Encompass Health Corp (EHC) 2012 Q1 法說會逐字稿

Good morning everyone and welcome to HealthSouth's first-quarter 2012 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). You will be limited to one question and one follow-up question. Today's conference call is being recorded. If you have any objections, you may disconnect at this time.

I will now turn the call over to Mary Ann Arico, Chief Investor Relations Officer.

Thank you, Lynn, and good morning everyone. Thank you for joining us today for the HealthSouth first-quarter 2012 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, Executive Vice President and General Counsel and Corporate Secretary; Andy Price, Chief Accounting Officer; Ed Fay, Senior Vice President and Treasurer; 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 the website at www.HealthSouth.com.

Moving to slide 2, the Safe Harbor, which is also set forth in greater detail on the last page of the earnings release. 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 first quarter 2012, which will be filed next week, and its previously filed 10-K for year-end 2011 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 this call will include certain non-GAAP financial measures. For such measures reconciliation to the most directly comparable GAAP measure is available at the end of the slide presentation or at the end of the related press release, both of which are available on our website and as part of the Form 8-K filed last night with the SEC.

Before I turn it 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 ask a question. If you have additional questions, please feel free to put yourself back in the queue. And with that I will turn the call over to Jay.

Great, thank you, Mary Ann, and good morning everyone. The first-quarter was a strong start for the year for HealthSouth as key operating metrics, discharges, net revenues, adjusted EBITDA and pretax income all grew significantly compared to the first-quarter of last year.

We also continued the development of four de novos, one that will open later this year and three that will open in 2013; received favorable rulings on Certificate of Need proceedings involving two additional de novos that we expect to begin construction on later this year; and repurchased 25,000 shares of our preferred stock, which simultaneously reduced our cash dividends and our diluted share count.

Most importantly, we maintained our focus on providing superior outcomes and continued to outpace the industry with our FIM gains and length of stay efficiency.

We believe our hospital's commitment to providing this high quality, cost effective care resulted in quarter-over-quarter total discharge growth of 6% and same-store discharge growth of 5%. The benefits of leap year notwithstanding, this growth occurred despite very difficult comps. As a reminder, discharges increased by 7.8% in the first quarter of 2011.

Net operating revenues were $538.6 million in the quarter, an increase of 6.4% over last year, and was driven by the strong discharge growth I just mentioned, and pricing per discharge that was in-line with expectations.

Adjusted EBITDA came in at $127 million, representing an 8.1% increase over prior year and was achieved through a 40 basis point improvement in our operating leverage.

Diluted earnings per share from continuing operations was $0.40, and reflected an effective tax rate of approximately 40%. Last year we had a $0.27 per share benefit primarily from an IRS settlement for tax years 2007 and 2008. Adjusting for this one-time benefit, diluted earnings per share from continuing operations would have increased 33.3% quarter-over-quarter.

We are obviously very pleased with these results and the quality of care our employees continue to provide to their patients. We also believe these results underscore the strength and consistency of our business model and positions the Company for another good year.

Doug will now provide a more detailed review of our operational and financial results.

Thank you, Jay, and good morning everyone. As Jay mentioned, Q1 represented a very solid start to 2012. Revenue grew by 6.4%, driven by inpatient revenue growth of 8.3%, offset by a 13.4% decline in outpatient and other revenue. Revenue growth in the quarter did benefit from the additional day attributable to leap year.

The growth in inpatient revenue resulted from a 6% rise in discharge volume, 5% on a same-store basis, and a 2.2% increase in revenue per discharge. The discharge volume growth for the quarter was particularly encouraging in the context of a difficult 7.8% comp from Q1 of 2011.

The factors contributing to the increase in net revenue per discharge were similar to those cited last quarter, and included the 1.6% increase in our Medicare reimbursement rates, an increase in average acuity -- stroke and neurological comprised 35.9% of our patient mix in Q1 2012 versus 33.8% in Q1 2011 -- and a shift in our payer mix -- 73.5% Medicare in Q1 2012 as compared to 71.5% in Q1 2011.

