Encompass Health Corp (EHC) 2007 Q4 法說會逐字稿

Good morning. I'll be your conference Operator today. At this time I'd like to welcome everyone to the Healthsouth Corporation fourth quarter and full year 2007 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer period. (OPERATOR INSTRUCTIONS) Thank you.

It is now my pleasure to turn the floor over to your host, Jay Grinney, President and Chief Executive Officer, sir, you may begin your conference.

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

Thank you, Jay. There are a number of disclaimers, risk factors and other cautionary statements set fourth in the Form 10-K we will be filing with the SEC later today, and in the press release we filed yesterday in connection with the filing of our Form 10-K. We will not the review these disclaimers, risk factors and other cautionary statements, however, we urge you to read them carefully. I would, however like to highlight the following: Some of the information provided today may include certain estimates, projections, guidance, 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, guidance 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 risk, uncertainties and other factors, many of which are beyond our control that may cause actual results to differ materially from the views, beliefs, estimates, and guidance expressed here today. All such estimates, projections, guidance and other forward-looking information speak only as of the date hereof. Healthsouth undertakes no duty to publicly update or revise such projections, guidance, or other forward-looking information, whether as a result of new information, future events, or otherwise.

Great, thank you, John. I trust that everyone has had a chance to review our fourth quarter earnings release, which we sent out last evening. You'll note that in addition to summarizing the results of the fourth quarter, we also provided 2008 guidance for some key operating and financial metrics. We'll cover both of these on today's call.

As you saw, we ended 2007 with a solid quarter. Volume growth, top line growth, and EBITDA growth all create, we believe, an excellent platform and good momentum going into 2008. Our discharges in the quarter were up just under 1% compared to the fourth quarter of 2006 and showed a 1.9% sequential improvement from the third quarter of 2007. We achieved these results despite weakness in acute care admissions in some of our markets, and headwinds from the 75% rule. Specifically, we have nine hospitals that were operating under the 65% compliance threshold in the fourth quarter of 2007 compared to the 60% threshold the previous year, which created challenging year-over-year comparisons. Additionally, 67 of our hospitals were preparing to move to the 65% compliance threshold on January 1, and as a result, were forced to deny admissions to ensure they began the New Year at the correct compliance level.

Fortunately, public law 110-173, the Medicare, Medicaid, and State Children's health program extension act of 2007 was signed into law on December 29. As you know, we worked hard as a Company and an industry to achieve this. This law permanently sets the compliance threshold at 60% and allows co-morbidities to be considered when determining a patients qualification status under the rule.

As we've indicated previously, we regard this law as a significant positive for the Company. It removed the single biggest uncertainty facing the Company and our industry. It allows us to provide needed high quality rehabilitative care to more patients who require this care and it significantly enhances the predictability of our business on a go forward basis, something I'm certain investors will appreciate. Our discharge growth coupled with good unit pricing increased consolidated net operating revenues by 3.8% in the quarter to $439 million. Importantly, our inpatient net operating revenues were up 4.6% compared to the same quarter of 2006.

Our efforts to manage cost have also been successful. Total operating expenses were 1.5% less than the comparable period a year ago driven primarily by our management of supply, occupancy, and bad debt expenses, as well as lower professional fees as we concluded most of our restructuring activities. Our ability to reduce our non-labor expenses allowed us to invest in our employees. We invested through our annual merit increase program, which is effective October 1, of each year, for all employees, except senior officers, and by significantly enhancing our benefit package by increasing the match to our 401(k) plan, providing benefits for part time employees, providing more choices in our benefit selections and not passing on to our employees the increase in our medical benefit costs. All were done to retain existing employees and recruit new members of the Healthsouth team. Objectives that are especially important as we seek to attract more patients to our hospitals.

Finally, EBITDA for the quarter came in at $87.1 million. As noted on page 10, of the earnings release, there was one non-recurring item in the fourth quarter of last year, a recovery of $12.8 million in bonuses from the Company's former CEO. If you back out this recovery from the fourth quarter of 2006, EBITDA would have increased by over 21% quarter-over-quarter. With that, I'd like to ask John Workman to walk you through the numbers for the quarter.

Thank you, Jay. First I will walk through the income statement. Regarding revenues, as Jay mentioned our inpatient revenues increased by 4.6% over last year. The fourth quarter did have the benefit of the October 1, 2007, price increase that will go away in the second through fourth quarters of 2008. Outpatient revenues were down 1.9% with 21 fewer satellites than a year ago. Regarding operating expenses, I will comment first on those that are primarily hospital related. Salaries and benefits increased as a percent of revenue by 150 basis points over the same quarter a year ago. Merit increases to all employees other than senior officers were effective October 1, 2007, and are part of that increase.

Next, combining the three captions, other operating expenses, supplies, and occupancy costs, which are all generally hospital related, you see that these costs total $87.5 million this quarter versus $90.1 million a year ago. As a percent of revenue this equates to 140 basis points decline meaning we were largely able to offset the increase in wages in the fourth quarter of 2007. The provision for bad debts was extremely favorable compared to a year ago. Last year we had just finished converting all billing and collection activity into one new platform.

Turning next to other operating expenses, general and administrative expenses included $2.5 million for 123 R cost. Excluding this brings G&A expenses to $25.2 million or 5.7% of revenue. This amount does include some residual costs related to the divested divisions but is minimal in the 1 million to $2 million range. To achieve our goal of 4.75% of revenues by the end of 2008, we will need additional reductions of about 10 million to $12 million. The sale of the corporate campus that has been announced along with organizational changes that we're making in the fourth quarter and that will be made in the first quarter of 2008 should allow us to achieve this target by the end of 2008.

