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HealthSouth Corporation (NYSE:HLS)

Q3 2012 Earnings Conference Call

October 26, 2012, 08:00 a.m. ET

Executives

Mary Ann Arico - IR

Jay Grinney - President and CEO

Doug Coltharp - EVP and CFO

Mark Tarr - EVP and COO

John Whittington - EVP, General Counsel and Secretary

Andy Price - SVP and CAO

Edmund Fay - SVP and Treasurer

Julie Duck - VP, Operations

Analysts

Sheryl Skolnick - CRT Capital Group

Gary Lieberman - Wells Fargo

Ann Hynes - Mizuho Securities

Colleen Lang - Lazard Capital Markets

Whit Mayo - Robert W. Baird & Company

Darren Lehrich - Deutsche Bank

AJ Rice - UBS

Kevin Fischbeck - Bank of America/Merrill Lynch

Frank Morgan - RBC Capital Markets

Miles Highsmith - RBC Capital Markets

Operator

Good morning everyone and welcome to HealthSouth Third Quarter 2012 Earnings Conference Call. At this time I’d like to inform all participants that your lines will be in a listen-only mode. (Operator Instructions) Today’s conference call is being recorded, if you have any objections you may disconnect at this time.

I’d now turn the call over to Mary Ann Arico, Investor Relations Officer.

Mary Ann Arico

Thank you, Lynn and good morning everyone. Thank you for joining us today to the HealthSouth third quarter 2012 earnings call. With me on the call in Birmingham today are Jay Grinney, President and Chief Executive Officer; Doug Coltharp, Executive Vice President and Chief Financial Officer; Mark Tarr, Executive Vice President and Chief Operating Officer; John Whittington, Executive Vice President, General Counsel and Corporate Secretary; Andy Price, Chief Accounting Officer; Edmund Fay, Senior Vice President and Treasurer; and Julie Duck, Vice President of Operations.

Before we begin if you do not already have a copy, the press release, financial statements, the related 8-K filings with the SEC and the supplemental slides are available on our website at www.healthsouth.com.

Moving to Slide 2, the Safe Harbor, which is also set forth in greater detail on the last page of the earnings release. During the call we will make forward-looking statements which are subject to risks and uncertainties, many of which are beyond our control. Certain risks, uncertainties and other factors that could cause actual results to differ materially from management’s projections, forecasts, estimates and expectations are discussed in the company’s Form 10-Q for the third quarter 2012 which will be filed later today and it's previously filed Form 10-K for year-end 2011 and other SEC filings. We encourage you to read them.

You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented. Statements made throughout this presentation are based on current estimates of future events and speak only as of today. The company does not undertake a duty to update or correct these forward-looking statements. Our slide presentation and discussion on this call will also include certain GAAP financial measures. For such measures reconciliation to the most directly comparable GAAP measure is available at the end of the slide presentation or at the end of the related press release, both of which are available on our website and as part of the Form 8-K filed last night with the SEC.

Before I turn it over to Jay, I’d like to remind you that we will strictly adhere to the one question and one follow-up question rule to allow everyone to ask a question. If you have additional questions feel free to put yourself back in the queue.

And with that I will turn the call over to Jay.

Jay Grinney

Thank you, Mary Ann, and good morning everyone. We are very pleased to report the results of another strong quarter. Discharge growth of 4.2% along with solid pricing produced a 7.9% increase in net operating revenues. Our hospitals continued to provide high quality care on a disciplined and cost effective basis resulting in a 13.3% increase in adjusted EBITDA. Importantly, the company also continues to generate strong cash flows as reflected by the $71.6 million of adjusted free cash flow produced in the quarter compared to $32.3 million in the third quarter of last year.

These strong operating results along with lower interest expense generated earnings per share of $0.44 including a net $0.05 per share after-tax benefit from two non-recurring items. This compares to $0.17 per share earned in the third quarter of last year. As a reminder last year’s results included an $0.08 per share after-tax loss on the early extinguishment of debt. Excluding these items earnings per share grew by 56% quarter-over-quarter.

On the development front, we continued the construction of our new wholly owned hospital in Ocala, Florida which we expect to open this December and two hospitals we expect to open in 2013, our joint venture hospital in Stuart, Florida and our wholly owned hospital in Littleton, Colorado.

While we have purchased the land, completed the design drawing and finalized the permitting process for our Southwest, Phoenix de novo. We are delaying the startup construction on this project until growth trends in that market improve. Two Certificates of Need for de novo Williamson, Tennessee and Middletown, Delaware remain tied up in (inaudible) litigation. We now expect final CON approvals for these hospitals in 2013 and openings in 2014.

On the acquisition front we signed a letter of intent to acquire Walton Rehabilitation Hospital a 58-bed free standing rehabilitation hospital located in Augusta, Georgia and announced the signing of this LOI on Wednesday. We expect to close on this transaction early next year.

Lastly, in September we broke ground on a 53 bed replacement hospital in Ludlow, Massachusetts. This hospital is currently in a leased facility that is over 100 years old and as you can imagine quite antiquated in terms of layout and design including wards with multiple patients and shared bathrooms. The lease expires in December 2013 which gives us the opportunity to build a replacement facility. The replacement hospital will be owned by HealthSouth and will be designed with our standard efficiencies and amenities including all private rooms.

These solid results underscore the strength and consistency of our business model and have contributed to vary strong year-to-date performance. Through the first three quarters discharges have grown 4.4%, net operating revenues have grown 6.6%, adjusted EBITDA has grown 9.9% and adjusted free cash flow has grown 29.6% compared to the first three quarters of last year.

