Encompass Health Corp (EHC) 2006 Q3 法說會逐字稿

Good morning, everyone, and welcome to HealthSouth's third quarter 2006 conference call.

At this time, I would like to inform all participants that your lines will be in a listen-only mode. After the speakers' remarks, there will be a question-and-answer period. [OPERATOR INSTRUCTIONS]

Today's conference call is being recorded. Your participation implies consent to our recording this call. If you have any objections, you may disconnect at this time.

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

Thank you, Jessica, and good morning, everyone.

With me today in Birmingham are John Workman, Chief Financial Officer; Mike Snow, Chief Operating Officer; John Whittington, General Counsel; Tyler Murphy, Senior Vice President of Treasury; and three of our division Presidents, Joe Clark with Surgery; Diane Munson with Outpatient; and Greg Brophy, with Diagnostic.

Before we begin this morning's call, I'd like John Whittington to review some cautionary statements.

Thank you, Jay. Good morning.

Some of the information provided today may include certain estimates, projections, and other forward-looking information that reflect our current views with respect to future events and financial performance. These estimates, projections and other forward-looking information are based on assumptions that HealthSouth believes as of the date hereof are reasonable. Inevitably, however, there will be differences between such estimates and actual results and those differences may be material.

There can be no assurance that any estimates, projections, or forward-looking information will be realized. All such estimates, projections, and forward-looking information speak only as of the date hereof.

HealthSouth undertakes no duty to publicly update or revise such estimates, projections, and forward- looking information. You are cautioned not to place undue reliance on the estimates, projections and other forward-looking information as they are based on current expectations and general assumptions and are subject to various risks, uncertainties, and other factors, including those set forth in the Form 10-Q we filed this morning, the Form 10-K for the fiscal year ended December 31, 2005 and in other documents that we've previously filed with the SEC, many of which are beyond our control, that may cause actual results to differ materially from the views, beliefs, and estimates expressed here today.

Thank you, John.

I'm going to begin with some general comments and then we'll ask Mike to provide some surgery division highlights before turning it over to John Workman for a more thorough walk through of the numbers.

As we've previously discussed, 2006 is a transition year for HealthSouth. We are moving forward with the strategic repositioning of the Company with an emphasis on inpatient rehabilitation services, while also continuing to adjust to higher compliance thresholds under the 75% rule.

We're moving our inpatient facilities and imaging centers to billing and collection systems that will be unique to and consistent across each division. We're also continuing to implement internal controls to ensure the accuracy of our financial and operational reports.

Finally, our recent relisting on the New York Stock Exchange underscores the progress we have made this year on many different levels with regard to financial reporting, systems, and governance.

Results for the third quarter were mixed. Revenues were off 4.6% compared to last year, primarily because of volume shortfalls in our inpatient and outpatient segments. The inpatient division experienced the typical summer seasonality, although unusually soft volumes in many of our upstream acute care referral sources resulted in fewer admissions in many markets.

Also, last year we were moving our hospitals to the 60% compliance threshold with respect to the 75% rule, and at that time our overall compliance was 57%. This quarter, we were at 63%.

The higher threshold meant we had a smaller universe of patients to choose from, although we did see exceptional compliance case growth. These factors combined resulted in 1.5% fewer admissions in our inpatient division and lowered our net revenue by approximately $10 million.

As we have reported in the past, our inpatient division also continued to experience the effects of last year's IRF PPS update which we have previously indicated lowered our revenues by approximately $10 million per quarter. Fortunately, beginning with the fourth quarter of this year we will see an increase in our Medicare unit pricing thanks to an increase in this year's IRF PPS update.

Also on a positive note, we are encouraged by a promising uptick in our inpatient volumes as we enter the fourth quarter and anticipate this trend will continue as we close out the year.

With respect to the 75% rule, I also was pleased with our compliant case growth. As you know, our target compliance case growth range is 3% to 5%. In the quarter, we performed at the top end of this range, coming in at 4.9%. And as previously mentioned, our overall compliance was 63% for the quarter. I believe these indicators suggest a very strong performance and is a testimony of the focus of our local management teams and the high quality reputation of our hospitals.

In both of these segments, we are adjusting our operating expenses to accommodate less than expected volumes and while we were able to reduce our costs somewhat, we were not able to mitigate the volume declines completely.

With that, I'm now going to ask Mike Snow to talk about the progress we continue to make in our surgery division and then John will review our financial statements. Mike?

Thanks, Jay. Good morning, everyone.

The surgery division posted revenues of $177.3 million and operating earnings of $21.2 million during the quarter compared to $180.9 million and $18.2 million during the same quarter last year.

Lower revenues for the quarter are fully explained by the conversion of facilities to equity method accounting, plus those facilities that were closed during the year -- during the last year, not qualifying for discontinued ops. Revenue was also negatively impacted by a decline in same-store cases per workday of 2.7% in the quarter versus a year ago.

Although we've used 63 working days for this quarter's calculation of same-store results versus last year's 64 working days, it's important to note this year's timing of the July 4th holiday, which was on a Tuesday, had the effect of making this year a 62-day quarter because caseloads were very light on that Monday prior to the 4th. This also negatively skewed our results.

Despite the pressure on revenues, however, the division improved operating earnings more than 16% through a combination of pricing from managed care, case mix changes as a result of resyndications and cost management, particularly supply chain results. Accordingly, operating margin for the quarter improved to 12% compared to 10% in the year-ago period.

This improvement was primarily driven by operational initiatives, not by the aforementioned conversion to equity method accounting and is further evidence that the stabilization of the portfolio is substantially complete. We also still believe that we will achieve same-store growth by the end of the year, especially in light of our sequential results, both for the year and within the quarter.

Finally, on the regulatory front, the division participated with the ASE coalition to respond to CMS's proposed reimbursement change changes for the industry. Our collective comments were submitted this week and detailed the opportunity for Medicare to move substantially more business from high-cost hospital settings to lower cost ASEs while maintaining budget neutrality as mandated by Congress.

In addition, the coalition has expressed its concern that certain specialties are being hit with an undue portion of the burden and should receive special attention in the final rule, which is not expected until mid-2007.