Relative to government and class action expense, this is non-cash, and relates to marking to market the 5 million shares of common stock and 8.2 million warrant with a 41.40 strike price that we agreed to contribute as part of litigation settlement. The remaining amount is $230 million that is on our balance sheet that is due from the insurance companies but that's offset by a comparable receivable on our balance sheet. We will be required to mark the shares and warrants to market until these are distributed to the plaintiffs. Last year by reference the mark-to-market adjustment was a $ 31 million credit compared to the $31 million charge that exists this year.

Next, turning to the caption of professional fees. In 2007, these primarily relate to legal fees being incurred in pursuit of derivative claims against Ernst & Young, Richard Scrushy, and UBS, with some small portion attributable to the tax recovery that we received in the fourth quarter. Next, I'd like to address the items below operating expenses. The loss on early extinguishment of debt primarily relates to the write-off of debt discounts and fees on debt repaid from a receipt of the tax recovery. Second, we had a non-cash charge on our $1.1 billion interest rate swap of $23.6 million due to the drop in LIBOR. As LIBOR has continued to decline, there will likely be a similar charge in the first quarter of 2008. A lower LIBOR will allow us to reduce our cash interest payments but will largely be offset by cash payments we will need to make under the swap arrangement.

Next, turning to taxes. They were a benefit in the quarter as we recognized the remaining refunds we expect to receive. And a final comment on the income statement, if we exclude the government and class action charge, the mark-to-market, the professional fees, and the loss on the interest rate swap, we were basically at breakeven for the quarter on a pre-tax basis which is a strong accomplishment for Healthsouth.

Next, addressing the adjusted consolidated EBITDA. As Jay referenced this is reflected on page 10 of the press release and profiles adjusted consolidated EBITDA of $87.1 million in the fourth quarter of 2007. This compares to $84.4 million a year ago, but last year included $12.8 million of recovery of amounts from Richards Scrushy. Eliminating that from last year results in a significant improvement quarter-over-quarter. One comment I would make for those of you who are trying to annualize the fourth quarter of 2007 to gauge 2008, I would remind you we had a price increase in the fourth quarter of 2007 which will go away in the last three quarters of 2008.

Next, turning to some balance sheet and other information , and looking first at our long term debt, the tax recovery we received in October was used to reduce our total debt to $2.042 billion, as of the end of the fourth quarter. Our total debt reduction during 2007 was $1.334 billion. In addition, we made our final payments due to the SEC and the DOJ and CMS in 2007. These payments were $139 million for the full year 2007 on the principal portion. Capital expenditures in the fourth quarter were $14 million. As to non-operating cash flows that we continue to expect to receive, we expect to receive $43.5 million for the sale of the campus in the first part of 2008. The tax recovery reflected on our balance sheet is expected in 2009, though we will be attempting collect it as quickly as possible. And lastly, the derivative proceeds from the litigation for which we are spending legal fees against UBS, Ernst & Young and Richard Scrushy in an attempt to recover moneys, while we cannot provide guidance as to the amount or exact timing of these proceeds we believe the amount to be significant.

Next I'd like to talk about cash flow for the quarter. In looking at cash flow for the fourth quarter starting with adjusted consolidated EBITDA of $87 million, our cash interest payments were $50 million, and as I previously mentioned, CapEx was $14 million in the quarter. This left $23 million available to the Company for other purposes in the fourth quarter of 2007. As a reminder, we have NOLs on our future deductions in excess of $2.5 billion that will shelter future taxable income of the Company for many years to come.

Before I turn it back over to Jay and Jay is going to walk you through the 2008 guidance, I did want to mention some cash flow elements regarding 2008. First, from a cash flow perspective, if you take the mid point of the adjusted consolidated EBITDA range of $328 million, we would expect interest expense on a cash basis due to lower LIBOR to be approximately $175 million, and while you'll see that we believe that the budget for 2008 is 50 million to $85 million total for CapEx, we would characterize $40 million of that as maintenance CapEx. So backing off the 175 and the 40, leaves us available cash for deleveraging and future investment of $113 million. There will be some payments on the interest rate swap but I can't determine those with certainty at this point in time.

Next I'd like to talk about the share count. Primary shares are 78.6 million shares. For diluted shares we're using 91.9 million. The diluted shares include the convertible preferred as if all shares were converted which would equate to approximately 13.1 million shares which is quite easily the $400 million of convertible preferred stock divided by the $30.50 per share strike price. It does not include the shares for the shareholder litigation. Those 5 million shares will only come into the share count once those are issued. I would remind you that that's a liability on our balance sheet so there will be a corresponding reduction in that liability and in addition to paid in capital when that occurs. So if you look at the cash flow being North of $100 million and look at the share count, clearly the available cash flow even after swap payments is North of $1 per share which I think indicates a strong cash flow characteristics of Healthsouth. And with that I'll turn it back over to

Great. Thank you, John. Before we take questions, I want to address guidance for 2008. As a reminder, effective April 1, of this year, and extending until the end of the third quarter of 2009, our Medicare pricing will be rolled back to rates similar to those we received in the third quarter of 2007. As everyone knows this pricing roll back was a component of Public Law 110-173 and was intended to help pay for this legislation. While we anticipate this roll back will have a negative impact to our top line in the range of 25 million to $30 million in 2008, this short-term revenue hit is more than offset by the benefits of the permanently lowered compliance threshold and the inclusion of co-morbidities as qualifying admissions criteria.

I'd now like to direct everyone's attention to page four of the earnings release sew with can walk through the items that the will need to be considered when evaluating our '08 guidance. As noted on page four, there are two non-recurring items that will affect our earnings in 2008 but not in subsequent years. The first item is approximately $8 million of consulting costs associated with our Teamworks initiative. This expense will show up in professional fees and will be incurred in the first three quarters of 2008 on a fairly evenly distributed basis. As we've discussed in the past, Teamworks is the name of our Companywide initiative of identifying best practices across a wide spectrum of operational activities and then standardizing these best practices in all of our hospitals. This $8 million is an investment in our volume building strategies that we believe will help us gain market share in 2008 and beyond, but will have a near term negative EBITDA impact in 2008.

