Encompass Health Corp (EHC) 2007 Q1 法說會逐字稿

Good morning, ladies and gentlemen. My name is Sharita and I will be your conference operator today. At this time I would like to welcome everyone to the HealthSouth Corporation Q1 '07 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. (OPERATOR INSTRUCTIONS)

Thank you, it is now my pleasure to turn the floor over to your host, Mr. Jay Grinney, President and CEO. Sir, you may begin your conference.

Thank you, Sharita, and good morning, everyone. With me today in Birmingham are John Workman, Executive Vice President and Chief Financial Officer. John Wittington, Executive Vice President and General Counsel. Mark Tarr, President of our In-Patient Division. Dave Clements, Chief Financial Officer of our In-Patient Division. Tyler Murphy, Senior Vice President of Treasury, and Christy Gilmore, Vice President of Public Relations. Before we begin this morning's call, I'm going to ask John Wittington to read some cautionary statements.

Thank you, Jay. There are a number of disclaimers, risk factors and other cautionary statements set forth in the Form 10Q we filed with the SEC on May 9th, 2007, and in the press release we filed on the same day in connection with that filing. We will not review these disclaimers, risk factors and other cautionary statements, however we urge you read them carefully. I would like however to highlight the following. Some of the information provided may today include certain estimates, projections and other forward looking information that reflect our current views with respect to future events and financial performance. You're cautioned not to place undue reliance on the estimates and projections and other forward looking information presented today as they are based on current expectations and general assumptions that HealthSouth believes as of the date hereof are reasonable, and such forward looking information is subject to various risks, uncertainties, and other factors, many of which are beyond our control that may cause actual results to differ materially from the views, beliefs and estimates expressed here today.

In addition to those factors identified in the company's annual report on Form 10K for the fiscal year ended December 31, 2006, and the Form 10Q filed on May 9th, and other filings with the SEC. Factors that may cause future results to differ materially from the company's current expectations include, but are not limited to: the company's ability to consummate the sale of its surgery centers division on terms previously disclosed and the timing thereof. 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 forward looking information, whether as result of new information, future events or otherwise.

Great. Thank you, John. I hope everyone has had a chance to read the press release we issued late yesterday afternoon. As we indicated in the release, we have reclassified our outpatient surgery centers and diagnostics segments as discontinued operations which means this quarter marks the first time we are reporting as a single segment pure play entity. In conjunction with this reclassification, we also have added a new line item, general and administrative expenses, to our income statement. This line item approximates our previous corporate and other segment and includes corporate overhead costs associated with managing and providing shared support services to all of our divisions. In-patient, surgery, outpatient and diagnostic. As we have previously stated, overall G&A expenses will decline over time as we sell our noncore divisions and eliminate the support services attributable to these divisions. Our goal is to target G&A expense at 4.75% of net revenues by the end of 2008.

In addition to reducing corporate overhead costs as we complete the sale of our noncore divisions, we also will realize corporate overhead cost savings once we sell our corporate campus and relocate into smaller more efficient space. As I indicated in our press release, the results of our first quarter were an encouraging start to the year. Net revenues and operating earnings were up year-over-year as we saw good volume growth in many of our markets and continue to focus on expenses both at the operating and corporate levels. You will note we provided a new schedule in the supplemental information depicting the phase-in of the 75% rule for our consolidating hospitals. There were 16 consolidating hospitals with May 31 cost report year ends that had challenging quarter over quarter comps due to the fact that they were at the 50% threshold last year and had to be at the 60% threshold this year. Five of these hospitals were in the Texas markets.

While overall discharges were flat quarter over quarter, most of the unfavorable trend can be attributed to the Texas markets. And if you exclude Texas, the remaining portfolio saw a .8% increase in discharges which was slightly under the low end of our expectations of 1% to 2% increase per year. During the same time compliant case gross -- growth was up 4% sequentially and 2% for the quarter. Our outpatient satellites continue to struggle under the same competitive forces we experienced in the outpatient units we just sold which were a proliferation of new entrants into the market and a commodization of this service. While out-patient visits were down this quarter versus -- versus the same quarter in 2006, they were up 2.2% sequentially and net revenue per visit was up 3.7% compared to Q1 of 2006. While we believe our out-patient satellites are a valuable service for our discharge patients, we are constantly evaluating the profitability of these units and will take necessary action including closure to ensure that they are not a drain on the company, however at this point we continue to believe they a net positive to our operation.

As we have seen in the past, our unit pricing continued to grow increasing 1.6% in the quarter which corresponded to an increase in the acuity level of the patients we served. From an expense standpoint I would like to express labor and bad debts before turning things over to John Workman for a more thorough walk through of the numbers. As we stated in the press release, our labor costs were elevated in the quarter compared to where we want them to be in large part because of the scarcity of key clinicians in certain markets. Finding and keeping high quality health care professionals remains a key operational imperative for us. To address this situation we recently hired Cheryl Levy as our new Senior Vice President of Human Resources. Cheryl comes to us from KPMG where she was the National Director of Human Resources and Recruiting, and one of her top priorities will be to strengthen our recruitment and retention efforts at the facility level on a go-forward basis. You will also note that bad debts were elevated in the quarter as a percent of net revenues and compared to last year.

