Encompass Health Corp (EHC) 2007 Q2 法說會逐字稿

Good morning, and welcome to the HealthSouth Second Quarter 2007 Earnings Conference Call. At this time I would like to inform all participants your lines will be in a listen-only mode. After at speakers' remarks there thereby 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 objections you may disconnect at this time.

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

Good morning, everyone. With me today in Birmingham are John Workman our Chief Financial Officer, Mark Tarr, Executive Vice President of Operations, John Wittington, our General Counsel,l along with other members of our senior management team. Before we begin today's call, I'm going to ask John Wittington to read some cautionary statements.

Thank you, Jay. Good morning. There are a number of disclaimers, risk factors, and other cautionary statements set forth in the Form 10-Q we filed with the SEC on August 8th, and in the press release we filed on the same day in the connection with the filing of our Form 10-Q. We will not review these disclaimers, risk factors, and other cautionary statements. However, we urge you to read them carefully. I would like, however, to provide highlights of the following.

Some of the information provided today may include certain estimates, projections and other forward-looking information that reflect our current views with respect to future evens and financial performance. You are cautioned not to place undo reliance on the estimates 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. 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 a result of new information, future events or otherwise.

Great, thank you, John.

We are very pleased to report the results of what we believe was a positive second quarter for the Company. Total discharges were up 1% quarter over quarter, while compliant cases grew both over last year and sequentially. This is especially noteworthy since it is the first time we've been able to report quarter over quarter growth. Revenues from our in-patient hospitals were up 3.4% from the same quarter of 2006.

We executed on our stated goal of reducing G&A expense and will continue to reduce this expense throughout the remainder of the year. We use the proceeds from the divestures to eliminate over $1 billion of debt from our balance sheet. And excluding the gains associated with such divestures, we generated income from continuing operations of $1.1 million compared to a loss of $31.7 million a year ago. I believe these solid results indicate we are executing on our strategy, seeing the benefits of our deleveraging plan, and are well on our way to becoming an EPS growth company in 2008.

We also are pleased with what we accomplished through the divestures, both in terms of being able to focus on our core in patient rehabilitation business and in terms of significantly reducing our debt. Based on feedback from numerous bankers and private equity firms, and in light of recent credit market volatility, I believe our timing with these divestures was very good and do not believe we would have been able to sell these divisions in today's market.

As we stated on our first quarter call, we are reporting our 2007 results as a single segment. With this new reporting, we have added a line item, general and administrative expense, to our income statement. This line item approximates our previous corporate and other segment and captures overhead cost associated with managing, and providing support services for our operating units.

On the previous call, we said shareholders would see G&A cost trend down as we completed our divestures. In the second quarter, we saw a sequential reduction of G&A expense of almost $10 million, attributable primarily to the divestiture our outpatient division which closed May 1st. John Workman will address our success at reducing G&A expenses later in the call.

From an operations perspective, we are very pleased with our growth in discharges. As I noted, this is the first time we've been able to report quarter-over-quarter growth and I believe this is especially significant since most of the acute care companies that have reported earnings have posted declines in their admissions. This suggests that our focus on providing high quality in-patient rehabilitative care is a differentiating factor in the markets we serve.

This quality advantage is further evidenced when we compare our compliant case growth against those of our competitors. Using the methodology employed by CMS to determine threshold compliance, which is referred to as the presumptive method, and industry data published through the Uniform Data System for medical rehabilitation, commonly referred to as UDS data, HealthSouth's rehabilitation hospitals showed a 4.1% growth in compliant cases in the first quarter of this year compared to Q1 of last year, while the rest of the industry experienced an average 2.7% decline during the same period. We are reporting the first quarter industry comparison now because this information wasn't available when we reported Q1 results due to a lag in gathering this data of approximately two months. This swing of almost 700 basis points suggests our hospitals are continuing to gain compliant case market share under very challenging market conditions and further reinforces our confidence in the long-term prospects of our pure play post acute business model.

Finally, during the quarter, we were able to maintain our overall compliance threshold in the 62 to 63% range. As we have stated on previous calls, our goal is to maintain a slight cushion between our hospital's thresholds and the thresholds set by the 75% rule and we remain comfortable that this practice is still an appropriately conservative approach.

From a development perspective, we plan on opening a new 60 bed hospital in Fredericksburg, Virginia later this month and a new hospital in Manatee, Puerto Rico later this year. These are in addition to the previously announced joint venture involving new hospital with the Wellmont System.

Given the possibility of some relief with the 75% rule, we have shifted our focus on a growth strategy weighted more on [de novos]. We have developed a proprietary tool that allows us to sort markets on a variety of factors that contribute to an IRS success. Using these screening criteria, we have identified approximately 30 markets we believe will be good sites for new hospitals. We will have these markets prioritized and at least new two hospital sites identified in the next several months. I remind everyone that the results from future de novos will take some time before we see them in the numbers.

We also continue to negotiate several market consolidations in existing markets, but believe our ability to close on all of these will be in part dependent on the outcome of the 75% rule.

With that, I'm going to turn things over to John Workman for a more thorough discussion of our quarterly results.

Thank you, Jay. As Jay said, overall we are pleased with the quarter. My first comments relate to the income statement. I'm going to address selected captions compared to last year or generally just explanatory comments those items.

