Encompass Health Corp (EHC) 2011 Q1 法說會逐字稿

Good morning, everyone, and welcome to HealthSouth's first-quarter 2011 earnings conference call. (Operator Instructions). Today's conference call is being recorded. If you have any objections, you may disconnect at this time.

I would now like to turn the call over to Mary Ann Arico, Chief Investor Relations Officer. Please go ahead.

Thank you, Brandy, and good morning, everyone. Thank you for joining us today for the HealthSouth first-quarter 2011 earnings call.

With me on the call in Birmingham today are Jay Grinney, President and Chief Executive Officer; Doug Coltharp, Executive Vice President and Chief Financial Officer; Mark Tarr, Executive Vice President and Chief Operating Officer; John Whittington, our Executive Vice President, General Counsel and Secretary; Andy Price, Senior Vice President and Chief Accounting Officer; Ed Fay, Senior Vice President and Treasurer; and Julie Duck, Vice President of Financial Operations.

Before we begin, if you do not already have a copy, the press release, financial statements, the related 8-K filing with the SEC and the supplemental slides are available on our website at www.healthsouth.com.

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-Q for first quarter of 2011, which will be filed next week and its previously filed Form 10-K for the year ending 2010 and other SEC filings. We encourage you to read them.

You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented. Statements made throughout this 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 the 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.

Before I turn the call over to Jay, I would like to remind you that we will adhere to the one question and one follow-up question rule to allow everyone to submit a question. And with that, I will turn the call over to Jay.

Great. Thank you, Mary Ann, and good morning, everyone. By any measure, HealthSouth's first quarter was exceptionally strong and provides an excellent start to the year. Topline growth of 9.6% was driven by a 4.5% increase in same-store discharges, while another 260 basis points of growth was added from hospitals acquired or built in the past year. All of our new hospitals are performing well, and as we will discuss in a moment, their success has reinforced our commitment to our de novo strategy.

From an expense standpoint, our hospitals continued to provide high quality care on a disciplined, cost-effective basis as evidenced by the 16% increase in our adjusted EBITDA compared to the first quarter of 2010.

Productivity and as a percent of net operating revenues, labor, hospital-related, and general and administrative costs all showed solid quarter over quarter improvement.

We also took a significant step toward repaying a portion of our most expensive debt by raising $122 million through the reopening of our 2018 and 2022 senior notes.

As Doug will explain later, we plan on calling and repaying $285 million of these notes at the initial call date of June 15 with additional repayments expected later in the year.

Finally, as previously stated, we are reporting earnings per share from continuing operations attributable to HealthSouth on a GAAP basis beginning this quarter and are no longer reporting adjusted earnings-per-share.

On this GAAP basis, first-quarter EPS was $0.60 per diluted share compared to GAAP EPS of $0.40 per diluted share for Q1 of 2010.

With that summary of the quarter's highlights, I'm going to ask Doug to provide a more thorough review of the numbers.

Thanks, Jay, and good morning, everyone. I will provide some additional color on our operating performance for the first quarter and also discuss our immediate plans for repaying the 10.75% senior notes.

As Jay summarized, we had a very solid first-quarter. Our consolidated net revenues for the quarter grew by 9.6%. Inpatient revenue was up 9.2%, driven by a 7.1% increase in discharges and a 1.9% rise in revenue per discharge.

Our volume increase included 4.5% same-store growth, as well as the positive contribution from hospitals opened or acquired over the last 12 months.

Now please note that our Q1 results include a $1.1 million net benefit to income from continuing operations related to state provider taxes. And although this net amount is not material, its components impact a number of line items, and so I would like to take just a moment to explain this more fully.

A number of states in which we operate hospitals assess a provider tax to certain health-care providers. Those tax revenues at the state level are frequently matched by federal funds as part of the Medicaid program.

In order to induce healthcare providers to serve low income patients, many states redistribute a substantial portion of these funds back to the various providers. These distributions are frequently based on different metrics than those used to assess the tax and are thus in different amounts and proportions than the initial tax assessment.

As a result, some providers receive a net benefit, while others experience a net expense. These provider taxes are a regular component of our financial results.

However, during Q1 a new provider tax was legislated in Pennsylvania, a state in which we operate nine in-patient rehabilitation hospitals. The Pennsylvania Provider Tax Program contributed $5.1 million to outpatient and other revenue in Q1 of 2011, but was offset by an $800,000 decrease in inpatient revenue from a similar program in Missouri in which we operate two inpatient rehabilitation hospitals, resulting in a $4.3 million benefit to our Q1 net operating revenue. This revenue increase was partially offset by a corresponding expense of $3.2 million included in our Q1 hospital-related expenses, leaving us with aforementioned $1.1 million net benefit.

Now with that said, we once again exhibited disciplined expense control during the quarter. SWB for Q1 was 48.2% of net revenues, a 110 basis point improvement over the first quarter of last year. Approximately 30 basis points of this decrease was attributable to the inclusion of the provider tax revenue. The residual 80 basis points of improvement was driven by higher volumes, pricing adjustments and enhanced productivity.

