Encompass Health Corp (EHC) 2011 Q2 法說會逐字稿

Good morning, everyone, and welcome to the HealthSouth second-quarter 2011 earnings conference call. At this time I would like to inform all participants that their 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. 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, Melissa, and good morning, everyone. Thank you for joining us today for the HealthSouth second 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; and Ed Fay, Senior Vice President and Treasurer; and last, Julie Duck, Vice President of Financial Operations.

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

Moving to slide 1, 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 the second quarter of 2011, which will be filed next week, and its previously filed Form 10-Q for first quarter, Form 10-K for the year-end 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.

Most of you know that the operating results for our LTAC has been moved to discontinued operations. In an effort to assist you in recasting your model, we provided a number of slides in the appendix. Of the supplemental slides, we have quarterly reclassified numbers for 2010. In addition, we will be providing you 2009 quarterly reclassified numbers when we file and release the second quarter 2011 investor reference book in mid August.

Before I turn it over to Jay, I would like to remind you that we will adhere to the 1 question and 1 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. We are pleased to report the results of another excellent quarter and believe the value of our business model was again evident as net operating revenues increased 8.1%, driven by solid discharge growth of 6.1%, and an increase in net revenue per discharge of 2.6%, while adjusted EBITDA grew 14.8% compared to the second quarter of 2010.

Discharge trends were good across all regions, and our quality and outcome measures remain strong. Not only did our hospitals treat more patients and enhance outcomes, they did so in a highly cost-effective manner as salaries, wages, and benefits as a percent of net operating revenues declined 60 basis points over the second quarter of last year, while hospital related expenses as a percent of net operating revenues declined by 40 basis points.

Importantly, the Company continued to generate strong cash flow. Our adjusted free cash flow for the quarter was $63.5 million, and this compares favorably to adjusted free cash flow of $52.6 million during the second quarter of last year.

Finally, recognizing there was a total of $0.33 per share of nonrecurring and tax-related items that negatively impacted our results compared to last year, our earnings per share was $0.14 for the quarter, compared to $0.40 per share last year. We also strengthened our balance sheet in the quarter by calling $335 million of our 10.75% senior notes, leaving an outstanding principal balance of $164 million, which we intend to call in the third quarter using a combination of the proceeds from the sale of the 5 LTACs, cash on hand, and some revolver capacity.

The final repayment of these bonds will achieve our goal of eliminating this high-cost debt, a strategy that was initiated a little over a year ago by Doug Coltharp and Ed Fay, and should bring our leverage ratio to 3 times by the end of the year, significantly ahead of schedule.

In addition to these strong operational and financial results, we also announced 2 development projects in the quarter. The first was the announcement that we received final approval for a new 40-bed hospital in Ocala, Florida. This project began in 2008 but had been mired in the CON review and appeals process for the past 2 years. We will begin construction in the fourth quarter and are targeting a Q4 2012 opening.

The second was the announcement of our intent to purchase substantially all of Drake Center's inpatient rehabilitation assets in Cincinnati, Ohio. This 38-bed hospital will be our first hospital in Ohio, and once some necessary renovations are completed, we expect to admit patients in the fourth quarter of this year. With that summary of the quarter's highlights, I'm going to ask Doug to provide a more thorough review of the quarter's results.

Thank you, Jay, and good morning, everyone. I will provide some additional color on our operating performance for the second quarter and also discuss our continuing enhancements to the capital structure. I will remind everyone that during the quarter we entered into an agreement to sell our LTACs to LifeCare. Although this transaction will close in the third quarter, for financial reporting purposes, the LTACs moved to discontinued operations in the second quarter. And this change is retroactive for 2011 and prior periods. As such, the results I'll discuss on the call exclude the LTACs for all periods.

As Jay summarized, we had another a very solid quarter. Our consolidated net operating revenues grew by 8.1% over the second quarter of 2010, driven by an 8.8% increase in inpatient revenue. The growth in inpatient revenue resulted from volume and pricing improvements. Discharges grew by 6.1%, with 3.5% in same-store growth and the balance contributed from our hospitals opened or acquired subsequent to June 30, 2010.

Revenue per discharge for the quarter was up 2.6%, primarily attributable to an approximately 2.1% increase to our Medicare reimbursement rates, which became effective October 1, 2010, and an approximately 3.5% increase in our managed care pricing.

Outpatient and other revenue for the quarter was flat on a dollar basis compared to Q2, 2010. Within this line item, outpatient revenue declined due to the operation of fewer units. We operated 29 outpatient satellite clinics at the end of the second quarter of 2011 versus 38 at the end of second quarter 2010, as well as the impact of the 25% rate reduction for reimbursement of therapy expenses for multiple therapy services, which we had previously estimated as a $1.4 million annual reduction to outpatient revenue.

The decline in outpatient revenue for the quarter was offset by the inclusion of $1.9 million in state provider tax revenue. The rate of decline of our outpatient business continues to slow as we have successfully closed our most unproductive units.

We continue to demonstrate appropriate expense discipline and realized operating leverage in each of our significant categories for the quarter. SWB for Q2 was 47.8% of net operating revenues, a 60-basis point improvement over the same period in the prior year.

We continue to roll out our TeamWorks care management initiative, and at the end of the second quarter, had completed implementation in 86 of our hospitals. This initiative is designed to further enhance the quality of our patients' clinical outcomes as well as their satisfaction with our services, and the initial results are encouraging.