In-patient revenues as Jay mentioned discharge volume was up 1%. Even with nine facilities preparing to move from 60 to 65% threshold. The length of stay improved, which accommodated a discharge increase but creating a lower occupancy percentage. Said another way we're turning our beds faster.

Compliant case growth was improved as Jay has mentioned and we do report ours on a method different then the presumptive method cited by UDS and as Jay mentioned, that the UDS data, which is lagged, showed a nice increase in gain of market share. In in-patient revenues our payroll mix remains fairly consistent.

In outpatient revenues we had a significant decline. To remind, everybody, these facilities are generally tied to a a hospital, but some are not. Many of these face similar threats that we had in our outpatient division. We have said in the past that we are going to look at rationalization of these facilities and will continue to do so. There are 18 fewer facility his year then there were a year ago which represents an 18% decline. I would also mention that most of these facilities do not qualify as discontinued operations, hence the facilities visits are still counted up until the date of closing and clearly there's a decline or we wouldn't be closing those facilities.

Looking at the various expenses categories, salaries and benefits were 49.1% of revenue versus 46.4% a year ago. While the dollar amount was equal to the first quarter, it was on a slightly lower revenue base. The majority of our increase is from merit increases last October, which was a little over 3% and also people needed to accommodate the discharge increase. There was a small reduction of FTE's in the second quarter from a year ago of about 78 people. Consistent with prior calls, this is a key area of focus.

Our Head of Human Resources is working on curtailing turnover which adds to the cost. Having said that, we're not likely to see much change in the third quarter in this category because those programs will take some time to become effective.

Looking at the category, other operating expenses, even though it looks fairly consistent year-over-year, I would remind you that there was a $6.9 million recovery from Source Medical in the year ago numbers, so this year does reflect an improvement.

Turning to general and administrative expense. It declined from a year ago, despite our higher expenses due to investing and development, internal audit and a new general ledger accounting system. There was a significant decline from our first quarter G&A expenses, as Jay mentioned, of approximately $10 million, more then 25% reduction. As I reminder, G&A includes costs for all four divisions, though for outpatient it was only partial as outpatient closed in the second quarter. As a percent of total revenues, including discontinued operations revenues to which they relate, G&A was 5.1% of total revenues. Discontinued operations had revenues of $243.2 million in the quarter for a total revenue with the continuing operations representing $686 million.

As Jay mentioned, we should see G&A decline in each subsequent quarter from a dollar perspective consistent with the closing of our surgery and diagnostics divisions. As we have previously stated, our goal is to get to 4.75% of revenues by the end of 2008. We believe this goal is still achievable despite the termination of the transaction to sell the corporate campus to Trammel Crow.

Next turning to professional fees. Professional fees declined $14.4 million. The fees reflected in this line, to remind everyone, are ones viewed as non-recurring. There are significant recurring fees for accounting, internal controls, tax and legal that are part of G&A cost. In 2007, these costs are primarily costs for tax work on our 1996, 1991 tax years and legal fees related to effects of 2003 or before.

Turning next to the impairment charge. The impairment charge for the the quarter of $14.7 million was for the write down of the corporate complex to expected net realizable value.

Turning to provision for doubtful accounts, it increased as a percent of revenues to 2.4%. The principal cause is our continual practice of reserving against ADRs from one fiscal intermediary as they age out, even though we typically prevail in a percentage of these appeal. The appeal can take up to 18 months. We have established an on going dialog with the fiscal intermediary and are working jointly to reduce the number of ADR's under appeal going forward.

Turning to caption government class action and related settlements expense. It's income this year, due to the favorable market-to-market of our liability per shareholder litigation. The number of shares to be issued and the warrants which are at $41.40 per share conversion price are fixed but we have to market-to-market this liability based on our stock price. You will continuous to see volatility in this liability until those shares are distributed, which could be up until a couple of years.

Next the interest rate swap. It generated $19 million of income which will likely go down in subsequent quarters if the forward LIBOR rate moves down. We have an interest rate swap for $1.8 million that steps down to $1.1 billion in early 2008 which locks in LIBOR at 5 .22%. As a consequence of the debt paydown from our divestures and our interest rate swap, we thus have no floating rate exposure on any debt.

We have an income tax benefit arising from certain of our gains which are being recognized because deferred taxes being able to be recognized in the quarter.

And lastly, income from discontinued operations, a significant number includes a gain on the sale of surgery in the amount of $268.4 million and gain on sale of outpatient of $134.6 million. There is no gain from the sale of diagnostics.

Next I would like to turn to selected balance sheet captions. The balance sheet overall remained fairly consistent other than charges related to items classified as assets or liabilities held for sale, which were impacted by the closing of the outpatient and surgery sales in second quarter. There are a few other items of note, however. The income tax receivable of $209 million, which we expect to receive in late 2007 or early 2008 as we mentioned before. The added work we are doing for the 1996 and 1999 return could cause this refund to be higher. If so, we will likely increase that refund receivable on the third quarter or fourth quarter on the balance sheet.

The next caption on the balance sheet I would like to comment on is government class action related settlements. This liability included a reduction of $47 million for payments to Department of Justice, CMS, and SEC on previously agreed to settlements. All payments totaling another $69 million will be made by the end of the year and this liability will be eliminated by the Company.