The second item is approximately $10 million in accelerated depreciation resulting from the sale of our Corporate Campus. This sale is expected to close by the end of the first quarter, which is when we will take this charge. Obviously, since it's a depreciation expense, it does not affect EBITDA or cash flow, but will have a negative impact on 2008's earnings per share. Also on page four of the earnings release, is a reminder that we expect to incur approximately $25 million in professional fees related to the derivative litigation and the pursuit of additional income tax recoveries. While we anticipate incurring some additional professional fees related to the derivative litigation in 2009, at this time, we expect these costs to be significantly lower, perhaps in the 10 million to $15 million range. And we think these professional fee investments are appropriate given the strength of our legal cases and the recoveries possible for our shareholders.

With these items in mind, we anticipate discharges will grow in the 2 to 4% range in 2008, with more of this growth occurring later in the year as we complete the rollout of our Teamworks sales and marketing initiative. Net operating revenues are expected to be in the 1.8 billion to $1.85 billion range which factors in this anticipated volume growth and the pricing roll back I mentioned earlier. Adjusted consolidated EBITDA is expected to be in the range of 320 million to $335 million. However, if you add back the $8 million one-time Teamworks consulting fee, normalized 2008 EBITDA would be in the 328 million to $343 million range. Our ability to achieve the higher end of this range will be predicated on our continued ability to execute on our volume building strategies and to manage our operating costs. Finally, our as reported earnings per share is projected to be between a loss of $0.08 a share to breakeven. However, if you add back the one-time $10 million in accelerated depreciation and the $25 million in restructuring costs, our normalized EPS is projected to be between $0.30 and $0.38 per share, and as John just mentioned, and as we note in the release, these EPS estimates are calculated on a fully diluted basis using approximately 92 million shares.

It is important to note that as John mentioned our EPS guidance does not take into consideration any mark-to-market adjustments we may take in 2008 related to our securities litigation liabilities, nor does it incorporate any gains or losses associated with our interest rate swap. It's also important to note that we are only going to provide annual guidance and will not be giving quarterly projections. Like a lot a lot of other companies, we believe chasing quarterly numbers is not a good use of managements time and undermines the focus on what the we believe to be a healthier, long term outlook on our business. Our ongoing priorities will be deleveraging our balance sheet and continuing to build a platform for growth. As John indicated we anticipate generating a significant amount of free cash flow beginning in 2008. Free cash flow is a key metric for this management team and has been incorporated into our senior management bonus plan at both the corporate and operational levels. The primary use of this free cash flow will be to repay debt and deleverage our balance sheet.

As we have stated previously, our goal is to achieve a leverage ratio in the 4.5 times range by the end of 2010. We plan on achieving this through operating cash flow as well as non-operating cash inflows from additional tax recoveries and derivative proceeds. We also believe there will be sufficient resources to add new hospitals. Our goal is to add between five and eight new hospitals a year, either through market consolidations, new hospital construction, or acquisitions of other freestanding IRF's. Fortunately, any market consolidations we consummate are not expected to require cash. And in the near term, we will fund de novos using off balance sheet financing which will require only a modest amount of our cash. And acquisitions will be considered and pursued only if they generate a superior return for shareholders.

In summary, with 2007 behind us, I am pleased to be able to declare our turnaround complete and now look forward to bringing Healthsouth to the next level. We have made significant progress in executing against our strategic plans and we will continue to do so. Over the last three and a half years, we have been tested and we have emerged a stronger, more talented and more efficient provider. You have my committment and that of this management team, that we understand the importance of delivering results for our shareholders. And we look forward to doing so over the coming year and into the future. With that, Operator, we'll open the lines for questions.

Thank you. (OPERATOR INSTRUCTIONS) Your first question is from Ann Hynes with Leerink Swann. Please go ahead.

Good morning.

Good morning, Ann.

So on the volume growth in the quarter I was actually surprised it was so strong. I expected negative, just because one, hospital acute care volume the were so weak and two, you're ramping up so what were you seeing in your markets that actually produced volume growth?

Well, as you know, Ann, we have been focusing on taking market share for the last three years and in the middle of 2007, we launched our Teamworks initiative. Clearly, we have a lot more hospitals to roll this out to, but we did start to see some of that improvement in the fourth quarter, and as we move into the first quarter, we are very encouraged by the results that we're seeing.

Okay, and when you look at 2008, I guess you look at your hospitals, they've been positioned to almost shrink volume to meet the criteria for the 75% rule and you almost have to change your entire strategy now from shrinkage to growth, so I guess how are you doing that on a hospital to hospital basis and with your team and I guess it's such a change from the past two years.

That is a great observation, and from a cultural standpoint, that's probably the biggest challenge that we face because as you correctly point out, the industry over the last three years with the 75% rule has been shrinking considerably. We felt very good about the fact that we kept our head above water and on a relative basis, did much better than our competitors but as we go into 2008, clearly, our focus at the corporate office and definitely at the hospital level is to grow volumes, to bring more patients in, and to ensure that we continue to provide high quality care.

