Kindred Healthcare, Inc. Q2 2008 Earnings Call Transcript

Kindred Healthcare, Inc. (KND)

Q2 2008 Earnings Call Transcript

August 1, 2008 10:00 am ET

Executives

Eddie Jones – IR, Corporate Communications, Inc.

Paul Diaz – President & CEO

Rich Lechleiter – EVP & CFO

Analysts

Newton Juhng – BB&T Capital Markets:

Bill Bonello – Wachovia Securities

Robert Hawkins – Stifel Nicolaus

Adam Feinstein – Lehman Brothers

Frank Morgan – Jefferies & Co

Dawn Brock – JP Morgan

Presentation

Operator

Good day, everyone. Welcome to the Kindred Healthcare Inc. Conference Call. Today's call is being recorded. At this time, for opening remarks, I'd like to turn the call over to Mr. Eddie Jones. Mr. Jones, please go ahead.

Eddie Jones

Good morning. Welcome to the Kindred Healthcare Second Quarter 2008 Conference Call. This is Eddie Jones from Corporate Communications.

Before the company's presentation, I would like to read a cautionary statement prepared by the company. This conference call includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended, and Section 21E of the Securities Exchange Act of 1934 as amended.

Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize the actual results may differ materially from the Company's expectations, as a result of a variety of factors including, without limitation, those discussed later.

Such forward-looking statements are based on management's current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company's actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements.

The company refers you to its reports filed with the Securities and Exchange Commission, including the Company's annual report on Form 10-K, the Company's other reports filed periodically with the SEC, and its press release regarding the second quarter 2008 operating results for a discussion of these forward-looking statements and other factors that could affect these forward-looking statements. Many of these factors are beyond the control of the Company and its management.

The Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance. The information being provided today is as of this date only, and the company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.

It is now my pleasure to introduce the speakers for today's call, Paul Diaz, President and Chief Executive Officer of Kindred, and Rich Lechleiter, Executive Vice President and Chief Financial Officer. Mr. Diaz will begin the call.

Paul Diaz

Thanks, Eddie, and good morning, everyone. Last night, we announced our second quarter results that came in at the high end of our earnings guidance. We also raised our earnings guidance for fiscal 2008 and provided earnings expectations for the third quarter of 2008.

During the second quarter, we continued to make progress on our quality, customer service, human resource and business goals. Progress in these critical areas translated into solid overall operating results for the quarter.

With respect to our earnings, we reported second quarter net income per diluted share of $0.38 from our continuing operations, which included income of $0.05 per share of certain items noted in the release. This compares to our guidance range of $0.29 to $0.34 per diluted share, which excluded the impact of any separate items.

In our Hospital Division we reported strong same-store volume growth, driven both by Medicare and Medicare Advantage, as well as managed care and commercial insurance admissions. Our Nursing Center results in the second quarter improved over last year, as we continued to demonstrate more consistent clinical and operating performance, resulting in a higher census and better quality mix.

Peoplefirst Rehabilitation services also continued to grow as we increased the volume of our services, improved productivity and expanded our external customer base. Before commenting further on our second quarter results and our opportunities going forward, I would like Rich to recap our operating results. Rich?

Rich Lechleiter

Thanks, Paul, and good morning, everybody. Our consolidated revenues for the second quarter of this year exceeded $1 billion, excluding the KPS business that was spun off last summer. Our revenues rose 9% in the second quarter compared to the same period a year ago.

Consolidated operating income, or EBITDAR, totaled $145 million in the quarter, compared to $135 million in the second quarter of 2007. A reconciliation of EBITDAR to our consolidated results of operations is included in our second quarter earnings release, which is available on our Web site, www.kindredhealthcare.com.

In our Hospital Division, we reported revenue growth of 7% to $470 million in the second quarter, while EBITDAR of $79 million included a $5 million asset impairment charge. Reported second quarter hospital admissions grew 7% compared to the same quarter last year, while same-store total admissions in the quarter were up 6% compared to the second quarter last year.

Same-store non-government admissions climbed 19% compared to the second quarter of last year, while Medicare same-store admissions increased 2%. Overall division operating cost per patient day rose 4% in the second quarter 2008 compared to a year ago.

In our Nursing Center business, revenues of $542 million were up 9% in the second quarter of 2008 compared to the same quarter last year, primarily due to favorable overall rates, quality mix improvements and acquisitions.

Our Medicare and managed care census improved from last year's second quarter, as we continued to invest in our operations to better care for high acuity patients. Our quality mix revenues improved to 57% of total revenues in the second quarter of 2008, from 56% in the same period last year.