We believe the disciplined execution of our business plan, protecting our balance sheet, expanding our IRF footprint through debt expansions, de novos and acquisition and investing in our operational infrastructure through enhancements to our management reporting capabilities, rolling out supply chain initiatives, installing an electronic medical record system and successfully implementing various team work initiatives, all have allowed us to produce this consistently strong results. We also believe they serve as a foundation for continued success going forward.

With that I will turn the agenda over to Doug for a more thorough review of the quarter.

Doug Coltharp

Thank you, Jay and good morning everyone. As Jay mentioned Q3 represented another strong quarter for our company. During Q3 we amended the partnership agreement governing our 50-50 joint venture with St. Vincent rehabilitation hospital. St. Vincent has been one of three JV hospitals operated by HealthSouth that is accounted for under the equity method rather than being consolidated at the HealthSouth’s financial statements.

The amendment revise certain participatory rights related to the governments of the St. Vincent JV resulting in HealthSouth gaining control from an accounting perspective. And accordingly the results of St. Vincent rehabilitation hospital are now consolidated into HealthSouth’s financial statements beginning with Q3 2012.

This is purely an accounting determination, our ownership interest in St. Vincent has not changed and no cash outlay was involved. The impact of the St. Vincent consolidation on our Q3 financial and operating metrics detailed on Slide 32 and 37 of the supplemental slides filed with our press release.

Now let’s move into the Q3 results. For Q3 2012, revenue grew by 7.9% driven by 8.7% increase in inpatient revenue offset by a 2.1% decline in outpatient and other revenue. The growth in inpatient revenue resulted from a 4.2% rise in discharge volume. 1.7% attributable to same-store and a 4.4% increase in revenue for discharge.

The St. Vincent consolidation contributed 130 basis points to our Q3 discharge growth and it was treated as a new store. Our Q3 discharge volume was unfavorably impacted and conversely our Q3 revenue for discharge was favorably impacted by the timing of patient discharges from the last week of September into the first week of October.

We experienced a modest increase in the length of stay of our September patient population which we have seen normalized in October. Because we accrue revenue on a per DM basis much of the revenue associated with the carry over patients was recognized in Q3 even though the discharge has occurred in Q4. It's difficult to be precise in quantifying the impact of this modest increase in length of stay. With that caveat we estimate that it adversely impacted Q3 discharge volume growth and positively impacted Q3 revenue for discharge by approximately 100 basis points each.

In addition to the lapse they increased, the factors contributing to the increase and net revenue for discharge were similar to those cited for the first half of the year and included improved pricing for Medicare and managed care payors, an increase in the average acuity of our patients, growth in neurologic comprised 37.3% of our patients in Q3 2012 as compared to 33.9% in Q3 2011 and a higher percentage of Medicare revenue.

The decline in outpatient and other revenue was primarily attributable to the operation of two fewer satellite clinics. At the end of Q3 2012 we operated 26 satellite clinics as compared to 28 at the end of Q3 2011. There were no closures during the quarter. As anticipated, bad debt expense increased to 1.3% of net operating revenues in Q3 2012 as compared to 1% in Q3 2011. The factors leading to the increase was a same as those we have discussed throughout the year. An increase in medical necessity reviews and the lengthening of the Medicare denials adjudication process.

During Q3 we continued to exhibit improved operating leverage and labor productivity. SWB for the quarter was 48.8% of net operating revenues, a decrease of 40 basis points from Q3 2011 as enhanced productivity evidenced by decline in EPOB to 3.46 from 3.53 a year earlier more than offset our continued investment in a higher skills mix, including additional CRRNs and support personnel and outgrowth of our TeamWorks Care Management initiative.

Our hospital related expenses which includes other operating supplies and occupancy improved by 90 basis points in Q3 2012 versus Q3 2011. This was primarily attributable to supply chain efficiencies notably drug cost and lower occupancy expense which more than offset the increased expenses associated with rollout of our new clinical information system.

Our G&A expense which includes stock compensation expense as a percentage of net operating revenues remained flat year-over-year at 4.3%. The combination of strong revenue growth and improved operating leverage generated adjusted EBITDA of 125.2 million for Q3 2012 an increase of 13.3% over Q3 2011.

For the first nine months of 2012 adjusted EBITDA was 377.3 million an increase of 9.9% from the same period last year. The St. Vincent consolidation contributed approximately $500,000 to 2012 Q3 and nine months adjusted EBITDA. As we look to Q4, please be reminded that as previously disclosed and reflected in our guidance, we anticipate a higher run rate of bad debt expense, workers’ compensation cost and expenses related to the rollout of our clinical informational system to continue. Also contributing to year-over-year increase in Q4 expenses is our recent decision to replace the 2012 merit increases which normally would have taken effect on October 1, with a one-time merit based year-end bonus to be paid in December of this year to all eligible non-management employees. As a result we expect SWB to increase by approximately $11 million in Q4. This is reflected in our revised guidance. Our previous guidance had assumed a merit increase of 2.25% effective October 1, 2012 which would have increased Q4 2012 SWB by approximately $5.5 million. Additionally, please recall the Q4 2011 benefited from a $2.4 million non-recurring franchise cash recovery.

