Encompass Health Corp (EHC) 2007 Q3 法說會逐字稿

Good morning, everyone, and welcome to HealthSouth's third quarter 2007 earnings conference call. At this time I would like to inform all participants that your lines will be in a listen-only mode. After the speakers' remarks, there will be a question-and-answer period. (OPERATOR INSTRUCTIONS). Today's conference call is being recorded. Your participation implies consent to our recording this call. If you have any objections, you may disconnect at this time.

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

Thank you, operator, and good morning, everyone. With me on the call today are John Workman, Executive Vice President and Chief Financial Officer; Mark Tarr, Executive Vice President of Operations; John Whittington, Executive Vice President and General Counsel, and other members of our team. Before we begin today's call, I'm going to ask John Whittington to read the cautionary statements.

Thank you, Jay. There are a number of disclaimers, risk factors, and other cautionary statements set forth in the press release we filed yesterday in connection with the filing of form 10-Q and in the form 10-Q we will be filing later today. We will not review these risk factors and cautionary statements, however, we urge you to read them carefully. I would, however, like to highlight 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 events and financial performance.

You are cautioned not to place undue reliance on the estimates, projections, and other forward-looking information presented today, as they are placed 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 result 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.

Thanks, John. Today we are pleased to report the results of our third quarter. At $43.3 million, our operating earnings were up 50% year over year. While total discharges were down slightly due to nine of our Pennsylvania and Massachusetts hospitals moving to the 65% threshold July 1, and acute care weakness in some of our markets, total net revenues increased $18.1 million or 4.4% due to very solid pricing as we continue to treat higher acuity patients. We were especially pleased that our inpatient net revenues showed a 5.1% year over year increase. It's also worth noting that a portion of the discharged weakness occurred in September following a very slow start after the Labor Day holiday, although we are very energid by the rebound we have seen in October.

As we did last quarter, we are again reporting on our compliant case activity using industry data published through the Uniform Data Systems for Medical Rehabilitation, commonly referred to as UDS data, which is available to us on a one-quarter lag basis. We believe reporting compliant case activity on a comparative basis provides investors with a more valuable measure of our relative performance. Using this UDS data, our hospitals showed a 6.7% growth in compliant cases in the second quarter, compared to a 1.8% decline for the rest of the industry reporting through the UDS system. As previously noted, the industry number is exclusive of HealthSouth data. This demonstrates that our hospitals continue to gain compliant case market share despite industry headwinds and reinforces our confidence in the long-term prospects of our pure play post-acute business model.

We also are pleased with our ongoing efforts to match our cost structure with our new business model. G&A expense declined $7.5 million sequentially and almost 25% from prior year, as we continue to eliminate overhead costs following the divestiture of our three noncore divisions. Labor also was in-line with expectations for the quarter. Salaries and benefits as a percent of net revenue improved 20 basis points year over year, and we were able to manage the increase in salaries and benefits to 3.8%, which compares favorably to the more than 5% increase in the previous two quarters. This increase is within our targeted range, as we continue to invest in recruiting and retaining top talent for the company.

Provision for doubtful accounts also showed solid improvements as bad debt as a percent of net revenue decreased to 1.3% in the quarter versus 2.7% a year ago. This improvement was in part attributable to the effectiveness of the Patcom billing system we installed in all of our hospitals throughout 2006. From a development perspective, in the quarter we executed a letter of intent to form a joint venture with another provider in one of our Pennsylvania markets, whereby we would consolidate our respective operations into the HealthSouth hospital. And we submitted a certificate of need to build a new 40-bed hospital in Louden County, Virginia.

Finally, adjusted consolidated EBITDA for the quarter came in at $88.7 million. As noted in the second to the last paragraph on page 8 of the press release, there was a $35 million recovery from Richard Scrushy in the third quarter of 2006, and an $8.6 million recovery from Source Medical in the third quarter of this year. Both of these are included in adjusted consolidated EBITDA. If you net these recoveries out, adjusted consolidated EBITDA increased 10.8% year over year.

John Workman will now provide a more detailed analysis of the quarter and discuss our recent tax recovery.

Thank you, Jay. First I'm going to address comments related to the income statement. On page 10 of the press release, we provided you with the revenue breakdown in our inpatient hospitals and our outpatient satellites. Inpatient revenues were up 5.1% in the quarter, as Jay mentioned. Outpatient and other revenues were basically flat. We've had a program of continuing to rationalize our outpatient satellites and continue to do so in the third quarter of 2007. As Jay mentioned, volumes were down slightly with nine hospitals moving to the 65% threshold. However, strong pricing more than compensated for the volume decline. Pricing was driven by an increase in our CMI and also an October 1, 2006, price increase. As a reminder, we will have a further price increase of approximately 2% that becomes effective on October 1 of 2007.

Turning from revenues, I'm going to make some general comments about certain captions in our total operating expenses. Salaries and benefits showed a sequential improvement for the second quarter of 2007. We have merit increases that will affect this line in the fourth quarter, to remind everybody, we put in merit increases at the same time as we get price increases from CMS. This will increase salaries in the fourth quarter of 2007. We expect that to be in the 3 to 4% range, as Jay has indicated before, in our attempt to manage that expense growth year over year. In the caption "other operating expense," it was benefited in 2006 from the benefit of lower insurance reserves as we continued to improve in our claims performance and settlement of claims and also benefited as a company from exiting the acute care hospitals, and we saw the tail of those go away. This year, the line item includes expense from our standardization program that we are investing in to enhance our performance now that we are a pure play company and able to focus on operations for the first time.