An important component of this initiative was to design a staffing model for case management that results in an increase in employees in the hospital case management department.

We are also utilizing more registered nurses and certified rehabilitation registered nurses than in prior years. We have encouraged our nursing and therapy associates to heighten their skill sets by seeking additional accreditations. Our Company absorbs the cost of these educational programs and rewards the recipients of these accreditations with higher compensation. We believe these staffing and skill mix changes are both a necessary and worthwhile investment as they further differentiate our service offering. However, this initiative will impact our ability to achieve SWB leverage in the second half of 2011.

Hospital-related expenses for the quarter declined by 40 basis points over the comparable period in 2010 to 23.5% of net operating revenues. Within this category, bad debt expense for the quarter was 1% of net revenue versus 1.1% in the second quarter of last year. Collection activity has been strong, and we continue to benefit from the collection of prior period medicare denials, although the number of claims that have completed the review process continues to decline.

Based primarily on the resumption of medical necessity claims reviews we witnessed in the first quarter, we continue to believe it is appropriate to anticipate bad debt expense at approximately 1.5% of revenue in the second half of 2011.

Finally, we also experienced operating leverage in our G&A expenses which excludes stock-based compensation. G&A for the quarter was 4.4% of net revenues, an improvement of 50 basis points over the second quarter of 2010. Our strong operating performance generated adjusted EBITDA of $115.5 million for the second quarter, a 14.8% increase over the prior-year period. For the first 6 months of 2011, adjusted EBITDA was $232.8 million, an increase of 15.5% over the first 6 months of 2010.

As anticipated, interest expense for the quarter increased by $4.8 million from the second quarter of 2010 to $34.9 million. Interest expense for the first half of 2011 was $70 million as compared to $60.6 million in the first half of 2010. As I will discuss in a few moments, we now expect to complete the payoff of the 10.75% senior notes during Q3. As a result, we expect second-half interest expense to approximate $52 million and the interest expense in Q4, which will fully reflect a complete pay off of the 10.7% notes, to approximate $24 million.

EPS remains a bit of a complicated story. Please recall that beginning this year, the release of a substantial portion of the valuation allowance against our deferred tax assets and its corresponding impact on the reported tax provision expense let us discontinue our use of an adjusted EPS measures and to focus on GAAP EPS.

During the second quarter, our income from continuing operations attributable to HealthSouth per share included a number of nonrecurring and tax-related items that in aggregate decreased our earnings by $0.33 per share as compared to the second quarter in 2010. These specific items are detailed in our press release as well as in the supplemental slides, and they include a $26.1 million or $0.28 per share pretax loss on early extinguishment of debt related to our call of $335 million of the 10.75% senior notes in June; a $12.5 million or $0.13 per share increase in income tax expense in the second quarter of 2011 compared to the same period of 2010, resulting from the Q4, 2010 valuation allowance reversal I mentioned just a moment ago; a $10.6 million or $0.11 per share pretax gain related to a recovery from a former disloyal employee; and a $2.7 million or $0.03 per share pretax increase in professional fees due primarily to our obligation to pay 35% of the aforementioned recovery to attorneys for the derivative shareholder plaintiffs.

After giving effect of these items, income from continuing operations attributable to HealthSouth per share for Q2, 2011, was $0.14 per share as compared to $0.40 per share in the same period of 2010. Our basic and diluted earnings per share were the same for both periods. EPS will be impacted in the second half of 2011 by the estimated $13 million pretax loss on extinguishment of debt we will occur with the anticipated call of the remaining 10.75% senior notes.

As Jay mentioned, we continue to generate significant adjusted free cash flow. As a reminder, in our definition of adjusted free cash flow, we add back the cash premium paid on the early retirement of debt.

For the 6 months ended June 30, 2011, we generated $111.7 million in adjusted free cash flow as compared to $98.3 million in the same period last year. Adjusted free cash flow in 2011 has benefited from increases in adjusted EBITDA and the expiration of interest rate swaps in March of this year. These improvements have been partially offset by anticipated increases in maintenance CapEx and interest expense.

Maintenance CapEx for the first 6 months of 2011 was $22.3 million, an increase in $9.5 million, largely attributable to 2 significant hospital refurbishment projects. As we had previously suggested, based primarily on the impact of these projects, we expect maintenance CapEx for all of 2011 to approximate $60 million.

During the second quarter we also entered into a contract with Cerner for the system-wide implementation of a new clinical information system. This decision follows the successful piloting of the system in our Northern Virginia hospital. We have worked closely with Cerner to design a system that will digitize patient care and improve efficiency within our hospitals. The rollout of this system across our hospitals will begin in 2012 and extend over approximately 5 years.

The installation will be a component of our maintenance CapEx. The installation cost will vary some by hospital depending on items such as the size and physical plant, and are expected to be a range of $1 million to $1.5 million per hospital with approximately 75% of the initial spend being CapEx and the balance being expense. Accordingly, we anticipate maintenance CapEx of approximately $75 million in 2012.

Turning to the balance sheet, as Jay mentioned, we are nearing the completion of the capital structure enhancement strategy we first discussed with you in the second quarter of last year and which we began implementing last fall. As we approach the closing of our LTAC sale, we expect to proceed with the call on the remaining 10.75% senior notes. Once completed, we anticipate that annual cash interest expense run rate that will be approximately $22.4 million lower than the annualized run rate that existed in the first half of 2010, which was before we began the implementation of this strategy.

