Encompass Health Corp (EHC) 2008 Q3 法說會逐字稿

Good morning, everyone, and welcome to HealthSouth's third quarter 2008 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 conference over to Ms. Mary Ann Arico, Senior Vice President of investor relations and corporate communications. Please go ahead.

Thank you, Julianne. Good morning, everyone. Thank you for joining us today for the HealthSouth third quarter 2008 earnings calling. With me on the call in Birmingham today are: Jay Grinney, President and Chief Executive Officer; John Workman, Chief Financial Officer; Mark Tarr, Executive Vice President of operations; John Whittington, our general council; Andy Price, Senior Vice President of accounting; and Ed Fay, Senior Vice President and treasurer. Before we begin, if you do not already have a copy, the press release, financial statements and the related 8-K filing with the SEC are available on our website at www.healthsouth.com. In addition to the required information we have also provided a robust set of slides, which are available on our website. The slide deck is intended to give you a better understanding of the business dynamics and answer many of the day-to-day questions we receive on HealthSouth from the financial community. We will continue to refine these slides going forward.

Moving to slide one, the Safe Harbor. During the call we will make forward-looking statements, which are subject to risks and uncertainties, many of which are beyond our control. Certain risks, uncertainties and other factors that could cause actual results to differ materially from management's projections, forecasts, estimates and expectations are discussed in the Company's Form 10-K for the fiscal year ended December 31, 2007, and the other quarterly SEC filings, including the Form 10-Q for the third quarter scheduled to be filed today. We encourage you to read them. You are cautioned not to place undue reliance on the estimate, projections, guidance and other forward-looking information presented. Statements made throughout the presentation are based on current estimates of future events and speak only as of today. The Company does not undertake a duty to update or correct these forward-looking statements. Our slide presentation and discussion on this call will include certain non-GAAP financial measures. For such measures reconciliation to the most directly comparable GAAP measure is available at the end of the slide presentation or at the end of the related press release, both of which are available on our website and as part of the Form 8-K filed last night with the SEC.

And with that, I will turn the call over to Jay.

Great, thank you, Mary Ann: We are very pleased to report the results of another solid quarter. Same-store discharges were up 8.1% compared to prior year, reflecting the continued benefits of our TeamWorks best practices initiative, which focused on sales and marketing. Our pricing remained fairly consistent, which contributed to a 6.5% increase in quarter-over-quarter net operating revenues. Adjusted consolidated EBITDA was essentially flat with prior year when you consider two factors. Third quarter 2007 benefited from an $8.6 million gain related to our investment in Source Medical and the impact of three hurricanes in the quarter that disrupted the operations of some of our Texas and Louisiana hospitals. The increased revenue, driven by higher volumes, was offset by our labor expenses, which I will address in a moment.

Hurricanes reduced adjusted consolidated EBITDA for the quarter by approximately $1 million, due to costs associated with protecting our hospitals during the storms and sustaining them in the recovery phase, interrupted stays and the inability to discharge many patients resulting in a reduction of net operating revenues, and costs associated with higher-than-normal overtime hours. On a side note, I want to take this opportunity to compliment our employees for their efforts and sacrifices during these devastating storms. Not only did employees from these hospitals perform heroicly, but employees from throughout Texas and Louisiana traveled to these hospital to provide needed assistance in getting this back to normal It was a real team effort and I am extremely proud of how these folks stepped up to meet these challenges.

Finally, our adjusted earnings per share on a fully diluted bases was $0.15 per share compared to a loss of $0.07 per share for the third quarter of 2007, or an increase of $0.22 per share quarter over quarter. As we have noted previously, our focus during the Medicare pricing rollback phase has been on driving EPS growth through our operational and deleveraging strategies and we are pleased to see continued positive results from these efforts. Year-to-date adjusted earnings per share are $0.50 per share compared to a loss of $0.63 per share for the same period last year, which represents an increase of $1.13 per share.

With those highlights in mind I want to spend a couple of minutes discussing what we are doing to address our labor costs. As we mentioned on the second quarter call our strong volume gains have presented us with a high-class challenge; the need to adjust our core staffing levels to reflect this higher demand while simultaneously managing the contract labor and overtime required to serve these patients as we recruit, hire, train and orient permanent employees. While salaries, wages and benefits increased as a percent of net operating revenues, in part because of higher costs for certain benefit plans, we saw a 2.4% improvement in our productivity as measured by employees per occupied bed, or EPOB. So from an efficiency standpoint our employees are responding to the additional volumes and we are very pleased with the productivity gains we've realized.

Against this backdrop of improved productivity, our primary operational focus is on our labor costs, which on a per discharge basis have increased year over year due to four factors: An average 3.7% merit increase given to employees on October 1st of last year; range adjustments in select markets; recruitment and orientation costs for new hires; and the higher cost of benefit plans, some of which involve higher accruals for paid time off. Accordingly, we are reviewing our benefit programs to ensure they are competitive in today's environment. We've already made some adjustments, like eliminating the automatic enrollment to our 401(k) plan and reducing the number of paid time-off days for new hires. Beginning in 2009 we will make further refinements to our paid time-off program and also will share the increase in our medical benefits for the first time in four years. We are confident these actions, coupled with continued productivity improvements, will allow us to manage our labor costs effectively while continuing to provide high-quality patient care.

With that, I'm going to ask John Workman to provide a more thorough review of our third quarter results. I'll then come back with some concluding remarks about four issues: How HealthSouth is positioned to weather these challenging economic times successfully, our revised guidance, the recent UBS settlement, and our November 10th investor conference in New York. John?

Thank you, Jay. In addition to the press release and as May Ann mentioned we have filed some supplemental slides on Form 8-K which will be used as we discuss our results. I will reference the slide numbers in some of my comments.