Under the caption "occupancy costs," it included a facility that was leased last year but is owned this year due to the relocation of our Sarasota hospital. In the caption "bad debts," as Jay mentioned, it showed improvement as we moved all hospitals to one system, which was installed in late 2006. Our 2006 disclosure indicated we took some added charge for this in 2006, related to the new installation. We have previously discussed our ADRs, which continue to prevail on appeal, but they were generally flat for the quarter compared to increases we had seen in the prior quarter. The basic improvement in the bad debts is attributable to the new system and is allowing us to improve both our metrics and collection efforts and we're enthused by that in looking at a 1.3%, we believe is more appropriate and in-line with kind of our expectations on a go-forward basis.

Professional fees caption dropped significantly from a year ago. I want to remind everybody that the expenses on this line are related to events dating back to 2003 or prior. Our regular costs are reflected in other expense lines in the income statement. For the third quarter, the expenses reflected in this line were primarily for legal fees and pursuit of claims against Ernst and Young, UBS, and Richard Scrushy, and some remaining costs for pursuit of the tax recovery. As we have said before, we expect to incur approximately $25 million next year in 2008 as we pursue the derivative claims against Ernst and Young, UBS, and Richard Scrushy. We look at this as a return on investment and we evaluate the expenditure in light of that.

Under the caption "interest expense" in the quarter, it does not yet reflect the further deleveraging as a result of the tax recovery. Calculating the impact on our reduced bank debt would have lowered interest expense in the quarter by 7 to $8 million. G&A did show a steady decline from the second quarter under that caption. It was 6.4% of revenue in the quarter, but still did contain costs related to the divested divisions. Also as a reminder, we are investing in a new general ledger system this year, funding development expense, and increased internal audit costs.

We believe taking year-to-date G&A expense as a percent of all revenues, including those of the divested businesses is the best proxy for a run rate in the quarter. Looking at year-to-date G&A cost of $107.2 million, year-to-date continuing revenues of $1.3135 billion and as disclosed on page 11, the year-to-date discontinued revenues of $603.3 million for a total of $1.9168 billion, the $107.2 million would equate to 5.6% of total revenues. Normalizing the quarter to 5.6% would be a $3.3 million adjustment in the quarter or an addback. 123R cost in the quarter were $2 million, which equates to 0.5%. As a reminder, our goal is 4.75% of revenues, excluding 123R costs, which would have been $20.5 million or $7 million less expense in the quarter or $5 million less including 123R costs. We did recognize a gain on the sale of our Source Medical stock and it unlines that completely at this point in time. That gain was $8.6 million and is reflected in the other income line.

Turning to cash flow items, we would evaluate consolidated adjusted EBITDA for the quarter similar to what Jay has mentioned. The reported number of $88.7 million includes a nonrecurring gain on Source of $8.6 million, bringing us down to $80.1 million. If we look at last year at the $107.3 reported number and backing out the $35 million nonrecurring recovery from Richard Scrushy, that would equate to $72.3 million, more than a 10% improvement in the quarter over a year ago, which is the first quarter we have shown improvement this year. As a reminder, everybody, the third quarter is typically a lower quarter than the other quarters within the year.

In analyzing the run rate for EBITDA, we believe the year-to-date results provide the best proxy for an EBITDA run rate. Looking at the year-to-date results, consolidated adjusted EBITDA of $236 million, less the Source gain of $8.6 million, then adding back the normalization of G&A at 5.6%, as a reminder, that is the total G&A cost as a run rate of total revenues, including divested divisions. This would equate to $261.1 million on a normalized run rate basis for the first three quarters. If you were to annualize this number, it would approximate $350 million of consolidated adjusted EBITDA, which we have said in the past we believe is reflective of the company's run rate.

As to our debt paydown, we paid off $1 billion since the beginning of the year as a result of our divestitures. We paid an additional $400 million after the end of the quarter from our tax recovery. We also purchase $51 million of the 10.75 bonds. We purchased $32 million during the third quarter of 2007 and $19 million in October. The average purchase price from those bonds was $103.8 as we purchased them in the open market. As a reminder, the fixed rate bonds are not callable until 2011 at $105. Our floating rate bonds are culpable in 2009 at $103. We have previously indicated our cash interest on a go-forward basis would be $195 million. We are now below this point and believe the run rate on cash interest cost to be approximately $190 million.

As you know, we had a $1.8 billion swap with LIBOR at 5.22%. With falling rates, we unwound $740 million of this subsequent to the end of the quarter. Since inception, we have realized cash of slightly under $2 million on these swaps. We will continue to evaluate our swap in 2008, but it may produce fluctuations in subsequent quarters. Remaining with the cash flow items, on October 15, 2007, we made our final payment to the SEC, resolving our $100 million settlement with them from 2005. Our final payment to the CMS DOJ will be made in December of 2007, resulting in the extinguishment of our $325 million settlement negotiated with that group in 2005. We will no longer have these payments consuming cash flow, which is a positive sign for the company.

So looking at future cash flow, if you start with the annualized adjusted consolidated EBITDA of $350 million, which to remind everybody, is taking our year-to-date consolidated adjusted EBITDA, backing out the Source gain, and normalizing for G&A and an approximate run rate results in $350 million. Looking at cash interest of 190 now and as we've said before, maintenance CapEx we believe is in the $35 million range for the remaining business, which is an improvement or an increase over what we'd been spending historically, that would leave available cash of $125 million before preferred dividends. Our preferred dividends run about $6.5 million each quarter.

One last point before I look into the fourth quarter. We have stated we expect to be a positive EPS company. In looking at this quarter, we believe it's a move in that direction. If you look at the pretax loss that was reported of $31.1 million, included in that number is a loss on the swap and some expense for debt extinguishment. Those two items of $21.4 and $2.2 total $23.6 million. We also had class action professional fees that we would characterize as nonrecurring of $13.1 million, and that's $3.9 on the government and class action and $9.2 in professional fees.