The $5.9 million decline in outpatient and other revenue was primarily attributable to the $3.4 million in nonrecurring state provider tax revenue in Q1 2011, with the residual resulting from the year-over-year decline in the number of satellite clinics. We ended Q1 2012 with 26 outpatient satellites in operation, six less than Q1 2011. There were no closures during the quarter.

As a reminder, we continue to offer outpatient services at all of our hospitals, and the vast majority of our outpatient revenue is generated from these hospital-based outpatient departments.

I want to point out that in Q1 2012 we adopted new accounting guidelines, which require the presentation of revenues net of the provision of doubtful accounts. This is an income statement geography issue only, and simply moves the provision line up from a component of operating expenses. The adoption of this accounting guideline had no net impact on our financial position, results of operations or cash flows, and it did not change our accounting policies or methodologies for determining our revenues or provision for doubtful accounts.

As anticipated, bad debt expense increased to 1.2% of net operating revenues in Q1 2012, as compared to 0.9% in Q1 2011. The factors leading to the increase were those identified in last quarter's call -- an increase in medical necessity claims reviews, and a lengthening of the Medicare denial adjudication process related to a mounting administrative backlog. We continue to anticipate a $6 million increase in bad debt expense for the full year 2012 over 2011.

During Q1 we again generated improved operating leverage and labor productivity in spite of the ramp up costs associated with our two new hospitals and the incurrence of $1.6 million in incremental expenses related to the installation of our new clinical information system.

SWB for the quarter was 48.5% of net operating revenue, an increase of 30 basis points from Q1 2011. Excluding the benefit of $3.4 million in nonrecurring state provider tax revenue in Q1 2011, SWB as a percentage of net operating revenue would have been flat year-over-year, as increased labor productivity in Q1 2012 evidenced by a decline in EPOB to 3.34 from 3.39 a year ago, was offset by a ramp up of operations in two new hospitals, a continued investment in higher skills mix including additional certified rehabilitation registered nurses, or CRRNs, and support personnel for our case managers resulting from our TeamWorks initiative. It also included the annual merit increase for our nonexecutive employees.

We generated improved operating leverage within hospital related expenses, which is comprised of other operating, supplies and occupancy expenses, as that declined to 20.8% of net operating revenues in Q1 2012 as compared to 21.4% in Q1 2011.

We also achieved leverage in G&A, which excludes stock-based compensation, which declined by 10 basis points to 4.4% of net operating revenues in Q1 2012.

The combination of strong revenue growth and improved operating leverage generated adjusted EBITDA of $127 million for Q1 2012, an 8.1% increase over Q1 2011. We were able to overcome the higher bad debt expense, the increase in installation costs for our clinical information system, and the $1.5 million net benefit from nonrecurring state provider tax revenue in Q1 2011.

Interest expense for Q1 2012 was $23.3 million, down from $35.1 million in Q1 2011, with the decrease attributable to the year-over-year decline in total debt and the other improvements we have made to our capital structure.

During the quarter we repurchased 25,000 shares of our convertible preferred stock, requiring a cash outlay of approximately $25 million. The repurchase of these shares will reduce our annual dividend obligation by $1.6 million and our diluted share count by approximately 800,000 shares.

Our leverage ratio at the end of the quarter was 2.7 times, unchanged from year-end 2011. With the expected acceleration of free cash flow generation over the remainder of the year, we will continue to evaluate opportunities to repurchase our debt and equity securities, balanced against incremental growth opportunities.

Diluted earnings per share from continuing operations for Q1 2012 were $0.40 per share as compared to $0.57 per share in Q1 2011. Once again, the earnings per share comparison for the first quarter was impacted by fluctuations in the effective tax rate.

The effective tax rate for Q1 2012 was approximately 40%, in-line with our expectations. However, as Jay mentioned earlier, Q1 2011 included a tax benefit of $0.27 per share related to items such as a settlement with the IRS on prior year tax audits and reductions in unrecognized tax benefits.

