupancy rate.

Jay Grinney

And I do think, that’s a very important point. Our compliance level we feel comfortable with, we monitor that very closely, hospital by hospital. And frankly we haven’t really seen any meaningful change in that overall number over the last several quarters, kind of settling into a very normal steady state.

Miles Highsmith - Credit Suisse

Okay. Great. That’s helpful. So you have a little room to go there. And secondly I guess just stepping back kind of bigger picture, where are we in terms of kind of next steps on more meaningful research around looking at total cost of care, readmission rates, all of the things associated with the state and the IRS versus the [sniff] and cost versus out comes, where are we there and where are you guys pushing, and when can we expect to get the next meaningful data points there? Thanks.

Jay Grinney

Yeah, I think that the efforts right now to be very frank are in a bit of a holding pattern. And we remain very interested in supporting research that would underscore the efficacy of in-patient rehabilitative care. We know it because we see the success. We see the patients who come in, they are unable to bathe themselves, clothe themselves, oftentimes they can’t walk, oftentimes they can’t communicate. Two weeks later, they are out. And they are out back into their activities of daily living. So we have set up a matching program with [AMPRA] which is one of the national organizations for rehabilitative providers to help fund that. So there isn’t any one large undertaking at this point. There are a number of smaller efforts and we think that the collective contribution of those smaller efforts will in fact continue to add to the argument that inpatient rehabilitative care not only is needed but it’s adding a lot of value to a lot of peace of people’s lives every day.

Miles Highsmith - Credit Suisse

Okay, thanks a lot.

Operator

Thank you. Our next question comes from Dawn Brock of J.P. Morgan. Please go ahead.

Dawn Brock - J.P. Morgan

Good morning, guys.

Jay Grinney

Good morning, Dawn.

Dawn Brock - J.P. Morgan

Really quickly two things. CapEx, should we be looking for it to pick up with any planned expansions or facility improvement efforts?

Jay Grinney

On the latter case, Dawn, not much. I mean, I think, we’ve always said on the maintenance CapEx which we would call keeping up the facilities is the $35 million, $40 million a year range, we seem to be in that run-rate. That’s a little bit more than we might have historically spent. I think the thing that’s going to sway the CapEx is the development and the acquisition projects. So when we report third quarter results you’ll see some added CapEx for the Vineland acquisition, the Arlington acquisition, and those will be flowing through some of the CapEx numbers as part of our acquisitions.

Dawn Brock - J.P. Morgan

Okay, that’s really helpful.

John Workman

That’s investments in the de novos, but not in the maintenance for the existing facilities.

Dawn Brock - J.P. Morgan

Got it. And then the second thing really quickly can you give us an update on the rack audits how they are going, we are definitely hearing about some activity on the earth side?

Jay Grinney

I will ask Mark to answer since he’s much closer to that. I will tell you we haven’t really heard a whole lot and my understanding is that it’s a bit in a holding pattern but ultimately it comes down to coding and accuracy. We feel very good about our coding accuracy. As you know we’ve got the CIA, corporate integrity agreement. We monitor that. We have an outside auditor that comes in to look at that. And our coding accuracy is very, very, very solid. So --

Mark Tarr

Yes, this is Mark Tarr. As Jay said, the rack process has been put on hold right now, CMS has gone back in and taken a look at all the procedures. As you may know that was pretty controversial the last couple of years in terms of how some of those audits were being taken care of. So we have not had any activity and are waiting to see what changes in direction CMS takes with that program.

Jay Grinney

We are, Dawn, we are clearly focused on that. We are aware of this process. We have training that we have undertaken and trained our hospitals and so on. So we are not taking it lightly by any stretch. We take it very seriously. But fundamentally what we take seriously is the accuracy of our coding, and making sure that the documentation is in the medical record to substantiate the admission and to validate that that patient needs the care. And I believe, frankly, if we do that, then we are going to do fine in any kind of audit of our admission criteria or accuracy, and that’s really where the emphasis is. We are not emphasizing or trying to come up with strategies to counter the rack audit. We are just refocusing and making sure that we don’t loss any emphasis on the accuracy of the coding at the front end.

Dawn Brock - J.P. Morgan

Okay. Just real quickly have you guys been involved in any way in talking with CMS and maybe shaping some of their thinking around this?

Jay Grinney

The only -- not directly but certainly with our participation and membership in the Federation of American Hospitals and in the American Hospital Association, we have certainly lent our voice to those discussions, and as you know the AHA and the Federation are both very active and very involved in representing all hospitals across the country in this. Because the acute care hospitals are ones that really have I think a much, much greater risk profile, number one, that’s where the money is. So when they go out in these rack auditors are going out they are going to be looking at the big dollars which is I guess everybody would look. And it’s a much more complex environment in acute care hospitals. So, no, directly, we have not, part of Federation, yes, part of AHA, yes, and we support any effort to bring some rationality and some logic to this process.