Turning to the income statement and first looking at revenues on slide 4, in our inpatient hospitals our inpatient revenues increased by 8.2% over last year's quarter to $411.5 million. The current quarter included some revenues from the three acquisitions and consolidations completed, namely Vineland, Midland and Arlington. Discharges increased 8.1% on a same-store basis. We had a slight decrease in pricing per discharge to $15,539 for discharge generally related to a slight drop in acuity. I will remind you that CMS pricing was the same in this quarter as it was a year ago. Our length of stay was six-tenths a day shorter than it was a year ago, but even with a shortened length of stay we improved our occupancy percent to 65.6% from 62.4% in the third quarter of last year. In looking forward we want to remind you that the fourth quarter of 2007 and the first quarter of 2008 had a pricing benefit in them, which will make our comparables more challenging for the next two quarters. This was the result of the pricing rollback that was used to pay for the permanent compliant case level being set at 60%.

Turning next to our outpatient facilities, our outpatient and other revenue declined 6.7% compared to the same quarter a year ago, primarily as a result of 15 fewer outpatient satellites. We continue to monitor underperforming satellites and expect some additional closures before the end of 2008 and into 2009. I will remind you this is not a large proportion of our revenue base.

Turning next to operating expenses and slide 6 in the supplemental deck, as Jay has mentioned, salaries and benefits continued to be challenging in the quarter. We did see an improvement in our employees per occupied bed, a productivity measure we have started including this quarter and can be found on slide 7. This measure is also reflected on page 12 of the press release. It includes full-time equivalence for contract labor and looks at the number of FTEs we are using per occupied bed. This points out that the larger driver to higher cost is benefits and nonproductive time, including paid time off, in addition to normal merit increases and market adjustments.

As we mentioned to you at the beginning of 2008 we made some decisions to improve benefits. Examples include the increased 401(k) match and at that point in time we did not pass along a health care increase to our employees. We also attempted to standardized certain time-off and paid vacation plans, which were fragmented. Some of these efforts have provided unintended increases in expense. As Jay mentioned we are taking corrective action in the area of benefits and nonproductive time while still remaining competitive for the skills we need to operate our hospitals. The key takeaway here is it is not a productivity issue, which is harder to change and execute upon, but something we can change going forward. These steps also provide equitable changes to ensure the preservation of jobs to our 22,000 employees.

Turning next to the caption on the income statement of other hospital-related expense, expressed as a percent of revenues this ratio went up 0.3% compared to a year ago. We are seeing higher drug and supply cost, as well as higher expenditures on utilities. Some of the increase in drug and supply costs relate to our higher patient volume, but some of it's just a rate increase. We also saw increased external expense related to pursuit of the development opportunities and higher repair and maintenance costs, some of which related to our refresh programs. Bad debts were slightly higher than the same quarter a year ago as a percent of revenue, but were within the 1.5% to 1.8% run rate that we have previously mentioned. Overall, expenses related to hurricanes were approximately $1 million in the quarter.

General and administrative costs were down slightly, but our comparable as the divestitures were primarily completed by the third quarter of 2007. Stock compensation cost in the quarter was $2.5 million. As a reminder, our goal is to get to 4.75% ex -- 4.75% of revenues, excluding the noncash stock compensation cost as we end '08 and start into '09. Depreciation and amortization was below last year but will increase as a result of three acquisitions -- Vineland, Midland and Arlington -- that were completed in the third quarter. Government class action and related settlements includes our mark-to-market noncash impact for the five million shares and 8.2 million warrants with a 41.40 strike price that we agreed to contribute as part of the litigation settlement. We believe these shares and warrants will be distributed sometime in 2009.

Professional fees generally relate to amounts being spent in pursuit of the derivative claims against UBS, Ernst & Young and Richard Scrushy. As you know we recently announced a preliminary settlement of the UBS litigation, which Jay will comment on later. I will remind you the proceeds we expect to receive from the UBS settlement will be after legal fees to the derivative attorneys are -- and after those are agreed to and after payment of 25% of the amount to the plaintiffs associated with shareholder litigation. We have been expensing our costs in pursuit of these claims and it's been reflected in our profit and loss statement.

Next, turning to items that are below operating expenses. Interest expense is down due to lower debt levels and lower rates. I'm going to speak more about debt later. The mark-to-market charge on the interest rate swap was because LIBOR was lower at the end of the third quarter than it was the end of the second quarter. As a reminder, our swap covers $1.121 billion, a notional amount, and at a 5.22% fixed rate and is profiled on slide 15. We have a $22.5 million benefit on the income tax line this quarter. You will notice we increased the income tax receivable by approximately $20 million from the balance sheet at the end of the second quarter. I will talk more about this when I comment on the balance sheet.

Turning next to adjusted consolidated EBITDA, this can be found on page 8 of the press release and was $79.3 million for the quarter. As Jay mentioned, the third quarter of 2007 includes an $8.6 million gain from Source Medical that related to the sale of our stock in Source and effectively eliminated the last ownership linkage with Source, which is a relationship entered into by the prior management team. If the Source gain is excluded, adjusted consolidated EBITDA is basically flat to last year. Next, turning to net income earnings per share, which can be found on slide 11. In discussing net income and EPS in the quarter, we believe there are some adjustments that should be considered, These items are either noncash or nonrecurring when you're looking at income -- when considering income from continuing operations. The adjustments to EPS are similar in nature to adjusted consolidated EBITDA but not quite identical. The adjustments to EPS generally relate to payments on litigation, mark-to-market or fair value adjustments to liabilities and the removal of our income tax benefit. We have added an estimated state income tax expense to reflect a run rate for this element. Considering these items, adjusted income from continuing operations is $14.7 million in the quarter, representing a $21.2 million improvement in income from the same quarter a year ago. Adjusted EPS is $0.15 per share, representing a 22% share improvement in EPS over the third quarter of 2007.