If you then look at the interest savings from the tax recovery, as I said of a savings of 7 to $8 million in the quarter and took the midpoint that, would be a $7.5 million addback and then if you deducted the Source gain of $8.6 million, it would equate to a slight profit of $4.5 million in the quarter. So just to run you through that one more time, the pretax loss of reported of $31.1 million, the loss on the swap and the debt extinguishment, again, nonrecurring $23.6 million addback, class action and professional fees nonrecurring, $13.1 million addback, the interest savings for the tax recovery not yet reflected in the third quarter would be a $7.5 million addback and deducted from that would be the Source gain of $8.6 million, again, a slight profit, which we think sets the right stage to be looking at EPS as we move into 2008.

Turning to the fourth quarter, as mentioned, there is a price increase that becomes effective October 1 of 2007 of approximately 2%. Also as we've mentioned, merit increases will be effective October 1 of 2007 and will affect the salaries and benefits line. Those we expect to be in the 3 to 4% range. Some of you have asked for last year's information based on our current lineup. For the fourth quarter of 2006, here are some reference points to help you in that. Discharges in the fourth quarter of 2006 were 24,958. Revenues in the inpatient hospitals were $375.4 million in the fourth quarter of 2006, outpatient revenues were $47.4 million in the fourth quarter of 2006. One last item before I turn it back over to Jay. There was an additional recovery from Scrushy in last year's results, which equated to $13 million. As a reminder to everybody, for the year, we recovered $48 million from Richard Scrushy, $35 million in the third quarter and $13 million in the fourth. With that I'll turn it back over to Jay.

Great. Thank you, John. Before we open it up for questions, I would like to touch on two issues: 75% rule and guidance for 2008. With respect to the 75% rule, the industry, including the American Hospital Association, the Federation of American Hospitals, the Medical Rehabilitation Provider's Association, and numerous physician, consumer, and advocacy groups all continue to work with congressional leaders to find a permanent fix to this regulation.

We're very pleased that 238 representatives and 61 senators have agreed to cosponsor bills in their respective chambers to permanently freeze the compliance threshold at 60%. As we have said previously, the ultimate disposition of the 75% rule is the prerogative of Congress and the President. So we are not going to opine on the ultimate outcome. However, we will continue to work with other industry leaders to ensure patients have continued access to high-quality inpatient rehabilitative care. With respect to guidance, we will provide full-year '08 guidance when we report our fourth quarter and year end results early next year, after the completion of our annual business plan process and after the expected resolution of the 75% rule.

I want to conclude by saying that I remain pleased with the progress we are making in repositioning this great company. Although we are smaller than we were a year ago, we're also stronger and more focused, with a well-defined strategy and a proven track record of accomplishments that underscores the successful execution of that strategy. We are proud of our leadership position as the preeminent provider of inpatient rehabilitative care and proud of our ability to grow market share, despite the considerable head wind associated with the 75% rule. Our focus on managing costs has resulted in significant reduction in G&A expense, and we will continue to evaluate our cost structure for additional savings.

Since December 31 of last year, we have reduced our long-term debt by approximately $1.4 billion, thereby reducing our annual interest expense by approximately $125 million and achieving our stated objective of deleveraging the company. By year end, we will have completed all settlement payments to the SEC, OIG, and DOJ, which along with the other steps we have taken will allow us to generate significant cash flow on a go-forward basis that will be invested for the benefit of our shareholders.

In summary, we continue to be encouraged by the fundamentals of our business, our leadership position in the industry, the progress we are making in rightsizing our corporate support structure, and most importantly by the dedication of our 22,000 full and part-time employees who make this such a great company. With that, operator, we are now ready to take questions.

Thank you. [OPERATOR INSTRUCTIONS] Your first question is from David MacDonald with SunTrust.

Good morning, guys.

Good morning, David.

A couple of questions for you. Can you guys give us a brief update on two things. One, on the derivative lawsuit, Jay, can you lay out timing there and what the process is from here and any early signs on willingness to settle or something like that? And then also, can you talk a little bit about the corporate campus, if the credit markets start to firm up again, is that still something you guys would look to sell, lease up, kind of what are the thoughts there?

Sure. I'm going to ask John Whittington, who's our General Counsel, to address the derivative litigation. With respect to the corporate campus, we continue to look for alternatives to market this campus. We are in the process of downsizing in the corporate campus. We've engaged a local architectural firm to help us with the space planning. We're going to be looking at an initial draft of that plan early next week and the goal will be to collapse into basically one floor of this building and then lease out the balance of that. We've engaged a local real estate company to help us do that. And then ultimately to market the total campus. Certainly we will be looking for ways and we'll be very diligent in looking for ways to unlock the value of the corporate campus, try to sell it for a price that we think is fair and reasonable, and then use the proceeds to pay down debt. With respect to the derivative action, I'll turn that over to John Whittington for his response.

Yes. David, basically, we have a claim against UBS, E&Y, and Richard Scrushy. All of the claims are basically the same claims. They're state common law claims founding in tort and breach of contract. The cases are all proceeding together and the trial judges have consolidated discovery to so that discovery is proceeding at the same time. The discovery deadline, I believe, is the end of April 2008. The first phase of discovery has been completed, which is the production of document stage.