Nursing Center EBITDAR for the quarter rose to $90 million, which included $10 million of the favorable prior year Medicare reimbursement settlement. Our Nursing Center labor costs per patient day grew 4% in the second quarter of 2008, compared to the same period last year.

Peoplefirst, our rehabilitation division, reported revenue growth of 25% to $106 million compared to last year's second quarter of $85 million. EBITDAR for the quarter totaled $11 million, up 12% from the same period last year.

While we continue to manage through a very competitive market for therapists, we are pleased with the progress we're making in growing our rehab business. We're continuing to sign new external therapy contracts, adding 40 new contracts in the first half of this year.

Professional liability costs for the second quarter came in better than expected. Total program costs were $11 million in the second quarter of 2008 compared to $13 million in the same quarter last year. Our latest actuarial projection for 2008 indicated that this year's malpractice costs will approximate $50 million, down from the previous quarter's annual projection of $64 million.

In terms of the balance sheet and overall liquidity of the company, our financial position at June 30 remain strong. Our cash balances at the end of the quarter totaled $19 million, and we had $265 million of outstanding borrowings under our revolving credit facility at the end of the quarter, down from $275 million at December 31st, 2007.

Our operating cash flows for the quarter were better than the first quarter this year, as we made some progress with our accounts receivable collections. We expect more progress in this regard over the balance of the year.

With respect to the 22 properties that Kindred acquired in 2007 from Ventas, we have now completed the disposal of substantially all of these facilities through June 30, for an aggregate consideration of $94 million, better than the $80 million to $90 million that we expected.

In yesterday's earnings release, we raised our fiscal 2008 earnings guidance range to $1.50 to $1.60 per diluted share from $1.40 to $1.50 per diluted share, after adjusting for the effects of the final Medicare rule for Nursing Center payment rates.

We also provided our third quarter 2008 earnings guidance range of $0.20 to $0.25 per diluted share to provide more clarity around our earnings expectations for the next quarter. That concludes my remarks for the quarter. Paul?

Paul Diaz

Thanks, Rich. With a solid first half of 2008 behind us, we're continuing to focus on our efforts on improving the operations in each of our sites of service. As we have done in the past, we expect to drive our results of improvements in our operating fundamentals related to employee satisfaction and engagement, customer service and clinical outcome.

While our overall results so far this year have been good, we think that our results could have been better if we had more consistently executed in our Hospital Division. For the second half of 2008, we're focused on improving the results of our high potential and newer hospitals.

Finally, I'd like to spend a few minutes talking about how we continue to position the company for future growth. First and foremost, we continue to see more opportunities to improve the working environment for our employees, and the care of our patients in residence. The link between taking care of our people, quality and profitability has never been clearer for us.

We also see an environment that provides better visibility for Kindred shareholders, as we've worked through a number of internal and external challenges and now can focus on growing our core businesses and earnings over the next several years.

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

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

And our continued focus on our patients, customers and therapists puts Peoplefirst Rehabilitation in a strong market position to pursue our organic growth strategy and selective acquisitions. That concludes our formal remarks.

We would be glad to take your questions now.

Question-and-Answer Session

Operator

(Operator instructions) We'll go first to Newton Juhng with BB&T Capital Markets.

Newton Juhng – BB&T Capital Markets

Thank you very much. I was wondering on the med mal costs, if you can give us some idea how that's going to trend over the back half of the year here?

Rich Lechleiter

Good morning, Newton.

Newton Juhng – BB&T Capital Markets

Good morning.

Rich Lechleiter

I think, you know, first of all, in the second quarter review, as I've spoken to some of you last night, we saw a quarter in which our claims in flow was perhaps the lowest level that I've seen since I've been CFO here at Kindred for the last six years. So it was a really, really strong metric around frequency that clearly move the numbers, if you will, in terms of med mal. So that's definitely moving in the right direction. We booked $11 million this quarter. I think, on a $50 million run rate, you're expect around that same level of costs in the next two quarters.

Newton Juhng – BB&T Capital Markets

Okay. Excellent. I appreciate that. You know, Paul, I was wondering, you've been spending a lot of time inside the Beltway and the delay in the refinement [ph] obviously a positive effect from those efforts. Do you feel that the industry is now getting its appropriate due attention, or is there still ways to go in terms of effectively getting the message across to the decision makers?

Paul Diaz

Last time I spent in my buildings, but we're obviously engaged and we've got a great team in Bill Altman and Ray Zapina [ph] that they're active in Washington, and our Chairman is pretty active as well. Look, I would say that the Administration acted prudently. I mean, you know, I think they acknowledge that there were data that they had not taken into account or that we're still looking at, and we put forth information to show the savings that we were getting or creating by moving patients more quickly out of inpatient rehab facilities or eliminating patient rehab facility stays or out short-term acute care hospitals. And those savings should matter as one looks at the RUG system, rather than just looking at the forecasting era in isolation.