Next, turning to the balance sheet, available cash was $24.9 million at September 30, 2008. There was an additional $30.3 million in restricted cash, which was paid into escrow the last day of the quarter and then used to retire 10.75% bonds that were due on October 1, 2008, in the same amount. Intangible assets increased in the quarter as a result of the acquisitions. Vineland did include an addition to debt of $11 million for a long-term HUD lease, which met the criteria for capitalization. As I mentioned earlier, our income tax refund receivable on the balance sheet increased from the second quarter to $62.9 million at September 30, 2008. Approximately $46 million of this receivable was received on October 1, 2008, which was a refund for taxes paid plus interest related to our 2000 and 2003 tax years. These funds were generally used to reduce debt. The remaining receivable represents additional expected recoveries for amended federal and state income tax returns for years related to 2003 or before. We expect some portion of this remaining receivable by the end of the year. As a reminder, we have available $2.5 billion of tax NOLs or future deductions already reflected in the books, thus, we do not expect to pay federal taxes for many years.

In looking at long-term debt on slide 14 it was $1.877 billion at the end of the third quarter of 2008. Due to the tax refund received on October 1, 2008, and the bonds that were paid off on October 1, 2008, we have provided supplemental information as of the end of October that you can also see on slide 14. Through the end of October debt has been reduced by $208 million, representing cash payments -- cash repayments of $232 million and $24 million of capitalized lease obligations added during the year. I would remind you that $150 million of the year-to-date debt reduction was a result of our blocked trade transaction at the end of the second quarter of 2008. Our credit agreement contains covenants, namely a leverage covenant and an interest coverage covenant. We are in compliance with these ratios as of the end of the third quarter. The interest coverage ratio is based on interest expense excluding amortization. For the third quarter this was -- this amount was $38.8 million. Annualizing this amount equates to $155.2 million. Further debt reductions made in the fourth quarter should reduce interest expense but these may be somewhat negated by an increase in rates.

As we have disclosed previously, to violate our interest coverage covenant we would need to miss it four consecutive quarters. It would be our intent to disclose a miss in the ratio even if it was only for one quarter. In addition, with the uncertainty in the economy, we have also included a liquidity schedule, which can be found on slide 13. Based on our available cash and undrawn revolver, we had $373.5 million of liquidity at the end of the quarter. This will be increased by $33.6 million as a result of a letter of credit requirement being removed with the final UBS settlement. We did draw another $40 million on our revolver in October for seasonal needs, which includes being able to make the bond interest payment due in December of 2008. The debt reduction mentioned earlier of $208 million included this additional draw.

Next, turning to cash flow, which can be found on slide 12, free cash flow adjusted for interest rate swap payments and dividends on preferred stock for the nine months ended September 30, 2008 was $69.1 million. In the quarter and for the nine months ended $32.8 million was spent on acquisitions. Capital expenditures, not of a maintenance nature, were $14.3 million on a year-to-date basis. These were primarily in the third quarter and represented payments towards already-announced de novos or cost related to reconfiguring the corporate office and some in IT infrastructure. Maintenance capital expenditures of $25.2 million on a nine months basis include monies spent on our refresh programs and our hospitals. As Jay mentioned in his comments we will be focused on deleveraging the balance sheet in the future. As such we will be looking to finance the real estate on new de novos from inception.

Lastly I just want to make a comment relative to the fourth quarter. Since we confirmed adjusted consolidated EBITDA guidance of $330 million to $335 million, which was moved to the upper end of the range at the end of the second quarter 2008, and since we reported $254.1 million on a year-to-date basis, this means the fourth quarter amount of -- is a range of $75.9 million to $80.9 million. This is less than we reported in the fourth quarter of 2007. A few items to mention, though. Last year had the benefit of a pricing increase, which we've profiled before, is in the range of $7 million to $8 million worth of EBITDA impact. Secondly, as Jay as mentioned, we gave merit increases averaging 3% to nonexecutives effective October 1, 2008. And lastly, the changes to benefits, including PTO, will have the majority of the savings beginning 1/1/09.

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

Great. Thank you, John. Before we take questions, I'd like to touch on those issues I mentioned previously. First, with respect to our ability to grow and compete in these challenging economic times, I offer the following. First, we do not anticipate a reduction in the demand for our services. While some healthcare spending is discretionary, only a small portion of the patients we treat have nondiscretionary illnesses. The majority of the patients we serve have medical conditions that require inpatient rehabilitative care. People don't choose to have a stroke, they don't choose to break their hip and they don't choose to have debilitating neurological conditions. These conditions require medical intervention and follow-up care in a rehabilitation hospital and we are pleased to be able to meet this demand. Additionally, we believe our TeamWorks initiative will allow us to continue to take market share and drive solid organic growth for the foreseeable future.

Second, Medicare is our largest payor, which essentially eliminates any payment risk, and because virtually all of our services are covered by Medicare, our exposure to a spike in bad debts is negligible, unlike other healthcare providers who have to collect a lot of deductibles and co-pays. Third, most of our competitors are units within acute care hospitals and many of these hospitals have relied on investment income to help fund operations. As their investment income declines, some of these hospitals may choose to close or sell rehab units, which in turn may allow us to consolidated these markets. Fourth, while we are leveraged, our debt does not have any near-term maturities and we have adequate liquidity. As you will note when you read the 10-Q, our revolver matures in 2012, our credit agreement in 2013 and our bonds don't come due until 2014 and 2016. Fifth, our cash flow remains strong and we have a great deal of flexibility with respect to how we invest it.

Our annual CapEx spending is discretionary. We anticipate needing approximately $25 million per year to maintain our hospitals. CapEx above the $25 million per year level allocated to our refresh program can be curtailed or, if necessary, suspended going forward. And we will be very disciplined with respect to development projects. To preserve cash for debt repayment, we will not pursue any new de novos unless we have a developer lined up to finance the project from day one. Furthermore, tuck-in acquisitions will be carefully evaluated against our deleveraging priority. For all of these reasons, I believe HealthSouth is very well positioned to continue to grow profitably and to expand our market share. Our confidence in this is reflected in the revisions to our guidance for 2008.