We recognized back in early 2007 that either the rule is going to get changed by the end of 2007 or it wasn't, but in either case, focusing on volume growth was going to be paramount to our long term success, and that's precisely why we then developed this Teamworks initiative and I think what's important and it gets to the heart of your question, what's important to keep in mind is that this Teamworks initiative is consultant enhanced, and facilitated but the product is ours. What we did is we went out and we looked at I guess about 15 hospitals across the country. We mapped in excruciating detail every step of the process of identifying a patient as a potential referral to the point that they get placed into a bed for care, mapped that out, had then teams from across the Company come in and break that process down into its very discrete parts and rebuild that into a Healthsouth driven Healthsouth best practice which allowed us to then roll this out across all of our hospitals in a way that wasn't sort of a consultant saying, here is what you're going to do. It's us saying, here is what we can do, so what the we've seen has been incredibly gratifying that our hospitals, not only the patient care providers but also the sales and marketing teams, the CEOs, the Chief Nursing Officers have all embraced this notion that volume building and bringing more patients in is really the most critical success factor that we can focus on. So sorry for the long winded response, but it really gets to the heart of where we're going to either rise or fall over the next several years. We think it's going to be positive. We think that the results in the first quarter are very encouraging. Six weeks a quarter doesn't make but we feel pretty good about the start to the year.

Okay, and just on the volume question, in Q4, did you see any of your competitors maybe reducing capacity, thinking the rule wouldn't be frozen or anything like that?

Not really, Ann.

Okay.

There may have been some isolated situations but we really didn't see many closures or units being taken from 20 beds down to 15 beds.

Okay.

Ann, just one other comment on that volume. As you said, this is a dynamic change that had to be made very quickly with the change in the rule December 29, so we are ramping up and I would expect the volumes you will not see as strong volumes obviously in the first quarter as we expect to develop throughout the rest of the year, so that's a key element and then secondly don't underestimate that investment in people. Obviously we can't handle the added volumes without the people, so some of the investments that we decided to make are conscientious decisions so we had the people to handle the patient load. Great, thank you.

All right

Thank you. Your next question come is from Adam Feinstein with Lehman Brothers.

Thank you, good morning, everyone.

Morning, Adam.

A few questions here just real quick, a couple things I want to clarify, on the guidance, you said the $8 million will show up within professional fees but will you be breaking that out each quarter so we can track that?

No, and it's really, there's two categories of professional fees, Adam. I'm glad you asked that question. One is the professional fees of the $25 million which are the legal costs in pursuit of the UBS, Ernst & Young litigation and those we would characterize as non-recurring. The Teamworks fees are going to be included in an internal ledger account that is professional fees which would include things like our audit fees to PriceWaterhouseCooper, our normal legal fees so it will be grouped in that bucket of professional fees, that is in the other operating expense number but it was not our intent to break it out but I think for lack of any other purposes you can assume it's fairly even throughout primarily the first three quarters of 2008.

Yes, and we're not going to break that out. It's really an investment that we're making. It, as John said, will be evenly distributed through the first three quarters. I think you can certainly model that but the return on that investment is going to be evidenced in our ability to get at the top end of that volume guidance range.

Okay, and then just another question here, just with respect to the guidance. So Jay, you talked about five to eight hospitals so what's factored into the guidance for those five to eight hospitals in terms of additional facilities you plan to have in the future?

I'm sorry, I'm not sure I understood the question.

Right. You had said that your goal is to add five to eight hospitals per year so within the guidance you gave for '08 what does it incorporate in terms of those five to eight hospitals? Is there a revenue impact associated with that?

There will be additional revenues and earnings from the new hospitals. We are not going to be breaking that out. Most of those are going to be either consolidations we do have a couple of hospitals that we have launched, those new hospitals are not going to be opening, primarily those will be coming in through consolidations.

But we would tell you, in '08 it's a pretty minimal number, Adam, in terms of the earnings perspective.

Yes.

And the reason we would say that is because what we're in control of is de novos.

Right.

As you know, those take some time to build up and to add to earnings. What we can't predict for you is as Jay said if there's an opportunistic acquisition of a freestanding hospital, that would be accretive to earnings and adding EBITDA right away that would make a wise investment, we done have any of those built in basically at this point in time.

Okay.

Don't know that we have one yet either.

Sure and then just with respect to just the volume growth, as noted earlier, it was a very good number. I know you had said that with just the 60% threshold getting finalized at the end of the year, we won't see the full impact in the first quarter of 2008, but just as we think about that ramp up, throughout the year here, just so can you just help us in terms of thinking about just the magnitude of the first half of the year relative to the second half of the year? I know you don't want to put numbers around that but just in terms of just the, as we think about the revenue build up I guess just want to make sure we had the seasonality correct.

Yes, and I think that the seasonality will be pretty close to what we've seen in the past in terms of first and second quarter being stronger, third is being a little weaker and then fourth ticks up again. But I don't want to get anybody too far off on the first quarter, we started the year and the quarter soft coming out of the Christmas holidays and that's clearly going to have an impact but we have been very encouraged by the volume that we saw in the balance of January, the volume that we're seeing in February, so the growth will be a little bit more at the end of the year, clearly because we expect all of our hospitals to be out on this Teamworks platform by the end of the third quarter, so clearly, there's going to be more of that on the tail end but I don't want anybody to be thinking that the first quarter is going to be soft on volume. I mean, we're pretty pleased with what we're seeing.

I mean there's two questions that you asked, Adam. One was seasonality which Jay answered and the second one is the result of the Teamworks and the rollout, and as we said, that will be building, and being rolled out to all hospitals throughout the balance of '08, so there are two dynamics there that are a little bit different.

Okay, great. Thank you for the clarity and great job here.

Great, thank you, Adam.

Thank you. Your next question is from Gary Lieberman with Stanford Group. Please go ahead.

Thanks, good morning.

Good morning, Gary.

I'm not sure if you gave it and I missed it, but you've given it in the past, was hoping you could give some numbers around the compliant case growth. I guess you've used what you felt the presumptive method in the past?

Actually we didn't give that in part because now we're looking at sort of the total volume picture, but in the quarter, it looks like we were up about 5% and looking, excuse me, that was for the third quarter because remember, there's a quarter lag. We were up 5% and the rest of the industry exclusive of Healthsouth and using the UDS data system, which I think we've talked about that in the past, that's where abouts 65% plus or minus of all of the other IRFs was down 2%, so again, we wanted to -- back in '07 we started presenting compliant case on a UDS basis and we were up 5% the rest of the industry was down 2%.