Dawn Brock - J.P. Morgan

Excellent. Thank you very much.

Jay Grinney

You’re welcome.

Operator

Thank you. Our final question comes from Derrick Dagnan of Avondale Partners. Please go ahead.

Derrick Dagnan - Avondale Partners

Good morning. Jay, I was thinking, with the improvement in volumes and the use of contracts labor are you guys doing anything to expand your relationships with universities so that you might build a better pipeline of therapists and nurses in the future?

Jay Grinney

We are doing that. That’s a great question, Derrick, and, yes, our emphasis on recruiting the best and the brightest is as strong today as its ever been. First, we wanted to make sure that we had compensation and benefit programs that would be attractive, that would allow us to be able to recruit new individuals. But we’ve also put a focus on retention. I think you’ve heard us say in the past that in the last couple of years with all of the uncertainty, we did have a problem with turnover. We made a concerted effort in 2008 to focus on that, part of that was to put in place a new benefit program. We’ve been very, very pleased with the results on the improvement in our therapy turnover, physical therapists, occupational therapists and speech pathologists, and it’s in the mid to low teens and we are really pleased with that.

That’s significantly below what you see on a national level. Still have a little room for improvement in terms of nursing turnover, but what we have done is in many of our markets at the local level reached out working with the local programs either the LPN, the RN programs, to bring nurses in to train them, to mentor them, to bring them on in a way that allows them to see the benefits of working for a company like HealthSouth.

Derrick Dagnan - Avondale Partners

Okay, and thanks. And I will ask one more and get off. When you look at the acquisition candidates that you’re looking at today, has the mindset of the target changed any given the improvement in the reimbursement outlook and the legislative change on the 75% rule, or are the sellers thinking about their business differently today than they were six or 12 months ago?

Jay Grinney

I would say they are to some modest degree. What we have found is that there are a lot of acute care hospitals who recognize that they don’t have the expertise that we have. In fact I met with the CEO of a very large system, up in the North-East. They have a rehabilitation program actually in a couple of their hospitals and he acknowledged. We are never going to have the expertise that you have. We are never going to have the ability to treat those really medically complex and higher acuity patients. So that I don’t think has changed much. I think where we see the greatest opportunities are those hospitals where, and I guess the Arlington example is a great example where the acute care hospital had a bed need for medical surgical purposes and they recognized that it was much more efficient to reuse existing beds that were for a non-focus service, in this case it was rehabilitation and to reuse those for either a heart program or a tertiary program or just medical surgical beds. Better it is to give that up, the rehab, and focus on their core competencies.

That’s what we are seeing, is a lot of hospitals are saying, we can’t be all things to all people and we are going to focus on those things that we really know how to do well and the others will either sell the business to HealthSouth or in some cases would joint-venture and I think a couple of the things that we are working on right now is just that. There are joint ventures where we will be partnering within the acute care hospital and providing that service and collaboration with them. So the change has been slight and right now we see the biggest motivation where there is recognition that they don’t provide the service and the care and level that they would like. They know HealthSouth can, and/or they are running out of room and they would rather sell or get rid of that business and then use the beds for medical surgical purposes

John Whittington

One last comment, this is John, to make, as we said in our comments, we look at acquisitions of existing hospitals on a pretty disciplined process. So you can imagine that we are looking at a lot more than we are announcing. So, some have different expectations perhaps than, than we want to pay. So we are pretty disciplined about the process.

Jay Grinney

And again just so that everyone is appropriately focused. We are very, very committed to paying down our debt. We still had room to delever. We want to delever. That is always going to be a goal of ours, and we want to get to that four, 4.5 times as fast as possible. We want to have a balance sheet that will allow us to look at other complimentary services, down stream, but for the foreseeable future, it’s deleveraging and then very disciplined growth, focus on operations and bringing shareholder value to our shareholders.

Derrick Dagnan - Avondale Partners

Okay. Very good. Thanks a lot.

Jay Grinney

You bet. Any other questions, operator?

Operator

There are no further questions at this time.

Jay Grinney

Alright, excellent. Thank you all for joining us this morning on our call.

Operator

Thank you. This concludes today’s HealthSouth second quarter 2008 earnings conference call. You may now disconnect and have a great day.

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

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

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

Source: HealthSouth Corp. Q2 2008 Earnings Call Transcript
This Transcript
All Transcripts