Speaking next to long-term debt. As Jay has mentioned, it's been reduced by approximately $1 billion since year-end primarily from the sale of surgery and outpatient. Further we have approximately $40 million yet to come in from our outpatient and surgery divestures for facilities where regulatory approvals or consents were not obtained prior to closing. We expect the conditions to be met in the third quarter or early fourth quarter. We would expect the diagnostics proceeds, coupled with the remaining amounts from surgery and outpatient along with our tax refund to provide for further debt paydowns of at least $300 million. This brings the total debt paydown to approximately $1.3 billion generating interest savings of over $100 million per year. As a division is sold, represented approximately $100 million of combined incremental EBITDA, remember diagnostics had negative EBITDA, this means we received a multiple of over 11 times for all three divisions. With the divesture proceeds and our tax refund we will not only have payed paid down a lot of debt we will have improved our leverage ratio by a full term.

Next I would like to comment on adjusted consolidate EBITDA and make comments relative to cash flow. Consolidated adjusted EBITDA is on page six of the press release and as you can see, reflects EBITDA for the the second quarter of $77.6 million. This reflects the adjustments that we believe are non-recurring and 123R expense of $2.6 million in the quarter as I know a lot of you do not add this back. For reference point that 123R expense should get smaller as the year progresses as there will be fewer participants due to divestures.

As a reminder, the general and administrative expense number includes amounts of divested divisions up to the date of closing. If we were to normalize the G&A to the overall percentage of sales, again 5.1% for the quarter, that would add $12.4 million of EBITDA for a total of $90 million. The 5.1% is based on taking the $35 million for G&A expense divided by the revenues reported of 442.8 from continuing operations and the $243.2 million in discontinued operations of 686. This type of addback is also included in our credit agreement and that's foot noted respectfully.

If you annualize the $90 million which again is the 77.6 plus the 12.4 to normalized G&A, this would represent a run rate of approximately $363 million of EBITDA. If we adjust G&A to our target of 4.75, the amount for the quarter would have been $91.6 million annualizing at $366 million.

After our tax refund, we expect annual cash interest expense to be around $200 million with needed maintenance CapEx of 35 to $40 million, leaving excess cash flow of $125 million per year before preferred dividends of $26 million. These amounts are available for further debt reduction or development opportunities.

I know several of you have focused on the cash uses from operations which is reported in the press release. I think if you turn to page 52 of our 10-Q it provides more color for the first half. This usage includes discontinued operations which a year ago was a source. It includes $82.5 million on government settlements which were the cash settlements and reduction from market-to-market. That cash liability, as we mentioned, goes away by the end of 2007 and we would count as non-recurring. There's also a greater increase in the change in assets and liabilities usage being higher than the same quarter a year ago related to some of the the divesture activities, including the deferred tax accounts. If you adjust for these, and professional fees that will go away, we are in a positive position for the first half.

Just to let you -- walk you through that math that is $111 million usage, which includes 82.5 from government class action settlements, 15.9 of assets and liabilities changed from a year ago, again related to discontinued operations, as well as professional fees which we've described as non-recurring. For those items that would put us at $22.5 million in the positive use. Also interest, which is higher because we have not gotten tax refund and made the other reductions yet, will get lower as we progress throughout the year.

Finally staying with adjusted consolidated EBITDA as we've indicated on the past on a reported basis, which excludes a normalization adjustment for G&A, you should see adjusted consolidated EBITDA improve with steady G&A declines the divested divisions. We previously indicated a range of 275 to $300 million on a reported basis for 2007. Based other closings being completed by the end of July, we should be at the high end of this range for 2007.

Next I bo like to make some comments on the captial structure. We mentioned on a previous call that we would be looking at our captial structure after the divestures. Clearly, the credit markets have changed significantly since our last earrings call. Having said this, our analysis based on consultation with lenders, show that we have assets on our balance sheet that would be eligible for a CMBS financing alternative at attractive rates. This was under the assumption that current credit market turmoil was not impacting real estate financing which obviously could change. The CMBS financing have been coupled with a term loan and resolver. However to put in place the CMBS facility with a related term loan and revolver would have required us to purchase our bonds back early. As the premium was approximately $190 million, we do not plan to pursue this alternative as the interest savings would not yield a positive net present value over the next several years.

The bonds that we have that we talked about that would have to be taken out of premium have two different call periods. The floaters, $375 million are callable at 103 in 2009 and fixed rate bonds of $625 million are callable at 105 in 2011. Our current bond indentures that I just referenced provide a very limited basket that could be used to buy back stock, hence we don't have capacity to repurchase shares until we can take out the bonds. We will continue to reassess our alternatives as we move closer to the call periods of the respected bonds.

In conclusion, we believe our pure play company is one that will have a better credit profile and strong cash flow capabilities as we move into 2008. Excluding gains or losses from market-to-market our litigation liability and interest rate swap, we should be a positive EPS company in 2008. With that, I would like to turn it back over to Jay.

Great, thank you, John. Before we open up the lines for questions, I with like to address three issues. Our decision this week to close one of our eight long-term acute hospitals, the status of our corporate campus and the 75% rule.

With respect to our Terre Haute LTAC, as I had noted, this facility is just one of eight long-term acute hospitals in our portfolio. And to put this group into perspective, the EBITDA generated from all of our LTACs represent less then 8% of our total revenues and even less then our total EBITDA. This particular facility has been on our watch list for some time since it was on track to lose about $2 million this year. So, it's closure actually will be a net positive for the Company. And fortunately, it is immediately adjacent to a acute care hospital and since Terre Haute is a two hospital town, we believe there will a buyer for this property.

