Encompass Health Corp (EHC) 2006 Q4 法說會逐字稿

Good morning, everyone, and welcome to HealthSouth fourth quarter and year end 2006 earnings conference call. At this time I would like to inform all participants that your lines will be in a listen-only mode. After the speaker's 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.

Great, thank you, operator, and good morning to everyone. With me in Birmingham today are John Workman, our Chief Financial Officer; Mike Snow, our Chief Operating Officer; John Whittington, General Counsel; Tyler Murphy, Senior Vice President of Treasury; some of our division Presidents and CFOs, Mark Carr, and David Clements from our inpatient division, Brian Pope from our surgery division, Greg Brophy, and Greg Eisenhower from diagnostic, and Steve McPherson from outpatient. Before we begin this morning's call, I'm going to ask John Whittington to read some cautionary statements.

Thanks, Jay. There are a number of disclaimers, risk factors, and other cautionary statements set forth in the form 10-K we filed with the SEC this morning, and in the press release we filed this morning also. We will not review these disclaimers, risk factors, and other cautionary statements. However, we urge you to read them carefully. I would, however, like to highlight the following.

The information contained in our presentation may include certain estimates and other forward-looking information that reflect our current views with respect to future events and financial performance. Estimates are based on numerous assumptions and involve a number of risks and uncertainties. Including those set forth in the form 10-K and in other documents we have previously filed with the SEC, many of which are beyond our control. The estimates in the presentation and the information in today's press release are based on assumptions which HealthSouth believes are reasonable. However, there can be no assurance that any of these estimates will be realized. Your caution not to place undue reliance on the estimates and other forward-looking information contained in the presentation. I'll also note the following with respect to certain financial information.

The financial information contained in the presentation includes non-GAAP financial measures, including consolidated adjusted EBITDA, which has defined in our credit agreement, and should not be considered as a measure of financial performance under Generally Accepted Accounting Principles. For a discussion of consolidated adjusted EBITDA, please refer to the 2006 form 10-K and the 2005 form 10-K. The classification of certain restructuring charges and expenses used to calculate consolidated adjusted EBITDA is not in accordance with GAAP, and our actual financial reports include these costs. With that I'll turn it back over to Jay.

Great. Thank you, John. Before we open it up for questions, we're going to go over the following items with you today. First, John Workman and I will review the results of the quarter; second, I'll provide an update on the status of our strategic repositioning efforts; and finally, we'll discuss guidance for 2007. In many respects, the fourth quarter signaled a turning point for the company as we experienced improved net revenues and operating earnings in our two largest segments. Inpatient net revenues were up both sequentially and quarter over quarter, driven primarily by increased reimbursement as we continued to treat sicker patients. As part of the press release supplemental information, we included the number of facilities for each segment.

For the inpatient division, you'll note the total includes those outpatient clinics that are affiliated with our hospitals. The reduction in our inpatient facilities was attributable to the closure of 20 unprofitable outpatient clinics associated with our inpatient hospitals and the loss of our lease of a hospital in Macon, Georgia. The Macon facility had approximately 1,150 discharges in 2005 and approximately 840 discharges for the nine months we operated it in 2006. It contributed approximately $4 million in operating earnings in 2005, compared to a loss of approximately $770,000 in 2006. Total inpatient discharges were down 4.5% in the quarter compared to the previous year. The primary reason was due to the fact that the compliance threshold for 66 December year-end cost reports and 16 May year-end cost report hospitals jumped from 50% to 60%.

Despite the ongoing challenges associated with complying with the 75% rule, our hospitals continued to do an excellent job of marketing to physicians and family members of those patients who qualify under the rule. In the quarter, compliant cases were up 4.7%, well within our previously-stated goal of 3 to 5%. As we treated more compliant cases, we also saw an increase in our case mix index, which contributed to stronger unit pricing and a 2% increase in net revenues. Additionally, in the fourth quarter, we closed on our previously-announced acquisition of the 48-bed Wichita Valley Rehabilitation Hospital in Wichita Falls, Texas, and consolidated its operations into our 63-bed HealthSouth Rehabilitation Hospital of Wichita Falls.

Finally in the quarter, we approved bed expansion projects at five of our hospitals, totaling 54 beds. We opened 18 new beds at two other facilities and are awaiting licensure approval on another 10-bed addition. This added bed capacity from these projects is equivalent to adding two brand new 40-bed hospitals. Four of these expansions will come online in the second half of 2007 with the final project scheduled to hope in 2008. All of these expansions will come online in the second half of 2007, with the final project scheduled to open in 2008. All of these expansions were at facilities in growing markets, hospitals operating at 85-plus percent occupancy and 60-plus percent compliance threshold.

We were also very pleased with the continued improvement in our surgery centers segment. Net revenues were up 3% in the quarter compared to the fourth quarter of 2005, while operating expenses showed both quarter-over-quarter and sequential improvement, a clear signal our recent indication and operating improvement efforts are paying off. One of the most important metrics is the number of surgical cases we perform in our facilities. While total cases were down because of the closure of nonperforming centers, we saw an almost 1% increase in cases at those ASCs that were open for at least 12 months. This increase allowed us to achieve our previously-stated goal of realizing same-store case growth by the end of 2006. We are very proud of this accomplishment, and believe it sets the stage for continued growth on a go-forward basis.