John?

Okay. Thanks, Mike. Good morning.

We have made available a press release to help understand our complex business. As mentioned, we also filed our third quarter 10-Q this morning, which is the first time that we've been able to do that without filing the extension, which we're happy to do.

In the press release, we did provide some supplemental information. Hopefully that will be helpful to you as you review our results. Both the press release and the third quarter 10-Q can also be accessed at the HealthSouth Web site.

Speaking to the consolidated results, as Jay has mentioned, overall revenue was down 4.6% from the same quarter a year ago. All the divisions experienced declines with the most significant declines, again as Jay's mentioned, in the inpatient and outpatient division.

And the inpatient division, as Jay mentioned, the declines in inpatient come from the 75% rule, ramping up pricing that was enacted a year ago, and shortfalls in our outpatient satellite operations. The outpatient division was significantly impacted by fewer facilities and continued competitive pressure, including physician-owned physical therapy sites.

Looking at operating earnings and EBITDA on a consolidated basis, while operating earnings reflect a significant decline, there are some items to note. In 2005 we had a one-time pickup of $37.9 million from our recovery on Meadowbrook.

We did have a one-time recovery of $35 million for amounts due from our previous CEO, but it was generally offset by a provision for partnership settlements of $28.4 million. If you adjust for these items, 2006 would be approximately $13.8 million below the adjusted amount for 2005, thus narrowing the gap.

Further, if you isolate the diagnostics division's results, which we determined to be non-core a year ago, operating earnings would only be off $3.3 million, or 20 basis points as a percent of revenue.

Though it is a non-GAAP measure, adjusted consolidated EBITDA of $141.9 million for the quarter, or $411.8 million for the nine months reflect a run rate that's consistent with our full-year guidance of $525 to $550 million.

Still staying with the consolidated results theme, I'd like to talk about cash from operations. Cash from operations was a negative in the quarter compared to a source a year ago.

But to understand this variance, you will need to focus on the line change called, "Assets and Liabilities," which was $140.5 million worse than a year ago and this can be found on Page 57 in the Form 10-Q. This change is attributable to three major factors, which are generally timing.

Medicare withheld payments for the last nine days of the year which coincided with the government's fiscal year causing a growth in receivables and this impacted all businesses. Secondly, the receivable from our previous CEO was a receivable in the third quarter and would be converted into cash in the fourth quarter. And lastly, there were non-cash reductions and various liabilities, including accruals for legal fees due to our former CEO.

Having said that about the consolidated results, I'd like to turn to the individual segments. Jay has already covered the impact on the inpatient division relative to revenue and, again, we were pleased with the strong compliant case growth of 4.9%.

In the inpatient division, operating earnings declined by $20 million in the quarter from a year ago. However, included in the quarter was $6 million of charges related to consulting costs and an increase in the bad debt provision associated with the installation of a new revenue billing system.

As of today, this division has completed its conversion of all facilities to one common platform, which is a major accomplishment for the division, and a platform that should allow the division to improve its results, including potentially recouping part of the $6 million charge.

The remainder of the shortfall is attributable to volume declines going to the 60% threshold in 2006 versus a 50% threshold for most of 2005, as well as the negative pricing impact from the October 1 '05 CMS PPS pricing, as well as the continued inflationary increases in salaries and benefits, as well as supplies, some of which are related to treating a more acute patient.

As a reminder, we will get some pricing relief on October 1 '06, though it will probably be short of the inflationary impact. And secondly, the 60% threshold is frozen for another year, which should provide some relief.

We also announced yesterday the settlement of all claims related to the Braintree Woburn hospitals. This litigation has been going on for some time and related to the actions of prior management and will no longer be a distraction for the division management, so we're happy to have that behind us.

I will not comment on surgery, as Mike has already covered that.

Turning to the outpatient division, the division's revenue declined $9.6 million. There were 21 fewer facilities at the end of the third quarter versus the end of the second quarter of 2006. This, coupled with continued competition from physician-owned physical therapy sites and the Medicare cap that was effective 1/1/06, caused the decline in revenue. While the division continues to be very cost conscious, it was not able to reduce expenses quickly enough to offset the lost revenue.

Closing 21 facilities in the quarter, many of which were done late in the quarter, was also a challenge, but the benefits of closure should accrue to future periods.

Looking at the diagnostics division. The diagnostics division experienced a modest decline in revenue; however, it had a significant decline in operating earnings. It was $10.5 million worse than a year ago.

As we have mentioned before, the division is installing a new common platform, IDX, so it, too, will be on one platform. The early signs from the new system are promising, but collections, especially from the legacy system, continue to be challenging.

The division recorded a $5.8 million bad debt provision, generally related to the legacy system and incurred $2.7 million of installation costs in the quarter. IDX should be in place across all facilities by the end of 2006.

This division is in the process of upgrading multiple facilities, primarily via leased equipment, which is expected to improve scan volumes and mix as 2007 begins. The division closed or sold five facilities in the third quarter and is well through its portfolio rationalization, which should be finished by the end of this month.

The new management team is positioning the division well for much-improved performance in 2007.

Turning to our last segment, corporate and other, the operating loss in corporate and other increased by $14 million in the third quarter of 2006 compared to the third quarter of 2005.

As I previously mentioned, both quarters had non-recurring income items, $35 million of recovery from the former CEO in '06 and $37.9 million of recovery on Meadowbrook in 2005, however, '06 also has a $28.4 million provision for settlement expense relating to our partnerships, which offset the gain. Much of the settlement provision was non-cash of nature.

The third quarter '06 in the corporate and other segment also has a $3.6 million charge for compensation costs under Statement 123R, which was not something that occurred in '05.

One other comment relates to professional fees, which are generally in this segment. These fees declined approximately $10 million from a year ago, but there's also a change in the nature of the expenditures.

The third quarter included $7.1 million in fees directed towards identifying amounts in the pre-2000 period that would result in deductions in those years that may increase the amount of recoverable taxes and/or provide for a larger NOL going forward.