As evidence of this latter, employees per occupied bed, which we refer to as EPOB, improved to 3.40 from 3.41 last year. Hospital-related expenses for the quarter were 23.1%, a 10 basis point improvement over Q1 of 2010 even after absorbing a 40 basis point negative impact from the provider tax issue.

Bad debt expense for the quarter improved by 40 basis points to 1% of net revenues based on strong collections and recoveries of prior period write-offs. During Q1 we did experience the anticipated resumption of medical necessity claims reviews. As these claims move through the review and adjudication process, they will age out, resulting in an expected increase in bad debt expense over the balance of this year.

Our G&A expenses, excluding stock-based compensation for the quarter, declined by 40 basis points to 4.2% of net revenues as we achieved operating leverage against the revenue increase. As anticipated, our first-quarter interest expense increased by $4.6 million over the same period last year. This was attributable to the refinancing activity we completed in the fall of 2010 and the add-on to our 2008 gain and 2022 senior notes in March of this year, which Jay alluded to earlier.

Our income from continuing operations attributable to HealthSouth for the first quarter increased to $65.4 million versus $43.8 million in the same period last year, and earnings per diluted share increased to $0.60 as compared to $0.40 in the prior year. The increase in EPS was attributable to the improved operating performance for the quarter and a $0.27 per share tax benefit.

The tax benefit related to a settlement with the IRS for tax years 2007 and 2008, as well as a reduction in unrecognized tax benefits due to the last of the statute of limitations for certain federal and state claims, essentially a reversal of some prior FIN 48 reserves.

Our cash taxes for Q1 were $2.6 million as compared to $1.6 million in Q1 of 2010. For the full-year 2011, we anticipate cash taxes in a range of $7 million to $10 million.

As Jay noted earlier, please be reminded that we now report GAAP EPS only and no longer provide adjusted EPS. A reconciliation between these two measures is included on page 12 of the supplemental slides.

During the first quarter, we generated adjusted EBITDA of $123.4 million, a 16% increase over last year, driven by our strong operating performance. Adjusted free cash flow increased by 4.9% to $51.4 million. As we had anticipated, adjusted free cash flow growth was somewhat tempered by increases in working capital, interest expense and maintenance CapEx.

Looking to the balance of the year, adjusted free cash flow will benefit by approximately $33 million from the cessation of the interest rate swap settlements with this benefit offset by the anticipated year-over-year increases in maintenance CapEx and working capital.

Based on our intended exercise of the call option on a portion of our 10.75% notes, which I will discuss momentarily, interest expense for the final three quarters of 2011 should be roughly comparable to the same period last year.

Total CapEx for Q1 was $15.3 million versus $14 million last year, and maintenance CapEx for the period was $9.4 million versus $5.6 million last year. The increase in maintenance CapEx is primarily related to hospital refurbishment projects.

Turning to the balance sheet, based on very favorable debt capital market conditions, in March we raised $122 million via a $60 million add-on to each of our 2018 and 2022 senior notes.

The incremental notes were issued at a premium of 103.25% and 103.5% respectively, resulting in a blended yield of approximately 7%. Proceeds from this offering were used to pay down $45 million of borrowings under our revolving credit facility replenishing availability, and the residual $77 million is held as cash pending the initial call of the 10.75% notes.

Those 10.75% senior notes have an initial call date of June 15, 2011, at a price of 105.375%. It is our intent to exercise the call option on $285 million of those notes. With the premium, this will require a cash outlay of approximately $300 million, which we expect to be funded with the $77 million of remaining cash proceeds from the March debt issuance, and the balance will be funded under our credit facility.

These actions will generate interest savings of approximately $12 million in the second half of this year and will also trigger a non-cash loss on the early extinguishment of debt of approximately $23 million.

We are very pleased to be in a position to make such a substantial initial call on this expensive component of our debt capital and anticipate further repayment of these notes during the course of the year as we continue to generate free cash flow.

I will now turn it back over to Jay.

Thank you, Doug. Before taking questions, I would like to discuss the status of the E&Y arbitration, preview our accelerated de novo growth strategy, and comment on 2011 guidance.

The E&Y update is more of the same -- strong conviction in the merits of our claims, coupled with concern that the process is moving so slowly. As we have previously stated the rules of the American Arbitration Association require us to keep the arbitration strictly confidential.

Additionally, in accordance with E&Y's engagement letters, the arbitration process, which will resolve our allegations that E&Y negligently and recklessly missed a seven-year multibillion-dollar fraud, is confidential. Therefore, as we have said on prior occasions, there are limited comments we can make.

While we had hoped the arbitration process would be completed in the second half of 2011, significant scheduling conflicts will limit the number of hearings in the third and fourth quarters and will push the proceedings into next year. Since the beginning of the arbitration back in July of 2010, there have been approximately 10 weeks of hearings, generally in four-day blocks of time.