And any guess where the compliant growth would have been in the fourth quarter?

My guess is that compliant case growth in the fourth quarter might have been a little bit softer than that but probably not a whole lot. I mean, we've been tracking that--.

In the same zone.

The delta to the industry would have probably remained similar but I think as Jay talked about, Gary, you understand is for now we're focused on volume.

Yes.

We're froze at 60% so that was more important as we were thinking about ramping up to 75 and clearly, some of those may be higher billing per case, but we're going to be focused on all volumes so we're kind of having a directional change ourself but we will continue to have that information. It's not going to be as much a focus as it was in the past because of the change in the rule.

I guess my question is and maybe you can help me understand this, so if the fourth quarter was slightly less than where you were in the third quarter I think second quarter you said it was sort of in the 6% range if I'm remembering it correctly. And your guidance for '08 is 2 to 4% volume growth and you also have the headwinds certainly gone with the 65% rule and you would think you'd get at least some benefit as you're able to bring the hospitals that the have stepped up back down to some degree. The 2 to 4% sounds extremely conservative. Am I thinking about that the right way?

No. Let me come back to the UDS data. Because we narrowed out a subset of the UDS data so we only narrowed out the subset of compliant case growth. If you look at that same third quarter data, for Healthsouth, Healthsouth all cases, including compliant, was up 1% so that clearly tells you we were down in the non-compliant, the industry was down 6%. So the 1% is the overall volume growth on UDS data that Healthsouth had in the third quarter compared with the industry being down 6 so you've still got the same delta in outperforming the industry but I think that -- remember that volume growth we're quoting is total volume growth, not just compliant case growth.

But to your question, Gary, we don't think that those numbers are conservative, we think that they're realistic and it sort of gets to the point that we talked about with Ann just a minute ago, and I think I know everybody on this call appreciates what I'm about to say, but it's not like we have four quarters or eight quarters or 20 quarters that the we can look back on and use as a basis for predicting what '08 is going to be like let alone '09 and beyond. Now, clearly we've done our five year projections and we feel very encouraged by not only the EBITDA growth that we think we're going to be able to generate but particularly the EPS growth rate that we think is inherent in this Company and will be demonstrated out over the next several years. But as we begin this new era, I think the last thing that this management team would want and I would suspect the last thing that our shareholders would want is for us to get way out there and to try to be overly aggressive in our projections, and in the guidance that we're providing. We think it's realistic. We don't think it's ultra conservative, but clearly, as with any kind of guidance in any kind of metric out there, we're going to want to try to exceed those goals.

But I think for where we are as a Company, for where we've come and coming out of three years of decline, decline, decline, now we're ready to grow. We think we've got the platform. We think we've got people motivated. We believe we have the right strategies, but we're six weeks into the New Year, and into this new era. We think that a 2 to 4% range is very realistic. Clearly, we would all be delighted if we could exceed that.

If I could just ask one quick follow-up question on your other operating expense line, it came down pretty markedly in the quarter. Could you just talk about a little bit about what drove it down and kind of how we should expect that to trend in 2008?

Yes, I mean, I think that as our goal is always to try to manage the expense ratio, and so as you saw, we were, we invested more in the people side and we incurred some unfavorable costs on salaries and wages. We focused heavily and part of the Teamworks initiative is also focused on non-clinical cost, and so we're going to be striving to help recover that increased salaries and benefits through reduced other operating costs, including bad debt expense. I would tell you I would not feel as optimistic that we'll be able to do that in each succeeding quarter. I think that the we were successful in the fourth quarter but I would not expect the same rate of decline year-over-year in 2008 in those categories.

But I guess does that $48 million, does that include any kind of one-time benefit that won't exist in '08 or is that sort of what you're kind of targeting for on a quarterly basis for '08?

Again I don't want to get into the quarterly but I'd say that the items in '07 there's really not items that are non- recurring that benefited '07 that we should see turn the other way in '08 relative to other operating expenses. Obviously we expect a lower provision for bad debts and as we move forward, consistent with what we're seeing in the fourth quarter of '07.

And then just one final there, is there any seasonality in that other operating expenses that drove it lower in the fourth quarter?

It typically is going to be a little bit lower in the fourth quarter.

Thanks a lot.

Thank you.

Your next question is from Ken Weakley with Credit Suisse.

Thanks, good morning, guys.

Good morning how are you?

Doing well, how are you?

Great.

Awesome. One question I had for you was on the outpatient side. I'm curious how sensitive outpatient rehab is to the economy given obviously some of the concerns out there, how does your model incorporate the overall slowing of the economy relative to outpatient and workers comp as well, obviously?

Yes, I think that's a very good question. The bulk of our patients that we treat in our outpatient settings are actually patients who have been discharged from our hospitals and who require some level of continuing rehabilitative care. That portion frankly, is not sensitive to the economy, and I think that's certainly one of the things that we're very pleased with is our business tends to be non-cyclical and that built in volume, if you will or the growth in overall cases that MedPath predicted is just under 2% per year and is expected to stay at that level for the foreseeable future. Now there are patients and it's really sort of at the margin, Ken, there are patients that we treat in our outpatient setting that are workers comp, that are sort of the weekend warriors, the younger patients who come in, need their shoulder worked on or their knee worked on but that's a fairly small portion of the overall business that we perform, so we don't think that is going to be sensitive at all.

Okay.

And then just one follow-up. As you know we've closed quite a few of the outpatient satellites as we rationalized the base, we will continue to monitor those because they're all tied to an inpatient hospital. We don't expect massive closures at any nature but there may be a few that occur even in '08 as we evaluate those and as we evaluate the market circumstance that's driven by more the inpatient hospital, not the economy in general as Jay said.