In trying to analyze this segment, I know which is always confusing as to run rate, I'd like to try to walk you through some of the numbers. The reported operating loss in the quarter was $56.7 million. As disclosed in our supplemental data, there was $5.6 million of depreciation.

Settlement costs, as I mentioned before, were $28.4 million, which would also be non-recurring. The recovery from the former CEO of $25 million -- or $35 million would also be non-recurring. And lastly, the professional fees, which we intend to continue to wind down and not to be of looking backwards of $23.8 million, would be items that would be not indicative of a run rate. If you adjust for those items, you would end up with $33.9 million on an EBITDA basis in this segment for the quarter.

If you multiply that times four, that would be approximately $135 million, and as we've said before, the approximate run rate for that segment, I believe, is $130 million to $140 million as to all divisions.

To finish up with some costs, I'm going to talk about some finance-related expenditures. Net interest expense is higher than a year ago as we have less interest income from excess cash. The interest rate swap, which had a significant loss in the quarter locks in LIBOR at 5.22%.

As the forward curve declined in the quarter, we incurred a loss for the period ended September 30, 2006, however, this loss has already been reduced as forward rates have increased and this is a mark-to-market type of instrument. We expect, though, however, to receive some amount of cash on settlement during the fourth quarter based on the current LIBOR rate of 5.375%.

Finishing up with some liquidity and debt comments. Debt was reduced by approximately $21.1 million in the quarter and we made payments of $31.7 million against our DOJ, CMS, and SEC liabilities, and lastly, capital expenditures for the quarter were $35.2 million.

With that, I'll turn it back over to Jay.

Thank you, John, and thank you, Mike.

Before opening it up for some questions, I'd like to make a quick comment on the divestiture process and discuss our inpatient development efforts.

With respect to the proposed divestiture of our outpatient and surgery divisions, we have been extremely pleased with the level of interest expressed thus far from potential bidders. The process is on track and we remain optimistic that we'll be able to announce a transaction in early 2007.

As you may recall, the diagnostic division process is lagging about 45 days and will start somewhat later, but it, too, is on track and we are targeting to announce a transaction on it in the first half of 2007 as well.

With respect to our post-acute strategy, we are seeing better than anticipated traction from our development efforts. In the quarter, we achieved several inpatient milestones.

We closed on a market consolidation in Tucson, Arizona. The results thus far have exceeded our expectations. Following the closure of the competitor facility, admissions in that market are up 24%.

We also broke ground on a new 40-bed hospital in Fredericksburg, Virginia, which should be open by mid-2007 and will add a new hospital to our presence in that state.

Additionally, we finalized the internal approval process for a new 50-bed IRF to be built in Phoenix. The completion of this facility will bring to three the number of IRFs we will have serving the Phoenix market.

Finally, last week we announced the acquisition of Wichita Valley Rehabilitation Hospital in Wichita Falls, Texas. This acquisition will permit us to consolidate this facility into the HealthSouth Rehabilitation Hospital of Wichita Falls, thereby enhancing our ability to provide high-quality rehabilitative care to that community.

These development efforts underscore that our pure play post-acute strategy is sound and is beginning to take shape. Thus far in 2006, we have consolidated facilities in two markets, have begun three de novo projects and expect to announce several more growth initiatives by year-end, including several bed expansions at facilities operating at full capacity.

Finally, as everyone knows, we were relisted on the New York Stock Exchange on Thursday, October 26th. The ringing of the opening bell was a significant milestone in the Company's recovery and a testimony to the focus and dedication of our 34,000 employees over the past three plus years.

And although much of the turnaround at HealthSouth has been completed, we still have more that needs to be done. We need to remain focused on growing our businesses, exploiting the growth opportunities in the post-acute space, managing our costs, and completing the divestiture of our three ambulatory divisions and finalizing the outstanding class action in derivative litigation.

While the quarter did not meet our high expectations, I believe we are firmly on the road to recovery. As I said when I arrived in May of 2004, this turnaround was going to take three to four years. We are now just two and a half years into this process. While there is still more to do, I am very pleased with the tremendous progress we have made thus far and believe we will complete our recovery well within our stated timeframe.

Before we take questions, I also want to acknowledge that Brian Pope, our surgery division Chief Financial Officer is also with us this morning.

And with that, operator, we will be happy to open the lines for Q&A.

[OPERATOR INSTRUCTIONS] Your first question comes from Miles Highsmith of Wachovia.

Hey, guys, good morning. Definitely doing a lot of good things with a lot of moving parts here. I just wanted to get back to the numbers for a second.

Kind of looking at the consolidated EBITDA, maybe I can come at it from this perspective. With a lot of non-recurring things going on and some of those seem to be added back, I'm just trying to get a sense for -- am I right to think about the EBITDA including the $141.9 million includes the $35 million from the recovery, the $10 million from the reserve reduction, which you might want to subtract those, but then add back the $6 million or so from the provision and other related expenses on the accounting systems. Is that kind of a reasonable way to think about it?

You're right on the $35 million, Miles, but the $10 million is not added, it's not in the EBITDA calculation because that went against the professional fees which are excluded.

Okay. So not the $10 million.

Maybe if we want to add back a portion of that $6 million on the provision for the accounting systems, that might be fair?

That would be fair. And then I would also think you ought to consider some items in diagnostics which are deducted in arriving at EBITDA.

That was my other question. I guess you mentioned -- going back to my notes here, it was $5.8 million and $2.7 million. Would those be non-recurring, and are those outside of the $6 million?

They're clearly outside of the $6 million. The $6 million was only related to the inpatient division.

Okay.

And clearly, the $2.7 million in diagnostics were systems installation expenses so those would be non-recurring.

The $5.8 was the provision that we had taken. Clearly, we'd expect that to come down, but I really wouldn't want to speculate on what portion of that would or would not be non-recurring.

Okay. So maybe more like the $6 million and then the $2.7 million we could carve those out and maybe think about adding some or most of those back and then cutting out the $35 million as well?

Correct.

Does that cover most of it or am I missing something significant there?

I think that's a fair assessment.

Thanks a lot, guys.

All right. Thank you.