Our TeamWorks initiative continues to generate strong, same-store discharge growth. Year to date we are averaging a 5.8% increase in discharge and anticipate the fourth quarter will be in this range, as well. You'll recall we began the TeamWorks roll-out in Q4 of last year so we would expect the fourth quarter volume increases to be less robust than what we saw in the third quarter of this year, but still significantly ahead of initial projections. The lower interest expense year to date due to our deleveraging efforts, will yield an improvement in our earnings per share, which we have reflected in our revised EPS guidance. With respect to the recently-announced UBS settlement, we are very pleased to have this matter behind us. By getting this resolved before the January trial date, we are able to reduce professional fees while focusing on the binding arbitration with E&Y. It's worth noting that binding arbitration has no appeals process. Once a decision has been made, E&Y will have 30 days in which to settle the claim.

Finally, we are very pleased to be hosting an analyst and shareholder conference next month, November 10th, at the Grand Hyatt in New York beginning at 8:30 a.m. eastern standard time. This conference also will be webcast, so anyone wishing to listen may do so. I will provide an overview of the Company, an assessment of the competitive and regulatory landscape and outline the compelling value proposition we believe HealthSouth provides investors. Mark Tarr will present a refresher on the basics of our business, including a more thorough explanation of TeamWorks, And finally, John Workman will walk everyone through our balance sheet, discuss our swap, explain the value of our significant NOLs, highlight our strong cash flows and the success of our deleveraging strategy. We believe this conference will provide investors with an in-depth understanding of HealthSouth and why this management team remains confident in the future of this great Company. We hope you will be able to join us on November 10th.

Julianne, will you now give instructions for the Q&A?

Thank you. (OPERATOR INSTRUCTIONS) Your first question is from the line of Adam Feinstein with Barclays Capital.

Thank you. Good morning, everyone.

Good morning, Adam.

Very strong quarter here. Just wanted to just talk about the volumes. Clearly you're running well ahead of what you had anticipated earlier in the year. Just curious in terms of your thoughts in terms of what's leading to the acceleration. Is it market share gains, have you seen a big acceleration just in overall utilization for the industry? Just additional thoughts would be great. And just -- and then just curious, I know you'll file the Q later today, but if you can talk about the mix between the different types of patients and maybe just highlight where you saw the highest growth, that would be great? Thank you.

With respect to what's driving the volume growth, we really do attribute that to our focus on the standardized sales and marketing initiative of TeamWorks. We, as you know, in the third quarter had the TeamWorks platform rolled out across all of the hospitals with the exception of the recently-acquired Vineland hospital -- Vineland New Jersey hospital. So it's really just committing ourselves to going out, looking at a wider range of potential referral sources for patients who require inpatient rehabilitative care. In terms of taking market share, we do believe that that is exactly what's happening. As you know, we report from time to time on how our volumes compare to those participating in the UDS data system and for the second quarter of this year, if you recall, our discharges were up 5.6%. The UDS sites participating in that data source was actually down 2.4%. So there's clearly market share shifts that are occurring and we are very pleased with the efforts of our TeamWorks and now are actually putting out a sustainability module to make sure that the lessons learned, the standardized approaches and so on continue into the future. I'll ask Mark Tarr to talk about our program mix.

Hey. Good morning, Adam.

Good morning.

Our program mix, the single largest program mix category that we have is our stroke programs. The strongest growth that we saw for the quarter was in neurological nontraumatic brain injury and then another positive sign is we continue to grow our neuro programs, we continue to see a decrease in the joint replacement. So our efforts to better grow our neuro program and staff our neuro programs is starting to reach some benefits.

Okay, great. And then just one quick follow up, if I may. So with -- just back to the volumes and the revenue growth here, so just curious, the revenue per discharge, you have the Medicare impact, but just curious in terms of what you're seeing on the managed care side and whether the decline in length of stay suggests a change in your acuity in the quarter? Thank you.

Yes, in terms of the pricing we've said pretty consistently throughout the year that we envision a 3% to 5% increase in our managed care portfolio. We don't have all of the contracts that are up for renewal completed at this point. We have a substantial number of them completed and we do believe that that 3% to 5% on the managed care portfolio is still a very good number. And I think that the length of stay, the slight decline there is -- really, in our opinion, it's not a huge factor, it's not something that caught us off guard by any stretch of the imagination. And as you know, our length of stay will vary slightly from quarter to quarter, but it's still staying in that range of about 15 days per stay, and our managed book of business is also actually hanging in there, as well. So we 're really not seeing a whole lot of change. In fact, if you look at our managed care portfolio, our acuity within that segment is actually going up because, as you know, the managed care admissions do require a preauthorization, precertification. And so those patients who do make it into our hospitals that are managed care tend to be quite sick and really do need the expertise and the specialized services that we can provide.

Okay. Thank you very much.

You're welcome.

Your next question is from the line of Gary Lieberman with the Stanford Group.

Thanks, good morning.

Good morning, Gary.

Was hoping you could talk a little bit more about the productivity gains on the labor side. The 2.4% number was very helpful. Can you talk about what you think the opportunity there is? Can you improve the productivity another 2.4%, 5%, 10% and what the timeframe is for those improvements?

Well, what we always believe that there are opportunities to improve the mix of employees that we have in our hospitals and to improve the overall productivity measure. We don't want to focus exclusively on that number because, quite frankly, there may be a time as we go forward -- and in fact I envision this -- that we will see a change in our skill mix where we may have fewer of the RNs and more LPNs and nurse assistants, that may actually cause our EPO number to go up, but that should then see a corresponding decline in our labor costs.

So I don't want to go out and say that there's a specific target because I think when it comes to productivity, especially when we are talking about increased volumes, that's going to be a process that we are always going to be focusing on, we're always going to be trying to improve that, We know that there's improvement opportunities out there, but I would hate for us to focus on just one metric when it comes to labor cost management. We did think, however, that it was important to put that out there because clearly the increase in our overall labor costs, which is a function of not only the amount that we're paying, but the number of employees -- and you saw that there was an increase due to the higher volumes -- but the labor cost is really where we're focusing on right now and most of that labor cost focus is on our benefit plan and the changes that John and I talked about.