Cash income tax expense for the quarter was $2.1 million, and we continue to anticipate cash income tax expense in a range of $7 million to $10 million for 2012.

Let's move now to adjusted free cash flow. And you may find it useful to turn to the bridge that is included on slide 11 of the supplemental slides. Please recall that in 2011 our adjusted free cash flow increased by 34.1% over 2010. As discussed in last quarter's call, we entered 2012 expecting to again generate a significant level of adjusted free cash flow. We noted, however, that the growth in 2012 would reflect anticipated increases in net working capital and maintenance CapEx.

Our Q1 2012 adjusted free cash flow reflected these items as it decreased modestly to $45.2 million from $48.2 million in Q1 2011. A significant component of the working capital increase was a $16.4 million decline in accrued interest. This is an interest coupon timing difference related to our refinancing activities, and it will reverse in Q2, thereby providing a benefit to second-quarter adjusted free cash flow.

And you may recall that we experienced something very similar in Q3 and Q4 of 2011. As anticipated, and as we discussed in last quarter's call, our net working capital also increased due to a $16.1 million decline in payroll liabilities, primarily attributable to tax withholding payments related to the vesting of a 2009 restricted stock grant to our employees.

The combination of these items resulted in a $31 million increase in net working capital for Q1. For 2012 we continue to estimate the year-over-year increase in net working capital in a $30 million to $40 million range.

As anticipated, maintenance CapEx for the quarter was $19.1 million, an increase of approximately $10 million from Q1 2011. As stated previously, we expect maintenance CapEx for 2012 in a range of $75 million to $85 million, with the increase over 2011 primarily attributable to investments in our clinical information system -- and be reminded that unlike the acute care hospitals, we are not eligible for the high-tech payment subsidies on this investment -- as well as two substantial hospital renovation projects.

The strong free cash flow generation of our Company is allowing us to invest in these enhancements to our core business, fund our compelling growth opportunities, and continue to improve our balance sheet. With that I will turn it back to Jay.

Thank you, Doug. Before taking questions, I'm going to ask our general counsel, John Whittington, to provide an update on the status of the E&Y arbitration, and then I will come back and address guidance. John.

Thank you, Jay. As Jay and I have both mentioned in prior calls, the timing of the arbitration process, including the three-member panel's consideration of the evidence and legal argument, is not within our control. Starting in July of 2010 the arbitrators have held a series of hearings, generally in four-day blocks of time. We have now completed 88 days of arbitration during 25 weeks of hearings. We currently have additional weeks scheduled through December 2012.

At this date in the proceedings we do not know whether we will need all those weeks that are currently scheduled to conclude this matter or whether additional weeks will be needed in 2013.

What I do know is that we remain confident in our claims and we are absolutely committed to aggressively pursuing our claims to conclusion.

Okay, thank you, John. So although Q1 was a strong start to the year, we don't think it prudent to change full-year guidance based solely on one quarter's results. This is consistent with our historic practice and we continue to believe it is a correct approach, primarily because we don't take anything for granted.

We know physicians and patients have a choice when deciding where to receive inpatient rehabilitative services, and although we are proud of the high-quality care our hospitals provide and acknowledge our past success in driving market share, we also appreciate the fact that future success has to be earned one patient at a time.

Additionally, we face challenging discharge comps in the second and third quarters of 6.1% and 5.1%, respectively, and in May we begin the on-site installation of our clinical information system at 12 hospitals. While we believe the planning for these installations has been detailed and thorough, we appreciate the challenges inherent in moving from a paper to an electronic medical records system.

And although we are not raising guidance at this time, our strong first-quarter does allow us to guide shareholders to the high end of our adjusted EBITDA and EPS ranges. And if we continue to see better-than-expected volumes for the remainder of the year, we anticipate exceeding the high end of these ranges. As we have done in the past, we will revisit full-year guidance when we report second-quarter results.

With that, operator, please open the line for questions.

(Operator Instructions). Adam Feinstein, Barclays Capital.