Your next question comes from Adam Feinstein of Lehman Brothers.

Great. Thank you. Just a few questions here. Jay, maybe if you can just talk about the cost cutting. I mean, clearly, on the margin side things are starting to look better, some of the operating costs if we exclude some of the one-time items. Maybe just talk about what opportunity you see there.

And then secondly, just curious to know when you would anticipate being able to provide some guidance for 2007? And even if you can't provide formal guidance, just curious in terms of what your general thoughts are about volume growth in the inpatient business? Thank you.

Okay. With respect to the cost opportunities, we have been very focused on maintaining our cost structure to be consistent with the volumes that we're seeing. In the inpatient division, for example, if you look at it, we were able to reduce our FTE count by about $600 quarter-over-quarter and I think that that's consistent with what we've seen in the past in our ability to manage in a declining environment.

From a company standpoint, what we're focusing on is essentially labor management and supply utilization. As you know, we have put a focus on labor management with the introduction of a new tool that was developed here internally; it's called our benchmarking system. It gives us the opportunity to drill all the way down to the facility level. The facility managers have the ability then to compare their performance on a department-by-department basis against their peer group in the division.

That we rolled out this year. We're starting to see some traction. Obviously it's going to take a little more time to get everybody on that system, comfortable with it, and using it, but we are pleased with the results that we've seen.

And then on the supply chain, most of the supply costs, as you know, for the Company is actually in the surgery division. I may ask Mike to just talk about that real quick.

Yes. We've had quite a concerted effort to get our supply chain acting like a supply chain and not a purchasing organization and have had quite some nice success with many of our non-physician preference items driving compliance down and getting better pricing from our suppliers. That's starting to take effect.

As you may recall, we brought in a Senior Vice President for supply chain in the first quarter, put his team together in the second quarter, really started making the efforts, it started to pay dividends here in the third quarter. We think we'll continue to see some nice trajectory in that segment.

So I think that you're going to continue to see improvement in the cost profile. Obviously, this quarter was, particularly in the inpatient division, it was a tough quarter because of the double whammy, the soft volumes upstream in the acute care sector coupled with the pricing impact that we still are experiencing the last quarter of that from last year's PPS update.

With respect to guidance, we will be providing that when we report on the fourth quarter and full-year. We anticipate that we'll be filing on time. That will be early '07.

In terms of general expectations for volume, it's still probably a little bit too early to predict with any precision, but we are looking for a year-over-year increase in inpatient admissions in our inpatient division as we are in a 60% threshold environment, essentially in a 60% threshold environment for '06 and '07.

So we are looking for an increase. We'll be providing that guidance, Adam, then in the first part of 2007.

Okay.

And since you provided the volume, I'm going to ask you about the pricing now, too. With the Medicare update taking effect last month, I guess what kind of pricing would you anticipate?

We talked about this, I believe, in the last quarter call and we anticipate that we'll be slightly north of 1% in terms of -- about $5 million a quarter is what we'll see from a pricing pickup as we go forward.

Okay. Thank you very much. Appreciate the --

That would be for the inpatient division.

Okay. Great. Thanks.

Your next question comes from Rob Hawkins of Stifel Nicolaus.

Good morning.

Good morning, Rob.

Hey, can I get just a couple of housekeeping items? One, can you give us the facility counts by division? And then, I guess, two, I want to have a quick question on EBITDA.

Rob, those are in the press release in that supplemental information.

I missed it, okay.

The facility counts by division as of the end of September 2006 but I'll give them to you. It's 193 in inpatient, which includes 91 outpatient satellites, 149 in surgery, which includes three surgical hospitals, 585 in outpatient, and 71 in diagnostics.

That would be on Page 7 of the press release and supplementary information.

Sorry about that.

That's all right.

And then EBITDA, should I be looking at, when I take operating incomes for these divisions, should I be looking at trying to allocate the depreciation and amortization as in the past or is that now changed?

Rob, you haven't got to the press release. That's also in the press release. On that same supplemental information page.

I mustn't have the supplemental information page.

It's on Page 7 and it's got the operating earnings and the D&A by division.

On the new facilities, it sounds like you guys have some exciting things going on there. How do you guys see those ramping up on a quarterly basis?

At this point, we are looking to add somewhere in the five to eight facilities per year. That's what we target for 2007.

It's a little bit hard to predict right now what that's going to look like on a quarterly basis, Rob, only because we're actually ahead of what we -- where we thought we were going to be.

We've been -- we knew there was a growth opportunity, we knew there were development opportunities out there and consolidation opportunities, but we've been very pleased with how many and so we are ahead of schedule. We didn't think these were going to start coming to fruition until '07, as you heard.

We were able to announce several in the third quarter. We anticipate that there will be more we'll be able to announce at the end of the fourth quarter. But the five to eight for 2007 is, I think, is a reasonable number.

That's certainly not what we're going to envision on a go-forward basis. We think that we'll be able to increase that. And we'll be providing more guidance on that once we get into the '07 discussion.

I guess where I'm coming from is maybe a standard facility, how -- what kind of losses these things might throw off. Will they lose money for two, three quarters then become profitable [when they] mature?

No they, particularly the consolidations are accretive from day one because we're taking volume from a competitor, like in the Tucson situation. That was a consolidation, that was a joint venture with us and Tucson Medical Center, where we took their unit, our unit, combined them together in a new entity, but that -- new corporate entity, but then we brought the volume into our hospital. So it was accretive from day one.

If you look at the de novo hospitals, that does take several quarters before we start seeing it being accretive, and then the acquisitions, of course, would be accretive from day one as well.

All right. Great. Thank you.

Now, excuse me, Rob. Obviously, as you know, if we were to get into developing some new LTACs, that's a completely different story, as you know. There is that six-month period where you have to qualify, you've got to get your average length of stay 25 or greater and there are losses associated with that.

But as you know, we've really sort of slow-walked our develop efforts with respect to LTACs and none of the projects that I mentioned in the third quarter were long-term acute care facilities.

All right. Thank you. I'll jump back in queue.

Okay.

Your next question comes from Henry Reukauf of Deutsche Bank.