Combining this of the aforementioned expiration of the interest rate swaps, we will create an annual adjusted free cash flow run rate that will be nearly $70 million higher than the annualized run rate that existed in the first half of 2010.

As a result of these actions, we anticipate that we will achieve our target leverage ratio of 3 times during 2011 and we'll have in place a debt capital structure characterized by manageable, well-spaced debt maturities with no significant maturities until 2016; significant unfunded availability under our revolving credit facility; limited exposure to rising interest rates; limited principle amortization requirements; numerous debt prepayment options; and flexible covenants. We believe this capital structure will serve us well as we continue to navigate an uncertain regulatory and economic environment. And now I will turn it back over to Jay.

Great. Thanks, Doug. Before we take questions, I would like to discuss 2 topics, our accelerated de novo strategy and our updated full-year guidance.

While I outlined the rationale for our de novo strategy on our last call, I would like to reiterate several key underlying factors that helped shape this approach. The first is, we like the business we're in. We're the industry leader of an attractive segment of the healthcare continuum with a proven track record of providing high-quality, cost-effective care. We believe the inherent demand for inpatient rehabilitation services will continue to grow due to the aging of the population and the relatively nondiscretionary nature of the underlying conditions we treat. Furthermore, we believe our scale will allow us to add new hospitals in a highly efficient manner.

The second is our belief healthcare will continue to face uncertain reimbursement and regulatory headwinds for the foreseeable future, and that, in this kind of environment, successful healthcare companies will be those who have strong balance sheets that can accommodate additional pricing pressures, nimble growth strategies that can be funded without additional leverage, and a track record of differentiated, high-quality, cost-effective care provided through a variety of market cycles and conditions.

The third factor is the absence of any near-term structural industry catalyst that would motivate us to move into adjacent post-acute services. Beginning last year, a tremendous amount of speculation circulated around accountable care organizations and how they were going to transform the $2.5 trillion, highly fragmented healthcare industry into a series of risk-taking, economically-integrated providers focused on chronic care and prevention. Then came the proposed ACO rules and the realization that the industry's transformation will be evolutionary, not revolutionary, in nature.

Finally by pursuing growth in our core inpatient rehabilitation business, we can capitalize on our track record of achieving solid returns from investing in de novos and can avoid 2 significant risks associated with buying noncore businesses, risks that amplified during times of uncertainty. First, we avoid buying businesses that face known regulatory changes at prices that don't reflect those changes. And second, we avoid assuming integration risks that are attendant to non core acquisitions.

With these underlying assumptions in mind, we concluded an accelerated de novo strategy was an effective way to create a return on the cash we were generating. Based on our analysis of growth opportunities in both existing and new markets, we believe we can open 3, possibly 4, hospitals in 2012 and are targeting to open at least 4 new hospitals in 2013, 2014, and 2015. Opening the fourth hospital in 2012 is dependent on securing a final parcel of land in time to begin construction by the fourth quarter of this year. The number of hospitals we can open in the out years will be dependent on securing final certificates of need for de novos in CON states.

Finally, to the extent possible, we will attempt to balance our risk by opening some of these new hospitals in new markets and others in existing markets. Each de novo will be approximately 40-50 beds with all private rooms and will cost approximately $20 million to $25 million to build and equip, inclusive of land, IT for our new clinical information system, and working capital requirements. In most instances, we will purchase enough land to support future expansions.

Each de novo incurs between $350,000 to $500,000 of preopening costs, most of which is expensed in the 90 days immediately preceding opening. Based on the success of our most recent de novos, sustained positive facility EBITDA occurs within 3 to 9 months while Company average EBITDA margins are achieved by the end of the first full year of operations.

The incremental G&A required to support this growth is expected to be approximately $2.3 million in 2012, ramping up to approximately $3.6 million in 2014. The additional costs will be for a new operating region, the staff of which will be based in Birmingham, and additional accounting, IT, and human resources support. We are targeting all de novos to achieve or exceed certain return thresholds, including a minimum internal rate of return of 15%. It's important to note, we will be able to finance this growth exclusively from expected free cash flow, and if needed, by occasionally tapping into our revolver capacity.

One of the principal advantages of this strategy is that we are not putting the Company's balance sheet at risk. If the industry headwinds become too stiff, we can shut down the de novo pipeline, complete those that are under construction, and redirect our free cash flow to repaying our long-term debt. Alternatively, if regulatory clarity is evident and compelling post-acute opportunities present themselves, we will be in a position to pursue these opportunities with an unencumbered balance sheet.

As we said in May, and I think it's even more true today, this approach is a prudent way to manage the Company during a time of reimbursement uncertainty while positioning it to take advantage of future growth opportunities once the industry risks are clarified or removed.

With respect to guidance, we are increasing our adjusted EBITDA based on our strong year-to-date results and are revising our EPS guidance to reflect the planned repayment of our 10.75% senior notes. Adjusted EBITDA is projected to be in the range of $447 million to $453 million and is based on the following second-half assumptions.

Discharge growth of between 2.5% to 3.5% which would bring full-year discharge growth to between 4.7% and 5.2%. As a reminder, fourth-quarter volumes are difficult to predict because of the year-end holiday season. Furthermore, volumes grew by 5.9% in the fourth quarter of last year, aided by newly opened and acquired hospitals, which creates some challenging second-half comps. We expect pricing growth of approximately 3% on a per-discharge basis. This assumes an increase of approximately 2% to our inpatient Medicare reimbursement effective October 1 with no significant change to our managed care pricing before the new year.