Going forward the arbitrators have scheduled an additional 15 weeks through April 2012. Despite scheduling issues and the fact that the arbitration is taking longer than expected, we remain confident in our claims and are committed to aggressively and diligently pursuing them to conclusion however long it may take.

The good news is we are not dependent on receiving any E&Y proceeds to execute our business plan. Over the past several years, our primary objectives have been repaying our most expensive debt, creating a manageable maturity profile for the remaining debt, and positioning our balance sheet for growth.

Now that our leverage objective is within reach, we believe the highest and best use of our cash is to invest it in our core inpatient rehabilitation business. Since 2006 we have built and opened six new hospitals -- some to complement our presence in existing markets, some to provide high-quality inpatient rehabilitative care in new markets. The success of these hospitals has been undeniable. They achieve sustained positive EBITDA between three and nine months of opening and Company average occupancy levels within the year.

This strategy also is relatively low risk since it does not require assuming integration or new business risks and can be funded through cash on hand and if necessary through our revolver.

Furthermore, in the case of non-CON markets, we can control the number and timing of new hospitals, while hospitals in CON markets, like the one we recently announced in Ocala, Florida, can be added as the CONs are granted.

The success of our de novo strategy motivated us to expand our search for new markets. While our business plan calls for opening two to three de novos each year, we now are confident we can increase that number over the next several years. While we have not finalized these plans, we are targeting to at least double the number of de novos added to our portfolio each year.

We will complete this analysis during the next 90 days, and we will share the results with you on our next call. This emphasis on de novos will not affect our intent to acquire other inpatient rehabilitation hospitals, and we still believe two to three acquisitions per year is achievable.

A corollary to this accelerated de novo strategy is a more cautious approach toward diversifying into other postacute services. When health-care reform was passed last year, accountable care organizations received a tremendous amount of attention. Many heralded them as the new healthcare delivery model. As we contemplated this new world order, we reasoned it made sense to consider adding other postacute services to complement our facility-based rehabilitation services.

While ACOs certainly are an intriguing long-term model, the recently issued ACO proposed rules suggest the healthcare delivery system is not going to be transformed overnight. These proposed rules are well-intentioned, but in our opinion create outsized risks while providing little by way of a framework for assessing the potential returns from assuming these risks.

In many ways, ACOs echo decapitated model of the '80s and '90s, but with the federal government setting the rules instead of the insurance companies doing so. Given the inherent complexities of transforming a highly fragmented industry into one consisting of cohesive economically integrated providers, it is obvious ACOs are going to take years of pilots and evaluation before the merits of this concept are validated.

Accordingly we will focus our near-term development efforts on expanding our IRF portfolio while participating in select ACO pilots when and where it makes sense to do so.

Focusing on an accelerated de novo strategy versus acquiring new businesses is further supported by our belief that provider reimbursement will come under increasing pressure over the next several years as federal and state governments attempt to reduce budget deficits. Couple this scenario with the prospect of rising interest rates, and we believe the appropriate way to manage the Company over the near term is by capitalizing on our position as the leading provider of inpatient rehabilitation and keeping our balance sheet de-levered and strong.

The consistency of our operating results and strong cash flows reinforce this approach.

As we look to the remainder of the year, we anticipate we will continue to gain market share, although weakness in acute care admissions is something we will continue to monitor. Pricing should remain stable, and the proposed IRF-PPS net increase of 1.5% is consistent with the Medicare pricing adjustments we had assumed for the fourth quarter.

Although we had an excellent start to the year, consistent with our past practice, we are not going to increase our guidance at this time with the exception of adding the tax benefit to our EPS range. We will revisit guidance when we report second-quarter results and have retired a portion of our 10.75% senior notes.

While we are not raising guidance at this time, we do expect our full-year performance will be at the high end of or greater than the current $440 million to $450 million EBITDA and $1.28 to $1.33 per share EPS ranges.

With that, operator, we are ready to take questions.

(Operator Instructions). Darren Lehrich, Deutsche Bank.

So nice quarter here. I think the obvious question is really about the de novo strategy. It is pretty notable in terms of how much additional growth you are getting from a lot of these development activities.

When we were in Virginia, I guess it was in that facility we got a pretty full update on your targeting. And I guess I just want to understand, is what you are seeing now in the marketplace an expansion of what you have defined as your target markets?

I'm just trying to understand what is really driving the decision to increase the de novos. I think they are coming -- they are ramping faster so that may be part of it, but is there something different about the marketplace that you are seeing to make this decision?

You know, it is not so much a difference in the market as it is two factors. Number one, the success that we have had with the de novos. As we turn the corner at the end of 2007 and went into 2008, we had a strategy of de novos and acquisitions, the market collapse at the end of 2008 sort of put that on hold for well over a year.

So we did not have in that time period as we were de-levering the balance sheet and focusing on our debt, we really did not have a lot of track record to go on, but we had enough that now we believe we have the know-how to be able to ramp up and open additional hospitals in additional markets.

The new markets have really been a function of us going back and looking at markets from a more disciplined perspective and looking not only where the population and our projected demand for services was greater, but also looking at existing competitors in those markets to determine whether or not we could go in and believe that we would be able to be successful in continuing to take market share.