I'll tell you one thing, Ken, we're not second guessing our decision to get out of the outpatient segment. We're glad we sold it. We're glad we sold surgery and we're gland we sold diagnostics.

Sure. The other question I had related to the price roll back that you mentioned earlier and I was just curious if the commercial payers would look at the dynamic there and try to push down on pricing? I'm sure you already priced in a lot of your business for this year. Give me a sense and I obviously don't know the Company as well but give me a sense on how commercial pricing works in your business?

It works very similar to what we see, what you see in the other segments, a lot of our business is on a per diem basis. We don't see a correlation between the Medicare pricing and changes to that and changes in our Medicare or excuse me, reimbursement from the commercial side. So we don't expect that there's going to be much of a change there. We believe we can get somewhere in the 3 to 5% range on a consistent basis from our Managed Care portfolio. We still believe that's a good assumption on a go forward basis and we haven't seen anything thus far that would indicate that we should change our thinking on that.

Thanks so much.

Yes, thank you.

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

Good morning.

Good morning, Rob.

I'm sorry to belabor the volume issues but I'd like to drill in a little bit further on these. You did open a few new facilities and did some consolidations in 2007, late 2006. What kind of growth results are you getting out of those facilities right now and what kind of impact are they driving for you?

In terms of the new hospitals, we have two that are ramping up, Fredericksburg and Manatee, that's down in Puerto Rico, Fredericksburg came in a little bit slow to get out of the gate, but they have actually come on quite strong and it's a 40 bed hospital we're running probably 25 to 30 average daily census in that hospital which is right on plan. Manatee is a little bit behind but we expect that's going to be coming on later this year, very nicely. In terms of the market consolidations there were two. One was in Tucson and that has had I think a fairly decent track record. There have been ups and downs in that hospital in that market. Some of it is related to the partner and some of the issues there but overall, that's pretty much on target and pretty much where we expected it to be. So I think that the hospitals that we brought on we feel very good we've been able to bring them on within the context of our pro forma and plans.

Where are you guys seeing kind of your greatest competition and what may be stemming I guess some of the conservatism in the, as your outlook on the year not wanting to step out a little bit further, is it mainly nursing home competition, hospital units? Is it managed care receptivity part of it? I'm just trying to understand this a little bit better.

Yes, that's a great question, all of the above. I mean, we're seeing competitive pressure continuing in the nursing, from nursing homes. We don't believe that that's going to be an issue that we're going to have to worry about in a disproportionate way because we think that the quality of our care speaks for itself, although we're certainly developing many of our marketing campaigns and brochures and the materials that we use in our sales and marketing is designed specifically to differentiate the care that one would receive in the nursing home versus in an inpatient rehabilitation hospital, and we have found that to be pretty persuasive. Most people would just as soon be in a rehabilitation hospital for two weeks than languish in a nursing home for three to five weeks, and so that's a threat, but I think we're dealing with that very successfully, and we're certainly targeting a lot of our marketing efforts to differentiate ourselves between us and nursing homes.

Other hospitals, yes, I think there's definitely a competitive issue there, but it's really no different than what we've seen in the past, and again, I think by differentiating ourself from a quality standpoint, we have a broader base of programs that we can offer. We do try to focus on the neurological cases, also on stroke cases, and that's often outside of the sweet spot of what some of our competitors offer where they primarily look at some of the orthopaedic cases. So yes, I mean, the competitive threats are out there but we think we've been able to deal with them successfully in the past and we're very confident we'll be able to continue to do so in the future.

And just want to add one thing. One is that again, the industry data has been a decline, so it's fair to step back and say overall, the overall industry growth has been negative. We've been able to eke out positive here late in 2007. We're expecting that the to improve a little bit as we move into '08 but clearly we're still way outperforming whatever the industry metric is including MedPack, so it's a little bit, I don't think it's fair to believe that in the first quarter of 2008 the industry is all of a sudden going to turn around from having a decrease and have a large increase where as we are committed to delivering an increase and still continue to outperform the market and we've set our goals at outperforming the market going forward. So, we step back and put it in that context, and I guess that's why we take issue a little bit with the words of conservatism because we don't believe that, we believe they 're realistic and we believe we're outperforming the market.

Fair enough and then one last question, I guess for John, relating to kind of how you guys are going to treat taxes going forward because it kind of weighs in on an EPS guidance. It looks like you guys are going to, some people will impute a tax rate even though they're a non-cash tax payer for GAAP purposes, others will just put it down as zero or put a small state rate in.

That's a fair plan. I mean clearly as I said we have $2.5 billion worth of NOLs.

Yes.

And my and Jay's tenure at the Company we don't expect to ever pay taxes. We expect to hand over to our successor the ability to not pay taxes. So I guess we're not analysts, we're not smart enough to be analysts but I think the -- I can't tell you how to gauge that, which way to do it, do you look at it as it's not going to be any taxes for the next 12, 15 years, and you look at it a little bit differently and look at EPS without a tax impact or do you look at it and as you said, the alternative is compute a tax and then do a net present value of that. So we just look at it the way it will be reported, Rob, and the way it will be reported is there will not be taxes.

So you'll have a zero on that line?

And the way that works for accounting is to calculate a provision but we've got a $1 billion valuation allowance which is a tax number so if you gross that up that gets you back to $2.5 billion that gets collapsed to offset the taxes. On the same line of the income statement.

I just want to try to be able to forecast the way you're going to try to report it so there's less confusion.

That's a very fair question and just looking at this analysis that we've got of what you and some of your colleagues, how you're treating the NOLs and taxes, it really is across the board and I think that to the extent that everyone is comfortable, we certainly are and the way we're going to be reporting this is zero. So, as everybody starts to model their go forward assumptions, I think that that's a very good way of modeling it.