Good morning, guys.

Good morning.

Just a question.

First on professional fees. I know we back that out and count it in the EBITDA; it's been running, it's still running pretty high. Do you anticipate -- what is sort of the normalized level for that that you would anticipate?

That should -- that's an event that should go away by the end of '06 and will not be singled out. Again, one of the points I was trying to make is in the quarter, what we are seeing is, it's very little relative to the restatement reconstruction.

The professional fees there are really associated with the '05 because, remember, as we're doing '06, we're having to do the '05 quarter. So what you have are fees being incurred relative to '05.

There's some other noise in that number. As Miles mentioned, there was a reduction in some legal fees, but we also are responsible for legal fees on the amount that we will receive from Richard and those kind of net themselves out.

What I was indicating is that we're seeing a little bit recharacterization and an initiative by the Company in 2006 to go after some additional tax losses. And that all comes about because the restatement was done effective 1/1/2000 for all years before that and then from 2000 on, it was done by year.

If you think about translating this into income tax issues, what we're doing now, and I mentioned we've incurred about $7.1 million in the quarter, and I think the number is about $14 million year-to-date, for professional fees relative to the tax area where we are going back and looking at the by-year loss for prior to 2000 so that we can generate additional tax losses because we think there's a significant amount of money, probably over $1 billion or more, in terms of tax losses. And so we're spending money on professional fees to try to gain something.

And that gain would come out by having higher losses, which would allow us to recoup some taxes paid in '96 through '99 in addition to the amounts that we've already reflected and secondly, provide some potential NOL shield in addition to the large one that we have going forward. So there is a little bit recharacterization.

Another way to look at that is that is a, we're spending some money on something that is intended to make money and is discretionary and that is about $7 million of that $23 million that we had in the quarter. So you're really more like a half in the current quarter.

And by the end of '06, professional fees would be more normalized, except to the extent we are spending money to recoup or refine additional tax losses.

But in '06 you're going to stop breaking out, but that normalized level, what would that be? It's a good use of money right now, sounds like a very good use of money to spend it to get the money back, but --

We would expect that normalized level to be in 2007, maybe 15 to $20 million.

For the year?

Yes except for monies we might spend discretionary on taxes, but that shouldn't be significantly higher.

And then for the tax refund, I thought you said the tax refund might go down but the NOLs would go up. Should we still think about a $240 million tax return at some --

No, I think it's just the opposite. I think the tax refund at the end of the third quarter, because we did get some refunds in '06, is more in the range of about $215 million to $220 million. Extra effort that we're doing on the forensic might allow that number to go up.

But there are other taxes that were paid in those years, because you have to carry back losses that were not necessarily recoverable before, but if we identify losses in those years that are directly attributable to those years, then those taxes would be recoverable. So we're trying to improve the cash and the refund, not decrease it.

But still excess of $200 million about a year-and-a-half away or something like that?

Absolutely.

Then the next is, just [inaudible] some of your conference presentations, you talked about a leverage level of 6.5 times maybe going to 4 times after some asset sales. That amounted to, I think, about a $1.2 billion of asset sales. Is that still sort of in the right ballpark?

We haven't put any sort of number on the expected proceeds. I will tell you, Henry, that the level of interest has been very solid, very strong and the bidding process I would characterize as being very competitive.

So we specifically don't want to comment on that in terms of expected proceeds, because the environment is so strong we don't want to create any kind of artificial ceiling. We think that these assets will go for premium prices, quite frankly. We think that they are well positioned in terms of future growth.

We've got great management teams around each of those segments and I think that as we are going through the management presentations, I think that they are showing very, very well.

Okay.

And just maybe on the time line, particularly for the surgery center, any terms of bidding process or when you think that might be finalized?

What we would hope to do, and right now we have outpatient and surgery on a concurrent path and we are in pretty good shape. We're on track with that and the goal would be to have some type of announced transaction in the early part of 2007 and, obviously for us, the earlier the better.

What we're looking to do, though, is we're trying to solve, basically, a simultaneous equation. On the one hand, we want to move very quickly and affect a transition as fast as we can. On the other hand, we want to make sure that we're getting maximum valuation for the shareholders and if that meant to achieve the latter we had to delay, or not delay, but if we had to extend the process to get a top price, we would do that.

And just the last one. Sorry if it's taking a little long.

Just on the 4.9% compliant case growth, you're at 63% you only have 2% left to go to get to 65% level next July and really for most of your facilities beginning of '08, should you back that off since that business should probably run pretty well without a lot of this regulatory issue in front of you. The degree to tell your guys to back off to the degree of which you're experiencing compliant case growth.

That's a very good question and we have looked at that. Part of the issue, though, is we do want to make sure that we're erring on the side of conservatism.

As you know, the consequence of not making that threshold is pretty dire. One loses one's IRF designation, and that's not something that we would want to see happen in any of our facilities.

The other thing that is working a little bit against us and is resulting in that threshold being a little bit higher is that each of the fiscal intermediaries have what's called local coverage determinations, and they're basically assessing the medical necessity. And to be very candid, the way the FIs are administering that is quite different. I mean it varies across FIs.

And so in a sense, in some of the FIs are looking at this 75% rule almost as a 100% rule that unless the patient is in that category -- one of those categories, they -- in some of the FIs are saying, well, they are not medically necessary. And we're challenging that and we're winning, especially in our largest FI, when it goes to the administrative law judge, the final arbiter, the final process, we're winning 90% of the time.

So it's a little bit of hand-to-hand combat, if you will, and I think, you know, we are working with the FIs, we're trying to get some clarity. We've had some pretty good indication that they're willing to look at this because they acknowledge, too, that there's still a lot of confusion there.

So that's kind of a long-winded answer and I apologize for that, but there are a lot of reasons why we think keeping it at that 63% is conservative, is appropriate, but there are also some just structural elements that are keeping that level up a little bit higher than you might expect.

Just as a follow-on to that --

Wait, wait. Henry, if you don't mind. We've got other people queued up.

Absolutely.

Thank you.

Your next question comes from Frank Morgan of Jefferies & Company.

Good morning.