The second stage is the deposition stage, and we are in the middle of the deposition stage right now. The E&Y action is an arbitration and it is tentatively set for arbitration in the summer of next year, and the UBS a jury trial here in Birmingham, Alabama, and it is not set for hearing yet, but we would expect it to be set immediately after the discovery deadline in the summer. So hopefully that case will go to trial in late summer, early fall. We continue to pursue these claims, as John Workman said, pretty aggressively and diligently because we think it's a good investment in our time and money.

Then, guys, just kind of big picture, if this were to run its full course, is 2009 still a good time frame in terms of when we should get resolution? And then if they were looking to settle, would that likely be kind of a late 2008 event? Am I thinking about those time frames correctly?

I think that it's kind of hard to judge the timing with any precision, because it is obviously tied up in a legal process. It's a very complicated set of litigation, but I think directionally, what you outlined is not unreasonable. Certainly, we don't have control of the process, and as I said, it is going to be very complicated, but I think that that time frame, should the parties be willing to settle sometime in mid- to late '08 would not be unreasonable. If it went to trial and we were able to get it resolved sometime in '09 would also be a reasonable time frame to expect.

Okay. Then just two last questions. One, a housekeeping question. Did you guys say the Source gain ran through the other income line?

Yes, that's where it's reflected.

Okay. And can you talk about the standardization program a little bit. Where we are with that process and some of the benefits on the sales side that you would expect to be able to accrue from standardizing some of your internal programs?

Yeah, I'll talk about that a little bit, David, then I'm going to insist that be your last question, if that's all right.

Sure.

As I think everybody knows, we embarked on an initiative that we're calling Teamworks. It's a moniker that we have given to our operational improvement initiative, which is a multi-year undertaking, looking at all aspects of our operations with the eye towards improving those by identifying and formalizing best practices, standardizing them, and then rolling them out across the entire platform. We began with two areas. One is the sales and marketing and the second is the nonclinical activities in our hospitals. The sales and marketing is designed to address the headwinds, both with the 75% rule as we step up to that new threshold, 65% and then 75%, and to just be more competitive in the sales and marketing process and bringing patients into our hospitals.

What we're not going to do, David, is identify sort of line item by line item how that's going to impact the P&L. Because as you know, there are always going to be other factors that come in and affect it negatively. I think that the goal, certainly, is to take our previously stated 1 to 2% same-store volume increase and use this investment and use these initiatives to ensure that we meet or exceed that stated goal. So it's very difficult at this point -- or not difficult. We are choosing not to provide any specific guidance with respect to the return on that investment. I think it's sufficient to say that all of the initiatives that we are undertaking are designed to meet or exceed the goals that we've set out for ourselves publicly.

Okay. Thanks, guys.

All right.

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

Good morning, Gary.

Thanks, good morning. Was hoping you could put a little bit more color on the bad debts. It came down nicely in the quarter. It sounds like you guys are pretty confident it will remain at the 1.3%. It looks like DSOs went up, at least the way I'm calculating them from 44 days last quarter to 49 days this quarter. Could you, kind of maybe on the relationship there? Maybe they're not related and there's a timing issue.

There's a good reason for that and I'll come to that. In terms of the bad debt experience overall, as we disclosed last year in the third quarter, as we were putting in the new Patcom system, we took some little higher charges both in the second and third quarter related to installation of that system, which is not inconsistent with typically installing most new systems. We took a fairly conservative tact. You also know we've taken a fairly conservative tact relative to the denials we've experienced in the past and reserved against those, and they've aged. So two things happened in the quarter, one of which is the denials instead of continuing to increase, as they had been, have kind of flattening out. Secondly, we have not had those additional charges to compare against in the current quarter, and we are seeing improved collections as a percent of revenue with our current system.

Now to get to your specific question about DSO, the CMS through its fiscal intermediaries ask hospitals to change their user numbers and password IDs. As a sequence of that, amounts didn't get paid in September that should have gotten paid. Not to be critical, but it happens to coin coincide with the government's year end, and we did receive those payments in October. We really had no impact on cash, rather than a spike at the end of the month from delay collections.

Any number that you can give us in terms of how much those payments were?

I would say in the 20, $25 million range.

Okay. And then I just want to verify one number that I think I heard you say. The G&A associated with the divested assets was $3.3 million?

I was saying that would be the normalization addback.

Okay, great. Thanks a lot.

You're welcome.

Thank you. Your next question is from Ann Hynes with Leerink Swann.

Good morning, Ann.

Hi, how are you? So if you look at -- I got a little lost when you were talking about the Q4 guidance, but if you look at this on the EBITDA basis, your guidance is $275 to $300 million, so if you take the $236 million, the first nine months and back out that gain, you get a $227 million run rate, which means you only have to do $73 million to get to the high end of your guidance, so besides labor, is there anything else we should be looking at from an expense side?

I think you're looking at two different concepts, Ann. The 275 to $300 we had expressed before was on a pure reported basis --

Yes.

-- as reported, whereas what we were doing in the other was trying to point people towards a more normalized run rate.

Okay.

So as we get to the fourth quarter of 2007, clearly G&A is going to be close to a more normalized run rate since we will have the divested divisions gone. Typically, we find that we start to see the savings in G&A about a month after the division is sold. So once it's gone, there's kind of a month of some sorting out of expenses and then we start to see the benefit. So clearly by the fourth quarter, those will be gone. So there were two different concepts there.

Okay. And if you focus on -- well, first the repurchase of the bonds, can you remind us what you can do annually with that in the open market?

Sure. We have a basket in the credit agreement that allows us to buy $50 million a year to repurchase bonds or equity in the credit agreement. We don't have that same flexibility in the bond indenture relative to equity. We also have a $100 million lifetime basket in the credit agreement that can be used for the repurchase of bonds. So basically we filled up our $50 million bucket here in September and October.