I do think that the industry has made progress on making the case for this value proposition, but we have a lot more work to do. And, you know, my partners and I in ASA and the alliance, you know, we're going to continue to work on that in front of a new administration and in front of the new Congress. But we've got a lot of work to do. I do think, though, that on the margins we're making progress in how we're delivering that story of the value that we're creating for seniors in our nursing facilities.

Newton Juhng – BB&T Capital Markets

Thanks, Paul, for those comments. It was very helpful in getting a little look into what's in your mind right now. Last question for Rich is just the $4 million increase in the forecasted run expense, is that related to the escalators on those 10 leased facilities that you took the charge on for this quarter?

Rich Lechleiter

Some of it is. Clearly, we booked $2 million in the quarter to catch that up. That's $2 million of the $4 million increase. There is some increase related to that escalator adjustment, probably $200,000 a quarter running out. The rest of its just kind of a refinement of our estimates going forward.

Newton Juhng – BB&T Capital Markets

Okay, thanks for the update there.

Rich Lechleiter

Thank you.

Paul Diaz

Thank you.

Operator

We'll go next to Bill Bonello with Wachovia.

Bill Bonello – Wachovia Securities

Good morning, guys.

Paul Diaz

Good morning.

Bill Bonello – Wachovia Securities

Hey, I have a couple of questions. The first one relates to the guidance, which I am just really struggling to understand. If I look at what you laid out, professional liabilities are going to be about $14 million better than you had expected. The SNF rates should be about – should give you about $5 million of unexpected profits. And you had $3 million in Q2 that had not been factored into your initial guidance. But you're taking the low end or – well, both ends of guidance up only about $7 million. And so I don't know if that's conservatism or if there's something negative that's going on that you had not expected when you first gave guidance?

Paul Diaz

Well, Bill, I think that, you know, market basket increases as a policy matter there to pay for inflationary increases in wage rates, and fuel costs, and medical supplies, and plastics that are going up, incrementally higher than we would have expected, and food and other costs. So I think one has to think about the nature of that, and how much of that fully drops to the bottom line, both this year and next year, you know. But, as we look at the guidance and continue to refine the guidance, and look at the opportunities, that we're giving you our best estimates and refine them based on all of the moving parts in this Company.

Bill Bonello – Wachovia Securities

Sure. I hear what you're saying, Paul. Obviously, that's why you get a market basket update. All I'm thinking about is the last time you gave us guidance, you didn't expect to get a market basket update, and you expected your malpractice expense to be $14 million higher than you do today, and you didn't expect to have $3 million of benefits in the quarter. So something appears to have changed besides those that offset some of that benefit, so I'm trying to understand what that might be.

Paul Diaz

I'll give it another shot and then I'll have Rich fill in. You know, food and energy prices continue to increase much higher than expected. Those are real costs. We are making solid progress on all the basic operating metrics in all of our business units, but some of our new hospitals are behind their startup plans. Some of that is because of you can't exactly predict when we get a certificate of occupancy and open a new hospital. In some cases, we just didn't perform well with the start. And the startup losses have created some drag.

But in total, you know, what we're seeing is solid operations in all four businesses, and reflecting our view and our best estimates of guidance to help investors have a level of confidence about the predictability of our operations. So we'll use our best judgments every quarter to refine those estimates, Bill, and taking into account all the different things going on within the walls of our hospitals.

Bill Bonello – Wachovia Securities

Actually, that helps. That makes perfect sense. Can I ask a different question?

Rich Lechleiter

Yes. Let me just add something to that, Bill. I'm sorry. I think just to add a little bit of color to that from a financial perspective, on the hospital business, we are seeing our acuity go up, and particularly on the Medicare Advantage part of the business. That's driving some of this growth that you're seeing in our operating expenses.

As an example, if you look at all four quarters last year in the hospitals on the operating expense per patient day growth rates, we were really up very slightly year-over-year on a per-patient day basis. We're starting to see some growth or some creepage in those costs this year. In our first quarter, the operating costs per patient day was up 1.6% in the second quarter; excluding the impairment charge, they're up around 3%. So we're seeing some creepage there. That also kind of worked its way into the second half of '08 numbers as well.

Paul Diaz

And, you know, Bill, so there are a lot of pieces within this. You've got new startup hospitals and the startup losses associated with that creeping into that 3%. You've got, you know, as we lost volumes in May, there were a few existing hospitals that didn't cross that bridge on flexing their staff as well as we could have, and that's something we're very focused on and, quite frankly, I feel better about it. Ben [ph] and the team are all over as we wrap up July, going into August. So, you know, what we're trying to say is that, things are going really well. Our cup is more than half full. But we've got opportunities to execute better and more consistently in the portfolio.