With that brief overview, I'm going to ask John Workman to walk you through some of the numbers for the quarter.

Thank you, Jay, and good morning. What I'm going to do is walk you through the fourth quarter and talk about the total company, some segment information, some just overall comments on the total company for the full year and not go into that by segment, as it's pretty fully described in the 10-K, and talk about some balance sheet captions at the end of the year. We are pleased to be filing our 2006 10-K without need of extension. The 10-K in this press release is on the SEC Web site if you have not already accessed it.

Overall in the quarter, our loss from continuing operations was $70.5 million, an improvement of $13.5 million from the fourth quarter a year ago. Revenue was generally flat for the quarter. If we look at some of the line items on the income statement, there are some items of note. In the salaries and benefit line, it did include a $4 million charge under 123-R for stock option costs. Looking at the provision for doubtful accounts, it has a significant increase, which is primarily driven by our inpatient and diagnostic division, where we installed new, single platform billing and collections systems during 2006, and are pleased that by the end of the year we had those all installed and each of those divisions is now on one platform. In diagnostics, remind everybody the new system replaced eight legacy billing platforms.

The fourth quarter of 2006 includes $12.8 million of recovery from Richard Scrushy, satisfying the total amount due from him per the court order in paying back bonuses to the company. Also, the company's settlement with the plaintiffs on the securities litigation was affirmed by the court right after the end of the year. In connection with the finalization of this settlement, we agreed to an amount to be paid to the plaintiffs' attorneys of $25.5 million, which is reflected in professional fees. We also took a look at the warrant and stock as part of the settlement and marked that to market which created a credit in the line "government class action and legal settlements". In addition, related to the securities litigation and the court approval, we grossed up the $230 million from the insurance carriers, which has already been paid into an escrow account, and is reflected as an asset on the balance sheet with a corresponding increase in the liability account from what you would have seen a year ago, but again, those two net out.

Turning back to the income statement, other operating expenses improved as the costs we incurred to outside parties, which are beyond normal costs under Sarbanes-Oxley compliance, were approximately $9 million higher in 2005 versus what we incurred in 2006. I'll remind everybody we still have significant internal costs in both years. As we did note in the press release, we have come a long way from where we were two years ago relative to internal controls, and the fact that we have only one material weakness at the end of 2006 reflects a significant amount of hard work by a lot of people within the company and it's something that we're proud of. Last comment on the income statement for the total company, turning back to professional fees. During the fourth quarter, it represented approximately $43 million in legal fees, including the 25.5 that I mentioned before, $8 million relative to the pursuit of the tax refund from 1996 to 1999 as we attempt to maximize that amount, and $7 million of fees we incurred related to the divestiture activity.

Now I'm going to turn to the divisional results. In the inpatient division, as Jay mentioned, we saw an improvement in revenue and operating earnings in division. If you add the depreciation and amortization to operating earnings for both years as provided in the supplemental data, you can see that the division improved by approximately $5 million. In surgery, we also experienced revenue growth from the same quarter a year ago. Again, if you add the depreciation and amortization to the operating expenses for both years, this division will reflect an $11 million improvement.

On outpatient diagnostics, looking at those two combined, they did both experience revenue declines and operating declines. Again, if you add depreciation and amortization for both years to these two divisions, they would reflect an approximately $10 million decrease from the same quarter a year ago. And turning to the corporate and other segment, if you add back depreciation and amortization of this segment, it would also reflect a $10 million improvement in the quarter, which is primarily the result of the Scrushy recovery that we mentioned previously. This segment is also where the 123R cost of $4 million and the Sarbanes-Oxley cost savings are reflected compared to the fourth quarter of 2005.

If I turn to the full year, I'll just comment again on the consolidated results. There's a fair amount of description in the MD&A by segment and I do not intend to go through each of those. From 2005 to 2006, our consolidated net operating revenues decreased by 3.8%. We experienced volume decreases primarily contributed -- which would primarily contribute to this decline. Our inpatient division was negatively impacted by regulatory pricing and changes that occurred in October of 2005, as well as the continued implementation of the 75% rule up to the 60% level in 2006.

In our surgery centers and outpatient divisions, we were able to partially offset the negative impact of declining volumes through improvement in net revenue per case or visit relative to each division. Operating earnings increased by $159 million from 2005 to 2006 due primarily to the fact that we had a $215 million security litigation settlement in 2005. If we exclude the amounts for this in both 2005, operating earnings would have decreased $86 million. Again, primarily attributable to the volume declines in our operating segments. One other comment relative to the interest expense, interest expense is relatively flat in the total company for the full year, and you can see that on the face of the income statement. Clearly we are hopeful that as our deleveraging plan comes to play in 2007 we will see interest costs decline as our borrowings go down.

The other thing I should comment on relative to interest cost is that we did announce an amendment to the bank credit agreement about two weeks ago. That amendment is to seek approval for the sale of the various divisions as long as certain criterion are met and determines how the use of proceeds would be divided. It also would provide us some added flexibility in our credit agreement, and lastly, we are seeking a reduction in the spread on our LIBOR-based borrowings on the term loan to take advantage of the current market conditions, despite the challenge of two days ago and the fact that our deleveraging plan should play out in 2007.

