RehabCare Group Q3 2007 Earnings Call Transcript

| About: Rehabcare Group (RHB)
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RehabCare Group, Inc. (NYSE:RHB) Q3 2007 Earnings Call October 31, 2007 10:00 AM ET

Executives

Gordon McCoun - Investor Relations

John Short - Chief Executive Officer

Jay Shreiner - Chief Financial Officer

Peter Doerner - Senior Vice President

Alan Sauber - Senior Vice President of Government andRegulatory Affairs

Analysts

Robert Hawkins - Stifel Nicolaus

Derrick Dagnan - Avondale Partners

Balaji Gandhi - Oppenheimer

Robert Mains - Morgan Keegan

Operator

Good morning, ladies and gentlemen. And welcome to theRehabCare Third Quarter Earnings Call. At this time, all participants are in alisten-only mode. Later, we will conduct a question and answer session. Pleasenote that this conference is being recorded.

I will now turn the call over to Mr. Gordon McCoun. Mr.McCoun, you may begin.

Gordon McCoun

Thank you and good morning everybody. Welcome to theconference call to discuss RehabCare's third quarter 2007 earnings. With ustoday from management are John Short, chief executive officer of RehabCareGroup and other members of the senior management team.

Before we begin, I’d like to remind you that this conferencecall contains forward-looking statements that are made pursuant to the SafeHarbor provisions of the Private Securities Litigation Reform Act of 1995. Thisconference call contains forward-looking statements that are made pursue in theSafe Harbor provisions of the Private Securities Litigation Reform Act of '95.

Forward-looking statements involve known and unknown risksand uncertainties that may cause our actual results in future periods to differmaterially from forecasted results. These risks and uncertainties may includebut are not limited to our ability to consummate acquisitions and other partneringrelationships at reasonable evaluations.

Our ability to integrate acquisitions in partneringrelationships within the expected time frames and to achieve the revenue costsavings and earnings level from such acquisitions and relationships at or abovethe levels projected. Our ability to comply with the terms of our borrowingagreements changes in governmental reimbursement rates and other regulations orpolicies affecting reimbursement rates or policies provided by clients to otherpatients.

The operational, administrative and financial effect of ourcompliance with other governmental regulations and applicable licensing andcertification requirements. Our ability to attract client relationships or toretain and grow existing client relationships through expansion of our serviceofferings and the development of alternative product offerings.

The future financial results of any unconsolidatedaffiliates, our ability to attract and the additional cost of attracting andmaintaining administrative, operational and professional employees. Shortagesof qualified therapists and other healthcare personnel, significant increasesin health, worker's compensation and professional and general liabilityinsurance.

Litigation risks of our past and future business includingour ability to predict the ultimate costs and liabilities or the disruption toour operations. Competitive and regulatory effects on pricing and margins, ourability to effectively respond to fluctuations in our census levels and numberof patient visits.

The adequacy and effectiveness of our information systems,natural disasters and other unaccepted events, which could severely damage orinterrupt our systems and operations. Changes in federal and state income taxlaws and regulations, the effectiveness of our tax planning strategies and thesustainability of our tax positions.

In general and economic conditions including efforts bygovernmental reimbursement programs, insurers, healthcare providers and othersto contain healthcare costs. With these introductory comments out of the way, Iwould like to turn the call over to Dr. Short. Please go ahead.

John Short

Thank you, Gordon. Good morning and thank you for joining ustoday and Happy Halloween. I'm John Short, president and CEO of the company.I'm joined my by executive management team and Jay Shreiner our CFO. All of uswill be available during the question and answer period following our formalremarks.

On balance, we are pleased with the development of ourbusiness on the third quarter. We saw yet another period of sequentialimprovement in our contract therapy operating margins, which began in thelatter part of the first quarter and has been sustained in the second and thirdquarters.

Within HRS, we also saw improvement in both our inpatientand outpatient operating margins despite continued declines in the number ofunits and declines in the 75% rule impact discharges. In our freestandinghospital segment, we experienced growing pains during the quarter asperformance was impacted by start-up costs, increases in estimated contractualadjustments at one facility and a shift in pair mix at another.

Overall, we achieved operating earnings of $8.2 million forthe quarter or $0.22 per diluted share. These are the highest operatingearnings in EPS totals in the last eight quarters. I'll give you somehighlights of the quarter as they pertain to our operating results. Beginningwith contract therapy.

We're extremely proud of the progress that our contracttherapy business has made in the past 15 months. Integrating and acquiredbusiness that significantly expanded our number of clinicians, operatingrevenues and facilities. Operating earnings improved $2.1 million sequentiallyto $3.2 million.

The cumulative improvement in quarterly operating earningsfor the past six months was nearly $5.4 million. The divisions operating marginfor the third quarter stands at 3.2%, which reflects significant progresstowards our goal of 4.5% to 5.5% operating margins during 2008.