Bill Bonello – Wachovia Securities

That's very helpful. And then if I could, and I'll jump back in the queue, just trying to understand the other thing on guidance. You had a pretty big decrease in interest expense or net interest this quarter, but the guidance would imply that you expect it to tick back up next quarter. And I'm just wondering, Rich, if you can kind of give us the moving parts around that?

Rich Lechleiter

Sure. We're actually expecting an acceleration in capital spending in the second half of the year. We're actually, I think, below last year's level. And we still think we're going to come in around the $200 million mark, CapEx plus the construction activity on the new hospital. That's obviously driving most of that.

Bill Bonello – Wachovia Securities

Okay. Thank you.

Rich Lechleiter

Thank you.

Operator

We'll go next to Rob Hawkins with Stifel Nicolaus.

Paul Diaz

Good morning, Rob.

Robert Hawkins – Stifel Nicolaus

Hey, Good morning.

Rich Lechleiter

Good morning.

Robert Hawkins – Stifel Nicolaus

Just kind of following on some of this other stuff, I guess a little bit does kind of tie into Bill's question a little earlier. The hospital margin weakness, I think you mentioned the drag related to some of the new hospitals and some of the costs. Is there anything else going on there, and then how should we think about kind of the recovery in that margin kind of going forward?

Paul Diaz

I think we did touch upon them, Rob, and look, we're quite excited about it. I mean, you've got the startup costs of a lot of new hospitals in this run rate. And, as we finish the summer and we start getting the typical pickup in volumes in the back half of the year, and we improve our focus and the team solidifies themselves and these new hospitals, just a natural progression, and the marketing to physicians and payers, we see the opportunity to grow earnings obviously in the back half of the year and into next year. And, we remain excited about that.

You know, it's very hard to nail down the exact timing in terms of how we open, in which month we open these hospitals, and how quickly they fill. Sometimes, we've been pleased that they have been way ahead of plan, and we've got a few hospitals right now that are behind the estimates that we had for startup and, that's much more difficult to budget than a stabilized, open hospital.

Robert Hawkins – Stifel Nicolaus

And so the swing might be somewhere in the neighborhood plus or minus 100 basis points until kind of what stabilization mid next year? Does that sound about right?

Rich Lechleiter

You know, if you're looking at the overall EBITDAR margin which is high 17s, I think, in the hospitals, yes, I think there's room for that kind of movement. I think back to Paul's point, more consistent execution of a handful of facilities in this portfolio really does matter. And that was kind of the disappointment, if you will, in the quarter around the hospital results. Good quarter, could have been better.

Robert Hawkins – Stifel Nicolaus

And then, Medicare Advantage is becoming a bigger and bigger piece of everybody's business, and the acuity is rising, generally, I think that is, is kind of a nice problem to have. I mean–

Paul Diaz

Absolutely.

Robert Hawkins – Stifel Nicolaus

I mean, are you guys seeing that? Is there any kind of change? And now we're – you know, can you tell us a little bit about like how long your contracts are locked in for pricing and do you feel that there is a chance that these guys are now hurting and, therefore, pricing might change and acuity – any reasons acuity would be a problem going forward?

Paul Diaz

Look, I think overall, historically, as pricing and the cost pressures that the payers see, it does trickle down. And we've commented before at our Investor Day and otherwise, as we see the next few years, you know, we do see a tougher environment in terms of pricing and costs and the pressure on margins to that. The flip side is, as you commented on, Rob, we're very excited about the ability to change the mix of patients, make the case in our hospitals and nursing homes for caring for and delivering good clinical outcomes for the higher acuity patients, and we are finding great success in demonstrating that value proposition to payers, so that when they look at the ability to save money, they want to send the patient to a Kindred LTAC or skilled nursing facility. Because we are cheaper than the alternative of those patients staying in short-term acute care hospitals, or in some cases, going to an inpatient rehab facility.

So our thesis continues to be, and what we continue to execute on, is that we expect over the next few years to have pressure in pricing, whether it's Medicare fee-for-service, Medicare Advantage or commercial insurance, but that we'll be able to maintain a fair amount of pricing power by being able to demonstrate our ability to save them money in that short-term acute care hospital or other setting, and continue to improve our mix in the hospitals and nursing homes, and get the fixed cost leverage that we have in the hospitals. So you're actually seeing that in the first half of this year, as that mix continues to shift. Now, we are challenging ourselves on how we manage these higher acuity patients and the costs around them better in terms of managing drug costs, managing supply costs, how we engage our physicians in better case management around these patients, and that's an opportunity too. We've got to get better at doing it.