Some of this increase is attributable to the impact of migrating our entire platform to a new billing and collection system which was completed late last year. However, the majority of the change is a result of disputes with certain fiscal intermediaries, or FIs, regarding the medical necessity of some of our patients. As you know, in addition to the 75% rule, individual FIs can create their own guidelines for determining whether or not a potential in-patient rehabilitation hospital admission is medically necessary. These guidelines are called local coverage determinations or LCDs. Over the past year we have seen a slight uptick in the number of denials for some lower extremity joint replacement cases, especially from one FI in particular. We consistently appeal these denials by taking them through the very time consuming appeals process and have had an extremely strong success rate in winning at the appeals level. Unfortunately this appeals process takes months to resolve.

In the mean time, we book these charges as bad debts until the appeals are finalized. In the quarter, this accounted for approximately $4 million of the increase in bad debts compared to the same quarter a year ago. Because of our appeals success rate, we believe we will recover a good portion of this over time. With those comments as a prelude, I'm going to ask John Workman to do a more thorough review of the numbers, and once John is finished, I'll come back to talk about the sale of our corporate campus, the 75% rule, and then provide some guidance for the remainder of the year. John?

Thank you, Jay. I'm going to make a few comments that are similar to Jay's, just to remind everybody we have changed our reporting to be consistent with our current operations in the post acute sector. As Jay mentioned, the surgery outpatient and diagnostics division are being reported as discontinued operations. Consistent with the announced transaction to sell the divisions. The outpatient transaction did close on May 1st of 2007. As Jay mentioned we've shown a new line on the income statement, general administrative expenses to make it easier to understand the corporate overhead of the company. Since we did not allocate corporate overhead to the segments previously, we were not able to push down any of those costs to discontinued operations. As we have explained before, this causes the number to be much higher because it relates to all divisions including -- including those being reported as discontinued. The other overall changes is interest expense. As we are required under our credit agreement to pay the proceeds to pay down debt, we have allocated interest costs to discontinued operations based on the debt expected to be repaid.

Turning to the income statement and starting with revenues. Net revenues -- operating revenues did increase by 1.6% from the same quarter a year ago. Jay already described to you the changes in the volume and pricing so I will not repeat that information. As to payer mix we did see a slight change with more revenues coming from third parties as percent of the total this quarter versus the same quarter a year ago. Jay also mentioned we provide a table in the press release and in the 10Q that shows you how our 89 consolidated IRS will phase in under the existing 75% rule. We have 16 facilities that are moving from the 50% to 60% threshold during the first five months of 2007. Nine facilities that have to move from 60% to 65% during the second half of 2007, and 64 facilities that are at 60% for the whole year of 2007.

Looking at the various captions under operating expense as net. First, salaries and benefits. They increased to 48.5% of revenues from 46.7% a year ago for the reasons in the press release which Jay has already commented on. This line on the income statement is also where our 123(R) costs are reflected in both years. Other operating expense under the caption of total operating expenses increased to 15.7% of revenues from 14.4% a year ago. Last year had a $6 million recovery from source medical which accounts for the variance. We also previously had a line entitled professional and medical director fees. This was primarily fees related to the discontinued operations. There is a small amount that remains in the in-patient division and that's now included in our operating expense. The new caption, general administrative expense increased by $3.8 million from the same quarter a year ago. That's a result of our investment in a development function, increased internal audit cost, added divestiture cost related expense and the insulation cost of a new accounting system. As we have mentioned previously, our current accounting system is very old. The new system which would be functional in the beginning of 2008, will improve our controls and allow us to be more efficient as we move to lower our G&A cost to our targeted level.

Staying with general administrative costs as we mentioned before it includes the cost for all four divisions. As mentioned in our press release, the percent of revenues would be 4.1% lower or $18.2 million if it were computed against all revenues to which it implies including those in discontinued operations. One last comment on general administrative fees, they are usually higher in the first part of the year as we were incurring audit costs related for 10K and as well as the audit costs for many of the audited financial statements of individual facilities which are required under regulatory rules. We expense these costs as incurred versus in a year which they relate. On an as-reported basis on G&A cost, we would expect them to decline throughout the year as we close on the divestiture transactions and the overhead associated with those businesses will also decline.

Next, I would like to turn to professional fees. The professional fees line which has moved up on the income statement as we kind of resorted the items and they are kind of sorted from a highest to lowest category is intended to be costs that are nonrecurring. In 2007, these costs are primarily related at costs associated with filing of amended returns for the years 1996 to 2003. Divestiture expenses paid to outside advisors and legal fees related to resolution of the sins of the past. Relating to the taxes, we are making good progress and believe we will see a tax refund by late 2007 or early 2008. The extra work we have done helps assure we will recover as much of the cash tax as possible and also provides a tax shield against earnings for many years into the future. Regarding the professional fees line for the first quarter of 2006 or last year, we were still restructuring and reconstructing records so we could file our 2005 10K and putting in place controls that had never existed before. So our costs were significantly higher last year as you can tell from the description of a completely different nature than those of this year.

Turning next to bad debts, Jay's already commented on bad debts and -- and the reason for the increase. On the next line relative to the large credit in the government class action line, this relates to marking to market the liability we have regarding the sharehold litigation. As a reminder, we were -- are required to contribute stock and warrants as part of the settlement which is a fixed number. Since our stock prices declined, our liability is computed -- as computed is less. These shares and warrants will not be distributed for some time and we will likely experience fluctuations in earnings due to this in the future. They all noncash items. The last comment on the income statement relates to the area of other income. Other income this year is primarily gained recognized in our wholly-owned captive insurance company where we have our malpractice workers comp and self-insured retention, and we've seen good experience in the -- in our insurance related costs.