While we remain focused on improving our CT margins, we areturning our attention to stabilizing and growing our number of CT locations andexpect to return to net additions in our contract therapy portfolio beginningin 2008.

Moving on to hospital rehabilitation services, we continueto successfully manage our staff utilization and operating expenses, whichenabled us to achieve the 270 basis points sequential improvement in thedivision's operating margin, as operating earnings increased $5.4 million to$6.3 million in the third quarter, despite lower revenue quarter to quarter.For outpatient business saw continued improvement in operations to supportthese results.

In the third quarter, our same store 75% rule qualifyingadmissions increased by 1.1% compare to the second quarter of 2007 while totalsame store admissions declined by 1% sequentially. Same store admissionsyear-to-date ending third quarter versus the same time period of 2006 include a13.1% increase in non-Medicare volume.

On average, our units are currently operating at a 64.9%compliance level with 41 units having entered their 65% compliance level onJuly 1st. We expect to be fully compliant in all of our areas by the end oftheir special 65% compliance periods. We have increased our focus to supportthe hospital rehabilitation services business to a number of initiatives.

First, at the beginning of the second quarter, we rolled outa new initiative in collaboration with Gallup hoping to improve the process forselection and training of new field managers in HRS. To date, it is resulted inhiring of 15 new program managers. Operating results from the units managed byGallup's selected candidates have showed significant improvement in revenue andcontribution over the prior six-month performance.

Secondly, early testing of new products is underway. Ourfirst short stay rehab unit has met our performance expectations and offers analternative for patients that are negatively impacted by the 75% rule incertain markets. In addition, we're also testing a more comprehensive serviceoffering that includes nursing, case management, coding, denials and LTACHmanagement.

Thirdly, in late September, we signed a new three-yearagreement with Premier Inc. Premier is the largest healthcare provider alliancein the country with over 1,700 hospitals plus thousands (inaudible) otherhealthcare providers.

In addition, we renewed our relationship with VHA, whichrepresents over 1,200 hospitals for an additional three years. Both of theserelationships will give us a new or expanded Chanel to introduce our currentand future product offerings. Our freestanding hospital division saw operatingrevenue and earnings decline sequentially for the third quarter compared to thesecond quarter of 2007.

Several adjustments in both quarters significantly maskednormalized operating performance. However, in addition to these adjustments,the division experienced lower revenues in earnings due to case managementchallenges and isolated pair mix issues as well as start-up costs at itsAustin, Texas joint venture in the amount of $700,000.

Last quarter, I discussed steps that we had taken to turnaround one of our hospitals, which is underperformed in the second quarter. Wetook aggressive action by changing management, rebuilding referralrelationships, right sizing the staff and more closely monitoring expectedreimbursement.

This hospital has responded very well to these actions andhas significantly improved its operations during the third quarter. Rehabhospitals within the division, which the company managed through an average 75%rule compliance level of 63.7% during the quarter are expected to be fullycompliant at the end of their respective compliance.

As our prestanding hospital division continues to grow, weare accelerated our investment and leadership process standardization andinformation systems across the division in order to build a solidinfrastructure for more consistent operating performance in this division.

The division continues active development of five choiceventure projects. We announced one additional joint venture during the thirdquarter with which an agreement with landmark health systems Inc. of RhodeIsland to jointly operate the rehab hospital of Rhode Island and to develop along-term acute care hospital subject to certificate of need approval. Theacquisition of the rehab hospital subject to review by the state department ofhealth and attorney general. We expect to begin operations facilities duringthe second quarter of 2008.

The first phase of our 20-bed rehabilitation hospital jointventure with the Seton family of hospitals in Austin, Texas opened August 21stof this year. We're still awaiting state survey necessary to receive theMedicare provider network. This process may take longer than we haveexperienced in the past.

Second phase of this project will include a development of along-term acute care hospital and expansion of the rehabilitation hospital. OurLTACH in north Kansas City and the joint venture with St. Luke's hospital inSt. Louis are proceeding as scheduled. North Kansas City is currently underconstruction and will open during the first quarter of 2008. Groundbreakingceremonies for the St. Luke's joint venture occurred on October 24th with aplanned opening for late 2008.

Our planned 50-bed LTACH joint venture with Memphis MedicalCenter in Peoria, Illinois, which received certificate of approval, is subjectto the completion of definitive agreements. Construction will begin in thefirst quarter of 2008 with an expected opening date of the first quarter of2009.

Our last project is planned development of an LTACH with ourexisting rehabilitation hospital partner in Kokomo, Indiana, which should openin the second half of 2008. We have several letters of intent and additional opportunitiesunder review. Some of which involve acquisitions of existing facilities.