Robert Hawkins – Stifel Nicolaus

All right. And then can you speak to the opportunity, I believe, it was just with Aetna or UnitedHealth related to the nursing home – kind of the national nursing home contract, and what we might be able to see there and how that might impact the business?

Paul Diaz

You know, what we hope is that that continues to maintain the growth that you have already seen over the last few years in our nursing centers of growing – you know, net-net continuing to maintain and grow our Medicare fee-for-service. But essentially shift days from Medicaid, where we're losing $10 or $15 a day, to Medicare Advantage where we can make appropriate profit per patient day. What I think that contract which is really regionally-based, meaning within each region, we have a different set of pricing mechanisms and those kinds of things. But what it's allowing us to do is really create a better relationship with the case managers of Humana, and at the local level, make our facilities more accessible to them. So, we're excited about that opportunity. Really too early to talk about how that might translate into any specific metrics.

Robert Hawkins – Stifel Nicolaus

In terms of the way you look at it, is it something that's just like an incremental positive or is it something that changes the game?

Paul Diaz

It's how we continue to deliver the earnings guidance that we've given you.

Robert Hawkins – Stifel Nicolaus

Okay. Thanks. I'll jump back in the queue.

Rich Lechleiter

Thanks, Rob.

Operator

We'll go next to Adam Feinstein with Lehman Brothers.

Adam Feinstein – Lehman Brothers

Thank you. Good morning, everyone. I guess I had a few questions here. Maybe just, Paul, you were talking about the makeshift and the benefit from that. Maybe just talk a little bit about the transitional care unit. You spent some time talking about that at the Analyst Day. I just want to get an update there in terms of the rollout and just the progress. And I have a couple follow-up questions.

Paul Diaz

Sure. It's going quite well. As Rich said, we're still deploying capital. We've gotten some outside help to – help us do it in a more aggressive way, quite frankly, and we continue to sort of refine, our view around these transitional care units. And in many instances, Lane [ph] has found – we've got even more opportunity than we expected where almost a whole facility is moving to become a transitional care center. So that's quite positive as we try to reposition assets in this way. And I think that process will continue to happen in the back half of this year and into next year. And, we have a division now that's covering the cost of capital, so we have more confidence about deploying capital in the division, and we're seeing good returns on invested capital as we reposition these assets. And, tying this back to Rob's comments, that allows us to market to Humana and market to United that service line in a much more aggressive way, because it's a much more distinct service line physically, where Peoplefirst is providing the extra five or six therapists that we need when we have that growth in volume.

So it's a very concerted effort from a clinical program standpoint, attracting more physician support, increasing staffing, moving to a unit manager model in those transitional care units. It's a lot more than the capital piece, Adam. You know, as we talked about a little bit on our Investor Day, it's a whole program including physician support, what we're doing in – we're now starting to recruit respiratory therapists to cover some of our transitional care units, too. So we're borrowing clinical competencies from our hospitals in our cluster markets, because we find that we need a respiratory therapist around in our transitional care unit, too, given the volume of traches and other things. So we're having a lot of fun with this, and excited about the prospects of continuing to improve those outcomes and reduce lengths of stay, and make ourselves more attractive to those payers.

Adam Feinstein – Lehman Brothers

Okay. Great. And then just a couple follow-up questions here. Rich, you mentioned earlier, food and energy costs moving higher. Can you just quantify in terms of how you think like your total operating costs, what percentage are food and energy costs?

Rich Lechleiter

This is more prevalent on the nursing home side. Food and energy as a percentage of the total costs, I think are somewhere around 15%.

Adam Feinstein – Lehman Brothers

And how much has that increased over – it's 15% now? How much was it a year or two ago?

Rich Lechleiter

I think as you aggregate those on a per patient day basis, I think a year ago we were seeing cost increases of 2% or 3%. I think that's doubled.

Adam Feinstein – Lehman Brothers

Okay.

Rich Lechleiter

In categories. In terms of the growth rate.

Adam Feinstein – Lehman Brothers

Okay. All right. And then, just we think about margins, you had talked before just about some of the startup drag from the new LTAC's. Just I wanted to get – I know there are a few different questions about this but I wanted to make sure I heard everything. So as we think about margins in the LTAC business, do you think margins will be up as we get out to 2009, or do you still think we'll have some drag in terms of the operating margins?

Paul Diaz

You know, overall we believe that we can execute better when we're improving the volumes, and we can do better on the operating expense line. On a quarter-to-quarter basis, we've got a lot of new hospitals that we've opened, we've got more hospitals we're going to open. But I think, as we try to give investors more visibility and more confidence in our numbers, we're trying to take those things into account. And what I think you'll see, I think we can improve margins by the 100 basis points that Rob talked about. But more importantly we're going to increase EPS and EBIT, as these assets, move from being a drag to being cash flow positive and earnings positive.