Next I'd like to turn to the caption adjusted consolidated EBITDA. We are reporting adjusted consolidated EBITDA of $68.7 million for the quarter. This calculation adds back to professional fees related to amended tax returns for '96 through 2003. Divestiture cost and legal fees for sins of the past. We did not include the gain of the mark to market of sharehold litigation, but our calculation does add back $3.6 million of 123(R) costs that are noncash. As we complete the divestiture process, some of these 123(R) costs should also decline in the future as some of the options are related to people who will no longer be with the company. The adjustment not included in this calculation is a normalized general administrative expense. Which as I stated before would be an $18.2 million add back if we were to apply the percent of the total revenues of both continuing and discontinuing as a percent of our continuing revenues. As the closings occur we will be making pro forma adjustments similar to this calculation, in accordance with our amended credit agreement.

And next I would like to talk about the expected anticipated gain on the divestitures of the respected division. Still staying with the income statement. We do expect significant gain from the sale of our outpatient and surgery divisions ranging from $445 million to $515 million which are yet unrecognized. Diagnostics is not in the same situation. We impair the assets and discontinued operations down to the expected proceeds in the current quarter.

Next I would like to turn to cash flow. Regarding cash flow, if we normalized the adjusted consolidated EBITDA for the first quarter it would range from $85 million to $90 million. Cash interest expense calculated at historical rates and I will remind everybody our amended credit agreement also provides for some improved pricing related to the continuing operations with fixed -- $56.5 million in the quarter. CapEx which was primarily maintenance as no large development projects that occurred in the quarter was $6 million. Preferred dividends were $6.5 million. This start to profile the cash flow characteristics on an ongoing basis of the -- of the pure play company and we believe this will only improve from lower interest costs once the income tax refund is received. With that, I will turn it back over to Jay.

Great. Thank you, John. As we have previously reported, earlier this year we launched an extensive marketing effort reaching out to both local and national real estate developers to determine their interest in buying our entire corporate campus. We received bids from several parties and currently are in exclusive negotiations with one of those parties. While we do not have anything to announce today, our goal is to have a definitive agreement signed some time this quarter. We continue to believe valuations will be in line with previous guidance. With respect to the 75% rule, industry efforts are still under way to generate support for federal legislation which would amend this rule. Bipartisan bills have been introduced in both the house and the senate that essentially would do three things.

First, permanently freeze the threshold at 60%. Second, permit the continued inclusion of core morbidities. And third, standardize and codify criteria for determining medical necessity of in-patient rehabilitation admissions. While this certainly is an important issue for HealthSouth, it is a vitally important issue for the rest of the sector. According to a March 2007 MedPAC analysis of providers, HealthSouth's in-patient rehabilitation hospitals account for only 7% of the 1,231 IRFs nationwide. The vast majority of these IRFs approximately 75% are either not for profit or government facilities. As far as the timing of any potential legislative action is concerned, that would be for congress to take up and ultimately to decide one way or another. Our goal is to continue to participate along with the American Hospital Association, The Federation of American Hospitals and AMPRA, our National Organization of Rehabilitation Providers, in an industry-wide effort to protect Medicare beneficiary's access to high quality in-patient rehabilitative care.

Finally, let me address '07 guidance, ultimately we believe HealthSouth is a compelling EPS growth story. Organic growth fueled by a MedPAC projected 22% increase in the number of IRF compliant cases by 2015, the addition of five to eight new HealthSouth hospitals per year and significant deleveraging from our asset dispositions and tax refund should position the company to generate solid EPS growth on a go-forward basis. While we will begin providing EPS guidance in 2008, because of the noise surrounding the asset sales, the corporate overhead for these sold divisions and final restructuring efforts for 2007, we will provide guidance with respect to consolidated adjusted EBITDA after minority interest. And for 2007, we anticipate the as reported number to be between $275 million and $300 million, depending on how quickly we close on our transaction and eliminate the corresponding overhead costs. However, to understand the normalize run rate, investors need to factor out the corporate overhead cost that will go away once all noncore set -- segments have been closed.

As previously mentioned, we reported G&A of approximately 10% of revenues in the first quarter. This would have been, as John mentioned, 5.9% if we included revenues from our discontinued operations as the G&A related to both continuing and discontinued operations. And if we apply this 5.9% to continuing revenues only, we would have added, as John mentioned, $18.2 million to our adjusted consolidated EBITDA making the total $86.9 million for the quarter. If one were to annualize this $86.9 million, one would come up with approximately $348 million which is pretty much in line with the normalize numbers that many analysts have reported. And as we have stated, our ultimate goal is to reduce G&A to 4.75% of revenues by the end of 2008, which would result in an improved earnings base. I hope this has been helpful and we want to try to simplify a complicated situation as best we could. And with that we will now open up the lines for Q&A. Operator, we'll take the first question.

Thank you. Our first question is coming from Ann Hynes from Leerink Swann.

Good morning, Ann.

Good morning. How are you?

Very well.

Okay, just to focus on guidance, at $348 million. I -- the previous guidance you provided was run rate that only incorporated 4.75% of corporate overhead, so I'm try to do an apples to apples what you provided of $348 million. In my eyes, shouldn't we add back the difference between the 5.9% ongoing and the 4.75% -- 4.75%, which is going to be the actual run rate eventually?