Turning to the balance sheet, just a few comments. The total of cash and restricted cash and marketable securities declined by approximately $170 million from year end 2005. This cash was used to make our payments on the amounts due to the CMS DOJ and the SEC and the remainder was cash used to complete the refinancing in March of 2006. I would remind everybody that our obligations for the CMS DOJ and SEC payments will be satisfied completely by the end of the year 2007, and that will no longer be a cash drain on the company.

At the end of 2006, we had $170 million borrowed on our revolver at year end, which was largely due again to the timing of the CMS DOJ payments and our bond interest payments, which came due approximately at the end of the year. At the time we filed the 10-K, we have been able to reduce the amount of revolver borrowings by $40 million with unrestricted cash at about the same level it was at year end. The development growth that Jay commented on is being funded from our revolver. CapEx from the quarter was $20.7 million in the fourth quarter of 2006, compared to $3.8 million for the fourth quarter of 2005, so you can see that we have increased CapEx and most of that is in line with some of the development activities in the inpatient division.

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

Thank you, John. As all of you know, on January 29, we announced the signing of a definitive agreement with Select Medical to sell our outpatient division for approximately $245 million subject to certain adjustment, the proceeds of which we expect will be used to pay down a portion of our bank debt. Thus far, the preparatory work to closing has gone smoothly, and we remain optimistic we can wrap things up in the next 60 days or so.

The proposed divestiture of our surgery centers division also is progressing, although we are being very careful to ensure we optimize the value of this important division for our shareholders. For those ASCs that we expect will be divested, the 2006 EBITDA after-minority interest was approximately $100 million, normalized for nonrecurring items and fully loaded for corporate and divisional overhead. This number is somewhat better than what we projected when we began our divestiture process last fall, and is what we're using as our base line as we explore non-sale alternatives, such as a spin, an IPO, or a leverage partial disposition. Although no assurances can be given as to the terms or timing of such a transaction, or that any such transaction ultimately will be consummated.

While we will be unable to provide additional information on our negotiations at this time, we remain cautiously optimistic we can meet our goal of announcing a transaction for this segment by the end of the quarter. The proposed divestiture of our diagnostic division also is moving forward nicely. Management presentations have been completed, and we are extremely pleased with the level of interest from potential bidders. This process also remains on track and is consistent with our previous timetable.

Finally, before opening it up for questions, I would like to discuss guidance for 2007. As we have said previously, on a pure play basis, we believe HealthSouth will be a compelling earnings per share growth story. Solid, mid-to-high single digit organic EBITDA growth, coupled with the incremental earnings from the additions of five to eight new development projects annually, the significant deleveraging from the disposition of our noncore businesses, and the receipt of our tax refund and derivative proceeds should generate strong EPS growth over the long-term.

Having said that, circumstances will make it difficult to evaluate EPS growth as the basis for evaluating the company 2007. First, we need to execute on our repositioning strategy. As you've just heard, we're optimistic we'll be able to divest our three ambulatory divisions in the first half of the year, although there can be no guarantee we will be able to do so. Second, once these segments are repositioned, we will continue providing a variety of transition services to these divested businesses for another 12 to 24 months, depending on what we negotiate with the buyers. These transition services will include a range of IT support as well as certain other corporate support services.

Third, as we wrap up the restructuring we began in 2004, we will incur additional restructuring expenses throughout 2007, although these expenses will wind down by year end. However, litigation costs associated with the pursuit of our claims against various parties will continue into 2008 and possibly beyond. With respect to guidance for 2007, we believe investors should focus on our core inpatient segment since it is this business that will define the company on a go-forward basis.

We have previously provided guidance that once we work through the impact of the 75% rule, we expect our inpatient net revenues to be driven by annual organic volume growth of 1 to 2% and annual unit pricing growth of 2 to 3%. Because 66 of our 92 hospitals were at the 60% threshold for all of 2006, and will be at this same threshold for all of 2007, we anticipate overall inpatient volumes will grow in this 1 to 2% zone in 2007. Affecting the overall growth rate is the fact that nine of our hospitals step up to the 65% threshold beginning July 1 with another hospital moving to 65% starting October 1. From a pricing perspective, we anticipate a modest increase in 2007. Accordingly, we anticipate our inpatient net revenues will grow 2 to 3% with corresponding operating earnings growth of between 3 and 4% in 2007.

Once we have finalized our divestiture plans for the surgery and diagnostic divisions, we will be able to move these operations, along with outpatient, to discontinued operations assets held for sale. What we will not be able to transfer to discontinued operations are corporate overhead costs associated with these divisions. We will have to wait until these divisions are actually divested and these costs eliminated before we will see the impact at the corporate level. Complicating things even further is the fact that we'll be providing certain corporate services to these divisions on a basis for an extended period of time. These costs will also remain in the overall numbers. These factors combined with the costs associated with the upgrade of our general ledger system and expenses associated with the pursuit of our tax refund system will tend to inflate corporate overhead throughout 2007.

Our goals which we will target to achieve by the end of next year. While there will be noise in the corporate numbers throughout 2007, we believe investors should focus on four metrics to evaluate our performance in the coming year. One, deleveraging the balance sheet through the successful divestiture of our noncore businesses. Two, achieving inpatient net revenue growth of 2 to 3%. Three, achieving inpatient operating earnings growth of 3 to 4%. And four, consummating five to eight development projects by the end of the year. Once we get through this final transition year, we look forward to providing EPS guidance on a go-forward basis. With that we'd like to now open up the line for Q&A.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Henry Reukauf of Deutsche Bank. Please go ahead.