Adam Feinstein – Lehman Brothers

Great. And then just on the Peoplefirst side, to get an update there, same thing, as you think about the profitability ramping up as you get to the critical mass, so just any commentary on the rehab side?

Paul Diaz

Well, you know, I guess just one point on that side. You know, we're really excited. Chris Bird, who came to us from Tenet, we recruited from Tenet, is doing a great job. He's 90 days in. You know, we have gone through a beefing up of our bench, and Ben is now President of the Hospital Division. Frank is doing a great job as Chief Operating Officer. So we have added more bench strength. And I just comment that in the context of these last two quarters, we have made that transition flawlessly. Everybody has stayed focus. That's gone well. Those are not little things in the context of an operating company. And so we're really pleased that you've been able to see and that Chris is now in the chair. He's finding opportunities and providing new critical thinking, just like Ben is doing in the Hospital Division, making us think about ways to do and execute better. And we are seeing opportunities that continue to grow.

Our external contracts, we signed 41 new contracts in the first half of the year. Those take 120 days to become profitable. And we're improving the margins in our non-affiliated business. That was a big focus going into the year in terms of productivity and other things. So, you know, we're really pleased at the progress Peoplefirst has made, and we think that Chris and the rest of the team there are going to be able to continue to do that as we look to '09 and 2010. We also are – as Chris, further gets his arms around things, we will be looking at selective acquisitions there where we think we can continue to grow Peoplefirst as well, because we have a lot of confidence in the team and the infrastructure, and our ability to execute on selective acquisitions. So we'll start looking at that probably more over the next six months as well.

Adam Feinstein – Lehman Brothers

Okay. Thank you very much. Good quarter.

Operator

(Operator instructions) We'll go next to Frank Morgan with Jefferies & Co.

Frank Morgan – Jefferies & Co.

Good morning. A couple of questions. On the growth in the Medicare Advantage business, I did notice that the rates there, the revenue per admit was down about 5.5% year-over-year, and I was wondering if you could comment a little bit about that? I know the length to stay was down, and maybe it's just a function of how the business is pricing, if it's per diem, or maybe it's something about acuity, but if you could just comment on that. And then secondly, a question on the interest expense, it looks like it declined sequentially while the debt balances were actually up a little bit. Just curious if you had any commentary there? And then the final question. On the startup cost for the new hospitals, could you comment about exactly how many are in there right now and what if could you quantify the amount of quarterly operating drag from those? Thanks.

Paul Diaz

Okay. Frank, on number three, no, I can't. You know, it's difficult to call all that out for you, quite frankly. On number one, keep in mind, that volatility in the mix of patient, that probably our most volatile line in the Hospital Division is that revenue per patient day, driven by the acuity of patients in different times of the year and the mix of patients at different times of the year. Rich may have some additional color for you in terms of that.

You know, again, I just want to reiterate, in terms of the new hospital starts and the pipeline of hospitals that we've got under construction, West Palm is about to open, Melbourne, Springfield, we're really excited about this. It's really hard to get the exact timing of the openings and the startup losses in the context of quarterly guidance. But there are sources of immense opportunities for Kindred shareholders in terms of organic growth and something we can deliver on, over the course of 12 to 18 months, and we've shown to be able to do that in a pretty predictable way. So our enthusiasm for that is still quite high, both on the seven hospitals that have opened and the seven hospitals that are still in the production line, if you will. Rich, do you want to–

Rich Lechleiter

Yes. I think on the Medicare Advantage, you know, there is some – I tend to look more at the per diem rate there, because it is generally based on a per diem as opposed to a per case basis, Frank. And that's $13.44, it's just slightly higher than Q1 and a little – that tad lower than a year ago. Some of that's geographic. I mean, clearly, that was 3% of the business last year, and it's now 8% of the business this year. So you're seeing some fluctuation from quarter-to-quarter around geographic growth.

But, you know, I think the overall rates in the division I thought were pretty solid on a per diem basis, particularly, the commercial insurance and other. As Paul said, some pricing compression there, but year-over-year, 3% or 4% growth, given our history there, that's pretty good.

Frank Morgan – Jefferies & Co.

What about on the interest expanse, down sequentially?

Rich Lechleiter

Yes, I'm sorry. On the interest expense, you saw really this quarter a pretty significant pricing change on the revolver. We're generally running at about LIBOR plus 175 on the revolver, and the pricing was clearly better in this quarter than it was in the last quarter. That's most of the change that you see in the interest line. There's also some additional capitalized interest costs that you see, as we continue to progress on our construction projects in the hospitals.

Frank Morgan – Jefferies & Co.

Okay. Thanks.