Turning to the legislative and regulatory update, while theMedicare provisions of the children's health and Medicare protection act of2007, the champ act were removed from a stand alone states children's healthinsurance program or chip bill that remains to be seen what action the senatewill take on these provisions by the end of the year.

These provisions include a freeze of 75% rule at 60%.Extension of the Part B Therapy Cap Exception Process, refinement of LTACHpayments and an increase in physician fee schedule. Rehabcare is activelyworking with congressional offices, trade groups and industry peers toencourage the senate to finish work on Medicare issues by December 3 1, 2007.

RehabCare Group and others in our industry have assertedthat the rules imposed on Inpatient Rehabilitation Facilities or IRFs arearbitrary and not based on achieving the best patient outcome at the lowestpossible cause. To begin building a body of knowledge around the best treatmentlocations for certain patients, we recently completed a study documenting theimpact of 75% rule for IRFs.

The study compared the Medicare expenditures and outcomes ofpatients in the 25% category treated in our IRFs compared to those treated inour skilled nursing facility therapy programs. Study group consisted of 124,000patients treated in our programs from January 2006 through August of 2007.

Some of the study highlights include 81% of IRF patients weredischarged to a home environment compared to 37% of sniff patient. Average oneswho stay was 10.4 days in an IRF and 34.9 days in a skilled nursing facility.Based on average months of stay, the average sniff payment was approximately$13,855 per stay while the average payment per IRF discharge was $12,981 or6.7% less, and 52% of the sniff patients went on to other Medicare-fundedsettings upon discharge compared to 17% of the IRF patients.

This report is being circulated among members of Congressand healthcare associations in an effort to win support for legislative freezeon implementation of the 75% rule. The complete study document is available onour web site at www.rehabcare.com/75% study.

Moving on to part B therapy caps without further interventionby Congress, the current Part B therapy cap auto perception procedure isscheduled to lapse on December 31, 2007. As a response to the potential therapycap location, we have completed a review of our data and identified theconditions most frequently treated and reimbursed under Medicare part B.

Using this information, a care mapping process that will tietreatment plan to cost of care and development and will be completed byDecember 1. These care maps will allow clinician to plan treatment and managecosts within the financial constraints of the cap dollars, ensuring thepatients will not exhaust their limited benefits on one treatment episode earlyin the year.

Moving on to the physician fee schedule. Use of the chargebasis for Medicare part B therapy services, the physician fee schedule faces a9.9% scheduled reduction beginning January 2008 without intervention byCongress. CMS by regulation has proposed similar though smaller decreases inthe physician fee schedule over the last several years. Congress has passedlegislation each year to reverse the decreases.

The market basket increase became effective October 1, 2007when payment rates increasing 3.2% and 3.3% in patient rehab in skilled nursingfacilities respectively. Over the last two years, we have seen an increase inthe number of denying claims within our acute rehab units and hospitals as aresult of medical necessity determinations by both fiscal intermediaries andmore recently by recovery audit contractors or RACs.

In addition to local coverage determination, in regards tolocal coverage determination, a recent AHA and FHA study shows that nationallyover 63% of all denying claims are overturned and repaid to providers. Rehabcare continues to exceed the national average with a 90.5% overturn rate.

In regard to the RACs, CMS has issued a pause in the auditsin the state of California until the end of October while a review ofPRG-Schultz is conducted. In addition, as a result of issues, which arose inthe California RACs, the rollout of the RACs in Massachusetts, South Carolinaand Arizona will exclude the 27% downing for denied claims.

CMS has issued a request for proposal for contractors toimplement a RAC program in all 50 states beginning in March 2008. In order toplace rehab care in a preferred position for recruiting therapists, we haveinitiated two programs with academic institutions in markets that we believewill elevate our visibility with graduating students, and enhance our abilityto attract the best talent.

We're pleased to announce this quarter the RehabCare inconjunction with the University of Missouri is supporting the development ofphysical therapists assistant and occupational therapy assistant programs atcommunity colleges in rural locations throughout the State of Missouri. We'realso partnering with the university of Kansas to provide it out professorship.

The RehabCare professor will work to provide a geriatriccurriculum that supports appropriately trained therapist for rehab careprograms. The professor will also serve as a conduit for research betweenRehabCare and the university as well as provide significant disability forRehabCare for students and the national academic community.

The launch of these two initiatives will influence theavailability of therapists throughout the region. This is the largestcommitment to date by RehabCare to partner and support the academic community.I'll now turn the call over to Jay Shreiner who will review our financialresults for the quarter. Jay?