On the expense side, we are projecting salaries, wages, and benefits as a percent of net operating revenues to be in the range of 49% to 50% due to seasonality of second-half volumes, the additional personnel to support our care management initiative that Doug mentioned, and merit increases for all non senior management employees of between 2% and 2.5%, effective October 1. We expect bad debt expense as a percent of net operating revenues will be approximately 1.5%. On a full-year basis, $447 million reflects a solid 9.1% increase over last year's adjusted EBITDA, while $453 million translates into an impressive 10.6% growth over prior year.

With the complete retirement of our 10.75% senior notes and the resulting charges for the early extinguishment of this debt, our new earnings-per-share guidance has been revised to $1.17 to $1.22 per share. As a reminder, and as Doug mentioned, our second-half interest expense is expected to be $18 million less than our first-half interest expense.

So I know we have taken a lot of time in our comments, but we wanted to be as thorough as possible in discussing our results, de novo strategy, and the basis for our updated guidance. With that, we will now take questions.

Thank you. (Operator Instructions) Your first question comes from Frank Morgan of RBC Capital Markets.

Good morning, Frank.

Mr. Morgan, your line is open. You may have your mute button on. Your next question comes from Paxton Scott of Jefferies & Company.

Hi, good morning, Jay. How are you? Thanks for taking the questions. I understand your comments there towards the end on the 2.5% to 3.5% for the back year given the more difficult comps, but I'm just curious as we're thinking about this accelerated de novo strategy, and obviously, with the elimination of the LTACs, it should -- that is obviously going to boost your discharge growth as those were a slight drag. As we think of 2012, 2013, should we think about that 2.5%, 3.5% accelerating slightly?

I think it's too early to talk about the out years. But, clearly, we will be revisiting our guidance with respect to volumes and so on when we talk about 2012. So, I think it's premature to talk about them today. But, I certainly would have you expect us to update and to talk about that as we review 2012 with you in February.

Okay. Very good. And then as a follow-up just obviously with everything that is going on in Washington, there is general concern over reimbursement, particularly on the Medicare side, and to my knowledge I have not heard anything mentioned on inpatient rehab facilities, but obviously you are a little bit more plugged in than we are. What kind of color can you give us in terms of what you're hearing there? Thanks.

You know, I think that the -- everyone would agree that the situation in Washington is chaotic. Having said that, we are not hearing anything in the context of Medicare cuts that would severely impact us.

We don't have any effect on reducing graduation medical education payments. We would be affected if the bad debt payments were reduced. But as we look at our portfolio and analyze that exclusive of the LTACs, that is maybe a $3 million hit. And all of the other changes really affect other segments of the industry.

So, at this point I think -- and certainly what we're advocating is, listen, we gave at the office last year. Hospitals agreed when -- I don't know, agreed is maybe not the right term but, we certainly received a haircut on future payments for the next 10 years.

And I think what we're starting to see as the public companies start to report, and you start seeing the effects of the Medicare pricing reductions, if that is happening in the publicly traded, high performance hospitals, imagine what is happening in the 85% of the rest of the market that are not for profits and don't have the same cost structure.

So, I think that there is a realization out there that hospitals have already given at the office and already have sacrificed future payment cuts for 10 years. And I do not anticipate that there will be more, but there's always that risk. I think we are in uncharted territory. So we have to be careful; we have to be prudent; we have to be managing this Company so that it can deal with whatever comes down the pike.

Frankly, we are one of the few providers that has been able to demonstrate that even in an environment of flat and no increase -- back in 2009 and 2010, we grew. So, that is a long-winded way of answering, but obviously, we are spending a lot of time on it, and it is a major focus.

The other thing on the volume side, Paxton, that Doug was going to mention is, we're not going to see any of the value of these de novos in '12 because most of them, in fact all of them, are going to be opening in the fourth quarter. That is just a timing issue. It takes about a year to build them.

We are in the process of securing land today. We have got to then make sure that we have got it permitted, et cetera. So, if we start in the third quarter of this year with these projects, and we are, we should be opening them then in the third or fourth quarter of next year. So, it will not have an impact next year. That's not to say that we're not going to be looking at the kind of guidance that we give on volume, but it certainly is going to have a nice impact in '13 and beyond.

Okay. That's great. Have you completed your analysis of your potential markets that you are going to be rolling out these de novos, or are you still in the preliminary phase of that?

A few identified markets, and we're buying land as we speak.

Okay. Perfect. Thank you very much.

Your next question comes from Colleen Lang of Lazard Capital.

Hello, Colleen.

Hi. Good morning, Jay. Just a quick follow-up on the [earth] de novo strategy. How many of the markets that you are looking at right now are CON states versus non CON states just given the timing differences and getting stuff up and running?

It's about half and half. And several of those certificates of need states, we have already filed the CON.

Okay, great. Can you talk a little bit about the mix of volumes in the quarter and any areas where you saw stronger or weaker than expected growth?

Certainly from a geographic standpoint, it was pretty evenly distributed. We saw a nice growth across all of the regions. With respect to the program mix, I'm going to ask Mark to give a little color commentary on that.