Paul Diaz

Thank you, Frank. I hope that was responsive.

Operator

And we'll go to Bill Bonello with Wachovia.

Bill Bonello – Wachovia Securities

Hey, great. Thanks for taking my follow-up question. Just wanted to revisit the cash flow. You talked about it just briefly in your introductory comments. But I'm wondering, you've done this in the past, if, A, you could break out the CapEx in the quarter between routine and development, and then, B, you could give us some expectations. You told us about what you expect CapEx to be for the year, but maybe what your thoughts are on operating cash flow for the year?

Rich Lechleiter

Yes. Hey, Bill. In the quarter we had about $40 million of CapEx. I don't have it in front of me, but I think the construction portion of that was somewhere around 15 to 16. The remainder is what we would call routine or organic. For the year on CapEx, we're still in the 190 to 200 range in terms of the total spend. Year-to-date, as I indicated before, we're at $65 million. So that's going to accelerate in the second half of the year, partially driving the interest question that came up before.

Your question on operating cash flows, you know, we're starting to make some progress and we made some progress in the quarter around lowering our AR days, kind of catching up after a fairly disappointing start in Q1. But we have still got work to do there, mostly in the hospital business, mostly around commercial and managed care is really most of the opportunity I think we'll see over the balance of the year. But we continue to believe that our cash flow from operations in 2008 can still meet our annual goal of around $160 million or so. So we have got some work to do there, but we're on it.

Bill Bonello – Wachovia Securities

Okay. And then just as we think forward, is there sort of a point in time when you would think about being a net generator of cash rather than a net user of cash? Is that one of your objectives for '09 or 2010, or sort of how do you think about that?

Paul Diaz

Absolutely. I mean, I think that, as we think about what we've kind of come into this year and as we look to next year is improving the visibility and predictability of our operations, for all, the organic opportunities in our nursing homes around those transitional care units, and the opportunity that we had in advance of the LTAC development moratorium to build a very competitive, free-standing hospital in market where there was a lot of LTAC demand. As that hospital development concludes itself and starts to wind down, you will see that while we still have opportunities to put capital into our skilled nursing facilities there as well, we'll see that start to fall off and that will provide us the opportunity to pay down debt or pursue external opportunities as well.

Bill Bonello – Wachovia Securities

That's very helpful. Thank you.

Operator

And our last question in the queue is from Dawn Brock with JP Morgan.

Dawn Brock – JP Morgan

Good morning. So, Paul, I just wanted to go back to something that you said on the TCU development, that you're still deploying capital, but that you'd hired outside help to identify opportunities and to be more aggressive, both positioning and repositioning assets to this model. So my question there is what kind of demand assessment goes into that kind of decision? Because we really haven't heard about, you know, any one facility going almost all kind of high acuity rehab before.

Paul Diaz

That's true. What I was referring to specifically was we've engaged an outside firm to help us better coordinate the physical plant renovations and more comprehensive renovations so that – because what we found in some facilities, we were doing a really good job and accelerating the capital improvements within the unit itself, but not taking a good, full look at the whole facility. And that's important. Because, as you try to move people off the transitional care unit, we want, we want – we hope for them to – if they have the need and they can't go home, that's obviously our first priority, to have a good environment for them to stay with us in hopefully private pay, in our longer term care units. So that was really the comment there in terms of being more effective on how we deploy the capital.

With respect to the market analysis, in the same way that we've done on the LTAC side, we do a fair amount of work, and more recently (inaudible) has added to that market analysis in-house in terms of the managed care side. So looking at what Kaiser and northern California needs, and that both people with their feet on the ground working with Kaiser everyday, or the growing managed care penetration rates up the street here in Indianapolis, and positioning our new hospital there and our nursing centers there, where that's one of our cluster market pilot.

You know, but I would say that we're still in the early innings in terms of how sophisticated we are in that process, and one of the things that we're going to do, that's Frank and I, and Ben and Lane, are going to do later this summer, is we're bringing in our district managers in our hospitals and nursing homes, and we're going to spend more time with them about them engaging more and being market leaders and around that, and helping us identify and better deploy capital from their perspective, and engaging them in that process. You know, this is always a tough business in the scale and the breadth, and at the same time, trying to bring some more sophisticated processes, making them available to those local market leaders and engaging them in that process, but giving them the tools here from our support center.

Dawn Brock – JP Morgan

I guess my – and thank you for that. I mean, I guess what I'm still, you know, curious about is just the fact that one facility could potentially be a TCU in and of itself, and whether or not, there is the demand for that, whether or not there is enough volume that, that could actually work, and how you're seeing that right now?