Interest expense for Q3 was $23.5 million this compares favorably to the $26.3 million incurred in Q3 2011 and represents a modest increase from the $23 million experienced in Q2 2012. The increase over Q2 2012 is attributable to our September issuance of $275 million a 5.75% senior notes to 2024. Approximately $195 million of the proceeds from this offering were used to pay down the outstanding principle balance under our revolving credit facility. In addition, approximately $65 million of the offering proceeds were used to fund an optional redemption of a portion of each of our 7.25% senior notes to 2018 and 7.75% senior notes to 2022. These redemptions were completed earlier this month. We now expect Q4 interest expense to approximate $25 million.

EPS from continuing operations for Q3 2012 was $0.44 a share as compared to $0.17 a share in Q3 2011. Our Q3 EPS was reflective of strong operating results and also benefited from two items with an aggregate after-tax impact of $0.05 per share. A $4.9 million gain on the St. Vincent consolidation and a $3.5 million gain on a recovery from Richard Scrushy.

Our Q3 2011 diluted EPS included an $0.08 per share after-tax loss on the early extinguishment of debt related to the retirement of our 10.75% senior notes. The effective tax rate for Q3 2012 was approximately 37% compared to approximately 45% for Q3 2011.

Q4 2012 will include a $2.7 million loss on the early extinguishment of debt related to the aforementioned partial redemption of the 2018 and 2022 senior notes. Adjusted free cash flow for Q3 2012 was 71.6 million versus 32.3 million in Q3 2011. The primarily components of the year-over-year increase were higher adjusted EBITDA, favorable working capital flows and lower interest expense.

Working capital in Q3 2012 was favorably impacted by the shift of a $12 million interest payment from Q3 2011 into Q4 2012; this will negatively impact Q4 2012 adjusted free cash flow. These items were partially offset by the increase in maintenance CapEx. Adjusted free cash flow for the first nine months of 2012 was 186.8 million as compared to 144.1 million in the comparable period of 2011. Again the increase was largely attributable to higher adjusted EBITDA, favorable working capital flows and lower interest expense.

The 2011 period included a swap settlement payment of 10.9 million. The improvement in these items was also partially offset by the increase in maintenance CapEx. For the first nine months of 2012 our maintenance CapEx totaled $68 million as compared to $35.1 million for the first nine months of 2011. The increase is reflective of our planned investments in hospital refresh projects and a bed replacement program as well as the installation of our clinical information system. We continue to expect maintenance CapEx for the full-year 2012 in a range of 75 to $85 million.

With that I will turn it back to Jay.

Jay Grinney

Thank you, Doug. Before I discuss guidance, our General Counsel, John Whittington will provide an update on the E&Y arbitration.

John Whittington

Thank you, Jay. The rules of the American Arbitration Association required at all aspects of the arbitration remain confidential. So, as you know we are limited in what we can disclose to you. We can’t tell you that since the beginning of the arbitration in July of 2010 there have been appropriate 105 days of hearings generally in four day [bought some time].

We can also provide you with this brief update. Number one, HealthSouth requested a temporary stay of the arbitration proceedings shortly after we learned on August 17, 2012 that the Alabama Supreme Court will hear own appeal, a case where HealthSouth has previously prevailed on an income tax brief on claim at every administrative and judicial level, including the Alabama Court of Civil Appeals. And number two, on October the 12, 2012 the AAA panel ended in order temporarily staying the arbitration proceeding. We cannot predict how long the stay will remain in effect.

Although this income tax case before the Supreme Court is not related to the E&Y matter it does raise one very important legal issue which is present in the arbitration. Specifically, whether under Alabama law the wrong doing of disloyal employees can or should be attributed or imputed to the employer. In particular, the State Revenue Department of Alabama argues that the Supreme Court should consider the circumstances under which a tax fare is valid statutory refund claim maybe defeated based on the misconduct of its former employees and in turn the circumstances under which the wrongful conduct of such disloyal employees may be attributed to or imputed to the corporation. As I’ve said, we think this is an important legal issue in the arbitration proceeding.

Pending the stay, no additional hearing dates are presently scheduled and at this time we are uncertain when the arbitration proceedings might resume. We do know however that the Alabama supreme court has said oral arguments on this case were November the 7, 2012. We would expect a fairly top ruling from the Supreme Court after that oral argument. Meanwhile, we remain confident in our claims and we are committed to aggressively and diligently pursuing deals.

And with that I will turn it back to Jay.

Jay Grinney

Thank you, John. As Doug mentioned in his remarks and as we have stated in our press release, the company’s fourth quarter results will be negatively impacted by the decision to replace 2012 merit increases with a special merit based UN bonus for all non-management eligible employees. Management salaries also will be frozen and management will not be eligible for this special year-end bonus.

At the same time that we announced this special bonus, we announced that the company would absorb the full cost of medical plan benefit increases for employees in 2013, so, as to minimize any negative effect under take home pay. We believe this action will partially offset the effects of sequestration in 2013 and more importantly it rewards our employees for their contributions to the company’s success this year. The response from our hospitals has been positive.

We’ve had opening communication throughout the year about how healthcare in general and HealthSouth in particular would be negatively affected by sequestration. The feedback we have received indicates our employees understand the rationale for the action we have taken, and appreciate that while their base salaries are not increasing, their efforts are being recognized with the special bonus and their take home pay is not being reduced through health benefit increases.

As Doug mentioned the one-time cost of this special bonus is approximately $11 million and will be included in salaries and benefits in the fourth quarter of 2012. Our previous full-year adjusted EBITDA and EPS guidance assume a 2.25% merit increase effective October 1. So, the net effect of this bonus vis-à-vis our guidance is approximately $5.5 million.