Okay. So when you look at free cash flow next year, how would you characterize your priorities versus debt repayments or consolidation? Does it really have to do with what happened to the 75% rule?

It does, it certainly does. And what we don't want to do is we don't want to lock ourselves into a particular strategy with respect to how we're going to use that excess cash flow. But certainly we're going to be looking for where we believe the greatest return is achievable.

At the current time, we still believe that there are some very nice investment opportunities out there with respect to new markets, new hospitals. We mentioned the CON that we filed up in Louden County, Virginia. We have others that we are looking at and I believe by the end of the year we should have another couple announcements with respect to development initiatives. So we'll be looking at the alternatives, we'll be balancing those, but we're just pleased we're in a position today, here it is November 6 and we're talking about how we're going to use excess cash flow. A year ago, the question was would we have it.

Yeah.

So we're just delighted to be in this position and feel very good going into 2008.

Okay, great. And just one more question for the bad debt run rate. You now think it's going to be this 1.3% of revenue?

I would say 1.3, 1.5 is an appropriate run rate for the bad debt.

Okay, great. Thank you.

Thank you. Your next question is from Scott Schimpf with Lehman Brothers.

Hey, Scott.

One quick clarification. On the $50 million basket, is it like a calendar annual basket or fiscal annual?

It's a calendar.

Okay, great. That was it. Thank you.

Okay.

Your next question is from Kemp Dolliver with Cowen & Company.

Hi, Kemp.

Hi. Just to follow-up on the free cash flow discussion, Jay, what are your thoughts regarding your development strategy at this point given the uncertainty about the 75% rule? You've been, I think, probably for the last, I'd say 90 days somewhat quiet given the pace that y'all had laid out for yourselves. Obviously, the uncertainty would be a factor there. So just wanted to see if you had any additional color you could lend to your thoughts?

Sure. The thoughts really are, as you suggested, bifurcated between 75% rule getting fixed, 75% rule not getting fixed. If the Congress and President decide that this rule needs to be amended and there's a fix to it, we believe that the growth strategy is going to be more a function of entering new markets with new hospitals and/or expanding our footprint in existing markets with new satellite hospitals. We'll always be looking at opportunities to acquire units or hospitals that are out there and that is going to be a constant no matter what happens.

On the other hand, if the rule does not get fixed, we do believe that there will be a consolidation play and we would be putting our development efforts and focus on rolling up existing markets where we already have a presence. And we believe that in that kind of environment, that makes the most sense because we will be able to do that with no cash outlays. As you know, when we bring our unit with another unit together, we value both, bring them together in a joint venture arrangement and then bring those operations of the competitor into our hospital and then operate it on a combined basis with no capital outlays.

So that's kind of our thinking and yes, there has been a little bit of uncertainty in the market because of the efforts in Washington but as I mentioned before, I'm pretty confident we'll have additional announcements in the fourth quarter with respect to other development opportunities that we're pursuing.

And I would just add, I think it's important that we think we have a strategy whichever way the 75% rule goes.

Yeah. No doubt.

So if the 75% rule is frozen, it will lean towards more de novos, continue to perhaps look at acquisitions, probably fewer consolidations. If it does not get frozen, clearly as we've indicated in the past, that means we're going to have some EBITDA hit in 2009, but we believe that will provide a lot more consolidation opportunities and probably a little less focus on de novos, still look at acquisitions that might be accretive. So we think we're positioned with the strategy for either direction.

That's great. On the two specific situations that you mentioned today. Question one, on the joint venture in Pennsylvania, what would be the timetable for that going definitive or closing? And then is there a competing facility in Louden County that presumably would fight you in CON?

There are competitors in Louden County. We do anticipate that that will be a contested CON, but we believe we're in a very good position to prevail in that process. With respect to the Pennsylvania opportunity, we hope to be able to make that definitive by the end of the year. That's great. Thanks.

Okay.

Thank you. Your next question is from John Ransom with Raymond James and Associates.

Hi, good morning. Just to probe a little bit on your future interest expense, could you give us a good estimate of where your term loan will be by end of the calendar year?

Term loans -- I mean, if you look at our existing debt structure after the tax recovery, we have a total of $2 billion worth of debt, $950 million of that being in our bonds.

Okay.

We have the other $30 million of bonds of unredeemed. So that would be 980. There's 950 left of the $1 billion issue of last year and $30 million of 10.75 bonds that were never tendered as far back as March of '06, so totaling $980. We have approximately $111 million in capitalized leases and the difference between the $2 billion and those two numbers is our term loan. And that's kind of where we expected to be at year end. There is a timing issue at year end. Our bond interest payments come due right before the end of the year, as does the final payment with CMS DOJ. So there may be some borrowings on the revolver, but we would characterize that as temporary.

Okay. What's your current -- taking into account all these swaps and whatnot, what's your current effective interest rate?

They're locked in the at LIBOR at 5.22, our current on the spread loan is 250 basis points above LIBOR.

Okay. So is there any realistic chance to, as you deleverage, to rework some of this bank debt and get a better rate?

We will be evaluating that in 2008. We did, as part of our permission to use the proceeds of the divestitures to pay down the term loan, we did negotiate a stepdown in the spread back in March of '07, which now looks fairly favorable to us and we were able to bring down our spread by 75 basis points. So if you look at LIBOR plus 250 today, if we're able to gain a one notch improvement from Moody's, we would get an additional 25-basis point reduction in our term loan spread, and through our discussion with other institutions, we think a similar rated issue that was coming up today would be more likely in the LIBOR plus 275 to LIBOR plus 300. So it's not necessarily favorable, but that's under the existing credit market situation. We will continue to evaluate that in 2008. But right now we have a -- we would kind of say we're maintaining the status quo, but we obviously have looked at taking out the bonds, our highest-cost debt in the past, but I think as everybody knows, those have a significant premium, close to $200 million and that would not be cost justified.