Paul Diaz

Well, I think – think about it this way. We're already there at the volume. We're catching up with – I mean, this is coming up because we opened up a 45-bed TCU and we're at 65 ADC of short-stay patients. We're not building it based on some market analysis that we think we can get there. We're trying to play catch-up in a couple of situations where we already have the volume, and we're trying to make the physical plant and staffing, we're trying to keep up with the effort.

Dawn Brock – JP Morgan

And you feel as though that volume and the referral sources and everything are strong enough that you could maintain that level?

Paul Diaz

Absolutely. By the way, this is very fungible stuff. You improve the physical plant – when you talk about the hard dollars here, you're making a good investment anyway in preserving that asset and positioning that asset longer term, even in terms of long-term care, and the need to do that every five years in terms of keeping a building up to competitive standards. In terms of the staffing, that's infinitely flexible.

Dawn Brock – JP Morgan

True enough. The other thing that's very interesting is just, you know, you tend to have an advantage over maybe some of your competitors in the fact that, you do – you are able to leverage both, Peoplefirst and the LTAC in order to staff, you know, your TCUs. How much shift, I guess, between the three divisions is there really, you know, as you move into this model?

Paul Diaz

Well, look, this is a very localized business, and our competitors are doing a really good job in this regard, too, whether it's Sun or Skilled Healthcare or Manacare or Genesis and others, you know, many of us are pursuing similar strategies and are being very effective in this. And in each market we compete with all of those folks in different markets. Now, that being said, we think with the commercial payers, we do hope to differentiate ourselves with the physicians we do hope to differentiate ourselves, and we hope to differentiate ourselves in terms of clinical outcome, leveraging some of the tool kit that you mentioned, leveraging the competencies in our LTAC, where we care for the sickest Medicare beneficiaries and seniors in America, and others, and the ability to leverage the recruiting capabilities and the clinical program capabilities of Peoplefirst to have and expand the rehab departments, and, you know, that's a critical piece of this as well. And that varies from market-to-market.

And in terms of patient flow over the longer term, it helps us case manage patients in our LTACs. You know, we've got a number of hospital base of acute units opening. Because when you have a vent dialysis patient that becomes a long-term patient, that affords us the ability to create that environment, which is very difficult to replicate in a nursing home, to care for a vent dialysis patient. For example, that ends up being a chronic stay. So we're having fun with this. It's not a straight line in either execution, but we are finding lots of places where it is working, and we're learning from those, and we're taking those lessons to other markets. And, quite frankly, it's creating a lot of excitement inside the company, too. So, we're pretty ginned up about it.

Dawn Brock – JP Morgan

All right. Thank you very much.

Rich Lechleiter

Thank you, Dawn.

Operator

And we do have a final question from Rob Hawkins from Stifel Nicolaus.

Paul Diaz

Hey, Rob.

Robert Hawkins – Stifel Nicolaus

Sorry to keep you there. I just wanted – I'm curious, as related to the transitional care units and ones that are starting to fill up. Are they filling up in traditionally mature managed care markets or I mean, are you seeing some surprises there, or is it more the converse, places that are now starting to see a fair amount of Medicare Advantage?

Rich Lechleiter

I think, there is 228 different answers to that. I mean, it is all over the place. In some places we are way ahead. In a lot of places we're a little bit down against where we would have expected. And some places we're taking market share away from others, and some places the fact that the enrolments in the Medicare Advantage plans, at least as I understand it, continue to grow, notwithstanding some of the pricing pressures that they're feeling, and will feel, because I really believe that Medicare Advantage is here to stay and will continue to grow over the next few years.

And, I think, Rob, we're still kind of in the early innings of this. We're still learning a lot about this. And as I mentioned, Kathy is really – just joined us in November, and we're learning so much about, managed care and commercial insurance that we just didn't really know, and it is affording us an opportunity to think differently and change our processes. I mean, you know, managed care, Aetna and LA have a whole different set of expectations about the admissions process, the case management process, and how to interface with the case managers than Kaiser might in northern California, or the typical Medicare fee-for-service admission. So it's all good stuff because what we're seeing is we're growing. We're managing costs fairly effectively. It's allowing us to leverage our fixed costs and create earnings growth. And, but we still have a lot more to learn and a lot more to do.

Robert Hawkins – Stifel Nicolaus

All right. Thank you.

Paul Diaz

Thank you.

Operator

And we have no further questions at this time.

Paul Diaz

Great. Thank you all very much for your support. And, we will continue to push the rock up the hill and we're pleased about our operations year-to-date. And as we said earlier, we're continuing to work really hard to try to continue to give you more predictability and visibility around operations on all our divisions, and we'll keep working at that. Thank you for your support.

Operator

Ladies and gentlemen, this concludes today's conference. We appreciate your participation. You may disconnect your phone lines at this time. Thank you.

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