The biggest shift we saw in our program mix was shifting out of orthopedic, specifically the lower extremity joint replacement. We saw a drop of about 1% in that to an all-time low of 8.7% of our total patient mix and an increase in our neurological conditions. We saw an increase of that of about 1%. So, what we lost out of the joint placements, we increased in the neurological conditions.

Great. And just a quick one for Doug -- do you expect to see a similar benefit on the outpatient side for provider taxes -- some provider taxes in the second half of year?

No, we don't. It's a little bit lumpy, and it's getting harder to obtain, as you can imagine, because it is impacted by some of the battles and the squeezes that are happening in state budgets. So it's hard to predict, but I would not assume that there's any contribution from provider taxes in the second half.

Your next question comes from Darren Lehrich of Deutsche Bank.

Good morning, everybody. I just want to first say, Doug and Ed, you guys did a great job with the balance sheets, and it's just a great result. I wanted to ask just about -- a big change in Q2 just from a regulatory perspective in the post-acute sector was this face-to-face change for home health.

I know that you have a very small exposure in home health at this point, but I guess the question really is, Mark, was there anything that you saw in terms of benefit? Did referral sources ditch the lower acuity home health setting in favor of your setting because of the hassle of face-to-face? And then specifically, within your home health business, can you just talk to the trends there?

Darren, I can't say that we saw a big impact from that. I will say that the fact that the vast majority of the patients that go into our home health are conversions from our inpatient rehab side of the business. The whole face-to-face position requirement really did not impact us at all because our patients would have recently seen a doctor as they were in our inpatient rehab hospital. So, I do not want to say that we saw a big impact from a shift from outside referral sources. It's just -- the comment that I would make on that is just the whole face-to-face requirement really did not impact us at all.

Okay. And then, Jay, this is not really a question, but usually we get an update on the arbitration. It has been sort of quiet there. Can you just provide us with anything in terms of activity levels to the extent that you can?

Yes, and Darren, that was an oversight on my part, in part because it is just grinding on. But really no change from what we talked about last week -- or last call. There have been sessions that have been held. The arbitration is just grinding on.

And there's really no change in our forecast that this is going to be a first-half 2012 event that gets resolved there. Unless, [Ian Wise] is willing to come to the table to settle ahead of time and I don't expect that.

I think that Ian Wise is highly incentivised to drag this out, drag this out, drag this out. The arbitrators have to give both sides as much leeway and as much time to present their case. We are always available to meet. That is not always the case on the other side. So, I hate to say this, but it's the same old same old.

Your next question comes from Sheryl Skolnick, CRT Capital Group.

Good morning, everyone. Jay, I want to compliment you on the transparency that you have given us on so many points, not just the capital structure plans, kudos again to Doug, but also on the disclosure -- the titling disclosure of that OIG issue down in Houston and the handling of that, but also on your very cogent explanation for why you are expanding your de novo strategy, which is where my question actually is.

As you look at the timing and the pacing of this roll out of this strategy, the first question is, when should we, as we model this, when should we think about the costs beginning to ramp up?

I assume the answer to that is going to be third quarter, but if you can help us think about when we see cost; you've already helped us think about when we are going to see volumes and revenue. But, when we are going to see these costs, that would be very helpful.

The other related issue is if you could give us a sense of how many markets you are actually looking at and characterize them by, these would have been primary markets under the strategy before you've expanded it, and maybe perhaps now some more secondary or markets where you talked about last quarter considering going into markets that perhaps have either less dense population or smaller markets, etcetera. If you could characterize that pipeline for us, I'd appreciate it.

Sure. In terms of the expense, if you're looking at it from an income statement, the cost will -- there will be a modest increase in the fourth quarter of this year as we assemble a new region and office. We have got the space here, but we will be recruiting regional leadership, and again, that leadership is comprised of a regional president, regional controller, and a regional head of our marketing, and then of our human resources. So, it's not a huge staff.

We get a lot of support, then, from the corporate folks. And again, we have got the office already identified. It will be up here with the other Birmingham-based folks. So, there will be a modest increase there.

From a capital standpoint, the hospitals will begin construction in the fourth quarter, and the spend, that $15 million to $20 million spend will be obviously some up front as we buy the land, and then the spend will sort of ramp up into 2012 and really start to accelerate in the second half as we bring these hospitals to completion.

In terms of the characteristics of the market, what we did is we went back and we essentially looked at 4 things. And 1 was kind of a new way of looking at the market. But, they included population size and then the underlying growth of the over-65 segment of the population.

And we are still pretty consistent on the size of the market. I will say that, based on our experience and the success with the TeamWork sales and marketing, the size of the market has actually increased. Instead of looking at a tight cluster of zip codes, we are looking of a broader range of zip codes from which we would be able to potentially attract patients.

Second thing that we look at is the number of possible admissions that might qualify or would qualify for an admission into a rehabilitation hospital and the conversion of those into existing rehabilitation facilities. The third thing that we look at is, what is that base of existing rehabilitation providers? How much market share are they getting? And to what extent are they matching the kind of conversion that we are seeing?

And then the last thing that we look at is what kind of conversion rates in that population of potential rehabilitation admissions, how many of those are going to skilled nursing facilities.

So those are the 4 key components. There are other things that we look at. Cost of land. Frankly, we are not interested in jumping into a highly unionized environment. But we're looking at all those things.