As John mentioned we also received word on Tuesday that Trammel Crow has decided not to proceed with the purchase of our corporate campus. No specific reason was given, although they implied that difficulties in marketing the so-called digital hospital, along with credit market volatility, both played roles. Although we're disappointing that Trommel Crow backed out of the purchase agreement, we're talking with a local real estate company to explore other avenues of unlocking the value of this asset, including developing the property ourselves and lesion the main building to other tenants. Ads John said this will not impede our ability to reduce our G&A expense to our stated goal of 4.75% of net revenues.

Finally, I know a lot of you have been following the hospital industry's efforts to ensure Medicare beneficiaries have continued access to quality, inpatient, rehabilitative care. We are pleased that 224 Representatives and 60 Senators have co-sponsored Bills in their respective chambers to freeze the compliance threshold of the 75% rule at 60%. The American Hospital Association, the Federation of American Hospitals and the American Medical Rehabilitation Providers Association, as well as numerous patient and consumer advocacy groups and organizations all have played leadership roles in informing Congress about the differences in rehabilitation hospitals and nursing homes. While only the House CHAMP Bill has language pertaining to the rule, I believe it is important to note there is strong bipartisan support in both chambers to address this issue.

While Section 502 of CHAMP is a very good start at permanently fixing this rule, there are certain provisions that, in our opinion, need to be modified. The first provision needs to be addressed is Paragraph C of Section 502, the proposed nursing home based payments for hip fractures in knee and hip replacements. The level of care and the amount of resources rehabilitation hospitals provide to patients with these conditions is significantly greater then that received in nursing homes. Especially for hip fractures which is a qualifying condition under the rule.

We've modeled the financial impact on Paragraph C on HealthSouth and, based on our current understanding, we estimate our net revenues would be reduced somewhere in the 40 to $45 million range if these proposed reduced payments were implemented. I need to emphasize this is the estimated impact to revenues, not EBITDA. If these payments were enacted into law, we would take aggressive actions to mitigate their impact and estimate the net EBITDA impact would be less then half of this amount.

We believe these payment policy proposals are not supported by sufficient clinical or medical-based evidence. In fact, there are pure reviewed published studies in the medical literature that are generally supportive of our concerns and more research on this topic currently is being pursued by researchers. We also are concerned that the effects of these refinements on patient care and access to appropriate rehabilitative care are not sufficiently understood.

Finally, if this policy were enacted into law, the cut it would impose on rehabilitation hospitals and units would be disproportionate and inequitable when compared to other payment systems and providers that would be scaled back by the CHAMP legislation. Accordingly we respectfully believe this paragraph should be eliminated. We look forward to continuing to work with the AHA, the Federation and AMPRA in having a thoughtful discussion with congressional leaders on the merits of Paragraph C and its implications for patient care.

A second item of concern is the omission of language standardizing local coverage determinations or LCD's, which govern decisions medical necessity. Our concern is that without some kind of common definitions for medical necessity and more deference to physician judgment, patient's access to quality rehabilitative care could depend more on which fiscal ind intermediary administers claim for a particular hospital then on the patients underlying medical condition.

My final comment on the 75% rule pertains to the chances of getting something enacted into law. On this topic it's anybody's guess. Obviously, what ultimately happens is going to be up to Congress and the President to decide. One thing I do know is that we look forward to working with Congress once they reconvene after the August break to appropriately and permanently resolve these matters. HealthSouth will continue to work with the AHA, the Federation, and AMPRA to ensure Medicare beneficiaries have access to quality, in-patient rehabilitative care.

In conclusion, let me say I'm very pleased with where we are with our strategic repositioning and the trends we are seeing in our business, especially compared to our competitors. I believe our future is very bright, as is our ability to create long-term value for our stake holders.

Does that mean we won't have any challenges in the future? Of course not. But successful companies find solutions to their challenges and execute their strategies better then their competitors and I believe HealthSouth is such a company.

It maybe a bit of an understatement to say we have faced our share of difficulties over the past four years, beginning with the discovery of a massive accounting fraud, but I'm proud to know note that in each instance HealthSouth management and our talented employees have developed strategies to address these challenges and have delivered on everything we said we would do. Today, we are a smaller, but stronger and more focused company with a well-defined strategy, and well positioned for growth.

Our goal is to be the pre-eminent provider of in-patient rehabilitative services in the United States. Our strategy to achieve this is through clinical and service excellence, expansion in existing markets, building new hospitals in new markets and acquiring or joint venturing competitor facilities. We have the largest market share in the IRS segment and have demonstrated we can take market share from our competitors because of the quality of care that we provide. The aging population creates an attractive and growing market for us on a go-forward basis which should allow us to expand our IRS footprint in both existing and new markets. We expect to continue to pay down our debt, thereby reducing our interest expense, and enhancing our earnings per share growth. We will finish payments on our various settlements this year thereby freeing up considerable free cash flow that should enable us to derive additional shareholder value. And longer term, we expect to use our stronger balance sheet to opportunistic almost pursue appropriately, complementary acquisitions in the post acute space.

With that, operator, I would like to open up lines for questions.

(OPERATOR INSTRUCTIONS) Our first question comes from Ann Hynes of Leerink Swann. Please go ahead.

Thank you. Just to focus on that hip and knee. Obviously that's negative but isn't the alternative much worse if we had to go to the 75%.

There is no question that being able to freeze the threshold at 60% would be a very, very positive move for patient access to quality rehabilitative care. There's no question about that.