Okay. Thanks a lot.

You're welcome.

Thank you. Your next question is from [Darren Lieber] with Deutsche Bank.

Good morning. I wanted to ask you about your outpatient satellites, and if you could just comment, Jay, you did indicate that you continue to rationalize there. I want to get a sense of where you are with that process?

I think for the most part we have the portfolio that we will go with on a go-forward basis. I think we spent a lot of time this year looking pretty hard at those satellite facilities to determine their strategic fit and their financial contribution. That's not to say we won't close one or two or several in the year to come, but for the most part, we feel pretty confident that the platform that we have out there is the platform that we will go with into the future.

And this is John, I think it's important to add that we're not always just eliminating the outpatient satellite, sometimes we are consolidating it by moving it to the inpatient hospital or consolidating multiple units. So we're not necessarily making the service go away.

Sure.

We're trying to do reverse cannibalization, if you will, on existing sites.

Okay. I know it's relatively small, but could you just comment on the L-tax and their performance, just to give us a sense where you are. I know you've downsized there, but just trying to get a sense for that.

We have six today, we had ten 18 months ago. We think the six that we do have are those that we will keep. We still think, frankly, that it's a good business to be in. Unfortunately, as everyone knows, there's still a lot of uncertainty with respect to the regulatory environment and the future of L-tax, so we're sort of in a holding pattern, if you will. Those that we have are performing to our expectations, as you would expect. There are going to be some that are doing quite well and others that have opportunities for improvement.

But overall, we think that the six long-term acute care hospitals that we have are good hospitals. We like the quality that we're able to provide and we like the position in the marketplace and we certainly will be staying with them on a go-forward basis. We just won't be will becoming to add any new L-tax in the foreseeable future. Once the regulatory environment gets clarified, however, we said this previously, we definitely will be looking at growth opportunities in that space. But right now we think it's prudent to be on the sidelines, wait to see how things unfold and then make a decision once that clarity is obtained.

Okay. Thanks for that. Then just last question here is about the development. I know you commented a little bit on that. If you could just remind me where you are in looking at or pursuing other ancillary or post acute segments. I think that was pushed out somewhat, but if you could just remind us where you are on your thought process with that? Thanks.

Our thinking is that for the foreseeable future, and we really look at that as an '08 and '09 time frame in general, that there will be many opportunities in the IRS space to pursue. And that is, as John mentioned a minute ago, is going to be independent of whether or not the 75% rule gets resolved or not. We feel that if it gets resolved, then there are de novo opportunities. If it doesn't get resolved, there are consolidation opportunities with acquisitions always in the mix. However, longer term, and we see that as maybe '10 and beyond, once we have a balance sheet that can accommodate the expansion and the complementary services.

And once we have a better platform from which to build upon, I think it makes a lot of sense for us to look at other post acute services. When we do, there will be three basic criteria that we'll be looking at and evaluating those new services against. One would be a strategic fit. Does it make sense strategically? Number two would be whether or not there were sufficient synergies to warrant an acquisition and then obviously the third one would be do we have a balance sheet that has the capacity to be able to accommodate that kind of growth? So in summary, '08, '09, we look at that as primarily pursuing growth opportunities in the IRS space and then '010 and beyond, looking at other complementary post-acute services. Now if something were to come up next year and it was an extraordinary opportunity, would we look at I, certainly. We most definitely would. But in terms of the plan, what I outlined is our current thinking.

Great. Thanks for taking my questions. You bet.

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

Morning, guys. John, I may have missed it, but I think as of the second quarter, you guys were still owed some money from your asset sales. Did that come in in the quarter and did you apply that to debt paydown already?

It did not come in the in the third quarter, but it has been received subsequently and we are using that for some additional deleveraging, it's about $23 million.

$23 million, okay.

That just came in in the last few days.

Okay, great. Thanks. It looks like you were gaining some of the 10.75 in the quarter. I'm just wondering what that suggests if the floaters, if you were to use your basket again next year, do you use some of those, or do you save that for a tender down the road, what does that imply for the broader capital structure next year?

We'll monitor that, Mike, obviously. It had been our highest cost debt since it was a floater, since LIBOR is dropping, it's going to be close to the 10.75, was clearly the 10.75 fixed had the bigger hurdle not being culpable until 2011 at 105, which has the floaters are culpable in 2009, which is not too far out of and you heard the conversation around the potential dividend proceeds around the Ernst and Young, UBS, and Richard Scrushy outcome that that might time very well with the timing when those floaters would be culpable.

Sure, got you.

We're more focused on the ones that are harder to get out than perhaps the floaters right now.

That makes sense. The last one is on the G&A ratio. Obviously it's come down as a dollar amount. I'm just confused by one ratio. You talk about if you add in the discontinued revenue, the G&A ratio for the quarter would be about 5.8%. That looks to be up sequentially from 5.1% in Q2 and I would have expected that to trend the other way.

That's a good question. It was year-to-date that I was using and it was 5.6%. The third quarter is perhaps a little bit more disjointed relative to G&A, only because we disposed of certain segments in the third quarter and so typically we had had all of those segments in the quarter and we were able to take the total G&A relative to the revenues that were reported in that same quarter. In the third quarter, because the G&A goes away typically a month after the disposal of the segment, we were faced with the revenues on the discontinued operations not being there in the third quarter, yet we had G&A costs relative to discontinued businesses. All I was doing is a saying a better proxy would be to use the year-to-date G&A as a percent of year-to-date revenues to normalize G&A. Having said that, I remind you that our goal is to get to 4.75% of net patient revenues, excluding 123R costs. And 123R costs are about $2 million a quarter. So that is our goal, and we think we're making progress in the right direction towards that goal and it's clearly one that we're focused on as we go through the '08 budget process.