Hi, guys, good morning. Jay, what did you say your compliant case -- not growth, but the compliant case amount was currently and where do you -- are all those 11 or 9 hospitals that will go in July basically compliant now or not?

Yes. Overall our portfolio remains in that 62 to 63% compliance range. Clearly as the facilities move closer to to the threshold, there are efforts at the local facility to start ratcheting down on the noncompliant cases to bring that overall compliance level closer to that new threshold. So right now of those that are coming into the -- that have a June 30 year end, we're probably not seeing that today, but we will start seeing that some of that activity were they're a little more careful bringing noncompliant cases in, probably start seeing that in the April/May time frame.

But that is totally achievable to 65% for those facilities?

Yes.

Okay. Just the second one just on overhead, I think you've been running around 30, $35 million of overhead currently. I know you said 4.75%. Is that -- for the remainder of this year as you ramp it down, is that where it's going to stay? And secondarily, you are going to be providing services to the acquirers of your businesses. Will whatever that -- the payments from them for those services, will that be an offset to the corporate overhead?

Yes, this is John. A couple things. One of which is, as you know, we do not allocate corporate overhead to the segments.

Yes.

So one of the anomalies that's going to happen in 2007 is that you will see corporate overhead come down once a division is sold and closed and we would expect for some of our transition costs to be reimbursed by the buyers and that to be somewhat of a neutral element. One of the complicating factors further will be, though, that because we have to provide some of those transition services, some of the activities we would like to implement will be a little bit slower because we have to keep in place the existing system to transition the buyers out of HealthSouth, even though it would be our desire in 2007 to be moving towards a more improved structure and the PeopleSoft that Jay mentioned is one of those that we have to go a little bit slower with in 2007, and we think we'll create some efficiency.

To your point earlier, I would say the corporate overhead that you gauge in terms of an existing all four divisions is in the right range. And if you come to the annual numbers under operating costs and look at the $313 million loss, if you add back the professional fees and the settlement costs, then backing out the unusual gain on the Scrushy settlement and add back D&A as in the supplemental data, I think you'll get back to approximately $136 million. There are some other items that would be normalized, but those are the big items. So that's currently at about 4.5% of revenues.

Okay. And will payments just in this transition period, do you expect any dollar amount of payment from the people who acquire these that you can say as an offset?

We would expect to do that. Obviously, the only one that we've negotiated so far in that case is outpatient.

Okay.

and we will be providing minimal transition services to them, but some of them will take place over a longer period of time. We would expect that element to be somewhat cost neutral, but again, because we still have the other divisions, there's a certain amount of supervision, what Jay is addressing relative to some of the noise in the '07 numbers, you will not see us drop to that run rate even after all the divisions are disposed of and gone in 2007, but our plan would be clearly by the end of 2007 to be at that type of run rate.

Thanks very much.

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

Good morning. I've got a request, and this can be handled offline a little bit. It's pretty hard to follow your quarterly numbers given the amount of restatements and all the different businesses, and it's not -- as far as I can see, it's not provided in the K. Is there a way that you guys can give us '05 quarterly revenues either in a separate release or offline, quarterly revenues and quarterly EBITDA for the quarters in '05 and the quarters in '06?

Rob, those should be in the -- those are all filed in the 10-Q. I think what you're talking about is perhaps, when a facility becomes discontinued and you go back and reflect all of those years --

Yes. Well, I guess I'm trying to figure out -- I'm having a hard time to -- again, we can probably handle this offline.

We can work with you. If you look at the supplemental data in the 10-K and add to that the supplemental data that we provided in the press release, we can get fairly close. We can, I think, help you bridge that.

Okay. Quickly with the surgery center businesses, it's really improved significantly since last quarter and it's probably about two or three quarters ahead of where we expected and I think other investors did at well. Can we go into a little bit about how you guys achieve that improvement and what you expect to see going forward?

I think it's really a combination of a couple things. I'm going to speak for Mike here and then ask him to chime in if I don't cover it adequately. As you know, we have focused on basically improving the base group of facilities -- the portfolio. Enhancing that through the resyndication efforts. Making sure that we have the right facilities with the right physicians and that we have focused our growth on those surgeons who can bring the kind of ASE volume that is attractive.

The second thing is just focusing on some of the blocking and tackling of operations. Making sure that we are staffing our facilities appropriately, using some best practices to disseminate information. We've got a benchmarking system that allows our facilities to compare their staffing with other similar facilities across the portfolio. We've also in early 2006 brought on a new person to head up our supply chain initiative. We're seeing some improvement there as well. There's no magic to it really, Rob. There's a lot of very hard discipline, operational improvement, and focusing on the resyndication efforts and focusing on getting the right efforts into those centers. Mike, do you want to add anything?

I think you hit it, Jay. Rob, probably the one most significant initiative were those resyndications. As we got in hot and heavy through the year, we said it was going to take a period of time for those to gain traction, typically a couple of quarters even for physicians to change behavior. And we started to see that momentum in the second half of the year. While we were comfortable telling you we believe we can get to same-store growth by the end of the year. So that's what we saw. That's the primary driver of the improvement.

And do you think these margins -- there's still room to improve the margins as well going forward?