And I just might elaborate on that. On the PTO, the paid time off, w We did have quite a few of our hospitals already on a paid time-off program but we had at least six different varieties or versions and what we tried to do last -- at the beginning of the year was consolidate this. When we did that we actually increased the PTO days and thinking that was the competitive. We have a lot more analysis and we've dug into the competition and what we will actually be doing is actually changing the number of paid time-off day,s which will be a direct benefit, so just to clarify that issue.

I guess maybe just to follow up on this topic a little bit further. In terms of -- it sounds like you're taking market share, which is great. I guess in -- as you do that, you do need to staff up, so will the higher costs associated with the training and the orientation continue to put pressure on this line item for some time or do you think the productivity gains can offset that and then maybe some?

I think that we are seeing that leveling off and, in fact, as we mentioned on the second quarter call, at that time we were highlighting for everyone, hey, we got a lot of new patients coming in but there was also a lot of costs that we had to load up. We warned everyone don't expect to see improvements in the third quarter, do expect to see it in the fourth quarter, definitely expect to see it in 2009. And we are more confident of that today than we were then, in part because we have seen as we exited the third quarter in September, the improved flow-through. In other words, the amount of new net revenue that flowed through to the EBITDA line, we saw that start to improve. So we really do believe that this is a high-class problem. I'd much rather be talking with you guys about the fact that we've got such great volumes and we're adjusting our staffing to get that operating leverage, which we are very confident we will be seeing in the fourth quarter and definitely into 2009. Because, as we said, a lot of that cost is benefit related and we've already taken the steps, we've already started the communication, we've already made the decisions and we're very confident that we are getting on top of this issue.

Okay, great. Thanks a lot.

You bet.

Your next question is from the line of David MacDonald with SunTrust.

Good morning, guys.

Good morning.

Hey, Jay, just to follow up on that a little bit. I assume on the labor cost side you guys are probably seeing different experiences in different regions. Is there a chance we could see a best practices TeamWorks-type initiative on the labor cost side to help out on that front? Is that something that you guys have looked at?

Were you at our planning session, David? (LAUGHTER) That is precisely one of the two areas that we will be focusing on in 2009. The other is a more clinical orientation, looking for best practices from a clinical standpoint. But, yes, there is definitely going to be that. Now, I will tell you that we've made the decision, given the economic uncertainty, that we are not going to go out and there won't be an investment of outside consulting costs for the labor initiative that we saw with the sales and marketing. We believe we have the expertise internally to manage that successfully and we're beginning that process today. But we want to be very mindful as we go into 2009, we're not getting any pricing increase, we need to make sure that our G&A costs are well managed and so we will be addressing this under the TeamWorks umbrella but we'll be resourcing that with the expertise that we have internally and we believe in that area we really do have the opportunity to manage that with existing resources.

And, David, this is John. I 'll just add a follow up to that. The -- there are certain things that we're doing, we've already starting doing and foundationally to set that platform in place, but I also don't want you to walk away thinking that's going to change all sudden 1/1/09. We are needing to put in some new time clock keeping devices in our hospitals. We're in the process of doing that, rolling that out and, again, standardizing the practices that we have. So I don't want to give you the belief that that's going to be effective the first of the year, but that is clearly a major initiative for 2009.

Okay. And then just one follow up. Can you guys give us an update on the digital hospital. I've seen that Trinity's obviously interested and looks like some type of deal. Can you give us some sense in terms of timing of CON and what that means in terms of dollars in the door, just given your ownership percentage that you still have left there?

We believe from a timing standpoint that this will probably take about a year. There is a risk that it might be longer. I think the factors in Trinity's favor include the fact that the community at large and then the local government officials here are very, very supportive of having a hospital on 280. I think that that's unquestionably a major positive for us. Unfortunately, in the state of Alabama the certificate of need regulations do allow other providers to object and we fully expect that there will be objections from some of the other acute care hospitals because as you know, having been here, the 280 corridor leads right into one of the most high growth areas in this surrounding area. So there will be a challenge. We think it might take a year. It might take a little bit longer. As you know, we've maintained a 40% residual interest in the digital. I don't believe that the Daniel Corporation has revealed the purchase price, so I think it would be inappropriate for us to comment on what we might get from that until they have disclosed that since it really is their transaction with Trinity.

Okay. Thank you.

Yes.

Your next question is from the line of Rob Hawkins with Stifel, Nicolaus.

Morning ,Rob.

Good morning. How are you all? Just one thing I'm a little puzzled about, on the same-store 8.1% number, as I remember last year you had a smattering of hospitals that were starting to have to get ready for the 65% rule around August and September. Do -- did some of that make the comparable look a little bit better and is there maybe a way to dig behind the 8.1% in terms of the organic growth number there?

I think that that's pretty -- a pretty good number. We did look at those hospitals that had geared up and we tried to do a comparison and there really wasn't much of an impact there at all.

Yes, hey, Rob, this is Mark. We had, I think, nine hospitals that were ramping up to the next highest threshold and we did go back and take a look to see what kind of impact they had on this growth and it was negligible.

Okay.

I think the thing to recall is that typically our third quarter is one of the weakest quarters that we have in the year and this year we saw that the discharges from the second quarter going into the third quarter really hung in there pretty nicely and that's what I think really accounts for the differences that we didn't allow the summer slump, if you will, to occur. We really focused on maintaining the effort to bring patients in who need rehabilitative care and by going outside of the traditional -- only going to the acute care hospital and looking at other sources I think helped contribute to our ability to have the results that we did.

Okay, great. Can you help me a little bit with the labor benefits philosophy versus productivity in terms of where you're going with this next year? I understand you might be trimming some of the PTO, maybe putting a little more of the benefits increases on to some of the employees, but in this market -- and I spend a lot of time around acute care hospitals, so I apologize, not as much around rehab -- I know outpatient is still a difficult environment but I wasn't -- I haven't really been hearing too much pressure around rehab hospitals about attracting therapists as I have heard in the past. So can you help me understand a little bit where you guys are going with this in terms of how it might impact the margins going forward?