That's correct, Ann. The $347.6 million is staying at a more consistent G&A cost which we have said before will continue to be inflated even if you apply it to the just discontinuing revenues for part of 2007, as we transition out of a -- and restructure the company to a corporate overhead more in line with the remaining operations. One of the key components which is getting out of this corporate complex, but that should allow us to achieve 4.75% by the end of 2008. And I know you have done the same math and that is a core run on an annualized basis of $20 million.

Okay. So based on the previous -- I mean I think you gave a run rate of 3% to 4.3% on 3% growth to 4% growth. But I think that, like I said, the 4.57%. So if you add that $20 million it's more like a $368 million, which is in line with in my opinion what your previous guidance was.

Correct. What we were trying to differentiate was what one would expect to see for the balance of 2007 this year

No. That's fair.

For expectations.

Yes. And -- I'm sorry, Ann.

I said, just for expectation, because you really aren't changing expectations. You're just doing as reported.

And as we have said previously when we've talked about the corporate overhead and talk about the expenses that we know will go away as the noncore divisions are sold, we said that there was about a $15 million to $20 million delta at the end of the day and we were going to have to pair back and address by the end of 2008. And that would get us to that 4.75%. As we also have previously stated, a good portion of that savings will come from the sale of this corporate campus. As those of you who have been here know, it's a very large campus. It's an expensive one to own and operate. And we're pleased at this juncture, anyway, with the progress we have made in unlocking the value of this asset and using that as both deleveraging opportunity, but also as an opportunity to reduce our go forward-corporate expenses.

Okay. Great. And just to focus on future free cash flow I think on a pro forma call on you basically think the free cash flow rate will be $125 million assuming $50 million in maintenance CapEx which is about 3% of revenue in line with the industry and on a going forward basis interest payments of $193.

The interests cost will continue to decline. If you -- to focus on those two points, one of which is you look at the free cash flow, again, with EBITDA with G&A added back at a higher rate, the 5.9% that gets you to about $87 million in the current quarter. Maintenance CapEx was $6 million which may be a little bit lower than a typical run rate. And interest cost was $56 million on a cash basis. That interest cost will decline but on an annualized basis we aren't too far off with the a $56 million times four, but that will decline for two reasons. One is the tax refund comes in and we will have more proceeds. And secondly as we did negotiate a rate improve in the last repricing. So if you just take -- if you adjust for just looking at the current quarter and start with the $87 million less $56 million less $6 million, you're north of $20 million. And so with the -- if you add back the 4.75% of G&A cost, you start to -- you are in the range that you've just discussed.

Okay. So I guess once you become a free cash flow generator I believe you said the majority of it will go to growth projects. Can you just really give us some detail on what your priority is? Is it acquisitions? Is it JVs, have you been marketing to the local hospitals as 75% or 85% -- 75% to 80% of the industry is down for profit or possible base units I'm sure that they are having trouble meeting the 75% rule. I guess what are you doing to offset the implementation or continue the implementation of the 75% rule?

Well, let me -- there are two questions there. One is a development question and the other is a mitigation question. And maybe I will take the last one first. We have targeted our marketing efforts at the local level around a couple of different aspects. One is a quality difference that we believe and have confidence in our facilities. As you know in-patient rehabilitation hospitals measure the level of functional independence that each patient is able to have both coming into the facility and being discharged. We are able to market the improves scores to the physicians and to the case managers. It may be not something that the general public understands but physicians and clinicians definitely understand that by sending patients to a HealthSouth rehabilitation hospital, they will see an improvement and they will see a significant improvement in the patient's ability to live independently. We also have identified the qualitative differences between our services and those of other alternative providers that also claim that they offer rehabilitative services. And that has also been I think pretty successful for us from the marketing standpoint because of the higher level of intense services we provide. The greater amount of nursing care we provide. The team approach that is offered to the patients who are treated in our hospitals versus some of the other alternative settings.

From a programmatic standpoint we also have over the last year or so put a real focus on our stroke and neurological programs. A developing clinical pathways for those. Helping to standardize for that and bring those standardized clinical approaches out to all of our facilities. That's -- that's a big part of our mitigation strategy is to continue to focus on marketing to the patients, to the physicians, to the -- and to the case managers. In terms of the development is focus is primarily on two areas. One would be consolidating facilities, competitors in existing markets, and the second would be identifying de novo sites where we believe we would be successful in offering in-patient rehabilitative care. The former while there are a lot of opportunities that we are pursuing, I must admit the former does move a little bit slower. It does create, or require, excuse me, it does require that the -- that the competitor sees that there is a reason to do this. There is a compelling advantage to them. We have made some progress. As you know this last quarter we announced a joint venture arrangement in Kingsport, Tennessee with the Wellmont system there. And that includes not only joint venturing in existing facility but also building a brand-new facility.

So I think that coupled with some of the other development initiatives that we have been able to realize like the Wichita Falls which was an acquisition. Tucson Medical Center which was a joint venture. The De Novo facilities in Petersburg, Virginia. De Novo facility in Fredericksburg, Virginia. The de novo facility down in Puerto Rico, all are indicative of the kind of development opportunities that are out there. And we are pretty confident that as the year goes on we will be able to meet that five to eight new facility per year target that we have laid out there.

Okay. Great. Thank you.

I will take the next question.

Thank you. (OPERATOR INSTRUCTIONS) Your next question is coming from David MacDonald with SunTrust.