All in all still a net positive.

I believe that it is -- the proposed changes to the rule would be absolutely a net positive. As we mentioned, we are continuing to work with Federation, with the American Hospital Association, with others to help get this proposal, and that's what it is, it's a proposal on the pricing differential, changed. Especially as it relates to hip fractures because that is a qualifying condition and the amount of resources that are required to appropriately treat a hip fracture patient and get them back to their activities of daily living, is much, much greater then what you would find in a nursing home. And so, we will continue to work on that issue and we believe that there is some evidence that this proposal is being seriously reconsidered and being evaluated in light of the facts.

Okay. And do you have an exact compliant discharge growth rate or are you going to give that next quarter?

What we have, as you know and I apologize for any added complexity to this whole issue. There are really two metrics, two ways of looking at compliance case growth. One is the way CMS evaluates a hospital's compliance and that is using the presumptive method and that is also the method that is used in reporting industry data. When we reported, in the first quarter, our compliance case growth, using our internal which is much more conservative information data sources, much more conservative. We reported a 2.1% increase in the first quarter. If you then compare that to the data that the industry uses, that was actually 4.1%. So that's the first quarter we were able to compare those two, if you will because we mow have the industry data.

We don't have the industry data for the second quarter, but our internal, more conservative methodology stated that we had a 2.2% growth in compliant cases in the quarter. And we expect that if the trend that we saw in the first quarter is repeated that obviously on a presumptive method that would be higher. And I apologize if that's more complexity then people want, but I think -- this is a complex situation and I think it bears some time to understand that when others report on industry data in compliant cases, they're looking at it one way and we have consistently reported in the past a much, much more conservative way of reporting that data.

Okay on, one more question and I'll pass on. So your in-patient revenue was good your outpatient obviously declined year-over-year. Can you give us some guidance on how to model that out throughout the year. Do you expect more closures?

I can't give you exact guidance, Ann, I think the second quarter number for now would be an appropriate run rate. I would tell you we'll look at other rationalization of facilities and probably close those but I can't guarantee you when those will occur but there will be some impact.

Okay, thank you.

And it's likely to decline.

Let me amplify on, the outpatient units are associated with either a department of the hospital or somehow they are tied with our hospital. These are not the outpatient centers that we divested, obviously and we believe that in most of our markets, these services, while not as profitable as they have been in the past, are complimentary to the overall range of services that we provide and in some instances having those outpatient centers actually enables us to attract patients because we're able to offer a full continuum. We're able to bring them in and also offer them the outpatient care they might need after discharge. So, we definitely look at profitability of these centers but we do so through the prism of the quality of care that we are able to provide and how that's going to differentiate us as we look at bringing in compliant cases and being able to attract in-patients. There's no question that's an issue that we're focusing on, but it's not always going to be strictly a financial decision on that particular unit because virtually all of them are -- in fact, all of them, are associated with some type of in-patient facility.

Okay. Thank you.

Thank you, our next question comes from Gary Liberman of the Stanford Group please go ahead.

Good morning.

Good morning,.

You noted in your comments that the revenue impact from the change in the legislation on the hip and knee side would be $40 million but that the EBITDA impact would only be about half of that. Could you elaborate on how that math works?

Basically, it is a pricing, generally speaking, category, but two things we would look at doing. One is considering how much of our cost base is fixed and secondly, we would be making changes relative to the therapy that we would be providing with the different type of reimbursement rates. So, part of the reasons why that sounds like perhaps a high margin number, maybe that's your question, is because we do have a a fairly significant fixed cost base. Which works to our advantage when we bring on new patients.

I guess I was coming from the perspective that if you were doing the same amount of -- same number of cases and just getting reimbursed -- it was just a pricing hit, that all of it would flow through.

It basically at that pricing, we would adjust the amount of therapy we would provide for those cases, consistent with what the lower reimbursement rates that a skilled nursing facility or something else gets.

We would have to scale back and change our clinical pathways, change the resources that we commit to those patients and frankly, the knees and hips replacement today only represent about 12% of our total patient volumes and that's down from 20% plus several years ago. So, we have weaned ourselves away in large part because they're non-compliant. So I think that the focus would be to continue to try to bring patients in who are compliant cases and then secondarily to reduce the level of service, and regrettably, we would have to do that. It's not something we would want to do, but if the the payments change, clearly we would have to change the level of care and make that a different level of care then what we have today.

That's very clear. It wasn't clear that there would be a reduction of level of care. One quick follow up. In your other operating expenses, you noted in the queue that it benefited from a reduction in self insurance expenses in the quarter. Do you have that amount that it benefited from?

It was a few million dollars but I don't think that was necessarily inconsistent with what we've seen in prior years.

Okay. And were there any other similar type of benefits either in the other operating expense or in the G&A similar to that might be helpful?

No, the other item of note is last year's number in other operating expense has about a $6.9 million pick up from Source Medical.

Thanks a lot.

Thank you.

Our next question from David MacDonald of SunTrust. Please go ahead.

Good morning, guys.

Hey, David.

A couple of questions. Did can you give a little more detail on the initiatives the labor side. Jay, you touched a little bit on some initiatives to decrease turnover. Can you give us a little more detail there, and also just any initiatives in terms of maybe teaming up with folks to try to make the hiring side of the picture also a little bit easier and then I had one follow-up.