Jay Shreiner

Thank you, John. Consolidated net revenues for the thirdquarter of 2007 of $172.9 million declined 4.5% compared to $181.1 million inthe second quarter of 2007. Consolidated net earnings in the third quarter morethan doubled sequentially to $3.9 million or $0.22 per share on a fully dilutedbasis compared to $0.09 in the previous quarter. In the third quarter lastyear, revenues were $183.2 million and net earnings were $2.3 million or $0.13per fully diluted share.

As John said earlier, this is the best performance that wehave generated in the past two years, and demonstrates the success of theactions we have been taking. Consolidated net earnings for the second quarterincluded a $4.9 million pretax impairment charge or $0.17 per fully diluted shareafter tax to write down the value of an intangible asset related to theLouisiana Specialty Hospitals statutory exemption from the 25% rule for LTACH.

Net revenues for the contract therapy division were $98.3million, a decrease from the second quarter of $2 million or 2%. This declinewas driven by a 2.3% reduction in the average number of locations operatedduring the quarter partially offset by increased revenue per location.

The divisions operating earnings of $3.2 million in thethird quarter of 2007 compared to $1.1 million sequentially, and to a loss of$2.2 million in the first quarter of this year. This $2.1 million sequentialimprovement in earnings resulted from the operating efficiency and thereductions in expenses as previously discussed.

During the third quarter, 55 programs closed. Of thoseclosures, 27 were the result of self-operation or external competition with theremaining 28 primarily the result of low profitability or nonpayment. 30 newclient sites were open in the third quarter.

Backlog in the division was up to 20 compared to 15 in theprior quarter. Third quarter, HRS revenues were $40.3 million, a decline of3.6% on a sequential basis. Primarily resulting from fewer net operating unitsbut partially offset by higher in patient revenue per location and perdischarge.

Operating earnings for the division were $6.3 million, anincrease of $900,000 or 16.6% from the $5.4 million of operating earnings inthe second quarter. Primarily resulting from reduced division general and administrativeexpenses and improved operating performance over outpatient business.

The division finished the quarter with 154 programs, as aresult of three openings and ten closures. ARUs at quarter end totaled 108 downfrom 110, as three ARUs open and five ARUs closed. The five remaining closureswere two subacute units and three outpatient units.

One of the closures was for nonpayment and nine chose toself-operate. The majority of those that chose to self-operate wereunderperforming units. The division's backlog was four at the end of thequarter all of which are ARUs. One is scheduled to open in December 2007 andthree in 2008.

Operating revenues in the freestanding hospital divisiondeclined 9.6% sequentially or $2.6 million to $24.4 million in the thirdquarter from $27 million in the second quarter as a result of several items.During the third quarter, the division recorded a $1.4 million of additionalcontractual allowances principally at one of its facilities.

In the prior quarter, the division recognized a net $900,000reduction in contractual allowances, primarily related to prior year costreport reserves these adjustments, which totaled $2.3 million account for thevast majority of the $2.6 million sequential revenue combined.

The division reported an operating loss of $1.6 million inthe third quarter compared to operating earnings of $1.8 million in the priorquarter, excluding a $4.9 million pretax impairment charge on a LouisianaSpecialty Hospital intangible asset recognized in the second quarter.

In addition to the swing and operating revenues, resultingfrom contractual adjustments, which I previously mentioned, the division wasimpacted by case management challenges, isolated pay or mix issues and $700,000in start-up costs at its Austin, Texas, venture. Joint venture.

For the nine months ended September 30, 2007, we generatedcash from operations of $30.9 million and paid down $20 million in long-termdebt. We spent approximately $6.5 million for capital expenditures including$4.2 million in the company's freestanding hospitals division.

Primarily on developing our Seton joint venture in Austin,Texas and adding a high observation unit in one of our LTACH. The remaining$2.3 million of capital expenditures were principally related to informationsystems, day sales outstanding were $78.4 as of September 30 compared to $74.9at June 30, 2007, and $77.9 at December 31, 2006.

At September 30, we had approximately $14.2 million in cashand cash equivalents compared to $9.4 million as of December 31, 2006. We had$94.6 million in outstanding debt under our revolving credit facility with aweighted average interest rate of approximately 7%. Total debt outstanding atSeptember 30, 2007, was $100.6 million compared to $120.6 million at December31, 2006.

We anticipate our interest rate spread on our revolvingcredit facility will decline to 150 basis points above LIBOR during the fourthquarter.

Now, I'll turn the call back over to John.

John Short

Thank you, Jay. As you can see from our results, we arepleased with the direction of the company in particular by the progress in ourcontract therapy operations, in the operating expense management in our HRSdivision.

We obviously have some work to do in our freestandinghospital division to improve its business processes and technology and prepareit for further growth. We're confident that the fundamentals of this businessremain sound and support our continued investment in the future.

With the disruption of our symphony acquisition behind us,we move forward with a continued focus on improving margins developing ourfreestanding operations, reducing our debt and dealing with the numerousreimbursement challenges that we face.