Good morning, guys.

Hi, David.

Couple questions. Jay, on -- one on CapEx, you know the quarter was a little lighter than with a we were thinking. Is that really -- I have to imagine that's on purpose time -- tied to the expectation of the 65% leg up -- 65% leg up. I mean, why do development projects until that incremental pressure is visible. And is it somewhat tied to the timing of when the cash is coming in the door tied to the asset sales or is that just the way it happened to fall in the quarter?

Yes. I think it just happen too the fall. Certainly from a development standpoint we are moving forward. We have two dozen plus projects that we were working on. And as I said just a minute ago, we were pleased to get the Wellmont transaction over the line. That's an outstanding system there in northeast Tennessee and southwest Virginia. And we were pleased with that relationship. If you look on our CapEx on a historic run rate, it's been on a maintenance basis for the in-patient division. It's been in that 25% plus or minus range. So you take the 6% for the quarter, you annualize that. We are at that run rate right now. So we are in pretty good shape in terms of that. We do believe that there will be opportunities as we go forward and we take out some of the cash requirements for the settlements and so on. That we will probably be able to bump that up a little bit. But we are certainly not letting any facilities go by the way side. We're not letting any projects -- and Dave, customarily I think because there is a little more downtime for the holidays late in the year. You see a little bit more push around that time to do some of the maintenance projects which lags over in the first quarter being a little softer.

Okay. Two other questions. One on the labor costs. When I think about the 5.3% in the quarter and then the 4% target, is part of of this, guys, frankly just drilling down in the markets and maybe paying -- doing a little better job in terms of predicting the volumes so you can staff appropriately so the amount of the -- should we think about 4% as kind of the run rate and then the is 1.3% being variable depending on how effectively you can predict some of that stuff?

Yes. I think that's a way to look at it. I will tell you that we did have a slower start to the year in many of our markets which was a little bit unexpected. And what we typically want to do is to ensure that we have the staff in place to meet the traditional demand that you see in the first quarter. And so when that didn't materialize, we were carrying some costs that without the volume and the volume eventually came, I think that also contributed to the year over year flat volume. But if you take out the month of January we had some good volumes. And unfortunately it started a little bit slower. But the other thing is that frankly there are markets particularly in Texas and some of our western region markets where we are fighting for qualified personnel, particularly therapists and nurses. And I think that's something that will come and go. I don't think we will be making the same level of market adjustments in every quarter. But we certainly did have to go in and make some this quarter.

Thank you. Your next question comes from Gary Lieberman with Stanford Group.

Okay. Good morning, Gary.

Appreciate all the discussion around the G&A. I think you have done good job of clearing up whatever confusion there might have been. Can you talk just a little bit about that $18.2 million that it sounds like would have -- would be allocated to the other segments? Can you just talk -- a little bit about how detailed of an analysis you have done to get comfortable with that number? Have you identified every single last person that would be allocated and how you would go about doing it, or is there some -- some variability in that number?

Yes, Gary. First of all, I'm going to ask John to do that. And I do appreciate your comment on the -- our taking the time to drill down on the G&A. We -- we gave everybody a head's up when we did the year end and fourth quarter that as we moved into 2007, it would be easier, but it wouldn't be completely clean and all of the noise would not be perfectly eliminated. But I think we took a significant step and our goal was to try to make it easier for people to understand the go-forward numbers. We did that by bringing that G&A line into the income statement, so that it will be a place where investors and analysts can watch that number go down. Instead of saying, well, it's spread all over the different line items and then you play a little rope-a-dope on a go-forward basis. We want to be as transparent as possible. So, I appreciate your recognizing that. And John will answer your question.

On the -- again, mathematically you see how the mass is derived, but to give you comfort around the number there are a variety of things. One of which is we've done a very detailed analysis on what is the direct overhead number that goes with these divisions. And no surprise I'm sure to anybody on the phone most of those costs will be in the area of IT and accounting related. There are a lot of as you also remember from the past HealthSouth has tried to move toward one billing and collection system if you will for each of the divisions and correspondingly we have alignment with those in the IT area that allow for the costs to go in the most recent example of select that whole billing system migrated over to select very quickly and very smoothly. And so we are going to experience lower costs.

In accounting we have accounting functions representing each activity. Representing surgery, outpatient, diagnostics. Those are staffed by controllers and an accounting contingent in addition to the people that are in corporate and regarding surgery there is additional group of the partnership group which is significant that goes away. But last bit of comfort I would tell you is if you take that $18.2 million and just annualize it. That's still under what is allocated as corporate overhead in the carved out audited financial statement that we now have available for each division for the year ended '06. So the answer to your question, I think we feel comfortable about that being that.

And as Jay said which the mother cost primarily the corporate complex as we implement and remember the current year -- the current quarter and for 2007 we will have some costs related to the installing a new accounting system because we have a very dated one. That also will give us the opportunity to move towards that the 4.75% of revenue as we move forward in addition to getting out of the corporate complex and the other will come through just a rationalization of the remaining people. But we have a lot of activities in G&A that are specifically aligned with the divisions. That makes those going away easier. The other thing that we have done is that as people have become available, we were also using some outside consultants as basically temporary staff. And our view was that as we started getting some attrition knowing that we would have some people going away, we feel that in the interim it's kind of like the contract labor for G&A that we experience in in-patient. Obviously it's a little higher rate. What we have done now is as people freed up from outpatient moved those into other functions which allows the high cost consultants to go away.