So there are a couple of factors -- one, the success that we have had and the confidence that that has given us that we can, indeed, identify, open and make successful new hospitals; and then second is the fact that we have taken a more expansive approach in looking at markets for de novos.

That is great. And then I guess my follow-up on this topic would just be for Mark. You have a great margin structure to work with to do what Jay is talking about. I guess just from your perspective, operations, should we expect to see, with an increase of de novos, any real disruption in margins, or do you think you can sustain what we are seeing here?

Yes, I think we can absorb it within our existing structure. We have done a good job of building bench strength the past couple of years so that we would position ourselves for growth once we got to that point. So there would be no reason to expect a significant disruption at all.

And, at the corporate level, we have already modeled out the additional resources that we think we may need over the next several years as we launch a more aggressive approach to de novos and are very confident that that is a very de minimis investment, and think about it from a risk standpoint, pretty low risk way of investing our free cash flow and getting some very nice growth over the next several years.

Adam Feinstein, Barclays Capital.

I wanted to ask just back to the discharge growth, obviously a very strong number. Your guidance that you guys talked about at the Analyst Day at the end of the year last year was 2.5% to 3.5% growth. You obviously are tracking higher than that. I know your comments about you think you will come in at the high-end of the guidance range in terms of the EBITDA, but how should we think about the discharges for the year? Is the 2.5% to 3.5% still the right way to look at it? Is it safe to assume you will be at the high-end of the guidance range for volumes as well?

Yes, I think that is a very appropriate way looking at that.

Okay. And then just at the same time, I wanted to get some more color just in terms of mix, and what areas are you seeing the best growth in? Obviously I know stroke has been a big area of focus for you guys, but just curious in terms of the different categories.

As we have seen in the past several quarters, our neurological programs continue to grow. As a matter of fact from a category standpoint, that was the largest growth in discharges. We also had growth in major multi-trauma, amputee and pulmonary.

The programs that we saw a reduction in, we continue to see a decline in our replacement of lower extremities or the knee replacements, osteoarthritis and rheumatoid arthritis. So, as we have continued to beef up our program mix and competencies on our neurological, we see the nice volume growth in those categories.

Okay. And then Jay, I want to get your outlook on the reimbursement landscape. The reg came out last week, and it looked fine with the 1.8% increase, but just curious to get your thoughts just about anything in the regs. And obviously it does not impact you guys as much, but the nursing home reg was pretty negative last night. I just don't know what that signals in terms of future tone from CMS, so I was just curious in terms of your thoughts on the reimbursement landscape.

I mean I think that the reimbursement landscape, as I mentioned in my comments, I think is going to be pretty tight over the next several years. I mean it is obvious that we have a huge budget deficit. It is obvious that entitlement programs are going to have to be addressed. And one of the reasons why we have tried to manage our Company as conservatively and as prudently as we have is because we are aware of that. I mean we're not looking just today, we are looking down the road and saying, where do we think the industry is going to be and what are the pressures that are going to be facing us two, three, five years from now?

As far as the landscape is concerned, the expenditures on inpatient rehabilitation have been declining over the last several years as a percent of total Medicare outlays. So I think that the positive update that we received or the modest update -- I would not say it is positive -- but the modest update that we received I think is a reflection of the fact that this particular segment is not out of control. It is not going up at double-digit rates. The industry does not have the kind of margins that you find in other segments.

And then looking at the regulatory challenges that are facing segments, I mean I must admit I was a little bit surprised at yesterday's proposed rulings for SNFs, but only because of timing. It was not as if nobody expected that the windfall that was received over the past year was going to stay there.

So I don't know, the only thing that surprised me was the timing. I thought it would be a year from now, but it happened sooner rather than later.

So I think that the landscape is going to be tough. I think that providers who have strong balance sheets will do just fine, and that is how we have tried to position ourselves, and that is why as we look at growth we are not dependent on acquisitions. We don't have to go out and acquire anything. We can grow and grow significantly through the existing cash flow and focusing on our core business.

And we think with the pressure now off of the Medicare program coming out with those very difficult ACO proposed rules, we just don't think that there is this near-term imperative that you have got to jump on this ACO bandwagon. We will test it, we will participate, but we're not going to bet the Company on something that is untested.

Colleen Lang, Lazard Capital Markets.

I guess we have seen this quarter the acute care hospitals have been reporting that while volumes are weak in their businesses, in general the patients coming to the hospital are much sicker, more acute. Do you think you guys, your volume growth this quarter saw a benefit from that phenomenon in both the ERF and LTAC side?

Certainly there is going to be some benefit to that. As we have indicated previously, there's probably about 3% or 5% of patients who get discharged from acute care hospitals that are candidates for inpatient rehabilitative care.