I want to take this opportunity to thank Tom Davis for histen years of important service to the company, first in the hospitalrehabilitation division and more recently in business development andfreestanding hospital division.

His leadership in contacts and the healthcare industryprovided that the catalyst for the development of our newest division, adivision, which forms the foundation of our future growth. We wish Tom all thebest as he embarks upon a new career direction, we will definitely miss him.

As we celebrate our 25th year of operation, let me thankeveryone who has helped us reach this important milestone, especially our morethan 16,000 colleagues who continue to focus on our most important missionproviding quality care to help people regain their lives.

Thank you for your continued support and we look forward tosharing our future successes with you. With that, I would like our operator toopen the call for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from RobHawkins from Stifel Nicolaus. Please state your question.

Robert Hawkins - Stifel Nicolaus

Good morning. Nice quarter, guys. Looks like everything iskind of stabilizing and turning up. Can we go into one thing that I thought was-- that I would like to understand a little better is the contractualreimbursement issue, the $1.4 million number at the hospital.

John Short

Sure. Jay?

Jay Shreiner

Yes, good morning. What we're doing within our freestandinghospitals is standardizing and strengthening our processes surroundingdetermining of contractual allowances. And we believe that this will reduce therisks of variability of calculating these estimates.

We have a new lead in that division. Kurt Schultz joined usas Vice President of Finance as of about two months ago. He has career prior tocoming here was with kindred and brings tremendous knowledge and expertise intherapy so we made and are making significant progress in this area.

RobertHawkins - Stifel Nicolaus

Well, I mean, is it a one-time item, the $1.4 million in theone hospital or is this something that -- first of all, was it an LTACH orrehab? And then, is this something that, I think his name is Kurt, is going tohave to roll through, each of the hospitals and you might find a few everyquarter? How is this going to kind of play out?

Jay Shreiner

Now, we've gone through all hospitals in the third quarter,the quarter we just reported so the net of everything that, using the morestandardized processes came out into $1.4 million, which we just reported. Thatadjustment was in an LTACH but I mean, we've looked at all of our hospitals andfeel that, you know, that -- the changes that we've made have strengthened ourability to estimate these closer to what the actual cash will be.

Robert Hawkins - Stifel Nicolaus

Okay. And then one area I'm kind of curious about are theGPO contracts, you've had VHA for a while, I mean how should we b thinkingabout what this impact might mean for you going forward with premiere, andre-signing VHA?

John Short

Rob, let me have Peter Doerner, the point guy on that, forboth relationships, address that issue. Peter?

Peter Doerner

Rob, good morning. You're correct. We've had therelationship with VHA for nine years. We've just recently renewed it in thequarter as we reported. That's provided very good growth within the hospitalsthey represent.

The new relationship with premiere, we're as excited about,the premiere represents a larger bulk of hospitals between those twoorganizations, you know; they are the 600-pound gorilla in the nonprofit sectorof hospitals. So, what this allows us to do is give us a new and expandedaccess channel to these hospitals as we've reported, we have some new productsthat are testing and developing. Both of these access channels are greatopportunities for us to introduce these products to these hospitals and getsome traction.

So, we expect that the positive traction we've had with VHAwill be synonymous as we roll out the premiere, they have a very similar typestructure in terms of how they work with their hospitals. So, we're prettyexcited about these relationships. Obviously we're just getting started withthem. So, it's going to take us a little bit of time to roll out our message.But once we do, we expect some pretty good traction from these organizations.

Robert Hawkins - Stifel Nicolaus

Covering VHA, deals do we have?

Peter Doerner

We have 53 hospitals that are part of the VHA alliance.Currently, we serve 23 hospitals under premiere and about 125 give or takenursing homes that are premiere members as well. So that's where we're startingfrom and our objective is to build on the good success and performance we'vedelivered with those premiere VHA members and expand from there out.

Robert Hawkins - Stifel Nicolaus

Premiere is about two or three times the size of VHA, isthat correct?

Peter Doerner

Premiere represents, they have around 1700 hospitals andthen I don't know the exact number but it is north of 6,000 nursing homes. VHAis around 1200 hospital members, all in the nonprofit sector.

Robert Hawkins - Stifel Nicolaus

Great. And then one final question. I was pretty excited tohear about the IRS study that you guys did. How do you guys plan to use it? Imean, you've got a timely situation coming up here with the Medicare bill inthe next 30 days. Maybe 45 days. How will this kind of play into that process?

Peter Doerner

Well we're making the study available to all of thecongressional leadership in both the house and the senate and theirprofessional staffs. We're also meeting CMS. We provided them a copy of thestudy as well and we're going to attempt to get the study published in avariety of both trade and professional journals. It may take a little longer.But we're aggressively getting the word out especially in DC.