I guess just a quick follow up on that, with respect to the increase in G&A that you cited was attributable to the implementation of the new accounting system, I guess '06 versus '07 it was 4 -- $4 million or thereabouts.

There's really -- that is one of the components. I think that -- that's about a $5 million to $6 million cost for the year. But that's only one of the components. The other is, as Jay talked about, we're investing in a development function which was not there a year ago and we will see the benefits of that in the future. We've increase the internal audit costs and there are cost related to the divestitures that exist in the G&A line and that is primarily again because we had a lot of extra activity that we were doing internally, we brought in some -- some loan staff and support staff and we differentiated and included those on the G&A line versus those hired just entirely to work on the divestiture activity. So those are the -- really, there is really four components that make up that increase year-over-year.

Okay. And just where are you in terms of -- of those -- those projects? Is the expense ramping up or are you kind of in a mature state for the expense will be on a run rate basis?

I think the expense will go down. I mean we'd expect the expense to go down from here as we get out of those divisions, number one. The other parts will be steady, but clearly that divestiture cost that's in G&A will go away as divestitures close.

But the development to answer that specific line item, that -- that cost is mature. We have all of the physicians filled in terms of development. The implementation of the new accounting system that will continue through the year. And some of those costs then of course will go away once we get into 2008 and the system is fully up and running.

And if I could ask one quick follow up and then I'll get out of the way. Compliant volume growth looks like it was a little bit -- slowed down a little bit. Can you just discuss if there was something unique to the quarter or if this is a trend that you expect to reaccelerate or stay the same?

Well, the main reason was the facilities -- the 16 facilities that move from the 50% to the 60% and that created some difficult quarter over quarter comps. We do expect that the compliant case growth will be in the back end of that -- that stated range of 3% to 5%. And we saw a very significant increase in the month of March. And if you noted before I also mentioned that we did have a bit of a slow start to the year and that contributed to that. So, yes, it was a little bit below where we expected it to be. But we're still pretty comfortable with that 3% to 5% go-forward range.

And overall compliance, is it around the 63% level or bump up at all?

It's right at 62.5% for the total group. And that's Mark Tarr.

Okay. Great. Thanks a lot, guys.

Yes. Thank you.

Thank you. Your next question is coming from Rob Hawkins with Stifel Nicolaus.

Good morning. I will try to think what's not been asked already. Let's see -- just kind of a couple odds and ends. On the EBITDA calculation that you guys had to report, the $68.7 million, I'm not completely understand the add backs and so forth. But you've always stated that that is a calculation you have done for your banks. Will this at all kind of rub up against any covenants because you are having to report this lower number even though the normalized is better.

No. What happens when we did the amended we dealt with that in our amendment and said we will have that anomaly of having discontinued operations going down below and at the same time using all of the corporate overhead costs in the ongoing operations. So basically as I mentioned, as we go forward under the credit agreement we will carve out the G&A cost that related to the discontinued ops once they close. So our arrangement is once they close we get to back those out and that's a significant number and we will be doing that in future calculations as we close on each of the respected divestitures in accordance with what was the audited -- the audited number for 2006 that was allocated to division as separate carve out financial statements.

Thanks. And then, can you walk me through, John, the cash flow numbers that you went through earlier and try to normalize those? Because I picked up on some of that, but I was having trouble with it. You're kind of negative 5.8% cash flow from operations with a $6 million I guess maintenance CapEx expenditure giving you a $11.8 million. You were mentioning $80 million to $90 million.

We were talk -- for the quarter, Rob, you've got two different things there. And what we were talking about and again the -- remind you from cash flow from operations starts with net income, obviously includes a reduction for those professional fees that as I mentioned for 2007 relate to the amended 2000 -- 1996 to 2003 tax returns. It relates to the legal costs related to the sins of the past and some of the divestiture costs. So what we were really approaching at -- and there is a reconciliation both in the 10Q that reconciles from that cash flow from operations you mentioned to adjusted EBITDA. But -- but just very briefly what we were describing was take the $68.7 million of EBITDA that was reported for the quarter, normalize G&A by adding back $18.2 million which it puts you around the $86 million, $87 million EBITDA cash flow basis. Interest expense reported in the quarter, cash interest expense related to continuing operations was $56 million. There is some amortization on the income statement but that's disclosed in the footnote. That leaves you with over $30 million of cash available of which $6 million went to CapEx.

So that's kind of the math that we were going through and the points about that were two things. One is we would expect we're having to ramp up a little bit on the CapEx on an annualized basis. Clearly if we get to -- when we get to the 4.75% G&A as a percent of revenues, that can add on an annual basis $20 million or $5 million in the quarter and we would also expect interest expense decline, I think as Ann commented, we would expect that to get under 2 -- $200 million. If you annualize the first quarter, you at $224 million, but that's before the tax refund comes in which we expect in late 2007, early 2008. And that's before the lower rates on our repricing that was negotiated in the first quarter kick in. So that's -- that's the items. If you look at basically mid $80 million back out interest costs, back out CapEx, you are left with something in the low to mid $20 million as G&A costs improve that could add another $5 million. And as interest costs comes down, that will annualize out to another $5 million to $6 million per quarter also. So that kind of puts you in the quarter. And if you just annualize that times four you get the $120 million to $125 million that we were talking about.

Thanks for walking through that again for me.

Sure.