Good morning, very strong numbers here. Just maybe one quick housekeeping, Jay, then I've got a more in-depth question. Just on the ERF reg, what are you guys hearing? There has been some commentary that there may not even be a full rule coming out for various sectors, so just any update in terms of what are you anticipating.

Yes, in fact, we are hearing from multiple sources that there will not be a proposed rule, that there'll be a notice -- that that notice will be published on or before August 1, and clearly we see that as a very positive sign.

Okay, great. And then just with the volume growth in the quarter, obviously, a really robust number. Were you guys surprised by the trend here? I think back in March you were saying the quarter was kind of tracking in-line, but just curious as you think about this such a strong number.

And then just any other observations about things that may have benefited here -- anything at all just to better understand in terms of service lines or geographies or any thoughts. Thank you.

Sure. First of all, we were very pleased with the quarter and the volumes that we were able to realize. I do think that we all have to keep in mind there was an additional day, and it is very hard to know exactly what that effect might be. We have looked at it a number of different ways and have vectored in on about a 1 percentage point impact for the extra day.

We looked at that by the average for February, the average for the quarter. We dropped out the 29th day. We dropped out the 31st day. And it was really interesting, the numbers all migrated around that 4.8% versus the 6%. So about a 1 -- maybe a little bit more -- 1 percentage point impact.

Having said that, we were still very pleased with the discharge growth. And we think it really comes from a couple of different sources. One is the quality of the services at our hospitals. You saw in the supplemental slides we continue to outperform in FIM gain and length of stay efficiency. That really does drive market share. The TeamWorks initiative that we have had in place now for several years continues to drive market share.

We also have the continuing benefit of new hospitals that had opened up in the last say 15 to 18 months. They have anniversaried out of new store into same-store, but we are continuing to see really nice growth in those hospitals.

And then, of course, we have the benefit of the bed additions that were added in our -- in the hospitals where we were at or near capacity. And then, of course, we had some pickup from Drake and from Cypress.

So those are examples of what helps to drive the volume, but I would also say just in conclusion that all of those are part of the core strategy. So the simple answer is the strategy that we put in place and that we've been able to get results from over the last several years continue to yield positive results for the Company.

Okay, great. And then just one final question here. Just on the use of free cash flow you guys do a great job of outlining your priorities in the slides. But I was just interested with the repurchase of the preferred in on the quarter, maybe Doug, you could just comment on that and just how you're thinking about that opportunity.

The repurchase of any of our securities is going to be done on an opportunistic basis. During the quarter we liked the price that was made available to us on that purchase of the converts, and really like the fact that it accomplishes two things for us. It gives us an immediate cash return by reducing the required dividend payment and it also has the reduction to the diluted share count.

So as I mentioned in my comments, we expect free cash flow to accelerate over the course of the year. Our top priority remains compelling all -- or funding all of the compelling growth opportunities within the ERF space that we can identify. But we will also continue to look for opportunities to improve the balance sheet and to our -- invest our cash back into the repurchase of our own securities.

Darren Lehrich, Deutsche Bank.

Thanks, good morning everybody. So I just wanted to ask about the health care IT implementation you guys are embarking on a little bit more aggressively this year. And I guess the question I had is more about the resources that your vendor is giving you, and I wanted to get your impressions about how you think you're being resourced and whether or not you're getting everything you need to go at it as quickly as you are planning?

I'm going to ask Mark to provide a little more color commentary on that, but the answer generally is, and broadly I should say is yes. We do feel that the resources from Cerner have been excellent; the planning has been very thorough.

We had a session earlier this year with me, Mark, Doug, all of the CEOs of the hospitals that were involved or will be involved in this rollout, the leadership of the IT&G team. We have a specific team set up that helps with this installation. But the planning has been thorough. We feel that the resources absolutely are there, and Mark can provide a little more color on it.

Good morning. We feel like we are in good shape and ready to go. We have not only the resources working with Cerner, but we also have considerable resources that we have hired -- subject matter experts, that will divide up into implementation teams to go out and install this in our 12 new hospitals that will be installing it -- 13, if you count the Ocala de novo.