To clarify that, we have said previously that the goal would be to get there as we exit '08 and we feel very confident that we will be able to meet or exceed that target.

Okay, thanks, guys.

Thank you. Your next question is from Miles Highsmith with Credit Suisse.

Thanks, guys. I know this falls on some of the same comments, but back to the bonds again. If I'm kind of just looking at it in terms of like hypothetically drawing the credit facility to repay bonds can be pretty accretive to EPS, even at higher levels. I'm trying to understand what may create a need to not do that, I guess, in terms of the basket that you have. I know we've talked about some potential growth opportunities, maybe you want to keep some dry powder for that. I'm just wondering if it's that type of thing or if you need some flexibility with respect to calling the floaters in 2009. And without that, why wouldn't you continue to use that 100 -- use the 50 for next year and use the 100 lifetime basket that you have? Thanks.

I think we try to take a fairly disciplined approach to looking at those alternatives. What happened was we were going to become more comfortable, we were going to take the recovery, and it was going to be more significant than it was going to be at the end of the second quarter. We were able to go out and buy the bonds attractively. If you look at buying the bonds that we purchase in the open market, at less than their call price, which isn't until 2011, we think that's pretty attractive. So we know the calculation. We know how to run the net present value calculation and the price, but I think we'regoing to be fairly disciplined about the approach that we take and the credit market's having volatility may provide some opportunities. So we will continue to take a disciplined approach. We have another basket of $50 million available to us in '07 and as you said the --

'08.

I'm sorry, in '08. And we have the $100 million lifetime basket that still exists also. We have that $30 million, Miles, that I mentioned at the 10.75 that comes due in October of '08. That's a natural, we can buy those back at par. So that's one we will look at that's to us more of a no-brainer. But we will be looking at those and we don't want to overpay.

Great. Thanks a lot.

Okay.

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

Good morning, Rob.

Good morning. I got a couple of questions. One, I guess, kind of a strategic question. You guys have done a lot with systems in the last year or so. Can you kind of go over what systems you've put in what you still have to add and then maybe how this might relate to the G&A number and whether there might be, whether the decisions you've been putting in have been performing a little better than expected given the higher ROI and whether that might be reflected in the G&A number next year?

It's best to go back and remember what we inherited was a company with no infrastructure whatsoever. We had four divisions and 23 billing and collection systems, in inpatient alone, we had four. When you're looking at this business, billings and collections times a multiple of five or ten is the most important item. And that's the one we focused in in the inpatient division. We put in the new system that was installed in late '06 putting all the hospitals on a common platform, that's a plus. We put in place a stopgap or a bridge piece of software on supply chain in early '06.

As we've said, we're installing a new generation of PeopleSoft or the latest release, that's our ERP, and that brings with it some additional functionality that we do not have today and we cannot avail ourselves. That would be a very old system that was very customized and it itself may have a little bit more functionality, but we would be frightened to try to turn it on because of all the changes we've made. So what we've decided to do is move to the new system on as-is and that should come in place on 1/1/08 and with it, it has a suite of products that allow for some additional functionality which should improve the company going forward and we'll be looking at those in '08. Those are things like the accounts payable module, purchase order management, asset management, a lot of those things come with the human resources, a lot of those come with the new suite that we will have available to us and we'll be working on in '08.

That should, number one, improve the platform and will likely give us a chance to hold G&A costs down, so we don't perhaps have the same inflationary impacts and we might have some opportunity, but it's basically installing infrastructure that was just never there in the past and what the company needs on a move-forward basis. I think our one big expenditure is clinical systems. And maybe Jay wants to talk about that a second.

Rob, as you probably know, we currently do not have a clinical information system in our hospitals. What we're doing this year and we will continue to work on this into 2008 is to bring all of our hospitals on to a common platform of manually recording and following the clinical information system, so that we can look at it from a standardized perspective so that we are then ready to bring in some kind of automated clinical information system. We do not see that as a 2008 event. We see that as a 2009 expenditure. If we go that route, it is going to be expensive.

We are looking at the costs, we're evaluating systems. Unfortunately, there aren't a lot of off the shelf systems for rehabilitative care, so we want to be pretty careful as we evaluate the alternative, but step one is take the 94 hospitals and the 94 different ways of recording clinical information and the 94 different nomenclatures that we have out there and bringing that to one standard. And that we are undertaking today. We'll be doing that through next year and at the same time then we'll use next year as the year that we evaluate those systems that are out there and then make a determination, can we afford it and what is the magnitude of that undertaking and what's the timing.

I think that's the one that's out there, Rob. I think, otherwise, we're following a natural evolution of a company that had nothing to try to move forward and build the right platform, putting all of the hospitals on one billing and collection platform actually was kind of a necessary platform to accommodate the standardization process that we're going through right now in terms of sales and marketing that Jay mentioned earlier also. So that's a plus for that. So we will be looking at incrementalizing off of our platforms including the new PeopleSoft platform, which also has a module, again, they're not specific to rehabilitation hospitals, as to labor scheduling and staffing schedules, and We'll be looking at that in 2008.

Thank you. You guys, it looks like the client case growth, at least on a lag basis, was very strong. You mentioned you're getting some traction both on the managed care side and the hospital's marketing. Can you go into that, how the marketing's working out and how you think that's going to lead into next year?