Even after absorbing the cost of this special bonus, we are able to narrow our full-year adjusted EBITDA range and raise our EPS guidance range as follows; 2012 adjusted EBITDA is now expected to be in the range of 490 million to $495 million while 2012 earnings per share is now expected to be in the range of $1.49 to $1.53 per share. Some of the key considerations for this updated guidance can be found on pages 15 and 16 of the supplemental slides that we provided with the press release.

With that Lynn we will open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Sheryl Skolnick with CRT Capital Group.

Sheryl Skolnick - CRT Capital Group

Couple of questions, as you look at the business, clearly you are making preparations for what could be a challenging year from a reimbursement perspective in 2013, and I have to say that if I were a HealthSouth employee, I’d feel quite a sense of loyalty to management for having taking or the steps you have taken to communicate the banks, the appreciation and the care that you have. And in addition the other details are welcome in terms of management pay freezes and the like, could you outline at this point what other steps you think and I’d imagine it being broad terms at this point you would take if necessary if the 2% sequestration kind of ends up being the best case scenario for next year?

Jay Grinney

It's really a broad range of different initiatives obviously we have spend a lot of time on our non-labor costs, we have invested quite a bit into our supply chain initiatives and we believe that we will continue to see improvement there. And then of course on the labor side, we are always looking for efficiencies as we bring on new volume and we will be looking to continue to take market share into 2013. We believe that those additional patients can be served on a high quality basis and without having to add a dollar of cost for each additional dollar of revenue. From a global perspective, looking at it from a company standpoint if we were to find ourselves in a situation where the reimbursement environment was worst than sequestration, we have the ability to turn off some of the capital spend so as to preserve the integrity of our balance sheet moving forward.

Now we don't envision that having to occur but we are certainly prepared to do that and as we have stated over the last probably 18 months one of the beauties of our growth strategy as it relates to de novos and frankly even acquisitions is the ability to turn that switch on and off pretty quickly without incurring additional capital outlays that would obligate us for an extended period of time. So, kind of how we are looking at the business and again believe that the underlying demand for impatient rehabilitation is such that, we will be able to continue to treat more patients not only just through the organic growth but also through taking market share.

Sheryl Skolnick - CRT Capital Group

And one of the few companies actually that I’m dealt with is (inaudible). And then speaking of the volumes, you clearly continue to excel in that regard. And I almost have to take your assets because last quarter when I did the stock went down. Given as a shot at it Jay, so clearly [life point] is a disaster this morning, other companies have reported debt will cause a leak if not off of volume. Are you seeing, but there is clearly a change in the (inaudible) and it seems like it's shifting more towards Medicare. Why are you seeing slowdown from the upstream provides and if you could stick to it as qualitatively or by patient type, because I have to think it's efficient that while there may be fewer heads in the bed more of those heads maybe [attentive] what you treat i.e., stroke etcetera given the diabetes and the blood pressure issues etcetera in the country then the surgeries that are the (inaudible) hospital sector. And I’m wondering if you are beginning (inaudible).

Jay Grinney

We have seen that and I think it really is a reflection of some of that discretionary business that you see in acute care hospitals is probably where they see a lot of that slowdown. As I mentioned minute ago, the fact that the over 65 cohort is continuing to grow and inevitably we get even those of us who don't want to acknowledge this, the more susceptible we are to the kinds of conditions that we ultimately create in our hospital. So, what we are seeing is a pretty steady demand, increase in the demand for our services if there is anything that we might see upstream that might be a little bit in the orthopedic but as you know that is a very small part of our business. Those cases are not complying cases for the most part and so really we are not seeing that much of an impact on our volumes. And I think it's worth reminding those who maybe fairly new to the story that its really impossible to do a one-to-one co-relation between what’s happening in the acute care world and what’s happening in our world because a very small number of patients being discharged from acute care hospitals need impatient rehabilitative care and most of those are Medicare patients. So, it's somewhere in that 3 maybe 4, 5%. So, as you think about the acute care denominator that could go down a lot and still not really bet the kinds of patients that need rehabilitative care and that we are able to treat in our hospital.

Operator

Your next question comes from the line of Gary Lieberman with Wells Fargo.

Gary Lieberman - Wells Fargo

Maybe just going back to the comments that John made around the Alabama Supreme Court, just to make it really easy for us to understand. So, am I understanding correctly that if the spring quarter reverses the fire decisions and that would be negative for you guys and if they uphold it and that was essentially be positive?

Jay Grinney

That’s correct; I think you got it exactly right.

Gary Lieberman - Wells Fargo

And then earlier this week I guess last week there was a settlement announced between provider groups and CMS that would allow therapy to be provided to patients even if there wasn’t the likeliness that their function would improve. Do you guys see any potential benefit to (inaudible)?

Jay Grinney

Gary, we do think that there is a benefit. I think it's sort of hard to quantify exactly how that will directly impact us; we do believe that there will be a very direct benefit with respect to the adjudication of the denied claims. As you know we’ve talked about this fairly consistently, there is only one fiscal intermediary or [MAC] that’s the one here and Birmingham, that’s Cahaba and for the next short period of time until the [MAC] conversion is completed at which time only our hospitals in Alabama, Tennessee and Georgia will be under the [MAC] and currently we have like 70 hospitals. So, at some point we will be out from under this sort of arbitrary fiscal intermediary, but we do believe that it bolsters frankly a lot of our claims, that these patients that we treated whose physicians have said they need to care will benefit from the care and deserve that care. We will be able to look to this ruling we believe as further evidenced in substantiation that those patients should have been in our hospitals. So, we do hope that there will be that benefit whether or not it will result in new patients coming in, I think that’s a lot farther to really pin down, but I do think net-net this is a favorable ruling for patients who need and deserve inpatient rehabilitative care.