So we should not expect a one-to-one correlation between acute-care volumes and inpatient rehabilitation volumes, but we do see a sicker patient. There is no question that the patients who we are seeing today are more medically complex than those that we have seen in years gone by. And that is not just a reflection of the neurological shift, but also a reflection of the fact that these patients come with comorbidities, they are medically dependent oftentimes on a close monitoring, and that is one of the benefits of having those patients in an inpatient rehabilitation hospital versus, say, a nursing home when they are at that level of surveillance and cover just don't exist.

Thanks for the color. And given your commentary earlier on ACOs, have the hospitals or physicians in your market started talking to you about ACO programs and what their concerns are as well? And I guess the decision is just going to be a market by market decision based on the doctors?

It will definitely be a market by market, but I have to tell you that what we are hearing and what I said a moment ago about ACOs is really being said in a lot of different quarters.

And I think we have to step back and understand that to the best of our knowledge, Medicare never said that -- or CMS never said that ACOs were going to be the model for all providers, and that is where the industry -- and that is where we believe it was going to go. There has always been an acknowledgment that ACOs was one of several different kinds of models that might help to rein in costs.

I think that as we looked at the regs and as others did, you start thinking about the upfront costs associated with those regulations, the risks that you have to assume, the fact that the targets are set basically by CMS. And so you have got a target to perform against in year one. You have got to get at least 5% improvement before you start sharing in those, and then does that mean that the new target for year two is going to be set at where you were in year one, and does it mean that you still have to get 5% off of that?

I mean there is a lot of complexity and uncertainty surrounding this as you would expect. I mean it is a brand-new concept, and I know people at CMS have been working very hard to get these out. But I just think that rather than providing more clarity, we have really seen it provide more uncertainty, and with that uncertainty, a lot of the acute care hospitals in our markets have stepped back and said, whoa, we did not realize it was going to involve that. We may not be that interested.

And, again, this is just a pilot. And then after the pilot, you have to evaluate the results of those pilots, and then you have to modify those results and modify the model. And so it's -- I just -- our view is that, as I said, intriguing potential, but not anything that we are going to build a strategy around any time now that these proposed rules are out.

Kevin Fischbeck, Bank of America/Merrill Lynch.

I wanted to talk a little bit more about the de novo development pipeline. I mean how should we think about that from a modeling perspective? To the extent that you are doing more of these going forward, does that mean that there is going to be more startup losses that will be flowing through the numbers, or is that just going to be offset by the ramp-up of recent deals? How do we think about modeling that?

You said you are going through this process in the next couple of months. When should we reasonably expect to see these new openings? Is this kind of a second-half 2012 issue, or could it happen even sooner than that?

No, it will be a second half of 2012 and then certainly in 2013 and 2014. There will be -- we have started progress on the hospital in Ocala. We have got the hospital under construction in the Cypress area, Cypress, Fairbanks area of Houston. Those will become -- that will be coming on late in the fourth quarter of this year, obviously contributing significantly then next year. So the timing of this is going to be in 2012 and beyond in terms of the impact of these hospitals opening up.

In terms of the costs, there are going to be some modest startup costs. We will see that, but the growth and the success of the existing portfolio should certainly be able to absorb that. Will there be some temporary margin compression initially? Potentially, but I don't think -- it's not going to be a 200 basis point or anything of that magnitude.

Yes, I think the two line items where you might see some and I think Jay is exactly right, which is it is going to be a nominal impact. You will see as we have seen previously a little bit of pressure on the SWB line in the periods where these are ramping up, and then you will also see a little bit in the depreciation line as the CapEx comes on board.

But, as the number of our portfolio continues to grow, then the incremental adds are going to be less out of the total base, and therefore, the impact on the margin ought to be muted.

And Kevin, as you probably know, we have an investor reference book out online, and in that there is a section on our de novos and timeframe for developing those estimated startup costs and so on. So you can take a look at that. I think we have provided enough information for you to go in, and then you can make your assumptions as to the number of new hospitals and then use that information to help model.

Okay. And then just to clarify what you said about taking a more expansive view on de novos, it does seem like a great use of capital, high return, low risk. But whenever you start talking about doing more of something like that, you get a little bit worried that the incremental returns are not going to be as high as you would be getting if you were to do just a select two or three if you are going to be doubling that.

How do you think about the incremental returns from accelerating the de novo pipeline? Is it going to be just as good as what you have always seen, or by definition is it a little bit less but still better than any other use of capital? I guess how much of this is a view on we don't see a better use of capital versus this is just a huge opportunity that you probably were taking advantage of that, and should have been doing before?

Well, I would not say that we should have been doing it before. First of all, as I mentioned, in 2008, 2009 and into 2010, we were using the cash flow that we were generating to strengthen the balance sheet and to ensure that we had a very solid platform for moving forward.

So the return that we expect is really going to be just as good as what we have done thus far with those six hospitals. As Mark said, we have been building up the operational bench strength. We've spent a lot of time identifying what the resources are going to be needed here in the corporate office. We are definitely not going to bite off more than we can chew, but we are very confident as we look at how seamlessly we have been able to bring these other hospitals on, and I think, again, the results speak for themselves.