So not only do we have the Cerner, but we have a number of individuals that we hired ourselves, some of which came out of our hospitals as subject matter experts. So we feel like we will have the resources out there to do a good job, and not only implementation but adoption at the hospital level.

And one thing that we have committed internally is to make sure that we get this right. I know that there have been other instances where companies looking at a large portfolio move very quickly to get the system installed in as many hospitals as quickly as possible, not focusing on perfect execution and implementation with the idea that they can circle back and mop things up, clean things up at a later date. We are simply not going to do that.

But we feel very confident that we have the planning in place. We are looking forward to getting these 12 hospitals on, and then more importantly, looking forward to rolling that out to the other hospitals in the next several years.

One final note. The leader of our implementation team is a former hospital CEO for a company, so that lends itself well to working within the operations group.

That's great. Now my follow-up here is just a little bit more on the discharge growth, clearly a very strong number. We have been hearing sporadically about a little bit of strength on the surgical side from some of the hospital companies. It is mixed, I guess, in terms of what we are hearing, but I would be curious to see if you saw any benefit at all from surgical growth, and whether any of that was orthopedic related that may have filtered your way?

This is Mark. As you know, less than 8% of our total discharges came from the joint replacements this less quarter. So we don't always see a direct impact from the surgery schedules picking up, although from a secondary standpoint the busier the acute care hospitals are, the quicker they are looking for the ability to discharge patients to the appropriate setting. And in that case we absolutely benefit. When their surgical schedules pick up they get busy, they look for help on the post acute side, and we are there to help them.

Colleen Lang, Lazard Capital Management.

I was just curious about your discharge growth guidance for the remainder of the year of 2.5% to 3.5%. Q1 was your most difficult comp of the year and you came in far ahead of this range. And while recognizing Q2 as a tough comp as well, what would cause the volume growth to decelerate, so to speak, in the remaining quarters of the year? Is there anything embedded explicitly for the IT disruption potentially that you talked about earlier?

There is nothing specific. Quite frankly, we are being conservative and cautious as we typically are. And it really does go back to what we talked about a minute ago. And that is we don't take our successes for granted. And we want to get at least one more quarter under our belt. We feel good about the volumes thus far this year. And we feel certainly that the hospitals are all operating on all cylinders.

Having said that, we have got 12 hospitals, so roughly 12% of our portfolio will be going through a pretty big change. Now do we -- have we built in any sort of disruption? No. Is it prudent for us to think about the fact that there may be some? Yes. And, clearly, that is part of our thinking.

But overall we still feel good about the discharge growth. We don't want to take anything for granted. We are being a little bit conservative as we typically are this early in the year. And we think that we are going to have a good year.

Okay, great. And as my follow-up, can you just talk a little bit about the M&A landscape and the opportunities you are seeing to acquire freestanding ERFs as well as hospital-based units?

First of all, as you know, the number of freestanding ERFs is pretty limited, so there isn't a huge market to go after. And some of those that may be potential acquisitions, I think, frankly, there is still a little bit of a mismatch between pricing expectations.

As you all know, our multiple has gone down dramatically over the last 12 months, not because of anything that we are doing at the Company, but because of the perceived risks that are out there in the health care reimbursement environment.

So as you approach potential sellers, they are looking in the rearview mirror and saying -- well, that is the trailing 12 I want to use. And by the way, I would like to use historic multiples. So there is a little bit of a disconnect there.

In terms of acquisitions on the unit front, that pipeline is picking up, but a lot of that is going to be joint venture activity. What we are seeing is the emergence of a trend where more of the systems out there are acknowledging that as they look out over the next couple of years -- you know, 2013 was sequestration and the third year of paying for the Affordable Care Act. Who knows what is going to be out there in 2014.

I think there are a lot of systems that are saying -- you know, we may not be able to do all -- or be all things to all people the way we have in the past. We may have to be a little more disciplined in how we spend our capital, and that may require us to joint venture some of our non-core secondary services. And we are seeing some increased activity on that front.