I think that the difference today is not so much the size of the market as it is the market dynamics. Specifically, how many patients are being currently converted into a rehabilitation admission, and how many are going into a skilled nursing environment where clearly the level of service is much less, the quality is not as good, and we believe, just as we saw in northern Virginia, an opportunity to bring a higher level of care presents itself, and that's how we are looking at these markets.

That's very helpful. This is actually a question for Doug. I have to pick a nit here. I'm having some difficulty following your calculation for adjusted free cash flow. I get the fact that you are going to subtract some things and add some things back.

But, I guess I'll ask the question this way. Since I can't send an add back, and I don't know too many people who can, at what point should we begin to see straight off cash flow from operations as presented on the GAAP financial statements, year-over-year comparisons being positive?

I think you're going to see -- if this is the answer to question, I think you are going to see virtually all of the noise removed by the end of 2011. And a lot of the stuff, certainly the very substantial loss on extinguishment that we have had, we are about to recognize the last piece of that with the removal of the residual 10.75%. And I think some of the other things that have created noise that create a gap between those 2 measures will be eliminated by the time we exit this year.

Your next question comes from the line of John Ransom of Raymond James.

Good morning, John.

Good morning. I was going ask if Doug's going to be bored now; now that the capital structure's done, how is he going to spend his time? It looks like it's -- is it going to be -- is your capital structure pretty stable from here? Are there any other changes that you are thinking about?

I think it is going to be pretty stable.

So, what are you going to do with yourself?

(laughter) Dan and I talked yesterday about the fact that I hope it's not a disposable position.

It's definitely not. You know, 1 of the things, John, that was really an opportunity for us, when John Workman left and went up to Omnicare, great opportunity for him up there. And obviously, everybody has seen what he and John Pegar has done.

The opportunity for us to really focus on growing the business has been something that we look forward to. We now have a balance sheet that is in good shape. And Doug's expertise and background really lends itself perfectly to focusing on growth in the Company.

So, you know, I think that he will be very busy, and we are really pleased that he is on board. He's brought a lot of value in a very short period of time to this Company.

Well, I was kidding. Can you remind me how much pro forma, how much capacity will you have under your bank revolver once all the moving parts are done?

Say that 1 more time?

How much capacity will you have on your bank revolver once all of the pieces are put in place? What do anticipate that to look like when all is said and done?

To give Doug something to do, I will ask him to respond to the question.

About $300 million.

Okay. And you like to keep about that amount available, do you not? Isn't that your rule kind of --?

Our general rule of thumb is to keep at least $250 million in unfunded capacity. And actually, I think I was probably even conservative with that $300 million because I would actually expect that even after we fund the 10.75%, that may be closer to $350 million. So, we will be well within those parameters.

Your next question comes from Adam Feinstein of Barclays Capital.

All right. Thank you. Maybe just a couple of things here. Maybe you can comment on mix a little bit as well. Did you guys see any sort of change in mix? I'm just curious, if we look at some of the main areas, how your mix played out for the quarter.

The payment mix or the service mix?

The service mix.

Hi, Adam. The service mix, as we have seen in past quarters here recently, we continue to see the shift away from the orthopedic categories into the neurologic categories. As I said earlier, this most recent quarter we saw a shift.

The largest shift was away from the lower extremity joint placements where we dropped down to 8.7% of our total cases; and saw an increase of about what we lost in the joints, we increased in neurological cases. And that continues to be the trend that we have seen really for the last several quarters now.

Okay. And then how would you define the competitive landscape these days -- just with the nursing homes, and continued blurring of the lines here? Would you say that things are stable here? Or would you say that you think it's more competitive?

Obviously, you guys are showing pretty strong volume growth, so you are clearly taking market share. But just curious as you think about just the competitive landscape.

I don't see that the landscape is changing that much. And frankly, we do not see a blurring of the distinction between nursing homes and rehabilitation hospitals. In fact, quite the contrary.

I think that the physicians who have to make the ultimate decision, where does a patient get discharged once they're no longer an appropriate acute care admission, are focusing, as are the hospital case managers, increasingly on what is the best setting for the patient, and where is that patient going to get the best quality care?

And clearly there are patients that can go into nursing homes if they need some sort of low-level services, and it's more convalescent in nature. But if a patient has suffered a stroke, they've suffered a debilitating neurological condition, they are unable to care for themselves, and there is a concern that that patient may not be able to make it into an independent lifestyle, they are going to admit that patient to a rehabilitation hospital.

So, we are actually seeing more physicians, more hospital case managers appreciate and understand the quality differentiation that we provide, the better outcomes that we provide. And as everybody knows, at some point down the road, there's going to be -- 2013 I think, there will be a focus on acute-care readmission rates and some penalties associated with rates that go out of the expected range. So, the lines are actually becoming more distinct, and we think that that is, frankly, to our advantage.

Your next question comes from Whit Mayo of Robert W. Baird.

Thanks. I just wanted to follow up on John's question for a second. Even with the accelerated de novo strategy, which you've clearly put a lot of thought into, to me, it's almost inconceivable how your net debt is not going to go below 2 times next year with the potential to be even lower.

You're going to call bonds, you're selling the LTAC, so you have the proceeds there. So, I was just wondering, as you look out, what leverage ratio do you think is the minimum before you would think about buybacks to augment your capital deployment strategy, while still maintaining a lot of flexibility to be opportunistic with larger acquisitions if they should present themselves?