Good morning, Frank.

A quick question here. 63% is your average compliance. Could you tell me how many of your hospitals are at the actual 60% threshold or greater? Can you give us some color there?

Virtually all of them are.

Or if not, they're within a percentage.

Yes, if they're not, they're at 59.5%, or 59%. I mean it's a very tight grouping, as you would expect.

To be -- if you look at -- to be honest, the 63% overall portfolio compliance is in part driven by the fact that we have maybe a dozen or so facilities that are at or near capacity and so it's easier to drive a higher compliance rate there, and as I suggested in my comments, we're looking at some bed expansions in those facilities to bring on some new capacity.

Got you.

Could you give us any color on the mix of categories? Of the 13, is there any one or two or three categories that are disproportionately -- resulting in this compliance level?

Not really. I think that our emphasis across the full spectrum is really what's driving our almost 5% compliance case growth.

Clearly, the major emphasis has been on strokes and that's something that we have rolled out programs and clinical protocols and so on across the broad platform that has allowed us to go after that population, because there's a higher incidence of stroke patients that need rehabilitative care.

One final one and then I'll follow-up off line. On the Tucson transaction, I was wondering if you could give us a little more color in terms of how long this process took from the time you approached them, the sales cycle for the concept of doing a joint venture, what were the characteristics of their unit, what were the characteristics of your hospital in that market and how does it all look once you get it put together?

I mean, clearly, this is a good way to deal with the issue of meeting the threshold. But I would just appreciate some more color on the background of that deal. Thanks.

Sure. I will say that every transaction is going to be different. In this particular situation, it was two competitors, us and the Texas -- I mean, Tucson Medical Center competing almost side by side going after the same types of patients and on.

Theirs was a unit within their facility, ours is a freestanding hospital. We had a very good relationship with that provider. It's an excellent, excellent facility and medical center there in Tucson and my guess looking back, it was probably about a six-month process to bring these two together.

I think that the management at TMC is very innovative and forward-looking. They recognize that this was not in their sweet spot in terms of expertise. They still wanted to maintain a foothold and be able to say that they're providing that, that's why we joint ventured it.

We were able to take that unit, they were able to close it, reuse the beds and then we have been able to bring that volume over to our facility.

What was their compliance like and were they losing a lot of money? I mean I guess that's part of the hope that these money losing units will be induced to do this but --

Well, quite frankly, we're not able to comment. I don't know what the profitability -- we were able to look at the EBITDA and it was a positive EBITDA, so it was something that I don't think that they felt that they had to do.

I think that, as I mentioned before, I think that the leadership down there was very innovative and they were looking at this the way we expect a lot more hospital administrators to look at it, hospital CEOs, and that is, they've got beds, they're needing additional beds, they've got beds tied up with inpatient rehabilitative care.

That can go outside. They can reuse those beds for med-surg purposes and avoid, frankly, significant Cap Ex. I think that's really what they were looking at.

And I assume it helps your mix as well?

Yes, oh, yes.

Okay. I'll follow-up with others after the call.

Your next question comes from Derrick Dagnan of Avondale Partners.

Good morning. Thanks. John, you mentioned that it seems like the acuity picked up in inpatient rehab and that cost you something on the operating expense line, wages and benefits. Could you give us a feel for maybe the case mix index and any changes that occurred over the course of the year?

Derrick, I do not have that number. It did go up. I can't remember exactly how many points it went up, but it clearly went up. That's consistent with having more compliant cases that we're going to have higher cost clinical help and more supplies or drug expenses associated with it. Kind of links back to not having gotten a price increase back in October 1 of '05 and incurring these inflationary costs. But I do not have that CMI number, I apologize.

That's fine. And I guess another question. It looks like the run rate on capital expenditures ticked up in the quarter and you guys mentioned that you're ahead of schedule on some of the acquisitions development activity. So are we kind of, is that sort of $140 million annualized Cap Ex run rate still a good number?

That is with acquisitions. I think that the number for 2006, as we've said before, is going to end up more around $110 million.

There was some development costs in the third quarter and excluding that, I think the $110 million is the issue for 2006. We have indicated that for all four businesses, $140 million is the more appropriate run rate to include some development items, but, clearly, it's going to be driven by the development cost.

And clearly as we look forward, we're expecting to stay at about the $140 million level, being a pure play company, but having significant development dollars associated with that.

And Frank, excuse me, Derrick. As we have said in the past at some of the conferences and we filed this with 8-K, so it's in the public domain. As we go forward, we look at the remain co, if you will, once the disposition of the other divisions has occurred, we look at our ability to fund capital and we envision, as John said, about $140 million per year that we'll be able to continue to devote. Approximately $40 million to $50 million of that is going to be routine.

So you can see, we're going to have close to $100 million of growth Cap Ex that we'll be able to invest in this pure play environment. We think that that's significant and so we think that the kind of development activities that we're starting to see now will be able to significantly increase as we go forward.

All right. So looking into 2007, we're probably looking at something we're in between the $140 million run rate and the $110 million run rate. Is that fair?

I think it's a function of how quickly we're able to dispose of the other segments and the extent to which we see competitors out there acknowledging and realizing that it's in their best interests to consolidate their business with ours or sell.

So I think ultimately, I think that's probably not a bad way of looking at it, but I think if you look at, say '08 and beyond, clearly, the run rate at that level, we expect to be able to fund $140 million a year and be able to have at least $100 million of that be devoted to growth.

Thanks. I'll jump off.

Thank you, Derrick.

Your next question comes from Kemp Dolliver of Cowen and Company.

Morning. I wanted to get some understanding to the extent you have it of the upstream weakness in acute care hospitals. The question is that given that 75% or more of the patients are Medicare and there's not much going on in terms of their coverage, as we talk about with hospitals with co-pays and deductibles, and it sounded like from your comments this is more than just the Florida migration or snowbird phenomenon. What do you think is going on upstream that would have a broad impact on your volumes?

I honestly don't know, Kemp. I've, as you have, you've watched the acute care business for years and years and it's very difficult to pinpoint any one reason why there are the swings that we see. But clearly, the third quarter you saw that in Tenet, you saw that in HCA's release, I believe Triad as well said that the third quarter was a particularly soft quarter.