The way it's working out is we are looking to, as we said before with this Teamworks initiative, and we've started to roll this out in several of our markets, having pressure tested it and piloted it earlier this year, is to just standardize the process by which we are able to identify a patient who has the potential for needing rehabilitative care, working with the case managers in the acute care hospitals to streamline the admission process. And the objective of this, as I mentioned before, is to help ensure that we meet or exceed the stated goal of a 1 to 2% same-store steady state volume growth that we think is achievable. Obviously, we want to exceed that, but as I mentioned before, there are always going to be headwinds in the market and what we donate want to do is we don't want to try to dissect out one initiative and try to sculpt that and scale that and then add that on to what we were already doing. It's just part of the management of this business and part of what we're trying to do to bring new patients in and drive top line growth. To as I said before, either meet or exceed the targets that we'd set out for ourselves and that we'd communicated publicly.

All right, thanks.

I don't know if that answers your question or not?

If I may kind of paraphrase it, it sounds like this is kind of the standardization process that you've already kind of covered a little bit and it's kind of rolling in as a component of that and it's working, would that be the right way to look at it?

I think so. I think that we have always prided ourselves on being the differentiating force in a market. Because all we do is provide inpatient rehabilitative care. Most of the competitors out there are are departments of or units of in a an acute care hospital and it's one of many services they provide. Typically, it is not one of their core services, as you know, acute care hospitals tend to focus on cardiac and orthopedics, cardiology, obstetrics and rehabilitation is a bit of an afterthought. In our case, we focus exclusively on inpatient rehabilitative care and we've always had an industry-leading position with respect to strokes, with respect to brain injury and other neurological problems. So that, I think, has helped us in this environment the 75% rule environment. The fact that we are investing in this standardization and best practice Teamworks initiative, I think is of then adding some additional benefit and allows us to differentiate ourselves even greater from our competition.

Thanks. I'll jump back in the queue but probably follow up with you guys later on with a couple other issues.

Okay, operator?

We have time left from one more question from Andreas Dirnagl with JPMorgan.

Can you give some commentary with with a went on in the quarter, specifically with the growth in other third party?

The other third party is primarily the increase in managed care Medicare products and we are seeing that in some of our markets. That's why you saw the corresponding drop in the Medicare mix. So it's still Medicare, but we record that in a different line. And most of that's occurring out west.

Okay, great. So specifically, it's not out of network increases?

No. No, no.

Okay, great. Maybe you could also just comment. I know in the past you've tended to be a little more conservative when looking at compliant case growth, which is why in previous quarters it's come in a little bit lower than your own [ inaudible ] presumptive method. What does it look like your internal calces in 3Q and what's your overall compliance at the moment?

Our overall compliance is in that 62, 63% range and as you know, we are moving -- we have nine hospitals that moved up to the 65th percentile on July 1 and if you look at our internal for Q3, it was closer to 3.8, 4%, somewhere in that range.

Okay, great. Still a great improvement.

Yes, we feel pretty good about it.

Okay. We've talked about or you've made some comments on the Medicare fix or the 75% rule. You've kind of dropped, as we tend to do also boast 60 and 65% freeze into your commentary. Can you give a little color and comment on where you think it's headed at this point?

No. Only because we don't want to in any way get in the way of the legislative process. We respect the fact that this is the prerogative of congress. We know that there is very good deep bipartisan support to do something to fix this rule. As you know, there are a lot of different issues that are being discussed. The house, for the most part, has done their work. I think they're looking for the Senate and some kind of Medicare package from the Senate and then obviously it would have to go to conference and work out some compromises.

But we are very encouraged that legislative leaders on both sides of the aisle in both houses recognize that this rule, while presumably well intentioned, has far exceeded any of the initial projections by CMS or by anybody with respect to Medicare beneficiaries access to inpatient rehabilitative care. So we don't want to opine on how this is going to be resolved. I think it's fair to say that we, along with others, believe that it will get resolved one way or the other in 2008 -- excuse me, in 2007.

The reason we say that is because as we go into 2008, it's an election year, we don't think that there's going to be much appetite for any kind of Medicare legislation to be introduced and voted on NX year and as we all know, if nothing is done this year, the rule goes to 75% on July 1 of 2008. At that time, the genie will be out of the bottle and I think it will be very difficult to put it back in. And I think congressional leaders understand that. And I also think that they understand this is a policy issue. This is not a pricing issue. This is a policy issue. And because it is a policy issue and not a payment issue, it really does need to be addressed and addressed permanently and addressed permanently this year. And there appears to be some very good strong support to do that and we'll continue to work with the industry to try to affect that change.

Okay, great. Now, you've said that you're kind of using your words in a holding pattern, obviously based on the outcome of the 75% rule and I'll kind of paraphrase, with basically the idea for X organic growth to either go in a development direction or in more of an acquisition direction based on whether or not you get the freeze. Does that sort of decision to go development versus acquisition also hinge on 60 versus 65%? In other words, if it's frozen at 65%, do you still think there's going to be contraction in the industry overall?

I think if it goes to 65%, there'll be more pressure on many of our competitors and they will really have to look hard at their units to determine whether or not there might be a higher, better use for those beds. Remembering that when I say that, their competitors are acute care hospitals with the rehab unit inside the four walls of their hospitals. So I think that if it goes to 65%, while we're not goin to be certainly supporting that, we believe that a 60% freeze is where it ought to ultimately come out. If it went to 65%, we do believe that it will put more pressure on our competitors. I think there would be a consolidation and I think that many units, frankly, would decide to go out of business.

Okay, great. Thanks a lot.

All right. Well, thank everyone for participating on this call and thank you for your support of HealthSouth.

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