Sure. The labor issue is one that we are focusing on. It is a major challenge for us because, as everyone knows, the labor market particularly for highly qualified therapists and nurses, especially those who are specialized in rehabilitative care, is really tight and we understand that. We want to make sure that our salary and benefit packages are competitive. We want to make sure that in each of our markets, we are in a competitive situation vis-a-vis other providers. So one of the things we're doing is we're looking at that. The whole compensation and benefits structure.

Specifically, though, we believe there would be savings to be realized by reducing our turnover. And we're no greater or no lesser then the rest of the industry, but we want to be considerable better over time. And that's really where our focus is going to be and that has many different aspects to it that we're looking at, including creating mentoring programs for new hires and doing a better job of selecting new hires when they come in, making sure that there's a clear understanding of the job expectations, and then at the same time augmenting the benefit side as well as making sure our salaries are competitive.

We're also looking at our non clinical costs and labor costs specifically in our facility. We will be launching later this week, early next week, a major internal initiative, focusing on our so-called back office or non clinical services. And we believe that there are savings to be realized in that area. We think that we can reduce the variability in our labor expense across all of our hospitals in the non clinical, and by reduction that variability, we believe we can make some strides on our labor of costs.

And is it kind of late this year, early next year a realistic time frame where we might see traction in terms of the P&L.

We should start seeing this in the fourth quarter. In the early part of next year. The other thing I need to mention is we are at the same time that we're focusing on the non-clinical costs, we're also -- as part of this major initiative, looking at our sales and marketing activities and even though we are very pleased that on a relative basis, and we compare ours to our competitors, we have taking market share. We have a tremendous, dedicated staff out there bringing patients in. We think we can improve on that. And the same approach of looking at best practices, and then formalizing the standardization and rolling that out across all of our facilities and that's going to take some time. It will probably take well into the second quarter of next year. But we think that by taking the time, focusing on that activity and bringing additional patients in, clearly that will then help to address the overall cost of our labor because hopefully we can bring those in on an incremental basis.

Okay and then just one housekeeping question. I apologize, John, my line kind of cut out. Can you just give the number again. I think you said $300 million, at least $300 million of incremental paydown. Is that from the tax refund and diagnostic division together, did I hear that correctly?

That's three things actually. That is the tax refund, which as I mentioned could be higher than reflected on our balance sheet which we'll have more clarity on in the next quarter or two quarters, and secondly, the diagnostic proceeds, and there's about $40 million that's not been received on the outpatient surgery because of regulatory approval that just takes some time, primarily Connecticut is our big issue. They're just very slow, and certain consents, but those should be coming in late third quarter, early fourth quarter.

And John, if memory serves correctly, right now we're sitting at close to 300, correct with the 240, 245's and isn't the income tax receivable in the 210 range?

That's right.

Thank you very much.

Thank you.

Thank you, our next questions in from Adam Feinstein of Lehman Brothers.

Good morning, everyone.

Good morning, Adam.

Just a follow up to in the last one, so, the $300 million of debt on paydown you mentioned 200 million of interest costs, was that incumbent upon the $300 million of debt paydown to get to that level or should we get to that level next quarter?

That is assuming the tax refund comes in again late, I was trying to give a reflection of what the run rate might be and that's looking at the tax refund coming in late '07/early '08 that would put us at $200 million or maybe slightly below.

Okay. And then just with the professional fees, clearly you're seeing those continue to move lower. When should we really see those run off? As we think about those, how should we think about that as we look out in 2008 and looking forward?

That's a great question. Again, I remind everybody what we classify on that line are clearly items that we view as non-recurring. We have significantly more then that, based on the current quarter, up in the normal G&A kind of categories. The two primary components for this quarter were for maximizing the tax refund related to work done on '96/'99 tax return. That will be done very shortly. So we're in the kind of final stages of that. The other portion that contributes to that are legal fees that relate to 2003 or prior. Most of the legal fees that we're incurring today and will incur in the future, that will be the biggest item that moves forward, are going to relate to going after UBS and Earnst and Young to recover under the derivative lawsuit to maximize those proceeds. And I looked at John Wittington, our General Counsel it's probably not totally predict b predictable how those will come out. If you look at half of the number in the quarter being taxes and half legal. I wouldn't expect a legal run rate to be a lot higher but I'll look to John to see if he's got a different view.

Those matters should come to trial in mid 2008. So they will run through that time period.

We think that cost, that expense is an appropriate investment ,because we believe that there are considerable benefits to the company in pursuing UBS, Earnst and Young and Richard Scushie. We're not done with him.

Just a follow up question here. Just, I guess as we think about the G&A, I know you talked about the same goal, the 4.75% and you would have been at 5 .1% on a normalized basis in the the current quarter. As we think about the back half of 2007, what kind of range she we think about? Will it be closer to that 5.9% that you thought about last quarter.

That was the first quarter toll and the first quarter had again, the first quarter because you expense audit fees as incurred my the first quarter of '07 had some higher costs because of the audit fees because you incur those when the work is done and that's the way we expense anyway, but you should expect a decline from the $35 million that we are in the second quarter in each subsequent quarter. Surgery will be gone. Typically there's a month lag before we start to see the expense savings. So we should get a couple of months from the surgery savings in the third quarter. Probably not a lot from diagnostics, maybe a little in the third quarter. By the time we get to fourth quarter, we should have a fairly reasonable run rate. Without being specific about this because I can't totally predict it because part of it is contingent upon what are the expenses we incur in providing transition services and the way we priced those, though we price them to be neutral. I think the issue to bring up is I went from the 275 to 300 that we said on a reported basis of EBITDA and saying we would be at the higher and of that range. I think that's going to reflect that -- that's going to come through lower G&A for the rest of the year.