It usually is, as you know, third quarter is always a very challenging one, the seasonality. I honestly don't know what those underlying factors are, but I do know that we're very dependent on the upstream acute care business to be able to provide us patients and when they start to dry up, it does have a downstream impact on us.

Right, right. But to be sure I'm interrupting your comments appropriately is, what you're seeing is somewhat abnormal seasonality this quarter?

I think it is. As I mentioned, we're very encouraged by how we're beginning the fourth quarter and we are seeing an uptick. We hope that that will continue and be sustained through the balance of the quarter.

Clearly, when we hit the holidays, things do get a little bit shaky, but I think that overall we're feeling pretty good about how we're entering the fourth quarter. So, yes, I do think that that might have been unusual seasonality.

As I said before, you step back and look at overall acute inpatient utilization for the last, say, 20 or 25 years, it averages in the 1.5% to 2% per year growth. Sometimes it's more, sometimes it's less, you have a lot of variation and we've seen this previously.

I don't know that I can tell you exactly why, I'm not sure anybody in the industry, frankly, can really tell you exactly why, but I do think it's unusual that we saw it so weak this third quarter.

That's helpful.

And last subject is, that you've achieved compliance across a wide range of markets and I think in terms of markets that are competitive and markets where you are the sole provider, has there been much difference in terms of either how you got there or the impact on your profitability?

I would say that there's really no difference to how we got there. The focus has been and we've rolled it out across the entire division. The focus has been on the sales and marketing effort and trying to get the case managers and the administrative teams really focused on where the referrals are actually coming from.

As I think we've said before, we've rolled out a market assessment tool that we developed internally that allows our administrative teams and management teams to pinpoint where that compliance case growth is and then to go after it. And we've been very pleased that that has been well received by the management teams and obviously we're seeing the results.

That's great. Thanks a lot.

Operator, before we ask the next question, this is John Workman, I just want to go back to Miles Highsmith's earlier question, because I know we have a combination of high yield and equity people on the phone.

And in looking at EBITDA, one of the things that I think is an important to mention is that diagnostics has a lot of noise in it and we described that division as non-core almost a year ago and, clearly, the results that are seen in diagnostics today are not indicative of its run rate.

So when you're trying to get a handle on our EBITDA on a quarter-over-quarter and we have the $141.9 million reported and, clearly, we talked about backing out the $35 million and I think it's appropriate to add back the $6 million in inpatient, but I would encourage you to look at it without diagnostics, which would show $117.4 million on that basis in terms of EBITDA compared to $131.5 million, again, excluding diagnostics and excluding the $37.9 million Meadowbrook a year ago.

And that decline is kind of consistent with the year-over-year decline that we expected in '06 versus '05 and it's primarily driven in our inpatient division as we've always said because of the ramp-up in the 75% rule and the pricing impact.

So if you look at the three core divisions and, again, diagnostics, the team has inherited something that they're working through and there's a lot of noise in and, as we've said before, we believe the more indicative run rate in the diagnostics division is more like $20 million or north of there in terms of EBITDA and not at the levels being reflected in the actual results.

So with that, we'll go back to the question.

And Jessica, I think we have, I think, I know we're going a little bit over here, but I'd like to take the three folks who are in line and see if we can move through those questions as quickly as possible.

Thank you. Your next question comes from Andreas Dirnagl of JPMorgan.

Good morning.

Mike, in your comments you mentioned the word "same-store" when it came to the surgery centers, but maybe I'm just missing it, is there any color you can provide on what some of those same-store statistics actually are?

I'm not sure what you're asking me. We had the same-store with the 149 centers year-over-year, we looked at our case count on a per day basis and we were about 2.7% down for those facilities -- for the 149 facilities that were open this year and a year ago.

And anything on the revenue side?

Well, as we mentioned we had equity flips that was probably about $5 million of revenue change where facilities went from an investment to equity accounting and then we had the closures that didn't count as discontinued ops was about another $5 million.

We got some income from our minority and those that flipped into equity had about $3 million of income on that line. So all in all, it more than explained the revenue shortfall during the quarter.

Great.

And finally, John, could you just maybe give a little bit color, sort of what you did, I guess, in the meeting back in August or whenever it was, on what's the current value of the NOL and where you see that going over time?

Sure. At the end of '05, both the net operating loss available as well as deductions that will become losses because, as you recall, for tax purpose, sometimes those are only losses when the reserves are paid or the liability's paid, we will have well over $2.5 billion worth of potential losses for tax purposes.

That's not including the initiative that I mentioned earlier that we're trying to go after some additional losses. That clearly is sufficient loss to enable us, as we look at potential divestitures, to be able to absorb any tax, and we would expect to be paid for something by an acquirer relative to the higher tax basis, we may be able to provide that buyer and we'd expect to be paid something for that, but clearly we can absorb any tax gain as a result of any divestiture activity and clearly have sufficient NOLs going forward to shield the Company from paying taxes for many years to come.

I'm not going to be specific about the number of years but, clearly, with the remaining company, we would expect a much different taxable income situation and one that would allow us to utilize those NOLs on a going-forward basis.

So just to clarify that, the biggest delta in the growth is going to be as you actually unwind the reserve and pay some of the settlement, that's going to generate the NOL?

Yes. As we pay the amounts, again, in '06, remember we incurred about $360 million in tendering costs that are an additional deduction that was not there at the end of '05. So we've continued to accumulate some, and when I mentioned that number that included that, we continue to accumulate some additional tax losses.

But, again, in a potential divestiture scenario where you're looking at a lot less interest cost and a different profitability picture, we would expect to be a taxpayer and I mean, we would expect to have taxable income. We would not expect to be a taxpayer because we would use those NOLs to absorb any taxable income created for the next several years.

Great. Thank you very much.

Your next question comes from Mike Scarangella of Merrill Lynch.

Good morning.

Hey, Mike.

Hey. Jay, on prior calls, you'd given an update on your efforts to study the 75% rule and update Congress on its impact I think in the hopes of maybe getting some relief down the road.