Sure. I think that the overall philosophy is that we want to maintain a competitive compensation and benefit structure that reflects the market realities of the markets where we have the privilege of serving, and so we've actually stepped up our efforts to obtain and analyze that data and the -- frankly the capabilities within the Company to analyze that information. So we really are focusing on being competitive. Within that context, as we've looked at the compensation arrangements, we have made some headway in bringing people to market levels. We did that with range adjustments. We did a 3.7% Merit increase last year and we think that that really closed the gap, if you will, and we've seen that in our ability to maintain a pretty good level of our folks -- therapists. We still have a little work to do on the nursing side, but we are focusing on that and I think we're seeing some good results. On the benefit side, frankly, as John said when we brought these six plans together and then we let that settle out and now we're comparing ourselves with other competitors, our plan was very rich and so we believe that by trimming back some of the noncash aspects of our compensation and benefit plan, we're able to put more cash in our employees' pockets but at the same time manage our enterprise in a responsible way.

The only other comment I would make is you look around some of these markets and we're starting to see acute care hospitals have to lay off employees. New PMC in the Pittsburgh market announced that they're going to lay off 500 employees. Why? Because their investment income is down. Texas Health Resources in Dallas, huge player in the DFW market, laying off employees. The Medical University of South Carolina, even in the UAV system here in our market is announcing plans and measures that they have to take to tighten their belt. So we think we're very much in line. We want to be competitive and we believe that the structure that we have in place will allow us to do so. And I'll just -- the last comment is, although we have made a 3.7% increase -- merit increase last year, our average that we just put in for this year starting October 1 is actually 3%.

Rob, let me add one thing. You've been following the Company for a long time and I'll remind everybody that only since about a year ago did we get to start to focus on the operations and one business, and clearly our first focus was to focus on buyouts and I think you've seen the outcome of that. As Jay said, we didn't have any infrastructure that we inherited, we had to create that back in the '05, '06 timeframe and then get to one business and then start to look at that business. We focused on volumes first, we're now looking and getting better information, as Jay mentioned, to help us look at the next biggest element, which is salaries and benefits on our P&L and that's the approach that we've been taking.

And what we told our employees is we want to focus on preserving jobs. We don't want to be like those hospital systems that I just mentioned that are having to lay people off. We want to preserve jobs. We are going to have to tighten our belt. We're in a tough economic time, we all understand that, but if we can focus on preserving jobs, focus on putting dollars in our employees' pockets, making changes on the benefits side, we think that's the right combination and the right formula.

Thanks. I'll jump back in the queue but can you guys maybe specifically couch it into a range. Are we talking like tens of basis points improvements or hundreds or are we talking about one to two quarters to see an impact or four to six?

Well, I think what we'll -- first of all we 'l see the impact starting in 2009 and I think when we talk about our 2009 guidance, clearly you'll get a lot better picture on what we think we'll be able to do in 2009. But I will tell you that based on the preliminary budget numbers that we've seen, we're pretty confident that the steps that we have outlined to you in general terms will yield some very positive results.

Thank you.

Your next question is from the line of A.J. rice with Soleil Securities.

Good morning. It's actually Chris Rigg filling in for A.J.

Hello, Chris.

If I heard you guys correctly it sounds like you're going to significantly rein-in the de novos or stop them completely over the near term and that the acquisitions you're looking at are going to be of a tuck-in nature. I guess -- and that's not necessarily a bad thing. I guess what I'm wondering is if you could just provide us a little bit more color as to whether the rein-in on the de novo side is a function of that's just not a great use of your capital or whether the JV partners that you had been pursuing are -- they don't view that it's necessary to do a partnership anymore given the changes to the 75% rule?

It's definitely not the latter. Virtually all of the de novos -- in fact I can't think of a single de novo that we've announced that was a joint venture. All of the de novos were wholly-owned hospitals, either in existing markets like Mesa, Arizona, or new markets like Loudoun County, Virginia. Now the real reason for that very candidly is the fact that these are tough times. The credit markets are tough. I don't have to tell anybody on this call the challenges that we face. We believe that it is prudent for us to preserve our cash and to use that free cash flow to focus on our deleveraging priority. Acquisitions that come up we certainly are going to look at. Any consolidation that might present itself will always be a very, very attractive use of our capital. But those acquisitions are not huge dollar amounts.

The other thing that we're looking at and we've talked about this previously is the ability to add beds to our existing portfolio. Now, that's really fueling the organic growth, but the returns that we can get on a ten-bed addition or a five-bed addition are far, far superior to investing in a de novo and then waiting the two years for it to be built, waiting then for six months for it to ramp up. We think it's the right thing to do long-term. There's no question about that. But in today's really difficult credit markets and uncertain economic future, we prefer to manage in a more conservative manner, which I think most everybody on the call will acknowledge is the way we've tried to manage this Company all along. And some of the times when we've taken conservative action people second guess and question and wonder why we're doing it, but they've always turned out to be, in retrospect, the right things to do. So we think this is the smart course given where we are today and it's preserving the cash, paying down debt, looking for bed additions and we're definitely managing that process and then as acquisitions present themselves, particularly consolidations where we can really consolidate an existing market, we think that's the best use of our cash flow.

And to add onto that point, Chris, the -- we look at it as when do we get cash back for the cash that goes out and as Jay mentioned, if we were to do a de novo we'd spend cash now and we don't get the cash returned for a few years out. Clearly all the other alternatives that he discussed we're starting to see cash right away after the money's spent. But we have not given up on de novos and I don't want to imply that either. What we're looking to do is to find developers and there are still developers who are interested in doing that who would finance it from day one on the real estate side. And when you do that and you look at, yes, you're making a lease payment, but the cash-on-cash return is still pretty significant if you finance the real estate. So that's what we're focused on.