Honestly, Rob, we think that the amount of attention that we've paid to operating cost improvement can only get better from here. We've paid a lot of attention in 2006 to getting the portfolio dressed up from resyndication, ownership position, ownership perspective, putting out fires, putting in managed care leadership, supply chain leadership. I don't believe that we have made a material impact on the operating cost improvement opportunities yet.

On the IRS business, if we can shift gears to that, the margins -- from what was in the press release, the margins appeared to have fallen about 200 basis points. And it kind of looked like that last quarter as well, but there were some addbacks from consulting fees and some other things. Did I miss some of that in your comments? Is there some addbacks in there that might bring the margins back up in the inpatient business?

No -- are you talking about from a quarter ago, Rob?

It's looking -- yes. I'm kind of seeing your normalized margins in the IRS business being in the 25% range. If I add just the operating income -- [multiple speakers]

Actually, Rob, if you take the supplemental data and take the operating expense plus the depreciation and amortization divided by revenue, I think you'll show an improvement in the fourth quarter, or year over year in the quarter in terms of the rate.

That's right. It's up about 100 basis points over last year, but you've been kind of at a run rate for this year -- is there just something going on in the fourth quarter?

Remember, we've got a price increase October 1, 2006, in CMS which is one of the big drivers helping the margins, which we had commented in the third quarter that would help us in the fourth quarter.

I guess -- okay. Let me ask it another way. Is this a good, normalized margin for this business, what we saw in the fourth quarter, or more what we see blended over the year the better --

I think right now the fourth quarter, as you move forward, because again there is a pricing improvement October 1, 2006, should be what we would look -- as we look forward into 2007, remember price increases are effective October 1 '06 to September 30 '07 and Jay said, we might expect some modest. We obviously have increased costs as we have to pass along payroll increases, especially to clinical staff. So we do have some increased costs. But I would say right now the fourth quarter would be more reflective of the current environment than the full year.

All right. Thank you, gentleman.

All right, thank you.

Thank you. [OPERATOR INSTRUCTIONS] Our next question is coming from David MacDonald of SunTrust. Please go ahead.

Good morning, guys.

Good morning, David.

I had a couple of questions for you. One, you gave us some good detail on the Macon, Georgia, facility that closed, but could you give us an idea of the revenue impact of the facilities that were closed during the quarter?

I don't have that right off --

I can circle back with you on that. A couple of other questions. One on the ambulatory surgery center business. With the improvement in trends, are you seeing a willingness from the folks that are sitting at the table potentially look to buy this to acknowledge the run rate trends as opposed to the trailing nine months trends that I believe the books went out with in terms of trying to sell that?

That's certainly our goal, but as you can certainly appreciate in a negotiation process, the buyers come in with the glass is half empty and the sellers come in with the glass is half full. Hopefully through that process we're able to strike a deal that makes sense for both parties.

Jay, did you say the ASC EBITDA fully loaded after minority interest including corporate was about $100 million this year?

Yes.

Okay. I realize you want to pay the debt down as quickly as possible, but would sitting on that division and maybe getting some more results out, would that make sense? Or is time more valuable than maybe a couple of incremental bucks?

Well, I think that time is important. However, we are looking at other alternatives that might allow us to do just that. One alternative would be to spin and as you know that in today's market, we can put maybe 6.5 times on that business and then have the opportunity to unwind our equity position over time. We might want to bring in an equity partner, and we're certainly evaluating that where we would be able to put a comparable amount of debt on, and then get another bite at the apple through the receipts of an equity check coming in from a partner, and then ride the upside on a go-forward basis. So we are looking at all of those alternatives, but I do think it's fair to say that the overarching concern that we have is deleveraging the balance sheet.

Okay.

That's just -- that is very important to us. It does create the framework for growth on a go-forward basis in the remaining core business.

And then just two final questions. One on the tax work, can you give us a sense in the terms of timing, of A, when you think that work would be done? And ballpark, when you think the tax refund will actually come in the door?

Sure. The -- we've been -- we're continuing to do the work and I would say it would be through the first half. I would remind everybody, we are doing some incremental work to try to identify the net operating losses in the period '96 through '99. The reason for that is, one, when the reconstruction was done of the company's financial statements, it was only done annually for the periods 2000 to 2003. Everything prior to that was kind of a lump sum adjustment, if you will. So to the extent we can go back and determine by year for the periods '96 to '99 the appropriate losses, that can improve our tax position and it's important because that's when we paid most of the taxes. So that gives us an opportunity to perhaps improve over the refund that's reflected in the balance sheet if we can accomplish that, or alternatively at least to have some additional NOL tax yield going forward. As to the timing, we're optimistic that we can have that refund by the end of 2007.

Okay.

But we're not in complete control of that. We're making good progress. There will be a time before the joint commission, and so we can't predict that with absolute certainty. One other comment just to go back to surgery, though. So you don't start applying gigantic multiples to be thinking about divestiture proceeds. Remember, this is a business that has had to go through its own period of stabilization. Unlike some others who have been in a fairly stable environment for some time and the team has done a great job in working through that, it's still one that is just more recently, we believe, has stabilized. But that may not be accepted by the whole world.

Okay. And then just --

Secondly, we do not have a development pipeline in surgery yet. So when people are thinking about growth, and that's one of the key aspects that Mike and the team are starting to work on now that we have some stabilization that we think creates an added value.