Okay. All right, and just one more question here as we think about the business. The length of stay in the quarter. It was down about half a day. Can you just comment there what's driving that and just thoughts in terms of the overall trend there. Thank you.

I'm going to ask Mark Tarr, who is the Executive Vice President for Operations to answer that one.

Yeah, and good morning. The biggest driver on our length of stay typically is derived from our case mix. You'll see that go up and down from one quarter to the next, depending on the complexity of our patients. There is some seasonality included until that, but I think you'll see it range from pretty much that 15 day and 15.5. Okay.

Thank you very much. Great progress here.

Thank you.

Thank you, our next questions in from Rob Hawkins of Stifel Nicolaus. Please go ahead.

Good morning,.

Hi, Rob.

Hi. I guess a couple of questions. You talk about $40 million as the remainder proceeds related to the transaction division sales, but in the Q there's kind of discussion about $150 million in escrow proceeds. Can you help me reconcile the numbers. There's like a 126 number and a 40.

There's no escrow proceeds.

I guess I'm referring to it as these --

Okay. I can explain what you're asking.

We have actual cash to come in at $40 million, which is in the outpatient. We didn't have all of the CON approval in the state of Connecticut. That's in progress. Should be late third quarter, early fourth quarter.

In surgery, we had about 15 to $16 million related to needing to obtain a consent which we believe will be done in the third quarter.

What you're referring to, I think, is a deferred gain, because as I said we didn't have the approvals on Connecticut in outpatient. We have similar issues in surgery in certain states, I think it was Connecticut, Rhode Island and Illinois that just take some time. The difference is we already have the cash. So we have deferred gain proceeds on those, but we're not missing any cash.

Again, those are just perfunctory in terms of time. I think surgery is in pretty good shape already on Connecticut and it should be pap happing. Those are things that typically take some time depending on the load the state has, whether they have budget to fund the CON and deal with these things. They just take time. All of the economics are transferred to the other buyer. But just for accounting purposes since that has not been finalized. The gain has been deferred.

Okay and then --

No cash is being held in the $40 million.

That's what I thought. About a differential of $100 million. I think Ann asked about portfolio rationalization and I've got still a little bit of confusion on the outpatient. I understand you're still doing some outpatient rationalization, but what about the in-patient side. The LTAC side. Are we done there? Are we still going to possibly see more stuff and what might be the timing of that? And finally as to that on the in-patient side. If there's a way to see kind of what the beds were. Having a facility list with beds, might make it easier to try model it out when you guys have some of those changes. It's just a comment.

Let me, Rob, I can't give you the facility information.

I'm not asking for that now. I'm just saying at some point, on the next K or something.

But on the LTACs. As we have said previously, we will be looking at that segment against the back drop of the regulatory changes occurring in Washington. This particular facility was underperforming, not so much because of the regulatory environment, as it was just -- it was poorly located, it was poorly positioned, and there really wasn't the patient population to service. It was a facility that we inherited back through an acquisition.

And so we look at all of our facilities to determine can we fix those that are losing money? We make every effort to do so, but as I've said in the past, we'll be very disciplined with respect to closing underperforming hospitals.

We don't have any others currently that are on a watch list. So we think that the portfolio is fairly stable. There maybe opportunistically an opportunity to sell an LTAC here or there. But that would be something that we would do if it made sense, if it was accretive to the Company, but as you know, the LTAC business has been under a lot of pressure and as we have stated in the past, we want to be cautious with respect to pursuing opportunities in that segment until there's more clarity.

Now, at some point down the road I believe that clarity will be achieved. And we believe that it is a complimentary service and an appropriate service but we want to make sure that we are pursuing the opportunities in the IRS space first and there's a lot of opportunities there and we're going to kind of watch what's happening with LTACs. As we've reported previously, there's several LTAC projects that we were working on and we've pulled back from and said we're not going forward. The portfolio, I think is very stable.

This one facility was really kind of a one off. It was one of maybe two LTACs that we had on a watch list and because it was losing money, we didn't think we could turn it around, we made a tough call and decided to close.

But we will continue to look at those outpatient sites. A lot of the outpatient sites came through acquisitions as the company was put together. And so, and as again, there's been some competitive issues with some of the outpatient sites and we do go through those in different geographical areas, they're very successful. In others, they're not as successful, and it's largely tied to the reimbursement rate we get per visit. It is no different than our outpatient. These are higher, they're Medicare, as Jay said, they're associated with our in-patient hospitals, but we will continue to watch those and there will be some rationalization. I don't think it's going to be gigantic rationalization, but there will be some we look to change.

A couple of them, quite honestly, are satellites outside of our hospital and typically, we have one of these facilities inside the hospital. We just didn't have the space. As time unfolds we may look to bring those inside the hospital but that will make the outpatient facility and satellite go away.

And then I guess a growing problem for some of the hospital companies we're seeing is some of the local coverage determinations, you touched on and how you would like that to be changed. I think that's a great idea for the Bill, but are you seeing any kind of expansion before. I think we talked about as California as having some [rogue] contractors there denying stuff. Are you seeing any of it spread to other regions? Is this becoming for problematic or is it more or less static?