I think your observation is correct, that we would expect that based on the free cash flow generating levels of the Company, leverage should continue to go down as we move forward into 2012. In terms of what kind of level we ultimately achieve or feel comfortable with, it's really going to depend on how the regulatory environment continues to evolve and what kinds of external growth opportunities we are seeing.

As we've stated, once we get below 3 times, we are comfortable with the level of leverage, particularly given the composition of our debt capital. If we take it down further, it could be viewed as temporary as we evaluate those growth opportunities in the emerging regulatory environment.

To your point, Whit, we are going to be evaluating where is the best -- what is the best return for our cash. And Doug has mentioned before and we have talked about this, we are going to look at a wide range of strategies. So, we don't want to rule out anything and we don't want to put anything on the table because it will be a functional of what's happening in Washington.

You know, we are no different than so many other businesses that are waiting to see what kind of clarity there's going to be, if any -- there's going to be created in Washington from a regulatory standpoint so we can get on with our business.

No, that's helpful. And maybe just one quick last question. Jay, you've been -- in the past you've commented that you were looking at I think some new supply initiatives. Is there anything new there? Any opportunities on pharmacy that you're seeing?

You know, most of the initiatives that we have identified, we're working. There is nothing that is going to be moving the needle significantly. But, the supply chain focus has been here for the last couple years. We have got an outstanding individual running that. We have got an equally outstanding senior executive over that area. And they have been very good at finding savings throughout that entire supply chain, and obviously, focusing on standardizing our formularies from a drug standpoint and then using our buy to get additional savings.

So, we feel pretty good about that. And whatever I may have said in the past should not have been implied that we were waiting and that that was sort of next in line. That is something that Dave Clements has been working on for at least the last year and a half, 2 years.

These are ongoing initiatives, and you don't see them pop up on the radar screen, but it doesn't mean that we're not out there looking for opportunities to improve the efficiency. A great example of one that has been underway in 2011 that's producing some very nice results is on our overall food cost in our facilities.

And that's, Whit, where you actually see it is in the other operating expense as a percent of net revenue. We continue to see that decline; we continue to get leverage out of that. So, while it may not be a headline initiative, it is certainly something that we take very seriously and that the hospitals also take equally seriously.

Your next question comes from Kevin Fischbeck of Bank of America Merrill Lynch.

Good morning, Kevin.

Good morning. Since you guys had some LTACs previously, I assume you're reasonably up to date on the whole patient assessment criteria initiative there now. Theoretically, if that was to go into place, that would cut LTAC volumes, which could be a good thing for them based upon what they'll get in return, but that volume would have to go somewhere. Have you done any work around what type of volume might shake loose from the LTACs and whether that would be meaningful to your industry?

We have, based primarily on our knowledge of the kinds of patients that we have been able to treat in our LTACs and knowing that there are LTACs out there that frankly try to attract patients who may not technically qualify for an LTAC. So, do we think that there may be some upside? The answer is yes.

Have we quantified what that is? The answer is no. Because I think it's very hard to know with any certainty what the patient criteria is going to look like.

So, based on what we're seeing, there is some [grasp] of the patient criteria. You know, in my opinion, that really didn't meet what we believe the intent was. They really sort of just kind of codified existing parameters and regulations. It was not as if they came up and said, all right, these are the kinds of patients, as they did in the 75% rule.

These are the patients that you can admit. You've got to get X%. They just, well, you got to have -- every patient has to be a length of -- average length of stay of 25 as opposed to all of the population.

So, the criteria that I saw was pretty mushy, and the fact that it hasn't been scored yet, to our knowledge, suggests that it is going to be hard to get it through. So it needs to be clarified. Once we do that, we'll obviously look and say, hey, are there opportunities to bring some of those patients in? Are they appropriate for admission into rehabilitation hospitals?

Okay. Then just following up on 1 of the points you made earlier about the markets that you look at, 1 of the criteria that you were looking at was conversion of the rehab patient into nursing homes. You can just talk a little more about what the opportunity is there? Would a high conversion rate imply more opportunity because you can take them from nursing homes or less opportunity because it's just a lower acuity type rehab patient? I wasn't sheer exactly what the [multiple speakers]

We see it as an opportunity. If the conversion rate is high, we see that as a positive, because we believe that if we come into a market and are able to offer a higher level of rehabilitative services that some of those patients who do not have -- I mean, it's really -- our belief is that they do not have the option, and so if the option isn't, they default to a nursing home admission.

So, our belief is that what we've seen in every market where we've entered is that offering that higher level of care is a differentiated service, and it is something that physicians, patients, and families look for. So, we see that as a positive if the conversion rate is high. It's an opportunity.

Your next question comes from A.J. Rice of Susquehanna Group.

2 questions. First of all, just understanding the IT initiative with Cerner. If we think about 2012 and 2013, is that relocating capital dollars towards this, or are we going to see a bump up in your capital? And trying to think about free cash flow deployment, how much do you think that would represent possibly?

It would be a bump up.

I'd mentioned earlier that we would anticipate -- we include that as a component of our maintenance CapEx out of the total spend on a per-hospital basis, which will vary between $1 million and $1.5 million per hospital for installation cost. And the variance in that range really depends on the physical configuration and size of the hospital.

About 75% of the installation costs will show up as CapEx, the balance to be spent in the period leading up to the installation. We're anticipating the rollout across our existing hospital base will be relatively evenly paced over 5 years.