Robert Hawkins - Stifel Nicolaus

Okay and did you use an independent group to, I guess gatheror interpret the data or did you guys do it all yourself?

Peter Doerner

We did it internally but we did hire a third party editorto, you know, who is backed in a mission to go through it and you know makesure we were not overreaching the methodology was sound. So, we benefited fromthat kind of a second opinion.

Robert Hawkins - Stifel Nicolaus

Great. Thanks. Again, great quarter. I'll jump back in thequeue. Thank you.

Operator

Our next question comes from Derrick Dagnan from AvondalePartners. Please state your question.

Derrick Dagnan - Avondale Partners

Good morning and congratulations on a nice quarter. I wantedto ask kind of a bigger picture question, John. If I think back over the lastthree years, you guys have generally been when you look at these 75% rulecompliance thresholds, you have generally been ahead of them. At this point,you're kind of behind the 65% threshold.

And I guess is that, is that the company being a little morecognizant of when each individual hospital rolls into the threshold or is itmore of a market phenomenon, kind of the difficulty of finding compliant cases?

John Short

Well, I think it's absolutely true. We're working tighter towhatever compliance period our managed hospitals or owned hospitals are in. So,as we've gotten more experienced and improved both our clinical processes aswell as our monitoring processes, we've been able to run them tighter to theexisting compliance criteria.

It is also clearly true that, you know, the industry haslost 100,000 discharges over that time period. So, we continually have to bebrighter, faster, smarter than the competition to try and keep flat. You know,the good news that we've reported is we've seen significant growth in ournon-Medicare business as a result of our marketing efforts in that segment. Todeal with, you know, the ever-tightening 75% roll issue.

Derrick Dagnan - Avondale Partners

Okay. And in -- in the press release, I think it says thecompliant case growth in the freestanding business was 22% on the same storebasis. And I guess, when you reconcile that with kind of the overall same storerevenue growth, are we just looking at the difference in kind of the declineand the noncompliant cases? Or did I read something wrong?

John Short

Well, you've got us all scrambling.

Derrick Dagnan - Avondale Partners

Last sentence before your balance sheet commentary on thepress release.

John Short

Clearly, you know, we've been focusing on generating morecompliant cases. And you're correlating that with what

Derrick Dagnan - Avondale Partners

That's a major increase in compliant volumes it looks like.But the overall same store revenue growth in the freestanding hospital businesswas, you know, about .6%. I was just trying to understand the dynamics behindthat?

Jay Shreiner

Well, again, over the course of the year, the industry losta lot of discharges as we went from 50 to 60 and now 65%. So, yes, we had to dothis in order to stay flat.

Derrick Dagnan - Avondale Partners

Okay. And I guess, I'll ask one more question then get backin the queue. With respect to your helpful hints on the CT business, 4.5% to5.5% margin, is that kind of the average margin for all of 2008. Is that kindof what you're targeting there?

John Short

To date, we've been willing to say we're going to hit thatin 2008.

Derrick Dagnan - Avondale Partners

So, it could be fourth quarter or?

John Short

Well, clearly, we're very encouraged by the fact that in thethird quarter of 2007 we're already at 3.2%.

Derrick Dagnan - Avondale Partners

Okay.

John Short

But we're not willing to trap ourselves yet. Let's see whatthe fourth quarter brings and then we'll, you know, no doubt update the helpfulhint based on the fourth quarter.

Derrick Dagnan - Avondale Partners

Okay. And then the same question for the 17% to 19% margintarget for the mature freestanding business. I guess the same answer?

John Short

That's correct.

Derrick Dagnan - Avondale Partners

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

John Short

Thanks.

Operator

Our next question comes from Balaji Gandhi from Oppenheimer.Please state your question.

Balaji Gandhi - Oppenheimer

Good morning.

John Short

Good morning.

Balaji Gandhi - Oppenheimer

A couple of things. One, I just want to get back into thequestion we had about the contractual adjustments. I wanted to make sure whatI'm trying to figure out is the $24 million in revenue for the freestandingsegment, is that a good number that we can build off of in terms of, you know,just kind of organic growth, you know, excluding any new projects you do or asthe previous question was, you know, I think implying is could we see any kindof further adjustments to contracts.

Jay Shreiner

Yeah, I think a normalized, more normalized revenue numberwould be $25.8 million. So, we believe, again, through the process that Kurthas, his expertise that he's brought and the standardization that we'veintroduced here in estimating the contractuals, that the adjustments that wereported this quarter are now behind us.

Balaji Gandhi - Oppenheimer

So, going from 24 to $25.8, does that mean that you benefitfrom some of these adjustments as well?

Jay Shreiner

This quarter was the $1.4 million was a negative to thisquarter's revenue.

Balaji Gandhi - Oppenheimer

Correct.