Okay. Guys, final question on the reimbursement front. We've seen some talk about the 75% rule and potential freezes, some legislation introduced. Can you give us an update there? Body language from the hill, anything you're hearing incremental?

Were very pleased to be part of an industry effort to bring additional clarity on the impact that this has had on Medicare beneficiaries. I am spending a fair amount of time in Washington meeting with congressional leaders. We have always enjoyed very strong bipartisan support in the Senate. I think they have certainly always understood that the impact of this rule has far, far exceeded any of the initial projections from CMS and has had a very negative impact on Medicare beneficiaries and their ability to access inpatient rehabilitative care.

Fortunately, with the new house and new leadership there and I think quite frankly I'm getting some sense, despite what you might read in the paper, that there is really an effort even in the House at bipartisanship, certainly with respect to this issue, that there is a lot of support that is being developed. I think that they too are understanding that this is really hurting the Medicare population and so the body language, if you will, at least at this juncture is pretty positive. There can be no guarantees, but I do think unlike 2005, particularly in the House Ways and Means Committee and the subcommittees that there seems to be an openness and a willingness to at least talk about the issue and discuss the facts and to make sure that we're doing what we can to protect Medicare beneficiaries.

Okay. Thank you.

Yep.

Thank you. Our next question is coming from Andreas Dirnagl of JPMorgan. Please go ahead.

Good morning, guys. Just a couple of things. Jay, I just want to sort of restate what I think I heard you say and make sure I heard it correctly. Specifically, it's about some of the divestitures. Did you say you were cautiously optimistic that you would be able to announce a transaction on the ASC side by the end of this quarter, i.e., by the end of March?

Yep.

And on the diagnostic division, you're shooting to have an announcement there by the end of the second quarter?

Yes. That was our previously-stated goal. Actually, we said it would probably be in the middle of the second quarter. We said it was lagging about 45 days or so. Obviously, we're sitting here on March 1. There's a lot of work that still needs to be done, but there's also been a resurgence of interest. We're moving pretty quickly on the surgery front and we feel pretty good about the process for diagnostic as well.

Good. Just, Jay, maybe some clarification on the points that you put forward as your guidance. Specifically the last one of the five to eight development projects. Should we be looking for those to be sort of what we would consider to be pure development projects, i.e., building new facilities or expanding current facilities? Or does that kind of include everything including potentially joint ventures or acquisitions?

It does include -- it does include all of the above. Clearly with the 65% threshold looming, and forget for a moment if it's going to make any -- we're going to make any progress in freezing that, but with that looming, it creates an opportunity to move a little more aggressively on some consolidations. But long-term, we think that five to eight will be a mixture of de novos and acquisitions at the local level or consolidations at the local level.

Okay. Finally, John, I was wondering, we can see in the K that the federal and state NOLs at this point are around $2 billion. I was wondering if you could provide an update on your attempts to maybe try to find more NOLs and give us an estimate of where that number could go and in what possible time frame?

Again, that relates back to my comments earlier about what we're trying to do for the '96 to '99 period. We would expect that work to be done by the middle of '07, primarily, and will be used to try and maximize our refund for '96, '99. First of all, we're trying to see if there's an opportunity to improve our cash refund from what we've reflected on the balance sheet and then secondly, to increase the NOLs. I couldn't tell you exactly that split, but to the target is really to achieve an additional $1 billion, and that be that can be used to maximize cash tax refund or future NOLs. That's what we're shooting at at this point in time.

Thank you. Our next question is coming from Frank Morgan of Jefferies. Please go ahead.

Thank you.

Good morning, Frank.

Good morning. Thanks a lot. A couple of questions here. Based on all the resyndications you've done so far, could you gives us what the current ownership split is now as a result of all these resyndications between HealthSouth's ownership and the doctor ownership? And secondly, when you talked about guidance, I don't recall hearing a specific number with regard to what the core inpatient business EBITDA contribution would be. I think in the past I've seen numbers around $375 million. I'm wondering is that a good number to run off of? My final question is, as you've looked to go out and partner up and consolidate units, and you've had some recent success out in Tucson on the unit side, are you running into cases where you're seeing other acute care hospitals with rehab units trying to go out and consolidate, say with another competitor in town, or is that just something you don't expect to see? Thanks.

I'll take the last one first and then ask Mike to address the surgery center question on physician ownership and then John can respond to the other one. We are not seeing a lot of that -- in fact, we're not seeing any of that right now. Should that occur, I think we would be fairly -- I don't know that was. We don't anticipate that type of consolidation activity out there. As you know, Frank, many of our competitors have -- these are units inside the walls of a hospital. It's not usually their primary focus. Most of the acute care hospitals are focusing oncology, cardiac care, their obstetrics program, they're working about bad debts coming in through the emergency rooms, and oftentimes the rehabilitative care is really kind of secondary. That's where we think we can bring our quality focus, our core competency in patient rehabilitation and really add a lot of value in those markets. In terms of physician ownership, Mike, do you want to handle that?

Yeah in surgery division, Frank, we have -- we're still over 50% in our ownership across that portfolio. Remember that over a third of the portfolio resides in CON states where the pressure is a little bit less to sell down. But on balance, overall, we're still over 50%.

John?