And then, finally, we have the de novo pipeline. We are very excited about that. And we talked about the hospitals that are under construction. Talked about the two that have certificates of need that are still being litigated. We are making good progress on those. So all in all we are feeling pretty good about the M&A pipeline.

Sheryl Skolnick, CRT Capital Group.

Great job to all of the many people involved in meeting the challenge of the quarter. You have an interesting slide, which is slide number 10, which -- you know, you see the slides over and over again, and sometimes you actually have your attention called to it or you pay attention to it. And I would like to have -- we focus so much on EBITDA and less so on bottom-line earnings and its relationship to cash flow that I think maybe we overlook some things.

So I would ask you to interpret what I am looking at there, which is pretax income, but even the line above that which I guess would be income from continuing operations before certain items, and you had $77.3 million versus $58.6 million. So very significant growth.

Looking in part from the $6 million -- from the $10 million increase, roughly $9.5 million of EBITDA. But that is where we are seeing the real impact of the balance sheet, I think.

So, first of all, is that interpretation correct? Second, how much should we read into that kind of bottom-line earnings power, especially since you don't pay cash taxes in any substantial amount?

And then I'm going to relate that to my follow-up question, which is that clearly drives cash flow. So I'm curious as to why the working capital build-up this year will be as much as it will be, and therefore have a somewhat slower rate of growth on the cash flow?

Let me ask Doug to address that last question. But let me try to approach the first question. And the simple answer is, yes, that difference between the $58.6 million and the $77.3 million we think is a very important line. I wish we could label it, but as you know, the accountants don't let us do that, and frown on our ability to do so.

But that is really an important item that should be focused on. And it goes back to the free cash flow generating capacity of this Company, which is significant. Now as far as the working capital build-up this year and why that is, I will ask Doug to elaborate a little bit more on that.

Certainly, there are -- and there was some noise in the working capital build-up that occurred in the first quarter predominantly because we had that very significant decrease in the interest accrual, which is just a timing issue.

Right.

It is going to bounce around a little bit from Q1 to Q2 and you will see a little bit of the same kind of activity in Q3 and Q4, but on a year-over-year basis it is not going to have a big impact. And the fluctuations in the quarter, I think, are well illustrated by the bridge that we provided on slide 11.

The impact that is going to occur within net working capital for the year is really attributable to two things. One is we are anticipating that we will see our receivables balance build. And there are two components to that. One of them is just related to the slowdown in the adjudication and the increase in the number of medical necessity claims reviews.

And I know that we had cried wolf a little bit of that -- on that a little bit over the last two years, but we have actually seen an increase in that activity. And it showed up in the bad debt number in the first quarter, so it is starting to materialize.

And the second component of the increase in receivables is just the year-over-year growth that we are seeing. The other component of working capital, and you saw it manifest itself in the first quarter, was that reduction in accrued payroll liabilities. And that was related -- so that was kind of a one-time thing, but it impacted not only the quarter, it also impacts the year. And that again was associated with the withholding taxes on the 2009 restricted stock grants.

Right, okay, so it is not as if it is a timing difference, that is a permanent difference.

That is right.

Okay, I understand. That is very helpful because it did look to me like your ability to generate cash flow is quite a bit stronger than the EBITDA growth would indicate because of all the deleveraging, which of course is the beauty of it. So your point about the slowdown in the AR makes sense.

On the growth side, when you start a new facility, just to close this loop, when you open a new facility -- sometimes when you acquire a facility you may have to wait for a tie-in notice, but when you open a new facility you are fully licensed and able to bill from the day it is open?

That is correct, except that we have a 30 day period -- or we have to treat 30 patients before we become eligible for reimbursement.

So there is that start-up of 30 patients where we are open, we are licensed, we have to see those 30 patients. Once we cross that threshold then we are eligible to receive Medicare reimbursement.

Perfect. Thank you so much. And again, congratulations on an excellent job.

John Ransom, Raymond James.

I apologize, I had to jump off for a minute. But could you -- would you mind just resetting the comments you made on the E&Y litigation?

Sure. I'm going to ask John Whittington to just summarize what he said.