Operator

Your next question comes from the line of Ann Hynes with Mizuho Securities.

Ann Hynes - Mizuho Securities

So, I actually want to ask you about the presidential election Jay, I guess from a business perspective which [outcome] do you view is best for HealthSouth?

Jay Grinney

Ann, I don't think we heard that question. That’s a tough one. I think that frankly who is in the Whitehouse while that’s very, very important. I believe that more important is what’s the composition of Congress, means if there is no doubt that we are at [gridlock], there are huge problems that need to be addressed, they need to be addressed in a comprehensive manner. And so I don't know that there is any one that really is going to benefit us in terms of the Whitehouse one way or the other. I’d say that from an overall business perspective, having Romney win would be better because frankly the biggest challenge we face right now is just this huge amount of uncertainty because of the [gridlock] and that uncertainty that we feel in our little company is felt for our healthcare throughout the entire business community. And there are all kinds of reports about capital decisions being deferred growth decisions being deferred because of the enormous uncertainty coming out of Washington coupled with all of these regulations that keep pouring out of the administration. So, I’d say from that perspective it would clearly be better to have Romney win versus the President staying in.

Ann Hynes - Mizuho Securities

And my second question it has to do with between (inaudible) as it goes against you, would you be at risk of having to repay some of the tax income that you received in the past?

Doug Coltharp

First of all let me say the amount of the tax refund is a relatively small amount. I think it's under $500,000, but no, we would not have to pay it backward trying to get a rethought. We paid it and now we are trying to get it back.

Jay Grinney

Yes, so it relates to income taxes here in Alabama. And frankly we have been successful elsewhere in getting those refunds. It's ironic that our home state is fighting this, but the state is in pretty dire straight from a financial standpoint. So, we suspect that they feel obligated to try to defend this and we will know once the Supreme Court hears the case here in November.

Operator

Your next question comes from the line of Colleen Lang with Lazard Capital Markets.

Colleen Lang - Lazard Capital Markets

Just a question on the cash flow, just given how strong the free cash flow generation has been year-to-date as well as the solid position of the balance sheet. Can you just talk about your expectations for use of cash particularly either using it for buyback or potentially dividend?

Doug Coltharp

It starts with the fact that we will have, we already have had in Q4 $65 million outflow related to the call on the 2018 and 2022 notes. We also announced this week the acquisition of the Walton Rehabilitation Hospital and Augusta, Georgia that will be a cash outlay and we also discussed in our call today the fact that we are building a replacement hospital in Ludlow, Massachusetts and obviously it's an additive use of cash as well. With regard to buyback, you saw into the first half of the year, that we made some repurchases of our convertible preferred stock. We do not make any purchases in the third quarter, but there is a remaining authorization outstanding under that and we have an outstanding authorization, the value has been utilized for common stock repurchases. With regard to a dividend I think it's safe to say that at this point we have no immediate plans to initiate a dividend either ongoing or one time. That’s something that we continue to evaluate as cash accumulates, but frankly as we continue to face a period of uncertainty we think it's prudent to have little bit extra liquidity on the balance sheet.

Jay Grinney

And then the opportunity to buy out some of the leases.

Doug Coltharp

And we have talked before and really Ludlow is an example of this about the ability to move from a least real estate portfolio to more than owned real estate portfolio. You saw us through the course of 2011 take that action on a couple of properties, that’s on a way an effective deleveraging but it also reduces the ongoing operating cost for the company and gives us much better control over the real estate moving forward as well as putting us in a position to control things like bed life and the Certificate of Need. We got a number of properties where we believe we may have the opportunity to move from leased to owned in 2013 and 2014 and where those opportunities arise we will make financial determination to whether or not that’s a compelling use of the cash.

Operator

Your next question comes from the line of Whit Mayo with Robert Baird.

Whit Mayo - Robert W. Baird & Company

Jay I wanted to go back and follow-up on your comments about Cahaba since there has been some discussion in the past few months about some potential coverage determination changes and I think it was mostly proposed for lower extremity joints and is there just any material change that you have seen or I guess said another way, anything that you are paying attention to that we need to be paying attention to.

Jay Grinney

Nothing that we haven’t been paying attention to all along. We do believe that there are some unique circumstances there at Cahaba, w are planning to share our concerns with them because we don't see this kind of behavior from other medical directors of other fiscal intermediaries. And our take on this proposed coverage determination was that it was a huge, huge overreach. And frankly it was a sort we think big power grab that fortunately the rest of the industry agreed with us and there was so much commentary I think that they had to step back and rethink it. But there is one guy over there and he has had a fur under his saddle for a long time against this company. And we are going to be approaching that and trying to address that. We are very concerned and it's one individual, so I think we will be able to address it whether or not a changes in behavior I don't know.

The good news is right now we are sort of we are a little bit at Cahaba’s mercy and we made the decision when the MAC configuration was announced, we had the opportunity to either put all of our hospitals under Cahaba or go to a more regional orientation where the hospitals would be under the MAC that had the, one contract for that region. We made the decision to go the regional route. So, at some point when the MAC transition is completed nationwide, we will be able to pull all but a handful of our hospitals out from Cahaba and that will certainly be a big relief that we will be dealing with other fiscal intermediaries that don't have quite the same kind of internal problems that Cahaba does.