You can look at the number of hospitals that we have opened up over the last couple of years. You know, we have not missed a beat. And so we are now very confident that this management team can easily accelerate that and get exactly the same kind of returns on those new hospitals that we had with the existing ones.

One of the things that we looked at as part of this analysis is we took the criteria that we have been utilizing to screen new markets for de novos and we applied that against our best-performing legacy hospitals.

And it led us to two conclusions. One is that markets with a lower population density than we were utilizing to screen de novo opportunities could support a very successful rehab hospital, particularly our 40 to 50 bed prototype model.

And the second thing is we were not giving as much weighting to conversion rates in some of those markets as we think is appropriate as we evaluate new markets. And by conversion rates, we mean the percentage of total CMS eligible 13 discharges in a market that ultimately wind up in a rehab setting.

So, as we did that analysis, it broadened the number of prospective markets for us. And we are confident that as we move into those markets, we are going to continue to generate returns that are comparable to what we have seen from our recent de novo activity.

Kemp Dolliver, Avondale Partners.

The first question relates to the notes and your thoughts regarding permanent financing as you take out the notes over the course of the year.

We feel like we have got the financing in place. The actions that we began taking with regard to the capital structure in the fall of 2010 and then consummating the senior notes add-on in March really positioned us to make this very substantial move against the 10.75%.

With the revolver increased $500 million and with the maturity date pushed out to 2015, we are very comfortable funding that $200 million plus under the revolver. That also gives us pre-payable floating-rate debt, and as we continue to be a strong free cash flow generator, which is our expectation, we will be able to pull down that balance as appropriate.

Even with that $200 million plus funded under the revolver, it still leaves us with a lot of excess availability under that facility.

And then really the balance has already been taken care of with the layered senior note maturities. So we will -- this initial move is kind of taken care of, and then as we move into the second half of the year, we're going to continue to look at our free cash flow generation and assess incremental opportunities to pull down more than the 10.75%.

We fully anticipate that we will make progress beyond the $285 million in 2011, and our objective is to have those 10.75% notes completely out of our capital structure here in the not-too-distant future.

That is great. Thank you. Second question relates to the de novo discussion. One observation that has been made to me is that since the tightening up of the 75% or 60% rule, the number of providers has declined I think probably more so in, say, the hospital unit side than the freestanding hospital side.

Is it fair to assume that that is also a driver in your thoughts regarding accelerating de novos?

You know, it is a consideration, but I have to tell you it really was not a top criteria. We really looked at the markets from a demand standpoint, and, as Doug said, looked at it within the context of existing de novos, the success that we have had there, other hospitals that we have had in smaller markets, and we just concluded that we can enter markets and be very successful, not have to be constrained as much as we had been in the past.

And admittedly we are taking a little more conservative view. I mean we were investing shareholders money. We wanted to make sure that that investment was going to pay off. It has.

So I think that the decline in the number of IRFs is more a function of the quality of care. It is very hard to have a 20-bed unit with 10 patients or eight patients in there and be able to maintain the quality in that unit. It is also a financial drag, and as hospitals start to tighten their belts both the for-profit and not-for-profit and see their reimbursement squeezed, I think they are going to have to make decisions. And I don't think that there are many players out there that can be all things to all people.

So was it a factor? Yes, it played a role, but it was not -- it was a pretty minor role.

Gary Lieberman, Wells Fargo.

Maybe just a follow-up on the last topic. Your discharge growth continues to be really strong, and your marketshare gains look like they have certainly not decelerated and if anything have accelerated.

Can you give us any kind of perspective in terms of if there is an upper limit for the amount of marketshare that you feel like you can take, and are you close to that, and how should we think about that?

I don't believe that there is any upper limit that is on any kind of near-term horizon. When I say near-term, I mean as far as I can see. And so I think that the opportunity is really to provide that higher level of rehabilitative care in markets where there is not a rehabilitation provider and where that care is being provided in a sub-optimal level.

I mean we saw that in the case of our hospital in Loudoun County in Northern Virginia. Patients were going [to use] it nursing homes. They were traveling for hours to get rehabilitative care. We put a hospital in, and it has been, I think, a godsend for the patients in that community first and foremost, but it has also been very convenient for their families and a very much appreciated by the physicians.

Okay. And then maybe if I could just follow up, I have not heard you talk too much about the TeamWorks initiatives. Can you just give us an update? Are those fully implemented everywhere and kind of what -- is that one of the key -- continues to be one of the key strategies in terms of continuing to take market share?

Yes, TeamWorks from a sales and marketing standpoint has been fully implemented in all of our hospitals, all of our markets. As you may know, this year our TeamWorks initiative is focused on care management or those functions following up under that case management services, of which we have rolled out, I believe, 36 of our hospitals have now been in the process of having that implemented, and we would have that rolled out to all of our hospitals in the next couple of months.

So our effort to standardize best practices in those areas that we think will bring value and continue to increase the performance of our hospitals remains a very big focus for us.

And I think that the nature of inpatient rehabilitation lends itself more than any other service that I'm familiar with in healthcare to this best practice approach.