Are there any updates you can share with us today on that topic and then I'm wondering if the change in leadership in Congress, would you view as positive, negative, or neutral on those efforts?

All right. In terms of the work on the Hill and in Washington, we see 2006 as being a year to complete the various research initiatives. And when I say we, it's not HealthSouth per se, it's HealthSouth as part of a broad industry-wide coalition that is looking at the efficacy of inpatient rehabilitative care.

I know a lot of discussion heretofore has been on the cost per day differential between, say an IRF stay and a skilled nursing stay. We think that that's sort of a disingenuous argument at best because it doesn't factor in the differences in terms of lengths of stay, it certainly doesn't factor in the quality of care that is provided in the two settings, nor does it factor in considerations about how well and how functioning the patients are once they are discharged and how many of those patients get discharged to the home environment versus to a home health environment.

And part of the research that we're doing right now -- I've seen some of the very early results, suggest that patients who go into skilled nursing facilities actually have a higher incidence of being discharged to a home health environment, which is additional cost for the Medicare program.

They have a higher incidence of being readmitted back into the acute care environment, which is additional cost for the Medicare program. They tend to stay longer in skilled nursing units than they do in IRFs, additional cost to the Medicare program.

And then if you look at the functional capability and how well those patients are, how able they are to live independently and productive lives and so on, there's a big difference between patients who come out of a rehabilitative environment versus one who, basically, they've been sort of warehoused in a skilled nursing home for a period of time.

So we're doing a lot of research to really shed some light on the differences and the goal will be to bring all of this research together in a comprehensive and very open and transparent way in February of 2007.

We will be inviting our friends from the skilled nursing industry and we'll be inviting our friends from CMS and NIH and from across the spectrum to really join in a very intelligent discussion based on facts and to really look at what the differences are. That's our big push in 2006.

So we're not on the Hill, we're not lobbying. We feel that the one-year relief that we got was the time that we needed to complete the analysis and to bring forward facts and clinical evidence.

With respect to the second part of your question, typically providers do better, if you look just back historically, in Democratic-controlled Congresses. That's what we have right now. I would suggest that this is going to be neutral to positive.

I know that we had very strong bipartisan support in the Senate when we were up talking about getting some kind of relief in the 75% rule. I also know that when we are on the House side, typically the fiscal conservative Republicans only wanted to talk about cost -- they weren't as open to, as we saw on the Senate side, willingness to look at quality and quality of outcomes and quality of life for the Medicare beneficiaries.

I suspect that the Democratic House now will be more open to looking at this situation from a comprehensive view, not strictly, exclusively, and solely on cost data that may be very misleading.

Very helpful, guys. Thanks.

All right.

Your last question comes from Eli [Rudenski] of Citigroup.

Good morning. A couple quick questions for you.

The first one is, in your inpatient rehabilitation facilities, what percentage of your revenue comes from outpatient therapy services?

And then the second question is just a refresher on the NOLs that you have. Because of the amount of NOLs, is it your expectations that the gross proceeds that you receive from the divestiture will primarily equate to the net proceeds because you'll be able to shield taxes from the NOLs?

And lastly, what must you do with the excess proceeds if you don't invest them within a year or two years? Must you use those proceeds to repay bank debt or bonds? Thank you.

I can definitely -- I'll take the last one while John looks for the outpatient revenue information and he can address the NOLs.

Absolutely the goal in the divestiture of these three segments is to reduce our debt. As we've said before, the primary reason we're doing this is because we inherited an inordinate amount of debt. It is limiting the ability across our four divisions to grow.

And if you look at the amount of Cap Ex that we would need to fund the kind of growth we think is possible across all of the divisions, compare that to what we can afford, which we've said previously is about that $140 million a year level, that delta is $750 million.

And either we go out and borrow more, clearly, the banks aren't going to let us do that, raise more equity, clearly, the existing shareholders aren't going to be happy about that, or we say, hey, we've got to do something a little more radical and that's why we're moving into this divestiture and, definitely, it will be to take the proceeds, pay down the debt.

As you know, we have $2 billion of bank debt that is all prepayable. We have the ability to take that down and then on the high yield, we have about 300 and some million that are, or $375 million that is non-call three and then the balance is non-call five so longer term, we'll be able to address the capital structure once we're on the other side of the dispositions.

We have not, I'm just looking to see, because I don't want to start creating some other segment.

Clearly, the outpatient facilities are satellites of our inpatient facilities in reporting those revenues, it's clearly below 10%. It's in the single digits, high single digits.

You can kind of equate that with the, thinking about an outpatient and what the level of reimbursement per visit ought to be versus the type of discharge payment, if you look at our '05 10-K, but it's a generally small portion.

On the second question relative to the NOL, just make certain I understand the question, let me try to answer it and if I don't, you can ask a follow-up question.

What I was saying is that, clearly, we would expect to, you know, we would expect some giant sale of the divested activities and that would create taxable income. As you know, there are ways to create more taxable income under those scenarios by allowing a potential buyer to get a stepped up basis.

For example, if it's a stock transaction, it's referred to as a 338h10 election where you can in essence step up the basis from what the carry over basis might be which would give rise to additional taxable income. Clearly, the large amount of NOLs that we have would allow us to absorb that.

We would expect, obviously, to be paid something for that by a buyer either in a lump sum or in some form of annuity as they were able to utilize those additional deductions and get some value on the transaction. But having said that, there's clearly enough NOLs to absorb that type of taxable income and a step up in basis to a potential buyer as well as to shield taxable income even in the remaining company on a go forward basis, which would have a lot less interest expense.

As Jay said, our intent is to pay down debt for many years to come. I'm just not commenting on the specific number of years, because that will depend. But it's a -- for many years to come, we would not be paying federal income taxes. Did that answer your question?

Yes, it did. Thank you.

I want to thank everybody for participating this morning. I'm sorry that we ran so late, but we did want to get to all of you who were in queue for questions. I hope that has been helpful for you.

And with that, operator, this call is concluded.

Thank you. This concludes today's HealthSouth conference call. You may now disconnect.