Whit Mayo - Robert W. Baird & Company

I guess just to be clear, your understanding is that they have rescinded.

Jay Grinney

Yes definitely. So, whether or not it's over who knows, I mean it's this guy is a very hard to predict, but you can be very, very confident that this something that is on my radar. I have gotten to the point where so I got to the tipping point and said enough is enough. And we are going to be talking with the leadership over there. If need be we will talk to leadership in Baltimore but this is a situation that we think is really out of control.

Whit Mayo - Robert W. Baird & Company

And my second question just relates to your Cerner clinical IT initiative right now. I just was hoping that you could remind us where you are in that conversion and I can’t remember if you were planning to deploy CTOE this year or into next year, but I guess just in general I was wondering how satisfied you are with that conversion and any signs of benefit that you can see from that investment at this point.

Mark Tarr

This is Mark. The conversion or transition is done quite well, by the end of this year we will have total 13 hospitals converted over the Cerner platform. Next year we will add another 20 to 23 hospitals. So, we are very pleased with the way it's going so far. I think it's definitely too early to identify benefits as you had mentioned that earlier. But certainly there are going to be quality oriented benefit, it's just a blessing out better communication, coordination among the treatment teams. So, we are pretty pleased with how it's gone so far.

Operator

Your next question comes from the line of Darren Lehrich with Deutsche Bank.

Darren Lehrich - Deutsche Bank

My question is just as it relates to Medicare advantage. I know it's only about 7 or 8% of your revenue. But I guess I wanted to hear from you how the pricing model and just the pricing agenda is going with MA plans. We have seen from some other post-acute providers really in the home health space sort of devaluing of their services. So, I’d be curious to see your thoughts on how you think MA plans or thinking about your services is anything to note there and what your overall pricing outlook is in both MA and on the managed care side?

Jay Grinney

I think overall the vast majority of the Medicare advantage plans recognized the value of inpatient rehabilitative care. Now there will be from time to time difference of opinion between the plan and the admitting physician about whether or not the patient should be in our hospital, typically those end up being some of the orthopedic cases with co-morbidities. But for the most part we feel that the plans understand that we can bring value to them by getting the patients into our hospitals, rehabilitated, back to their homes and not cycle back into an acute care setting. So, we have over the last several years, worked pretty hard at educating and providing the data to the medical directors of the Medicare advantage plan to help them get to that point.

With respect to the pricing, I’ll make a general comment then I will turn it over to Mark for more specifics. But the one trend that we are seeing that we think is favorable is the movement away from per diem pricing to case rate pricing. And often times those case rates are very close to if not equal to the CMGs that we get from traditional Medicare. So, those two things working in concert I think really is sort of a good sign as we think about the next 5, 10 year's if Medicare advantage really starts taking off.

Mark Tarr

Darren we feel good about the work in progress that our managed care team made over past several years. We probably had some (inaudible) if you look back where we were several years ago in terms of working through the contract and building relationships with the payers. As you can imagine we are a pretty small portion of what the payers had to consider out there. But as Jay said we have work to design our contract to more at CMG type for discharge basis instead of a per day. And we have had some doing it; we are out there every day talking about our value proposition where the quality and our outcomes come into play. So, I’d feel overall it's been very positive.

Jay Grinney

As we move into an environment where quality and outcomes matter, and it is not just a matter of a press release day price which really is reflective of the past. Everybody was focused exclusively on one part of the value proposition and that was how much does it cost per day. And there is no question on that basis, nursing homes are always going to be able to provide or win that debate because they don't have the resources. They don't have the kind of nursing capabilities, they don't have the therapy capabilities, they don't have the investment in technology, they are not licensed as a hospital.

So, you go forward and all of a sudden now we are starting to see Medicare we are starting to see the commercial plans, acknowledge that there is a big difference between providers and those are big difference in outcomes and quality and the value proposition is becoming more comprehensive and we think that that really plays to our strength and if you then couple that with the investments that we are making in our infrastructure specifically in our electronic medical record system and the ability to integrate our patients data with those of other providers and it's an investment that to our knowledge none of the other post-acute providers are doing. They maybe waiting for some government (inaudible) to help them get there. We said we are going to do it because we think it positions us very, very well for the future and where this whole industry is going. So, I think that all of that really sort of speaks to the fact that as the industry moves in any direction be it more Medicare advantage, more traditional Medicare, it's going to be defined by a larger value proposition that what we have seen in the past and we think we are uniquely positioned to do very, very well in that kind of environment.

Darren Lehrich - Deutsche Bank

And just Mark if I could just understand what portion of your overall book of business at this point is on case rates; give us a sense for that. And my other follow-up question that I had was, in thinking about the fourth quarter action with regard to the one time merit. Is it right to think about that as essentially offsetting for next year by doing what you do in the fourth quarter? Around two-thirds of sequestration is that sort of a rough math.

Jay Grinney

First of all Darren I think what we will do is when we present our 2013 guidance, I think we will be able to provide some of the color commentary, because there is a lot of moving parts. Obviously we took this action as a way to help prepare the company for sequestration with the goal obviously looking to continue to grow and that’s clearly our objective going into next year. We want to grow EBITDA, we expect that we are going to be able to do that, we are putting the budgets together. They are not finalized but taking the action this year was really a way of saying we have one extremely important resource in this company and that’s our employees, without our employees we are nothing. They provide the care they are the ones that have the hands on direct contact. We do not believe that it was in the best interest of the company to increase our cost basis on a permanent basis going forward knowing that a) we got sequestration and b) the risk of additional cuts down the road.