Frank, on the guidance issue, what Jay said is that in inpatient, we'd expect 2 to 3% revenue growth, 3 to 4% operating earnings. If you look at the operating earnings for 2006 and the inpatient division, it was 359.5. If you grow that 3 to 4%, that puts you 370 to 375, in that range. D&A, as we report in the supplemental data for the press release for the full year in the inpatient division was about $65 million. So that would get you up at about the 435, 440 range. Taking that revenue base, if you're looking at 4.75 being where we expect to be able to get to on a run rate on corporate overhead as an EBITDA number, that puts you in the mid-80s. So hopefully that's helpful.

Thank you. Our next question is coming from Ann Hynes of Leerink.

Good morning. On the guidance from pricing, going from -- I think you had 2 to 3%, to 1 to 2, is that just the 75% rule, or is there something else in there? Is your case mix changing?

No. After that 2 to 3% is really on a steady-state basis and would be really after the 75% rule. The 75% rule in pricing are somewhat unrelated. They certainly will look at the overall performance of the IRS segment in determining what kind of increase is warranted, but we pegged that 2 to 3% on a steady state, really based on historical performance. Last couple of years, it's been a little choppy because they've gone in and they've made some changes, but if you look at it over time, that 2 to 3% is about right. What we figure is that since most of our volume is Medicare, we should be getting -- anticipating getting market basket and minus something, maybe 50 basis points, maybe a little more. That's conservative. Obviously we don't need full market basket. Then getting somewhere 3 to 4% on the managed care portfolio, which represents the other 25% of the business. So on a blended basis, that 2 to 3% is pretty good on a go-forward basis.

Okay. Getting back to -- I think Rob asked a get about the inpatient EBITDA margins, I think what he was trying to say is even though they improved year over year, sequentially they went down. They were probably 23.1% versus 24.2% last quarter. But this happened last year too, EBITDA margins went down Q3 to Q4, so I guess, is that a seasonal thing, are there incremental costs in Q4 that we should model that EBITDA margin goes down in Q4?

There's minimal seasonality. Typically the first quarter is a little better quarter --

What you do see is the increase in the sals.

Yeah. That was my next question.

In our hospitals we bring everybody on to their new day salary. We make those changes effective October 1.

Okay. So we typically -- it coincides with when we expect the price increase. Last year, obviously we didn't get a price increase. We still need to pass along the salary increases to our people. Okay. That's what my next question is. Your SG&A as a percentage of revenue went up, so it's mainly as a result of that?

Right. Actually, that's a good point, Ann. I know some operators will have merit increases spread throughout the year.

Yes.

At HealthSouth we had historically brought everybody up on October 1 --

Yes.

-- and when we came in, we just chose to continue with that same process.

Okay. So just going forward, it's probably good to do sequential downtick in EBITDA margins in Q4 because of that labor increase?

Yes.

Okay.

I think that's about right.

Minority interest was lower than I expected. What was the driver of that?

Well, if you look at the results and you calculate the percent, obviously we're not paying on the Scrushy gain in the fourth quarter, so there were some items of income that don't get passed along to the minority partners, and thus there's no minority interest calculation on that.

Okay. Do you give the amount in Q4, the incremental bad debt that probably won't be repeated in inpatient and diagnostic? I think last quarter was around $6 million. Did you give a number this quarter?

I didn't give a specific number for the quarter. I would say in the inpatient division, we clearly booked an additional provision. It's a little less than a $6 million we talked about in the third quarter. I think the bigger change going forward would be in diagnostics because of the new system being put in place. Again, we don't expect that to be an ongoing division for the full-year '07.

Okay.

Ann, remember, we did install in the inpatient division a brand new revenue platform in 2006. We didn't, at the facility level, ramp up our staffing to accommodate for that transition. So we anticipate that there's going to be some improvement in our collection activities in 2007 as we really get the full benefit and the full value of that investment that we made in 2006. So there's -- there's probably been a little uptick in our bad debts and our collection activities. We think now that the system is in place, it's throughout the entire division that we will see improvement there in 2007.

The other thing I would add to that, the same people that were taxing with the collection and the efforts and installing the new systems were also the same people putting in the controls so that we became a much more compliant Sarbanes-Oxley company.

Great, thank you.

You're welcome.

Thank you. Our next question is coming from Mike Scarangella of Merrill Lynch. Please go ahead.

Good morning, guys. I just have a few balance sheet questions left. Hi. John, did I understand your comment correctly about the insurance receivable, that when you collect that, it won't be cash to you? That just nets out to a third party?

That just passes through to the shareholders. What happens, Mike, is that technically you don't have the right to set off -- this is probably more you want to know about accounting. You don't have the right to set off, because the insurance carriers, we don't have a liability to them, they have responsibility to us, our responsibility is to the shareholders. So now that we have a court order and everything is final, these numbers didn't change at all. We're just putting on the asset side the receivable from the insurance carriers, which will be used to reduce the liability side that we also add the $230 million. It doesn't change any of the core economics. That money has already been paid into escrow by the insurance carriers.

Okay, understood. Thank you. John, you mentioned that given that your leverage is going to come down quite a bit, you're looking for some pricing relief on your credit facility. I guess that begs the question, it doesn't work that guess that begs the question, it doesn't work that easily on the bonds. Is there any chance you would consider some refinance prior to the call dates on these bonds to reset your coupons here to more reflective levels of the leverage.