John, just as we have said in the past, the arbitration process is continuing. We have a three-member panel. The scheduling is totally within their control, not within our control. Since July of 2010 we have completed 88 days of arbitration during 25 weeks of hearings.

Okay.

We currently have weeks scheduled through December. At this stage in the proceedings, however, we cannot say whether we will need all those weeks that are scheduled to conclude the hearings or whether additional weeks will be needed in 2013. And in conclusion, we continue to feel confident in our claims and we are committed to aggressively pursuing them to a conclusion.

Is there a structural reason why E&Y couldn't say, well, we will give you some dates in 2084, we are just so busy? I mean, can they -- how long -- I mean, from a practical standpoint, how long can they keep claiming schedule conflicts and pushing this out, because I know this has dragged on longer than you thought it would?

For sure. In actuality, what we do is get together with the panel and all the lawyers and we set our calendars out on the table and we go through and we all look at it and say -- we're going to need hearing dates through this time period. And then we all work together comparing schedules. And the schedules are of, say, 10 people or 11 people.

Okay.

And then we agree on dates that we think are sufficient. But the flow of the case is really not within our control. And sometimes a witness that we think will take a week, maybe takes six weeks. And then the end result is we have to come back and go through that process again and then get additional weeks scheduled. And that is what we have done now. We have these dates through the end of the year.

Right.

Hopefully (inaudible) but I can't guarantee it.

It sounds like a bunch of guys billing by the hour, doesn't it? (laughter).

I will say in that equation and in that process, our side has always said we will meet anytime, anyplace for as long as it takes.

Right.

So the scheduling conflicts are not on our side, but it is a complex process.

Sure.

And I do want to make it clear that when everybody is looking at their calendars to determine when they can participate, our attorneys are saying, and our team is always saying, we will be available at any time.

As I would expect. My follow-up would be -- you know, I ran into an interesting business model this week from our friend, Scully, who is trying to bring some coordination to the post acute discharge process. I know he is running around meeting with a bunch of not-for-profits. And it tells you that I'm not really concerned about your business as it stands that I am asking such a theoretical question.

But what is your thought -- even on the government side, bundling is pushed out four or five years, do you see any efforts on the managed care side using tools like this to bring more close coordination? Is that even on the forefront of your strategic planning for maybe a bundled world in the future?

It is certainly something that we are paying attention to. And I think you're talking about NaviHealth. It is a joint venture. From what I understand isn't United part of that? That is what -- I was under the impression. I don't all the partners. But if United is, I can't see Humana buying that. They may buy -- develop it for their own enrollees.

But I guess the question is, first of all, is it intriguing? Absolutely it is intriguing. Are we thinking about that? Yes, we are. But who is going to buy that product and at what price? What is the value that is created in that?

I know Select is -- it is my understanding that they are a joint venture in that -- a joint venture partner in that as well. So I don't know the whole details. I think it is intriguing. Whether or not it is anything that is imminent I would suggest it probably isn't. But we are certainly thinking along those same lines as well.

Matthew Gilmore, Robert Baird.

On the margin side, I think where you all have consistently beat our model is on the SWB line, and it seems like most of this is being driven by improvements on EPOB. So can you provide some commentary on what is driving that lower? I know a lot of those are probably obvious. And then also do you have a view on where EPOB can go over the next few years?

In terms of the EPOB improvements, obviously, a lot of that is driven by the volume increase in those hospitals where maybe the staffing was a little bit rich and we are able to leverage the growth across that existing platform.

In terms of the SWB as a percent of net, we do focus on that, but frankly, the number that really is important is the productivity number. Because we have made some conscious decisions over the last year to invest in more nurses, to invest in training and providing educational opportunities for CRRNs, or certified registered -- certified rehabilitation registered nurses. We then pay those nurses a higher rate. We have also beefed up our case management resource base, again, part of the TeamWorks.

So that we expect is going to probably hover in the range that you have seen this last quarter. The productivity though is really driven by the continued volume gains.