I mean you think about acute care hospitals and the range of services that they may offer, the capital that is required to provide those services, the personnel expertise that is required, in our case, as you heard from Mark a minute ago, the service mix is pretty much the same yet shifting. But it is shifting in virtually all of our markets.

So this is one service that really can benefit from best practices, and that is why we have made this a key operational priority.

A.J. Rice, Susquehanna.

Maybe just real quick on the labor front. We had not talked that much about what you are seeing in terms of therapist productivity, turnover rates, wage rate increases or trends in that. Can you tell us what you are seeing and what you are anticipating as you think about the rest of the year?

As you know, we make labor-management a big focus on our hospitals, including having rolled out an IT platform for our field-based managers to use in making adjustments as we see volume fluctuations.

From a market standpoint, we are not really seeing a large increase our tightening on the labor stand front. The nursing seems to be available in most marketplaces. There are certain markets where therapy availability is tighter than others, but overall it has been a pretty good couple of years for us from a staffing availability of staff standpoint.

Okay. And then maybe, I know we have talked around a lot with the discussion around the de novo strategy and you reiterated the desire to do the two to three acquisitions.

But as we progress through the end of this year and start looking out into the future, assuming you pretty much address the majority of that 10.75% notes, when you think about the $250 million to $300 million or so of free cash flow, how do you see that allocating between these strategies and anything else?

Well, recall that as we address the 10.75%, one of the things we are going to be doing is pushing a substantial amount of this $200 million plus under our revolver. So over time we want to see that come down as well. But I think on a go forward basis the prioritization of the cash flow is going to be to the de novos and acquisitions to a further reduction in debt on our balance sheet.

When we have moved completely through that, when the debt has stabilized at a level that we are completely comfortable with, which is somewhere inside that 3 times and we are not all that far from there, we can begin beyond the amount of capital that is devoted to the expansion of our ERF facilities. We can look at some other alternatives, including whether or not it makes sense for us to look at some of the shares that were issued as part of the shareholder settlement at the end of the third quarter of 2009 and get those back. We can look at a number of different alternatives.

And the other thing that we have mentioned in the past is the installation of an electronic clinical information system. We are piloting. We have piloted very successfully in Northern Virginia. We are going to be piloting it in two other hospitals this year. We are very pleased with the results.

And so that is another use of that CapEx -- excuse me, the cash flow to put into that IT CapEx, and that is going to be a five-year rollout, but it will involve additional capital dollars.

Rob Mains, Morgan Keegan.

I just have one question, and that is following up on one of Adam's questions. This is probably fairly hypothetical. But when you look at where clinically you are moving in your hospitals, I'm surmising that you have got a lot -- a fair amount of room in the -- under the 60% rule. And I am just wondering if we see because of this SNF rule if it gets finalized, that some SNFs might have less of incentive to do orthopedic-type patients that you used to see a while ago. Whether you would see a possibility of getting more of those hips and knees or whether that is really not the clinical direction that you see the Company going in?

I mean there is a chance that we could see some of those orthopedic patients come back. One thing that we have to be careful of, not only -- we have room under our compliance percentage. We have run north of that 60%, but the area of medical necessity comes into play when you take these orthopedic patients. So we would have to be careful that they do have those comorbidities, those medical complexities that would clear the hurdle from a medical necessity standpoint with our Medicare FIs.

Frank Morgan, RBC Capital Markets.

I'm really intrigued with this continued expectation of gaining market share from other providers out there. I'm just curious, is there any specific characterization you can give from where you are seeing the most market? Who are you taking market share from the most?

And with this continuation of market share takeaway, is this in some way maybe perhaps delaying you are considering getting into other business lines and just saying, hey, that market opportunity is so good here, we will stick with continued growth, de novos and maybe the notion of other postacute service lines, maybe we push that back? Is that the right way to think about it?

Definitely the second part is the right way to think about it. And that is that we are clearly signaling today that the interest level in pursuing other complementary postacute services is, in fact, much less today than it has been over the last couple of years, and it is in large part because we were looking for signals from CMS as to whether or not this ACO model was going to be attractive enough to drive business into that model. And our conclusion is that while it is intriguing, we don't see it as being transformational at least in the near term.

In terms of where the market share is coming from, I think we first have to understand it is not as if there is a defined market share number that we can go out and point to and say all right, we know with 100% certainty that there are X number of patients who qualify for inpatient rehabilitative care.

That is a bit of a fluid number because it is really a function of not only the underlying medical conditions of the population, but also judgment and decisions made by physicians with respect to where the patient can get the care and then availability of those services.

So I think that the market share, the actual market could conceivably continue to grow a) as a population ages, and that I think is one of the fundamental attributes of this strategy is the fact that we are in a segment that is growing. You know, as a population ages, there's going to be more patients who are going to be coming into that elderly group, and they are going to need rehabilitative services.

So I think that that share gain is really coming from physicians who -- excuse me, from patients who otherwise would have gone to skilled nursing conceivably from other inpatient rehabilitation providers, maybe even to some extent long-term acute care hospitals.