As you know, the ones that come up soonest would be the floaters.

Right.

and those floaters come up in 2009. The fixed rates have the five-year noncall, and they're pretty expensive to unwind. So I think after everything is done we will assess our capital structure. It will be a purely economic decision, because there's a lot of cost to unwind those. Clearly, we have to balance that against what the potential savings might be. The only ones that look like a potential, depending on the tax refund, if we are looking at some proceeds from the derivative litigation and the divestiture activity along with future deleveraging, then the '09s, the floaters could be something that we would look at sooner versus the fixed rate piece.

But it sounds like in terms of timing, you would want to have a lot of that cash in the door, the IRS thing is maybe end of this year, and the derivatives are next year at the earliest. We're not looking at anything near term?

No. I don't think it's economically feasible at this point in time, Mike.

Thanks, guys.

You bet.

Our next question is coming from Miles Highsmith.

I wanted to get to the consolidated EBITDA number. Exing out all of the non-recurrings, maybe you can tell me if I'm thinking about this right, taking out the 12.8 from Scrushy, and the 3.2 away from the 125.7 that was reported and then give me a back credit for 4 or 5 on the incremental bad debt guessing in the 113 to 114 range, that a decent run rate for consolidated?

That's a fair way to look at it, Miles. Because we've made great progress on the internal controls and we incurred some extraordinary costs a year ago to Sarbanes-Oxley, and ins that was added back, obviously we don't get credit for that going forward. I think the way you gauged it is an appropriate characterization.

Great. A couple others. Following an earlier question on the NOLs, I guess my question is more specific to the potential to give an ASE buyer a stepped up basis. What's the amount of the NOL associated with just that you might be able to capture some value associated with the sale by giving them a stepped-up basis, what proportion of that $2 billion?

We haven't disclosed a specific number. Clearly the NOLs are at the corporate, not at the division level. One of the things that we will make available to a perspective buyer, is the ability, because we would anticipate these to be a stock transaction, and through a 330-H-10 election allow them to get a step up in basis. It's going to be the difference between what our tax basis in that division, which is not something we've disclosed, and the purchase price that we might receive. And so that is something that has some value to it, but again, depending on who the nature of the buyer is and how they would be able to utilize that over a period of time, is kind of a calculation that can vary a lot again, depending upon how profitable the buyer might be of that division. If they're very profitable, can make use of it, then it's a fairly simple net present value calculation. If it's going to have a lot of leverage and less taxable income, obviously it's going to be elongated and the net present value comes down significantly.

That's a -- it could potentially take advantage of most of that amount, is that fair?

Remember, it's a stepped-up basis, not immediate items. It's only to the extent that you've got higher basis in the assets and thus get more tax deductions over a period of time that you achieve that. So even if you're very profitable, it's going to take some period of time to achieve that step up or the benefits from it.

Great, that's helpful. Just the covenants, just wanted to make sure I was refreshed on this. Sale or spin, we'll need to go to the banks, as you mentioned, but not the bondholders; is that correct?

A spin, if we did a spin, we would need to go to the bondholders.

You would need to go to the bondholders?

A sale would not require that.

and the spin, is that the asset sale test that would be looked at there?

It would be on the restricted payments test.

the RP test. Okay. I'll get back and look at that. Just the last question. I'm sort of looking at Q4. We talked about Q4 being a decent run rate for IRS EBITDA. Operating income, just for the IRF position for the release of 80 spot 7 adding the D&A of 17 and get to 89 and if I want to corporate overhead of 4.75% of revenue, that's about $20 million so I'll take that out and that gets me to 78 of EBITDA, assuming the seasonality is just going to annualize that, and call it roughly 311 on the IRS side for annualized EBITDA. Like I'm probably missing something there, with a do you think that is?

You're a little bit low. I think part of it is the improvement we would expect in '07 as we talk about volume gross and the continued pricing improvement as well as some of the development activities.

Okay, great. That's very helpful, thanks, guys.

We're running a little bit late. We have time for one more question.

Thank you. Our final question will be coming from Robin Russell of Jefferies. Please go ahead.

Good morning. Just with regards to potentially what happens with the surgery center and how you ultimately divest of it, I'm just wondering, as part of the bank amendment, are you going to seek ability to buy a basket to buy back bonds?

We, in the amendment process, there is a -- clearly, we're seeking the approval to not only sell outpatient, but the ability to sell surgery under certain criteria or do another alternative as long as that would be credit neutral or deleveraging to the company. We have in the amendment, but the amendment's not done yet, some flexibility to give us some use of proceeds. I don't want to say there's a lot, because we're not expanding any other covenants or changes relative to the existing debt agreement which has pretty significant limitations on the ability to buy back the bonds.

Okay, but you think that the banks are willing to give you some flexibility with respect to paying down debt in terms of the bonds?

Again, that's pretty -- I just want to -- the amendment we're seeking is not to change the basic covenants. That's pretty limited under the covenants that exist, not from a leverage ratio standpoint or anything like that, but from a payments test and what we can do with those proceeds. There's very limited opportunity to buy back bonds under the existing bank agreement.

Thank you.

Sure.

Anything else, Robin?

Nope, that's it.

All right. Operator, thank you very much, and for those of you still listening, thank you for dialing in.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day.