Jay Shreiner

So, what I'm saying is on more normalized revenue for thisquarter would be the $25.8 million.

Balaji Gandhi - Oppenheimer

So, you should start --

Jay Shreiner

build off for that going forward.

Balaji Gandhi - Oppenheimer

Got it, got it. Ok. Okay. Then, is there any kind ofaccounting rule change or anything? Because I only bring that up because it isdue the second company of come across in the LTACH area that has had to do thisor is it just kind of cleaning up?

Jay Shreiner

Now, there's no accounting rule change that was associatedwith this.

Balaji Gandhi - Oppenheimer

Okay. Okay, great. And then where was that facility, the onefacility with the $1.4 million?

Jay Shreiner

It is one of our LTACH. We haven't disclosed anythingfurther than that.

Balaji Gandhi - Oppenheimer

Okay. And then the other question I had was about the -- howshould we think about the Part B therapy cap, you know, last year, you werefortunate enough to get the legislation passed without really, you know, verycomprehensive Medicare bill and so, you know, is there anymore likelihood thatthat piece can pass without some of the other Medicare provisions?

Jay Shreiner

Alan Sauber here who is our regulatory guy.

Balaji Gandhi - Oppenheimer

Yeah.

Alan Sauber

Balaji, I think what you'll find is this is very wellentrenched into the discussions from the senate for any type of Medicarepackage. So, it is probably going to go with a host of other Medicareprovisions and we're hopeful that it gets done by the end of December.

Balaji Gandhi - Oppenheimer

Okay.

Alan Sauber

Part B therapy cap has probably more support to get fixedthan any of the other provisions we're interested in.

Balaji Gandhi - Oppenheimer

Right. That was the same kind of similar case last year,right?

Alan Sauber

Right. Correct. However, we're tired of this annual beingheld hostage so we're actually going to start engineering clinically tosignificantly reduce the potential negative impact of the therapy cap should itever be promulgated.

Balaji Gandhi - Oppenheimer

Okay. If I also remember correctly, you kind of had sometype of, you know, I guess fail safe plan to implement at some point inDecember. You know, if you do have to go back under, you know, into a capworld.

Alan Sauber

Yeah, I wouldn't call it fail safe. I would call it amitigation strategy.

Balaji Gandhi - Oppenheimer

Okay. Okay. And is it the same situation where at some pointin December, you'll have to decide to adopt that?

Alan Sauber

We're taking steps now to implement our new care -- our caremapping process and we're going to implement that regardless of what happens tothe part B therapy cap issue.

Balaji Gandhi - Oppenheimer

Okay. I mean just, you know, is there any way we could tryto think about -- I know 4.5 to 5 is, you know, best case scenario maybe or areasonable case scenario. Can the business be run profitably if we do have acap in 2008?

Alan Sauber

Oh, yeah.

Balaji Gandhi - Oppenheimer

Okay. So any kind of --

Alan Sauber

At least based on what we see now, we think we can engineermostly around it. Now, there are going to be some start-up interruptions forthe first quarter or two. But again, we're going to -- we're going to startputting the processes in place during the fourth quarter to deal with thatissue. So, we're not going to just wait and hope that Congress does the rightthing by December 31st of this year.

Balaji Gandhi - Oppenheimer

Okay. Great. That's helpful. Thanks.

Operator

(Operator Instructions) Our next question comes from RobMains from Morgan Keegan. Please state your question.

Robert Mains - Morgan Keegan

Good morning. John, in your commentary, you mentioned thatyou have a short stay rehab unit that's being tested. Could you describe that alittle bit? I don't know if I'm familiar with it.

John Short

Yeah, what we've -- as you're well aware, Rob, the 75% ruleapplies to all patients regardless of pair so there are a ton of non-Medicarepatients out there that also give precluded from accessing Medicare certifiedIRFs because of the 75% rule.

So, in a couple of markets, we have put together withhospital clients a smaller short stay non-Medicare certified unit and that'swhere we're running hip and knee patients that are covered by non-Medicarepayers. And the early -- the early results are very encouraging. It requires anentirely different marketing focus and an entirely different clinical approach becausethese really are short stay patients.

So, it is a volume play. You need big enough Geographic(inaudible) area in order to run sufficient volume through it to keep, youknow, a ten-bed unit profitable. But so far, so good and if we've got what, twoor three others benefit (ph), at some stage of development.

Robert Mains - Morgan Keegan

Now, kind of looping back to the study that you did,obviously to do something like this, you need payer buy-in. You've got it inthose markets. They're not seeking to put the patients in a sniff because theythink they can save money?

John Short

Correct. They recognize that, you know, they have alreadydone the study that CMS either should do or has done and won't tell anybodyabout which is to link all of the costs for an episode, a patient episodetogether and based on how successful they are, managing the care through theentire process judging the cost from that perspective.