It's a good question and I'm glad you raised it because it is a shift that we have made. It's a subtle shift, but it's also a shift reflective of the current economic realities.

And then a follow n on that -- and I clearly appreciate where you guys are today and where so many other companies are today with regards to the acquisitions -- but as we're thinking about the inpatient rehab market and other areas of the post acute continuum, you guys have said in the past that your goal is to look elsewhere outside of the inpatient business. Are the opportunities today as good or better outside of inpatient rehab or -- I guess I'm just trying to get a sense if there are acquisitions out there, are there better opportunities inside inpatient rehab today than there were maybe a year ago?

Well, I don't know that there are. Clearly from a fundamental business perspective there are different segments that are doing better, but I think that in today's market how are you going to finance it?

Right.

We're not going to lever up, that's for darn sure. If anything what we've said is we want to get our balance sheet at a point, and we think that that's going to be in the 2010, 2011 timeframe when we get our leverage below 4.5 times. At that point then we feel we have a balance sheet that will allow us to go out and pursue acquisitions. But today I think, and I think the management team here believes, that the most prudent course of action is focus on our core business, grow our market share, focus on deleveraging, strengthen the balance sheet and use that free cash flow to make sure that we are a very strong company as the credit markets start to improve, as the overall markets start to improve and it gives us then a lot more flexibility at that inflection point.

Okay. Thanks a lot.

You bet.

Your next question is from the line of Derrick Dagnan with Avondale Partners.

Good morning, Derrick.

Hey, good morning. Wanted to ask you, looking at some of these market consolidation acquisitions you've completed over the last year, I guess six months after the acquisition, have -- has the market performed the way you wanted it to or thought it would and has that impacted at all some of the same-store volume statistics?

Clearly the consolidations have been grand slam home runs. There is no question that they have been excellent transactions and we have been very, very pleased with the results. Similarly, the acquisition of the hospital in Vineland has been a terrific acquisition, in part because we have a great hospital, great employees, great management team, great physicians and that too has been a very impressive transaction for us. So, yes, there's some of the growth in that 8.1% that's reflective of the discharges coming off of Midland and Arlington, but, again, that's just -- it's really looking at an existing market and bringing that market into more focus and allowing us to take more market share.

Okay. And I'll ask -- I'll follow-up on the labor side. Do you have any anecdotal evidence on -- that this recent economic weakness may have caused nurses or therapists to come back to the workforce and could that have any positive impact on the absolute wage rate that you may be looking to pay in the future?

Yes. We're seeing that not so much in the therapist side, more on the nursing side. Our therapists tend to be younger and the nursing staff is a little more experienced and so we are seeing the ability to attract nurses who are interested in coming back into the marketplace.

I think that's pretty much what we have seen in just about any economic downturn in the past and we're seeing it again. By the way, Derrick, Mark just gave me a note. There were about a hundred incremental discharges in Q3 from the consolidations in Arlington and Midland.

Okay. That's helpful. Thank you so much.

Your next question is from the line of Kemp Dolliver with Cowen and Company.

Morning, Kemp.

Morning. Question relates to your high-class volume growth problem and that is given the changes in the regulatory environment and also the changes in your prototype hospital, what do you see as your -- what's a reasonable occupancy ceiling to think about? Year over year in the third quarter you're up about 300 basis points, which is a nice move, and I'm just trying to gear what are the limits on the sustainability of the volume growth?

Well, first of all, we're always looking at adding to that bed capacity and as I mentioned, that is -- that has been a phenomenal use of our capital. To be able to add five or ten beds is always going to be a desirable way of adding new revenues and new earnings. So just if you keep in mind the overall level -- occupancy level, that we target towards is about 85%. When you get to 85% in a typical HealthSouth hospital that has the majority of our rooms are going to be semi private with some number of private, that's going to be about maximum and that's when we start looking to add beds. If it's a certificate if need state we have to go through a few more hoops, if it's not a certificate of need state we can just make the decision and we add the capacity. So I guess one way of looking at that is just saying, okay, if we added 300 basis points each quarter when are we going to get to 85%, but you also have to realize that we're going to continue to add beds and so we want to stay ahead of that curve and we think that we've been able to do that pretty successfully.

Okay. And just to pursue this a little more, but a different angle. You have a variety of different markets where -- there are markets where you're the only player in town and then there are markets where you're part of a larger MSA, and have you seen any difference in the effectiveness of, say -- of the TeamWorks initiative by type of market?

Not really. We've been very pleased in all of our markets with the TeamWorks initiative. Mark, you want to --

Yes. I think one thing that we have seen benefit from TeamWorks on is pursuing what we call the secondary markets and not being so dependent upon a small number of referral sources within our main marketplace, but being able to diversify out and capturing referrals and admissions from a secondary market.

And that probably has more of an impact in those smaller markets than the larger ones, but even if the larger markets going out beyond the traditional referral sources has been a real positive.

That's very helpful. Thank you.

You bet. Thank you.

Your next question is from the line of Pito Chickering with Deutsche Bank.

Hello, Pito.

Good morning, guys. Most of those (inaudible) at this point, but a few quick questions for you on TeamWorks. Specifically looking at your class facilities in the first quarter that had TeamWorks installed, the (inaudible) to third quarter and have you seen it slow down at all or is it still continuing to go pretty strong?

We've seen nice, continued sustained growth throughout the entire year on those hospitals that went through the installation starting back in the Q4 of last year and then each -- we had three successive quarters this year where we had installs and they've all continued to sustain growth.

Okay, great and then look at the peer mix, there's a pretty big jump on the other third-party payors in the third quarter. Is that due to the TeamWorks or sales process or is that just a seasonal change that impacted you during the third quarter?

No. I think that that's in part seasonal, but I do believe that the focus that we've made has also allowed us to go after those commercial patients that's in that line item; those small number of patients that still have traditional insurance. And we're broadening the focus and it's really part of the growing effort that we've had to look beyond the tried and true and go out and pursue new avenues and so that has opened us up to being able to serve patients from a broader range than just primarily Medicare.