On the other hand we wanted to reward our employees for their contributions when we had the resources to do so. So, we paid or were going to be paying this one-time bonus to non-management, really in recognition of what their contributions at then. It will be a part of the mitigation, but quantify is it going to be a third or two-thirds or half a quarter. I mean at this point I think that’s very premature. I think what you can take confidence in is that this along with other measures that we are taking are all designed to create a foundation upon which we can grow EBITDA into 2013 and we will provide that commentary when we report fourth quarter results in February.

Mark Tarr

Darren, on the case rates I’d say that I don't have specific number for you but for last year and a half all the contracts that we have negotiated from the NA side has been more focused towards the CMG or case rate. And to point where the majority of that is coming from a case rate basis.

Operator

Your next question comes from the line of AJ Rice with UBS.

AJ Rice - UBS

Just two quick things here, can you comment, we had two quarters where the discharge on a same-store basis has been about 1.9, 1.7. You have given guidance for the fourth quarter of 2.5 to 3.5 on a consolidated basis. I guess, and that is the 1.3 of same instance consolidation, is that in that 2.5 to 3.5 in the fourth quarter. And then sort of that 1.7, 1.9 type of rate sort of the same store discharge growth numbers that you are expecting now settle into?

Jay Grinney

Well, yes the same is included in that and if you do the math that implies that there is some (inaudible) standpoint, because of the holiday period from Thanksgiving through the end of the year, it's just it's very, very difficult to predict. But as you can infer from Doug’s comments the fact that we had discharge is spilling into October certainly suggest that we are off to a very strong start in the quarter. It's just we want to be conservative, we want to be respectful of the fact that there is a lot of unpredictability in knowing precisely what kind of volume we are going to see in the holiday period. Having said that I think people can look back over the last five years and can see we do well. We just don't want to get ahead of ourselves and so we are kind of sticking with that 2.5 to 3.5.

Doug Coltharp

It's important to note it well, that the discharges that we realized in the beginning part of October which from carrier over patients from September and October, certainly are additive to our Q4 discharge volume growth, because much of the revenue associated with those discharges are included in the third quarter in a ways somewhat against the net revenue per discharge in Q4.

AJ Rice - UBS

Just another data point you referenced obviously the length of stay in September mean unusual. Obviously for the quarter you are only variants were about two-tenth of one or 0.2 I guess. Can you give us a flavor for how big swing that was in September and then did you drill down and was there anything unusual happening or is that just a one month anomaly.

Mark Tarr

(Inaudible) forecasting about discharges, each one of our hospitals have discharge calendars so that project out over the course of a patients day when they would expect that discharge to take place. There is a lot of factors that are going into it, the level of progress that the patient is making in their care; the discharge plans for the discharge home, the families have to stay in that, of course the attending physician. In this case the month ended the last three day a month were Friday, Saturday and Sunday. Friday is usually a large discharge day, for us Saturday and Sunday are light.

Operator

Your next question comes from the line of Kevin Fischbeck with Bank of America/Merrill Lynch.

Kevin Fischbeck - Bank of America/Merrill Lynch

In the past you have talked about sequestration being a headwind and being able to freeze rate to labor as being one of the levers that you do that. So, this is basically you are just implementing that, it sounds like. There was some commentary in the slide deck around updating the perspective way to adjustments when you talk about 2013. What is that referring to; you are saying that you might adjust your (inaudible) wages in 2013 and ’14?

Jay Grinney

We had said in the past that one of the ways that we can protect the company and ensure that we are positioned to deal with the uncertainty of sequestration or even additional cuts should they come would be to look at ways to be flexible on how we invest in our employees. And so by given them a merit while we have the resources, absorbing the cost of the health benefit increase to protect their take home pay was one way to do that.

Kevin Fischbeck - Bank of America/Merrill Lynch

Second question, what are you hearing if anything around things that might impact ERFs as far as either the doc fix adjusting sequestration or the next step ceiling. And I guess in particular there is some rumbling that we may see a delay of sequestration, but it kind of feels to me like it's just a delay rather than eliminating sequestration and any delay may come with additional cuts to fund. So, any delays comes with initial cuts somewhere else, so what your thoughts were around your positioning there and I guess do you believe that delaying sequestration is a good thing or a bad thing?

Jay Grinney

Well, first of all we think that delaying sequestration is frankly it's kind of a smoke screen and less there is some real changes that replace it. Remember that sequestration was put in effect to the budget control act in a modest effort to reduce our federal budget deficit. So, if sequestration is over turned, all that does is it then increases the budget deficit and makes the debt ceiling that much more vulnerable to be breached. Sequestration was never a great fix it was a default position. It wasn’t anything that people should be proud of the missed opportunity was to come up with a plan that was really going to substantively address the huge fundamental serious financial problems that this country faces.

The flip side is that we think we are very well positioned to deal with that because of our cost structure, because the fact that we don't have a lot of debt on our balance sheet, we got a lot of flexibility and how we invest cash that w are generating and we are fortunate to be in a segment where the demand is increasing because of the aging population.

Operator

Your next question comes from the line of Sheryl Skolnick with CRT Capital Group.