So, payers have already done that analysis and you know, weare a better bargain for patients that can tolerate three hours or more ofcare. Just what we found in our paper as well as in our short-stay units is ifyou can tolerate three or more hours of care, we can get you back to homefaster and cheaper than any other alternative.

Robert Mains - Morgan Keegan

Um, on this all-private pay option, do you have this goingon with any of your competitors in the markets?

John Short

No and I hope they're not listening.

Robert Mains - Morgan Keegan

Okay. I hope I don't wave a red flag by adding one morequestion. Would the model for this, or don't you know yet be ARU or IRF? Interms of would it be unit or freestanding?

John Short

It would be ARU.

Robert Mains - Morgan Keegan

Because it is so small?

John Short

Correct.

Robert Mains - Morgan Keegan

Okay. Okay, then just to belabor the freestanding hospitalissue, if I add back the contractual adjustment, add back the start-up loss, itstill is a down quarter on a profitability basis. You mentioned some of theother things that you're doing in terms of -- does it sound like, kind of like,infrastructure builds? Are these additions to your cost base that are going tobe with you and you got to grow out of or are they kind of one-time? How shouldwe look at that?

John Short

The specific issues in the third quarter at first to do withsome uneven care management processes between our units. That we're in theprocess of standardizing and secondly, a payer mix change in one of our unitsthat was a result of a lapse in our marketing focus.

So, we view both issues as eminently fixable. We're workingdiligently just like we are in improving the contractual adjustment process toimprove our care management and our pair mix management processes. So, you'llsee significant improvement in the fourth and subsequent quarters.

Robert Mains - Morgan Keegan

Payer mix change, I assume that means too much governmentbecause you weren't marketing to private?

John Short

No, actually, it meant that our Medicare mix went down. Wegot too much managed care business.

Robert Mains - Morgan Keegan

Oh, and this is in an IRF?

John Short

Correct.

Robert Mains - Morgan Keegan

Okay. And then the care management processes, could you kindof elaborate on what that would be?

John Short

Well, historically, we've let the individual facilities dealwith the admission process and care management process while they're in ourfacilities and the discharge disposition process. And we found too muchvariability in how that set of activity is being done.

So, we're better integrating our admissions coordinatorswith our case management nurses with our discharge planners. So that we'reusing the same approach in its monitor to be monitored centrally, so thatthey're not missing the right questions at the right time with the rightcoding.

Robert Mains - Morgan Keegan

You had some hospitals that weren't admitting the rightpatients, weren't keeping the right amount?

John Short

Not enough of them. That's correct.

Robert Mains - Morgan Keegan

Okay. And then last question, Jay, you mentioned DSOs beingup. Any reason behind that?

Jay Shreiner

No. The quality of our receivables hasn't changed. As younotice, we had a pretty big cash balance. What we did see this quarter is a lotof cash come in on the last day and the beginning of the next quarter, which isthe beginning of October. So, I would attribute it more to timing.

Robert Mains - Morgan Keegan

So, kind of noise rather than a trend.

Jay Shreiner

Right.

Robert Mains - Morgan Keegan

Okay, that's all I had. Thank you.

John Short

Thanks.

Operator

(Operator Instructions) Our next question comes from DerrickDagnan from Avondale Partners. Please state your question.

Derrick Dagnan - Avondale Partners

Thanks. I wanted to ask one follow-up. This year, you've hada number of net declines in the number of contract therapy units that you haveand some of those, you know, are self-operated and some of them are yourdecision. So, I guess two questions.

One, on the ones where it's your decision to stop operating,if it is in a market where you have some reasonable density, can you use thoseemployees and other businesses and does that help you with your, you know, wageproblems or wage shortages?

John Short

Absolutely.

Derrick Dagnan - Avondale Partners

Okay. And I guess the second question on the contracttherapy business, if we're looking at a potential Medicare package and if we goback to the champ bill, there were various areas of post-acute care where themarket baskets would be eliminated. If the skilled nursing market basket waseliminated, would that hurt you in your contract therapy business were yourpricing is tied to Medicare skilled nursing pricing?

John Short

Yes. The increase that we got in the fourth quarter would belargely rescinded in 2008.

Derrick Dagnan - Avondale Partners

Okay. Well, that's all I had. Thank you very much.

John Short

Thank you.

Operator

At this time, I am showing no further questions.

John Short

Okay. As a reminder, this conference call is being webcastlive on our website at www.rehabcare.com and will be available for replaybeginning at 1:00 pm eastern time today. Thanks, everybody, for joining us andhave a great Halloween. We're all in costume here.

Operator

Thank you ladies and gentlemen. This concludes today'sconference. Thank you for participating, you may now disconnect.

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