So I think we have to think about the market a) as growing, and then b) we are continuing to take advantage of that, and then we are trying to bring patients to our hospitals that might otherwise go to other settings.

John Ransom, Raymond James.

I'm just curious, kind of your latest thoughts about the home health sector. I know this is a sector you have taken -- you got kind of a long-term interest in. Just given the resets in SNFs today, as you're looking at home health businesses, what kind of odds would you put on the same kind of one-time reset administratively? And how would you price that in as you look at deals?

Well, first of all, we are now looking at any home care, and as I said, our interest level in that is significantly less, and we have no intention of pursuing any home care acquisitions. We are really looking to reinvest in our core business.

In terms of the probability, I mean I think that the fact that that line item continues to grow for Medicare as we have seen over the last several years, and the fact that the industry has some very high margins, Medicare margins, to me suggests that they are going to be looking at that.

We know right off the bat that they are going to be looking to re-base that. So I don't know, I think that we have said all along that we thought that those two segments had some risks associated with them, not because they are bad people or they are bad providers. They are just Medicare is spending more money on them. And in today's environment, that is going to draw some scrutiny.

Okay. And just one other follow-up for Doug. Just mechanically let's just say we are modeling something $50 million to $60 million a quarter in free cash flow. Would you, as you take out the rest of the 10.75%, should we think about that as kind of a one slug a quarter? How do you take bites at that, and how are you going to go about that mechanically?

The specific mode by which we will do that and timing is undetermined at this point, John, but I think there are a couple of things to keep in mind.

One is I know everybody on the call knows this, but just as a reminder, the call option is not something that exists just at one point in time. Once we get inside the call protection, if you will on June 15 of this year, that option is available to us for the duration that the bonds are outstanding with the premium required to call those decreasing on an annual basis every June 15.

So it is out there all the time, and with the proper notice to the trustee, we can call those in in increments of any size essentially on a rolling basis.

The second is there is the possibility that we might see attractive prices at or perhaps even below the call price for various reasons in the open market, and we have the ability to consummate open market purchases.

We also tend from time to time to entertain a reverse inquiry where somebody calls us and offers us bonds. So there are a number of different methodologies that we can utilize to pull those in, and we're going to continue to evaluate all those.

Sheryl Skolnick, CRT Capital Group.

It is actually [Nick] stepping in for Sheryl. Congratulations on some great results this morning. Just a question as to -- I don't mean to beat a dead horse here on the 10.75% notes. So we should not assume at all that any cash on hand will be used to repay -- to call those notes? It will only be free cash?

We are using $77 million of the cash that was on the balance sheet at the end of the first quarter.

Correct, but going forward? What I'm getting at, are you -- what is your target cash balance going to be now that you are considering the accelerated de novo strategy?

I get you. A couple of other things to keep in mind about the cash that existed at the end of the first quarter. One is that based on the restructuring of our capital structure, a very substantial coupon payment was actually dropped in the first week of the second quarter versus the first quarter. So that consumed some of the cash that you saw at the end of the first quarter as well.

And we also included in our press release that we had reached a settlement agreement with the state of Delaware regarding a dispute over unclaimed property, and that required a cash payment to the state of Delaware that also dropped out of that cash in the first week of April. The amount of excess cash that existed in the first quarter was perhaps not as large as you might otherwise have discerned.

On a go forward basis, we continue to believe that the amount of cash that is trapped in the system at any point in time is probably $25 million to $30 million. And then depending on what we are seeing down the road in terms of immediate other cash needs, it could be knowing that a bed expansion is coming online and that we have a required payment there, or if we know that we're getting close to the point where we are going to need to make an outlay related to some of the de novos, we might hold a little bit more. But I think on balance the amount of cash that we think we would require to retain on the balance sheet is somewhere between a low of 30 and a high of 50.

Okay. That is fair. And then one quick housekeeping question for you. Going forward modeling debt expense, should we -- is it safe to use that as a go forward run-rate what we saw this year as a percentage of revenue?

No, we have actually included that in our guidance slides as well. At the outset of the year, we had suggested that based on two factors -- one is the pool of prior period recoveries available to us was diminishing, and second, that we are starting to see already early in the first quarter when we had our last call the resumption of medical necessity claims reviews. We had anticipated that for 2011 we would see bad debt normalize in a 1.5% range.

In the first quarter, although we did see the ramp-up in the reviews, we saw more recoveries than we had anticipated, and that put us down to 1%. Factoring that in, we have now lowered our expectation for 2011 from 1.5% to 1.4%. It is a volatile number. It is kind of hard to predict, but that is what we are suggesting you should use as a modeling assumption.

Operator, Brandy, that will be our last call. I have some concluding comments. As a reminder, we will be attending the Bank of America/Merrill Lynch Healthcare Conference in Las Vegas on May 10 and 11. If you have additional questions, we will be available later today. Please call me at 205-969-6175. Thank you.

Thanks, everyone.

This concludes today's HealthSouth first-quarter 2011 earnings conference call. You may now disconnect.