Sheryl Skolnick - CRT Capital Group

My question is, and I apologize, we are so much distracted when Doug was going through the cash flow commentary. So, if you could just help me on a couple of things. First could you give us a pro forma cash balance for the 9.30? You gave us the pro forma debt, but (inaudible) assuming the pay down. And two, could you just refresh for me what your commentary might be about fourth quarter cash flows and whether they might be approximately in the neighborhood of the third quarter adjusted free cash flow, because my thinking is that you are not going to get the cash but the end of September discharges is over fourth quarter.

Doug Coltharp

In terms of adjusting the pro forma cash number, what’s really not included in there is that although the call on the 2018, 2022 notes was initiated in September is actually funded in October. So, that use of cash moved over into Q4. And that was approximately $65 million. With regard to the impact of those carryover discharges, that’s really factored into our working capital assumption and that was a full-year included one of our supplemental slides. The other thing that’s happening again between Q3 and Q4 is this shifting (inaudible) $12 million interest payment. It had a favorable impact on working capital in Q3; it puts the other way based on when the coupon dropped in Q4.

Sheryl Skolnick - CRT Capital Group

The pro forma guesstimate for cash at the end of September would have been around $98 million?

Doug Coltharp

It's approximation.

Sheryl Skolnick - CRT Capital Group

Then you have this shifting of the interest and that’s in the working capital. Was the working capital assumption terribly different from the prior assumptions, as I don't recall what it was?

Doug Coltharp

We tried to down a little bit.

Operator

Your next question comes from the line of Frank Morgan with RBC Capital Markets.

Frank Morgan - RBC Capital Markets

Obviously you are preparing for difficult environment for next year and so that make me wonder of the other rehab operators that are out there, either unit operators inside of acute or remaining free standing others. Is this really create an opportunity for the acquire and do you even really want to acquire year where things seem to be so uncertain.

Jay Grinney

I think that it does present some opportunities to acquire or to joint venture and yes we do have an appetite for acquiring and consolidating the space. And we feel that it is a very low risk way to continue to grow eve during times of uncertainty and we position the balance sheet to be able to do this. We are not going to have to rely on the balance sheet to grow. So, the cash flow that we are generating is going to allow us to pursue these growth opportunities and we do believe that the trends that we have seen over the last two to three quarters will continue. And that trend is the acknowledgement by many acute care providers that there they have limited ability to continue to offer a full remainder services in a environment where the reimbursement is being cut back. And I think there are lot of these providers acute care hospitals who are not only looking at 2013 and the affect of sequestration and Medicaid reductions, but they are going out to 2014 and saying, when the insurance companies no longer deny, they have got to price their products less aggressively.

Frank Morgan - RBC Capital Markets

And as it relates to valuations and may be if you could use your recent acquisition as an example, directionally if you can’t talk about specific valuations but directionally do you feel like valuations of your more recent transactions are starting to reflect that growing uncertainty and therefore getting better valuations or is it about the same?

Jay Grinney

I think the valuations are really acquisition specific, but clearly we are not going to acquire something that is not accretive, and in the case of Walton that’s a great hospital. I mean with the fabulous tradition, they have just really spectacular reputation there. I think that the board saw that the challenges going forward were such that linking with the largest provider of rehabilitative care in the country would be a good thing.

Operator

Your final question comes from the line of Miles Highsmith with RBC.

Miles Highsmith - RBC Capital Markets

You touched on this in a couple of prior questions, but getting back to the topic of you guys or once you factor in length of stay and percent readmits that you are on, total cost, total episode of rehab can be less than other alternate sites of care. That seems to be potentially pretty powerful information and data as we head into next year, coming years where we are looking at more value for healthcare and potential budget and other discussions. Have you pushed hard with CMS Congress and then the guys outside just the commercial payers on that information? And assuming so what’s been the response.

Jay Grinney

We have been working on that for several years and we believe that the messaging has been very well received, because the members of Congress and particularly their staff are the ones who really are knowledgeable about the need to move into a more value based delivery system where quality and outcomes matter and we believe long-term we will help to drive down price. So, it's been fairly mature process, we have got an outstanding individual whose name is Justin Hunter. He's our Senior Vice President for Government Relations and Public Policy. He is based in Washington DC and he does phenomenal job of constantly working with the members, their staff, the committees of jurisdiction and I mean it's just an ongoing process.

Miles Highsmith - RBC Capital Markets

And just one follow-up, (inaudible) I’m just curious if you said if there is any energy on the (inaudible) and then even if so is it right to think that that could realistically only apply to a small number of DRGs or cases if you were to compare to alternate sites of care?

Jay Grinney

First of all, we are not sensing that there is any momentum in DC on the site neutral. Now does that mean that it will never resurface? I suspect that it will be something that overtime we will be looked at but if you think about where the industry is going and let’s just assume that everything that CMS would like to see happen occurs, which is to say that we move from an episodic to a case (inaudible) arrangement where we have ACOs and our bundled payments. In that kind of environment the arbitrary distinctions between one provider, one post acute provider and other really become immaterial.

Operator

And this concludes today’s question-and-answer session, I’d like to turn the floor back over to management.

Mary Ann Arico

Thank you. As a reminder we will be filing updated Investor Relations book in November and attending the Lazard Healthcare Conference and the Citi Credit Conference in mid-November. If you have additional questions we will be available later today, please call me at 205-969-6175. Thank you.

Jay Grinney

Thank you everyone.

Operator

This concludes HealthSouth third quarter 2012 earnings conference call. You may now disconnect.

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