All right. And last question here, which you may not be able to answer, but thinking about TeamWorks in the next for or five quarters is there any feeling that the number of facilities that you may see capacity constraints from in CON sates, other than (inaudible) facilities?

We looked at that -- we look at that every other week to keep maintaining the focus on our occupancy and there may be one or two where we're waiting on the CON process, but we're far enough ahead of the curve that that's really not a big issue, and, in fact, as you may know, in some states, Florida is an example, if you hit a certain occupancy for 12 consecutive months -- and I think it's 90%. Is that right or -- 85%, 90%, you're able to expedite the CON process to bring beds on very quickly, either 10% or ten beds, whichever is greater. So what we're doing is we're monitoring that., those hospitals, for example, that might be in Florida running into that kind of capacity constraint, we're going ahead and we're taking the risk that we're going to see that level be maintained so we're geared up, ready to go. as soon as we are able to move. Because of the expedited process, boom, we're ready to do it and we move very quickly. So it's not a big constraint.

It's a much -- there is some timeframe because if you have to do some construction, it could be six months or nine months before you get the bed addition completed.

Yes Some are going to be you punch out a wall, you have to add bricks and mortar, there are going to be other times that we can re assign rooms that have been moved into a pain clinic or maybe there's some administrative capacity and we bring those back online as beds. Does that help.

Your next question comes from Miles Highsmith with Credit Suisse.

Hey, good morning, guys.

Hi, Miles.

Just a couple of questions. On -- as it relates to potential future derivative tax proceeds, et cetera, can you just remind us, are there any requirements to repay bank debt with those proceeds before you can look to buy bonds or do other things with that -- and I'm not talking about the restricted pay covenant in the credit agreement, just a general repay covenant? And then one follow up?

The answer to your question, the monies we receive for federal tax refunds that relate to, I believe it's '03 or before, need to be used to reduce the term loan but it's only the taxes, Miles, so when you think of a refund, you get taxes and interest., so the interest is available for other purposes. There is no such restriction on the derivative proceeds. There is an excess cash flow sweep that we have to be cognizant of but there is no specific requirement those proceeds be used to reduce a term loan.

Great, that's helpful. And then just curious -- Paul says I missed it -- but have you -- did you give us your company-wide compliance rate with respect to the 75% rule for this quarter?

No, we didn't, but that is right at 62%, which is right in the range of what we have said we're comfortable with. We don't want to get it all the way right smack-dab down at 60%. We wanted to have a little cushion because as we've seed before, the process of reviewing the compliance level is not a pure science. There's a lot of discretion involved on the part of the fiscal intermediary, a lot of subjective elements that come in, and so we don't want to get all the way down to 60% and be subject to an interpretation by a physician that we then have to appeal and during that appeal process, the hospital's being paid an acute care rate. So we feel very good at that 62% and I think you'll find that that's been pretty consistent at where we've been managing over the last three quarters.

That's great. Thanks a lot.

You bet.

And your next question is from the line of John Ransom with Raymond James.

Morning, John.

Hey, good morning. John, I'll just ask you to defer this if you're going to do this Monday, but are you going to update the Company's 382 calculation on your NOL?

I sure will be happy to do that. At this point in time we don't have exposure to that, as I remind everybody that we did the block trade transaction and there's something called a small issuance exception that was available to us that kept us under that and we do have that validated every year and we are not at risk and remind everybody that in March of '09 the convertible preferred stock, which was a significant change in ownership, drops off because it will have been there three years, which will even give us further relief from the 50%.

OKay, great. And just looking at your EBITDA, there was an unexpected, at least in our model, drop of minority interest. Is that a sustainable event or was there something happened with those particular assets this quarter that might bounce back?

I don't have a specific answer to that other than if you look at the -- those are with joint venture partners which means they probably did a little worse in the quarter --

Sure.

-- than some of our nonjoint venture partners and that can vary. Some quarters we see those a little bit stronger ,but those typically are tied to acute care hospitals and you're probably ,like everybody else seeing some, what I would say maybe softening in acute care hospital discharges, so it's not unlogic -- illogical that those two might be linked a little bit.

And then finally, I do agree with you with the -- the wheels have certainly turned with the not for profits in terms of the market conditions. Does that -- is your scope of opportunity there going to change materially in terms of accelerated shutdowns or maybe people approaching you to do things in certain markets where they might be looking to monetize an underperforming rehab unit, or is it too early to see that?

John, I think it may be too early to see that, but we certainly are putting our resources into a market-by-market assessment, gathering as much information as we can, reaching out where we think it's appropriate, because clearly you have to have a willing seller and a willing buyer and we're certainly a willing buyer, but we've got to make sure that they're -- that the not for profit is willing to see the benefit. We think that that's going to happen and as I mentioned we think that that's something that may present an opportunity for us, But I think you're right, it's probably a little bit too early to tell, but we should start to see -- get better indication of that as we move into '09.

Right. I mean, I guess the paradox is is the credit crunch is creating an opportunity, which is also inhibiting the opportunity to take advantage of it, which is kind of a paradox.

It's not really inhibiting us. We have the ability to execute on those kinds of transactions. We've got the cash flow, we've got the ability to do that. They're not huge transactions. We're not talking about $30 million, $40 million. These are $5 million, $10 million, maybe $12 million transactions.

And you get immediate lift in earnings.

Sure.

Actually when you look at them on a post acquisition multiple, they 'e pretty good.

It's huge, yes.

Okay. Thanks a lot.

All right, thank you.

There are no further questions at this time. I will now turn the call back over to Ms. Arico for closing remarks.

If you have additional questions we'll be available later today. You can contact me at 205-969-6175. Otherwise we look forward to seeing you on November 10th in New York City. Thank you.

Great. Thanks, everyone.

Thank you.

Thank you for participating in today's HealthSouth third quarter 2008 earnings conference call. You may now disconnect.