There will be state taxes going forward but they're fairly minimal. We've done some tax planning, I think, we used to quote 10 million, $15 million a year, we're now in to the mid single digits. Not necessarily for '08 but going forward if that's helpful too.

No, it is, thanks. I appreciate it. That's all. I'll jump back in.

Thanks, Rob.

Thank you. Your next question comes from Kemp Dolliver with Cowen & Co. Please go ahead.

Good morning, Kemp.

Good morning, a couple questions. First on the development side, the last earnings call, you mentioned discussions with a potential partner in Pennsylvania and you haven't mentioned that again. Is that particular project still alive or is that fallen by the the wayside?

No, it's definitely still alive and I think it goes back to one of the comments that we've made in the past about the consolidations, the market consolidations are a little bit more difficult to get across the goal line only because it involves creating a partnership and making sure that the partner devotes enough time, frankly, to getting the deals done. We still feel comfortable with that particular one. Actually we've got a couple others that we are working on. I think that the pipeline is filling up nicely. It is going to take a little bit longer to get these consolidations. That's why we're focusing on a balanced basis, we're putting a little more focus on the de novos than we are the market consolidations just because as John mentioned, we have control over that process, and we had filed for a Certificate of Need in Louden County, Virginia we did that in the fourth quarter and we're also also going to be announcing here in the not the too distant future another CON that we're going to be filing, and I think that as we get into 2008, we're going to see an increase in our development activities.

That's super. The next question relates to the comment around the NOL, and once you get, and this is probably going to look out a few years but once you get to a point where the balance sheet is much more normal, Jay, what are your thoughts about acquisitions of greater size at that point, because you certainly don't want to do anything just for the sake of the numbers alone, but this NOL could lie around this unrealized source of value, if you just use it strictly from continuing operations over the next 15 years.

Yes, I couldn't a agree with you more. I'll ask John to fill in after I respond to the question on the acquisitions, because I think this is a very important point. As we look at acquisitions, there's really sort of two buckets, if you will, where we look at it. The first one is what we've talked about today, which is freestanding rehabilitation hospitals that are either under a common ownership, maybe there's a small start up company out there, with three, four, six IRFs and those acquisition targets are definitely on the radar screen today, and will continue to be on our radar screen. I think we're tracking and monitoring and are aware of what the market conditions are, with respect to those, we will be making those investment decisions, however, based on what that free cash flow could be used for in other ways of investing, and clearly, we're going to be looking at deleveraging and taking down as much debt as we can. We think that the acquisitions in bucket one will play themselves out over the next two to three years, and we're very comfortable that in '08 and '09, our free cash flow we'll be using to pay down debt, we'll be looking for acquisitions, and we'll be also looking then to do off balance sheet de novo and market consolidation.

The other bucket is acquisitions of a larger scale, perhaps in complementary businesses. We think that we will be ready to pursue those in earnest in late '09 and then beginning in '010. If something came ut between now and then, you bet, we would look at it and we would look at it from a return perspective and what's in the best interest of the Company on a long term basis, but we do believe that there's some value in getting sort of our sea legs underneath us, in graining all of these operational initiatives into the Company, growing our business organically, deleveraging the balance sheet, strengthening that balance sheet so that we would be in a position to then go out and look at larger acquisitions, and that clearly is part of our long range plan. We don't believe that that's prudent to be pursuing those opportunities this year and next year, and making that a top priority, but clearly, we'll be looking at what's going on in the market, doing it opportunistically and then really ramping up that larger scale view towards the end of next year and into '010.

Just dealing with the tax attributes a second, if you acquired an existing Company, you're going to get future tax deductions that obviously would go with that. If you did the acquisition through some form of equity offering, there's a provision, a tax code called Section 382 which can limit the amount of tax losses that you can offset against future taxable income, and so we would have to do something to be careful not to trigger that, and we're at a fairly close threshold because once you trigger over 50% and unfortunately the convertible preferred that we issued in March of '06 got us up close to 40%, there's not a lot of room, and if you do the financing through debt acquisitions -- or through credit instruments, obviously you're going to come with a lot more interest expense too and you're going to find yourself kind of back in the same spot, about not creating a lot more additional taxable income. So those are kind of hard to structure. They have to be very fine tuned when you look at them.

All right, and just on a somewhat related subject, what are your thoughts on your post-acute expansion into home health, hospice, I think you've done at least one or two pilots. Can you give us an update?

Yes, on the home health, we actually have 25 markets where we have home health services that are being offered, again, most of those services are being provided to patients who have been discharged from our hospitals, and in markets where we have a partnership with an acute care hospital that they have a home health agency, we are very respectful of that, and will not go into competition with our partner. We're continuing to develop that. We are looking for new opportunities to add new home health services. Obviously in many of our markets we have Certificate of Need that, or in some cases we actually have moratoriums on new home health agencies but that is clearly an opportunity for us, and frankly, the other area that historically we have shied away from but we believe still has some very appealing business opportunities would be in LPACS. We own and operate six. We believe that the three year hiatus that was provided in Public Law 110-173 creates a unique opportunity. We'll certainly be evaluating opportunities in that space as well, but I think everybody needs to understand that really in the near term, our focus is going to be on building our base of inpatient rehabilitation hospitals, deleveraging the balance sheet, creating a stronger balance sheet so that we can then go out and start looking for complementary services that we could bring into our platform and we clearly have that as part of our long term plan. Kemp, we need to move -- you've asked a few questions and we got a couple other people in the queue if you don't mind.

Oh, that's fine. Thanks.

I hope that helps, Kemp.

Yes, it does.

Thank you. Your next question is from Derrick Dagnan from Avondale Partners.