Pretty static. We always are diligent with respect to our coding. We think that we have good internal controls with respect to our billing. There are going to be times where our physicians, our admitting physicians' judgment are going to be questioned by a local fiscal intermediaries and we understand that. We understand that process and we just go ahead and challenge as many as those denials as we can.

As John mentioned, that has resulted in an uptick in our bad debts only because we are taking a very conservative approach with respect to accounting for those denials. Now ultimately we win a good number of them, 85% plus, but it takes 12, 15 be 18 months to resolve those.

And what we're trying to do and we've had some recent success, particularly with our largest FI is trying to sit down and work collaboratively with them to address the underlying differences or misunderstandings or issues relates to the documentation. And in some instances, we're finding some very good success. And most recently we've received improvement in our relationship with Cahaba, which is the largest FI that we work with and is based in Birmingham. It's part of Blue Cross of Alabama. We're very encouraged by that and hope that dialog and that positive relationship will continue and that will help us reduce the denial issue.

To answer your question there's not a big sea change. Is it an issue in the industry? Yes, it's always been there. We're chipping away at that and interest. Ing to improve and get at some of the underlying conditions and underlying circumstance.

Do you reserve them, or how does that process?

We reserve them as they age out, meet certain criteria in the bucket we reserve.

One last kind of housekeeping issue. Just to confirm, the transition services are being netted out, kind of the revenues associated with that in the contract. It's all in the overhead, right?

It's all in the G&A line.

Thank you.

I think, given the time, we might have one more question, operator.

Thank you our next question is from Kent Dolliver of Cowen and Company.

Good morning, Kent. Quickly, on the headquarters sale and the associates reduction in corporate overhead. To get to that goal you've laid out at 4.75% how much of the change depends on the -- on the headquarter's resolution?

This is John. Basically, what we need to do is find a solution for the digital and we think, there were other bids when we went through this process, only for the digital. And that has operating costs because all your really talking about on the G&A line is the operating cost to go with the facilities. And so there were other stand alone bids the digital. We're likely to pursue those, and that will take out a good portion of the operating costs we're incurring to keep the air conditioning in so there's no mold, For added security, electricity, and all of those types of things.

As to the corporate complex, ironically, we have been receiving, because there will be some excess space, unsolicited inquiries about renting space in our building. So as Jay mentioned earlier, we will be looking at a local developer, not only to maybe manage the office building for us and thus lease up the excess space after surgery is gone and diagnostic is gone or placed someplace else. And we think that will allow us to get to the 4.75% because those won't be our operating cost. We'll only be bearing the operating cost on the space we occupy. We will look over time just to basically look at what somebody else maybe doing. There's a couple of parcels of land that are prime candidates for development either for realize, hotels, or apartment buildings that we will be looking at on this over 100-acre complex.

I think it's also worthy of note that -- I think we have been disciplined about our process, both in the divestures about not -- about staying in there to get the best price because we thought that's in the best interest of shareholders. I would say the same holds for the corporate complex. We could have had a lower price presumably, we just chose not to do so because we don't think that creates the most value.

We're going to hit that 4.75% by the end of '08. We have set that target and we absolutely will hit that. If we're in this building or not, we're going to hit this target. The sale doesn't really influence that one way or another.

Okay, that's helpful. And just my last question is, your volumes outperformed what was going on upstream with the acute care. In contrast, in Q1 acute care volumes were weak, and your volumes were weak also. Can you give us color what is going on below the surface in the portfolio that would account for the variation in trend?

What we did beginning in the latter part of last year and as I mentioned earlier, we're really going to be launching a concerted effort later this week, early next week, is on the whole process of bringing patients in. What we refer to as our sales and marketing efforts. And that, I think has been where we have seen the greatest turn around, if you will, or improvement.

The other thing that we have found is that the -- several of our hospitals that were lagging in the first quarter, some of the facilities that I think I mentioned in the Q1 release in Texas, had vacancies in the CEO level and in the sales and marketing department. We have seen some very nice progress as we have been able to recruit very high-quality CEOs, and then they in turn have been able to bring in high quality folks to help us on the sales and marketing. So a lot of it is filling those positions, making sure that we have the right people in those and we've got a great success story in Arlington, Texas. One of the facilities that had been really struggling, had not been meeting budget for many months, almost a year, we brought in a very talented individual to run that facility and now they're making plans.

So it's really function of getting the right people in the right spots, and putting a focus on it, and I think that's one of the take aways from this call. I hope it's one of the take aways from this call. We really do believe the industry has some very good fundamentals. We're now able to put our focus exclusively on our core business and over the last several years, we've been fighting lot of fires. We've been dealing with a lot of skirmishes on the periphery. Now we're able to put all of our attention on our in-patient business and we believe that focus will continue to yield results that will be positive.

We think that the strong cash flow characteristics of the company are very attractive. We think that's where shareholders ought to be focusing their efforts, and we think that as John said, we believe as we go into 2008, we're going to be a positive EPS and EPS growth story.

Great thank you.

Alright, well thank all of you for participating on this call. I'm sorry that it went over. We wanted to make sure we got as many questions answered as we could. We realized there were others that were not able to get their questions asked and we apologize for that. We do thank you for your support and look forward reporting next quarter.

Thank you.

Thank you, this concludes today's HealthSouth Corporation conference call. You may now disconnect.