So, you will have about 20 of those hospitals being converted in a particular year. (Inaudible) we take the maintenance CapEx in 2012, that $75 million, and we would expect, based on the existing composition of our business that it will remain in a $75 million to $80 million level for the years that follow.

Okay. That's great. And then just quickly, I know the focus is on the de novos and rolling those out, but there is also occasionally the opportunistic outright acquisition. Can you comment? I didn't hear you say what the state of play is there in the IRF space. Is there -- are you seeing properties in light of the different things that are going on with the capital markets, et cetera? And what are the prospects for doing some deals thereat?

Really, there's not a lot of change in what we've said in the past. There are some properties. We just announced acquisition of Drake. But clearly, those are more challenging; they're harder to come by.

I suspect that in the future, if the Medicare reductions and increases for the acute care hospitals had the effect that I think it is going to have, I think there are going to be many acute care hospitals looking for cash.

And certainly to the extent that they may be operating a rehab facility that is breaking even or maybe costing them some money, and we are in that market, and we can acquire it and then consolidate that into our existing hospital. We definitely will be pursuing those, and are. But, there's really no change, A.J., but I think it's something that may change based on the financial situation of the acute care hospitals.

Your next question comes from Gary Lieberman of Wells Fargo.

Thanks for taking my question. Maybe you can loan Doug to Jefferson County. He can help them as some of their debt issues.

There's an idea.

I think you talked a bit about the CONs, but for the 15 or 16 de novo facilities that you have in the pipeline, how many of those require CONs?

About half and half. And as I said, many of those CONs have already been filed.

Okay. And then, to the extent that you don't get all of those CONs for the other half, does that 15 or 16 assume that there is some higher gross numbers, or are you looking at potentially 20 or plus potential de novos, and you assume that 15 or 16 of them get done?

We're certainly factoring into our -- the number that we gave, some degree of slippage in the CON, the ability to get CON approval. So, there is some additional markets, additional hospitals that we're looking at. It's fair to say that there's a little bit of excess capacity beyond what we already talk about.

So, we can think of that 15 to 16 as sort of a net de novo number.

Yes.

Okay. And then just terms of -- it seems like your ability to continue to take market share in existing markets, it always seems endless. Can you just sort of give us an update there on your comfort with continuing to be able to drive the continued market share gains that you see in those markets?

I was thinking about that because I figured somebody would ask that question. I was going to ask Mary Ann to go back and see how many quarters we have gotten the question. And I think it's 1 that we've received a lot. The underlying demand has some momentum just by virtue of the demographics shift. The aging of the population.

As we have said in the past, there's maybe 1.5% underlying growth that is occurring simply because the population is getting older. But as we look out, we still feel comfortable that we are able to continue take market share. We think that the services that we offer truly do differentiate us.

We think that the shifting focus on quality and outcomes and re-admission rates will play into our strong suits. So, yes, we still think that our ability to grow organically can continue for the foreseeable future.

Your final question comes from John Ransom of Raymond James.

Hi. Just a quick follow-up. Let's say that our brilliant politicians retroactively give you a rate freeze in the effort to find some money. Is anything that you could do to immediately off set that, or would that have to be dealt with your next merit increases?

Yes, there clearly would have an impact on our merit increases. There is no question on that.

But, if you have already given it, would you take it back, or would you look at for the next year?

We wouldn't take it back. I cannot see doing that. That would be very, very hard. I think clearly the senior management levels would -- we would be able to be a lot more flexible there, but that's not going to you move the needle.

So, we should think about that. It'd probably ripple straight into your EBITDA then in the short term if that were to occur.

Yes, possibly. But if that were to occur, I would suspect that the effect on some of our competitors would be even more pronounced because at least we have got some flexibility. And I think that in that kind of situation, we would drive for stronger volume growth.

Okay. And my other question, is there a practical or structural limit to what ENY can do to drag this thing out?

I don't think there's anything structurally. I certainly don't think that this is going to be going on indefinitely. There's -- we're further along than we were 3 months ago, not by much, but we are further along.

And I think that the first half of 2012 is still an appropriate range to be thinking about at least including the proceedings. Now the arbitrators are going to have to take all of this and review it and make an ultimate decision. How long that will take is not clear.

So, let's just say that the arbiters -- you conclude this. The arbiters come back in June of 2012 and say, okay, NYU, you owe $100. Obviously, $100 is a funny number. But what could they do then to say, well, we need to meet in the fourth quarter of 2048 and figure it out, and we'll back to you sometime in the 28th century.

I mean, do they -- does the clock tick? Can they then push that out another year and hem and haw and appeal and anything like that? Or is there some way that they have to come up with the money certain amount of time?

I'm going to ask John Whittington to respond because otherwise I might get in trouble.

Okay, thanks.

John, generally in an arbitration you forfeit your appellate rights. There are limited, very, very limited appellate rights in arbitration. If there's a verdict, it has to be complied with in 30 days after the entry of the verdict.

30 days. Okay. Great. That's perfect. Thank you.

At this time, there are no further questions. I will now turn the call back to Mary Ann Arico for closing remarks.

As a reminder, we will be attending 2 conferences in September, the Baird and the Morgan Stanley healthcare conference in New York. If you have additional questions, feel free to call me later at 205-969- 6175. Thank you.

Thanks, everyone.

Thank you for participating in today's conference. You may now disconnect.