Good morning. Most of my questions have been answered. I just wanted to ask one thing on the legislative side, it seems like most of this has been put to bed but I just wanted to see what you guys thought about last year, in the Fall, there was talk of changing the payment for the single joint replacement hip and knee patients, and setting that rate similar to the nursing home rate, and I was wondering if you're hearing any more on that and if that is still something that could be a risk down the road?

We have heard and I think it was in the President Bush's budget, but I haven't heard or seen anybody that thinks that that budget is anything but DOA. I don't think it's a risk to answer your question. Clearly, the level of care and the level of service provided patients when they're in for two weeks in an inpatient rehabilitation setting is quite different than if they're in for three to five weeks in a nursing home. So it got kicked around. It was an issue. We don't think it's a risk on a go forward basis.

Very good, thanks.

All right

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

Hi, guys, good morning. First just a numbers question, I'm sure I missed this but I'm looking at the $11.1 million gain that was embedded in the fourth quarter. I'm just trying to get a sense for what line that fell in.

What line are you talking about on the--?

That loss included a gain of 11.1 related to additional outpatient facilities to receive regulatory approval during the fourth quarter of '07.

That's in discontinued ops, Miles, that was because as we on the surgery division, we had to get CON approvals in various states and as those approvals were granted, we recognized any gain or loss on the sale of those facilities. So, that's what was happening in the fourth quarter. It doesn't affect EBITDA, it doesn't affect anything from continuing ops, that's down in discontinued ops.

Perfect, just want to make sure. And then just on the bond buybacks, can you give us a sense I guess anything that you've done in 2008 and I'm just trying to remember too just with respect to like a derivative proceed, can that go towards bond repurchases or are you going to have to pay down the bank with that?

Well, we have, I mean, the credit agreement, two things. One is that it allows for some amounts like the tax refund happen to go against use for the reduction in the term loan. Things like the Corporate Campus, a portion of it will need to go for items like reduction of the term loan, derivative proceeds isn't as specific but will fall into an excess cash flow calculation, and a portion of that will need to go to the term loan but a portion of that will be available. I'd remind everybody we have a $50 million year basket under the credit agreement that we can can buy bonds and $100 million lifetime, and we've bought $59 million of bonds through this date.

Okay, so just, maybe just a modest amount in 2008; is that right?

Well,the 59 million is through the fourth quarter of '07.

Oh, and also through today?

No, it was through the fourth quarter of '07.

I'm sorry, any comments on anything that you've done so far in 2008?

It is a minimal purchase in the first quarter 2008 but the bonds have kind of gotten outside our price range.

Thanks, guys.

I think, Operator, we'll take one more question and then we'll wrap it up.

Thank you. Your final question is from Frank Morgan with Jefferies & Company. Please go ahead.

Hello, Frank.

Good morning. First was just housekeeping, I think I know the answer but I just want to hear you say it. I want to verify that your EBITDA guidance excludes the $25 million of expected litigation expenses?

It does.

Yes.

And then otherwise, any particular clinical diagnosis that you'll specifically target now that the rule has been rolled back to 60% or are there any particular areas you'll specifically focus on that you had shied away from in the past?

No, the only thing that I think we will, we will certainly continue to focus on the neurological and stroke related conditions. We think that we've seen some nice progress in our efforts to market our capabilities in that area. I think it is fair to say though, Frank, that with the threshold at 60%, we may see a few more orthopaedic related patients than we have in the past, and reaching out to those orthopaedic surgeons, establishing the connections again is going to be important. I do think it's very important to emphasize and I think everybody understands this, every patient that comes into our hospitals have to meet medical necessity so there are a lot of different criteria that have to be considered when determining if a patient is going to make it in and if they qualify for admission and certainly, one of the rules, one of the criteria is going to be the 75 or now the 60% rule, the other is going to be medical necessity. So when I say we're going to be looking for patients who would be orthopaedic related, knees and hips, we're going to be very selective on that. We're going to be very careful. Those patients all will meet medical necessity and we don't anticipate a huge influx but we do anticipate that there will be some outreach back to the orthopaedic surgeons.

On the topic of medical necessity, I read where the rack pilot program has now been expanded to going nationwide over the course of the next year or so. I was wondering if you have any thoughts or any updates on that? And then one final one I'll put up in there, do you think you can get to this 4.5% debt to EBITDA target by 2010, excluding -- purely from internal free cash flow generation or would that assume some kind of recovery either from on tax refunds or litigation? Thanks.

Yes, I'll take it in reverse order. It would not be exclusively through operating cash flow. That will certainly be a component. There will be a component associated with the derivative proceeds, and we still feel pretty confident in our arguments and in our case against UBS and Ernst & Young and Scrushy, and we expect that that's something that again hopefully will be resolved in 2009. In terms of the Rack audits, as you know, there's really an industry wide effort to draw attention to some of the real problems with this whole process and I think CMS understands that. I think that the early results of the Rack Audits suggested that a lot of those contractors were sort of out of control, and in the final analysis, we feel pretty confident that our coding capabilities and the accuracy of our coding will withstand any kind of audit. We're not taking anything for granted. We're being proactive in our hospitals. Is it an issue? Yes, it's an issue, but what business doesn't have problems that they have to deal with? I think that it's something that the industry is going to be pushing back pretty hard on.

I think that there are good opportunities to reform the process, and we'll certainly be part of that process. So, Operator? And all of you who participated on the call , thank you very much. We look forward to talking with you later this year on our first quarter results, and then ultimately, down the road we're going to have an Investor Day, probably in New York. We're not confident right now of the date. We're going to try to find something that makes sense for everybody but we do want to take some time later this year to build our story with all of you, and to share with you our optimism in the future, share with you the results of the first part of this year and then use that as a platform for looking out into the future so thank you very much and we look forward to talking with you

Thank you. This concludes today's Healthsouth Corporation fourth quarter and full year 2007 earnings conference call. You may now disconnect.