And then, on the CapEx question, I think Jay mentioned that you kind of think that the maintenance CapEx taking the $6 million and annualizing it and maybe a little bit more and call it $25 million to $30 million. That's still a number that's well below what your depreciation rate is about $18 million to $20 million a quarter. Why would the -- why wouldn't you guys be spending on a maintenance basis close to what the depreciation rate is?

Well, two things. That depreciation amortization does include on corporate assets as well as those in the facilities. But overall, that -- just the same reason when you look at building an in-patient rehab hospital, it costs a lot less money than acute care hospital, and so basically the maintenance for us to keep up these facilities is the things that you might think about which are painting, carpeting, reroofing, those types of things. With some modifications. We're not in for replacing significant amounts of equipment routinely. That's just not what part of the hospital needs.

Yes. Okay. Great. Alright. Thank you. That's all my questions.

Thank you. Your next question comes from Andreas Riedel with JPMorgan.

Alright. Good morning, Andreas.

Good morning, guys. Couple things I will tell you in advance that my head is always spinning with you guys in terms of trying to take in all the data that you are providing. Maybe a couple of drilling down questions. Mark, you talked about the overall compliance level of facilities being at 62.5%. If I'm remembering correctly that's kind of in line with where it was last quarter. And what I'm sort of trying to put the pieces together of is if you are pointing out the 16 facilities that went to 60% this quarter as having had an impact sort of on a negative basis. That means they were at quite a bit below the 60%. Shouldn't have pulling them up to 60% increase the overall compliance more?

Thanks, Andreas. If you look at the way the hospitals and cost reports are phased in, certainly there were certain portion of those that main area that were closer to 60% than others. But overall the way it weights out I would no have the expected to a huge increase in our total compliance percentage as a division.

Okay. Jay, just in terms of all of the discussion on G&A, one the things I'm still just trying to figure out, does the G&A of 4.75% or does the EBITDA of whatever it is $275 million to $300 million for '07, does that include or exclude options?

That excludes options. And that was $3.6 million in the quarter. Noncash and we routinely added that back and I know there's variance between. The comment I will make is it's tied to divestiture. That cost will go down. That's up in salaries and benefits, by the way, and that's not in G&A. So that cost will go down as the people who are part of those divisions go away, because they'll have options that were clearly unvested.

Okay. Okay, great. Also, just in terms of sort of debt in general, have you given any thought to any debt refinancing here and maybe even more specifically is there a potentially -- or is there potential to take advantage of the current market conditions and maybe put in place a portion of debt this might be either pick or toggle notes that would free up a little bit of cash to use for CapEx and expansion?

I'll answer that in two things. One of which is clearly we are -- we are focusing on what our leverage ratios would be post divestitures and post tax refund. And we think it makes the company a much different credit profile. And that does give us an opportunity to reassess the capital structure. And the one impediment to that is the bonds. We have the floating rate bonds that are not callable at a reasonable rate until mid '09. And then we have the fixed rate bonds that are not really callable at reasonable rates for a couple years after that. So that's a economic calculation depending upon the savings one would expect to derive. We would expect with a low level of senior secured debt post divestiture, post tax refund to be able to improve on the rates and to be able to improve on the provisions and we would be looking for a relaxation of some of those provisions. And it's not unrealistic to think that we might also negotiate for some capability if --

But again it would be tied to redoing the capital structure where we have more flexibility, not just for capital, because I think again as we've described, we think the free cash flow from operations starting in '08 once the CMS DOJ payments and SEC payments are behind us, too, and we were passed this professional fees kind of cash drain issue, will fund the development of the company. But that will give us an opportunity a little more flexibility to look at a variety of things. One of which, clearly were unhappy with the current share price and it would be great to have the flexibility to also consider that with the future of redoing the capital structure.

Right. Okay. That's great. And then finally, maybe, I realize it's still a little early, but can you give any color whatsoever on sort of how the Tucson and Wichita Falls arrangements are sort of working? How many more like that do you think you can do? Have you seen an impact from them especially given the recent Tennessee announcement?

Yes. I will ask Mark to talk a little bit about the -- the Wichita Falls. I was just down in Tucson, I'll guess about two or three weeks ago and met with the senior management team of the Tucson Medical Center, Frank Alvarez and his folks. And we are very pleased with the results down there. It -- I will tell you there was a little bit of a transition period where we had to get adjusted to one another. But I think that went through very quickly. We made some management changes there and the facility when I was there was virtually full. So we've really seen a nice result from that consolidation. And I think that in talking with Frank and his team they would say they are very pleased as well. And so we see that as a real plus. And I'll asked Mark to --

Yes, Andreas, I would say the same thing about our facility in Wichita Falls. It has been successful in terms of the transition. We had a period, particularly the first few months of where we had to add staff to bring in to handle the increased number of patients. But we have virtually been running close to capacity at that hospital now for the past 60 to 90 days or so. So I think that it is in line to meet our -- certainly meet our expectations of that transaction.

And what I think it takes into your question how many of these. We've said five to eight. And that would be a combination of de novo and consolidations. Clearly the return on consolidations is so great because we don't have to make any capital investment. On the other hand they are more difficult to bring to conclusion because it does involve convincing a competitor that going and consolidating makes a lot of sense. I think it's the forward thinking CEOs, like Frank Alvarez at Tucson Medical Center who really get it. They get it from the perspective that by consolidating they are able to join forces with the nation's leading provider of in-patient rehabilitative care, so they can continue to offer that as part of the continuum of care, A. B, they get to partner with an operator that has the expertise to operate it on a high quality basis, but also on a more cost effective basis. So they get an improved return and sort of an annuity -- a built-in annuity from that business.

And then most importantly and this is where I think guys like Frank are really way out there in realizing the benefit. They get to reuse those beds. It's not like those beds that were previously devoted to in-patient rehabilitative care in their facilities are now gone. They have the opportunity to reuse those assets for medical/surgical purposes or for other purposes. So they get the benefit of a better provider. Continuing the continuum, and then at the same time get a chance to use the existing capacity for other purposes. So I think we will see by the end of this year we will see more of those being announced. The de novo projects we are in the process of analyzing quite a few markets. We've established analytical tool internally, that we are comfortable with now in terms of assessing what the yield is of compliant cases in those markets we have identified and we will also see and increase in the number of de novo sites.

Great. Thanks, that's helpful.

And your comment on your head swimming and amount of information, we try to provide -- I mean I know this is a complicated story still. Although I hope people will acknowledge that it's getting a little bit simpler. I know the G&A portion is a little tough to kind of get everybody's arms around and tackle and understand. But I really do believe we are making some progress in trying to simplify the story and trying to explain how to watch this and monitor this on a go-forward basis. So hopefully your head will spin less and less as time goes on.

Thank you.

Alright. I think we will have time for one or two more questions.

Thank you. Your next question is coming from Mike Scarangella with Merrill Lynch.

Hi, Mike.

Hi, guys. How are you? Jay, you mentioned in your comments you are having trouble with your fiscal intermediaries about medical necessity and how that's a problem on cash collections which I understand. I'm also concerned that it could be a problem if you have an individual facility that's running close to their compliance level and you're at (inaudible) you could find yourself decertified and so I'm wondering if any of these cases don't get resolved in your favor will you lose certification at any of your hospitals?

I think the issue has been really of a particular one FI to be very candid. Yes, we have seen -- and it's primarily in the lower extremity joint replacement. So it's not like it's all the cases, it's just those cases that are near hip replacement patients. Because remember, there are a couple criteria that have to be met for a patient to be admitted to a facility. The most important is do they meet medical necessity requirements. And then in terms of the threshold which is really sort of another trigger or another criteria in determining where you are in the 75% rule, is does that patient then qualify and meet one of those 13 conditions. So in terms of the denials it may not always affect the ratio on the 57% rule because some of those denials as I said lower extremity joint replacement, that's a noncompliant case. So that's really more an issue of not getting the revenue. It would be more concerning if those denials were for strokes or for the compliant cases. But as I said what we are seeing is the vast majority of these are for the lower extremities. And so being denied or not won't affect the -- in fact in a perverse way it kind of increases your threshold, because you've taken a noncompliant case out of the equation.

Okay. Thanks. That's very helpful. On the topic of compliant, you are at 62.5% now in a couple of the months we start the clock at the 65% level. I assume you're still comfortable in your ability to get to 65% with not a lot of disruption to the business?

It's not going to be a cake walk. But, yes, we are comfortable. We are focused on the facility level. I think we have great CEOs in our hospitals and they have taken this on as a top priority. They understand that bringing the volume in and making sure we do it on a high quality basis is extremely important. But, yes, there -- it does create a bit of an operational challenge. But I think we were up to meeting that challenge.

And Mike, just to clarify, the -- right now both of those facilities that have a May 31st cost reporting year are the ones going from 50% to 60%. That 16. We only have nine facilities beginning July 1st going from 60% to 65%. So the big threshold comes 1/01/08. The 65% just to give you some comfort as to where we are in the process.

Sure. Understood. And, John, just one last question for you. I didn't -- I didn't fully understand all your comments on capital structure options. But just to clarify, with the asset sale proceeds and the tax refund, is your plan still to use that almost 100% depending on bank debt, or are you thinking about potentially nibbling on bonds?

We were required to use the pay down bank debt, Mike. But as quickly as the bank debt gets lower and lower and those ratios get pretty depressed in terms of leverage ratios, it gives us an opportunity to open the door to bank financing to give us other options of which could include buying back some of the higher cost bond debt or using it for other purposes that might drive some value for shareholders, too.

Thank you. But you -- that would require an amendment and obviously you don't want to take -- we would know about that. Okay. Thanks, guys.

Alright. Thank you. I think one more question and then we will wrap it up, operator?

Thank you. Your final question is coming from Henry Reukauf with Deutsche Bank.

Yes, guys, just a fairly technical one. With the FIs given you trouble with boosting up bad debt expense, how would -- when you recover that money, how does it come back in and will you identify it?

It will come back in as -- as recoveries of bad debts. Basically, I think, as Jay described, we take a policy once it ages out and these appeal take sometime. We win predominantly all the cases, and -- but they take sometime to develop. And as those age we have a policy we just -- we post provisions against those aging. So it will come back in as a reduction in bad debts as those are realized. And I'm -- if it's significant in the quarter we will certainly comment on it.

Okay. That's great. Thanks very much.

You bet. Alright. Well, we appreciate -- I know we've run a little bit late. I hope that the Q&A has been helpful for everyone. Again, we appreciate your participation on this call. And your support of HealthSouth. Thank you.

Thank you, operator.

Thank you. This does conclude today's HealthSouth conference call. You may now disconnect and enjoy your day.