Hey, Matt, this is Mark. You have heard us talk in the past too about some of the IT reports that were -- have created for our managers. We call it Beacon. It gives us real time feedback relative to our staffing and allows us to make staffing adjustments to better fit the fluctuations we have in volume. And that has been one of the key areas for the past couple of years that has helped us to maintain or drive up our productivity.

As Jay said, volume certainly helps, if you look at the hospitals where we have had bed additions. So we have been able to add that volume, but not add as many staff that you might have to if you're looking at it compared to a de novo hospital where you have got a lot of the overhead that comes on at the same time. But either way, rest assured, we stay focused on the productivity and labor management every day in our hospitals.

Okay, thanks. That is really helpful. And then just as a follow-up, this is kind of related to a question John asked. But I know in 2013 at least there seems to be some sort of consensus there will be a larger federal budget discussion. So I just wanted to see if you all had any expectations around that event? And does this change at all how you think about your planning process for next year?

Well, it certainly affects our planning for 2014, because whatever may be legislated next year -- and I think we all should hope for something to occur, because it is inevitable that the debt ceiling is going to be breached sometime either at the end of this year or potentially early next year. And with that will come another round of discussions about how to rein in that debt and how to reduce the budget deficit.

I think a lot of it depends on who is in control in Congress. I think that the other factor that is out there is what happens to the Affordable Care Act. So if the Affordable Care Act is deemed by the Supreme Court in its entirety to be unconstitutional, or they throw the whole thing out, the mandate they throw -- is deemed to be unconstitutional and it's not severable so everything goes, there will be short-term euphoria in the health care arena, I would suspect, because all of those cuts, those 10 years of cuts will go away at the same time.

The problem with that is that once the confetti drops to the floor, and they start looking at the -- we start looking at the baseline for Medicare spending, the reductions that were put in the baseline -- and I am not saying if they are real or not, I'm just saying they are in the baseline -- coming from Obamacare goes away. So then you have got a perfect storm of the spending curve is back up because all those cuts aren't there, and you have got a deficit reduction initiative that is that much more complicated.

So there is -- I think that there is a lot of risk out there for providers in general. Now there are some who take that and extrapolate that and say -- oh, anybody who is in health care should be really worried. And the sky is falling and this is going to be the end of the health care industry, which I don't buy.

The demand is not going away. The demand is not going away. Not all providers are created equal. You look at our space, we have top margins, top cost profile. There are 1,200 other rehabilitation providers and a bunch of them are down there with negative margins.

So in that new world order, whatever that might be, will it be one that is characterized by less reimbursement? I suspect so, but I think that all that is going to do is make it easier, if you will, for those who are profitable, those who do have a focus on quality and cost, to be successful.

It definitely is affecting our thinking. We are looking at our growth from a pretty focused core business perspective. It is one of the reasons why we are keeping our balance sheet as strong as it is. We have got a lot of dry powder because we do believe, and we have seen this time and time and time and time again when there is upheaval, with that upheaval comes a lot of opportunities.

So others may have decided to go down a different path. We are really positioning ourselves to take advantage of whatever comes down the road in 2014.

That may be more than you wanted to know, but I really do believe that the next couple of years is going to be pretty choppy, and that those providers who are strong from a financial standpoint, have a good product to sell, are going to do very well. And those who are marginal or at the low end of the quality and cost efficiency scale are simply not going to be around. But the demand is not going away.

(Operator Instructions). Gary Lieberman, Wells Fargo.

This is [Ryan Halstadt] on for Gary. Just going back to the discharge growth, and trying to, I guess, continue to better understand the strong discharge growth you guys have had so far.

I was looking at the occupied beds in your occupancy rate and I was wondering if you could comment on how you're growing the occupied beds so quickly, and how you think you can continue to grow those as you add bed capacity? Is there any seasonality or a ramp time with that or any comments on the occupancy side of it?

If you go back -- first of all, if you look at page 31 of the supplemental slides, you can see that over the last period of time the occupancy level has hovered in that 67% to 70% range. And that is pretty much what you would expect. What we do is we monitor very carefully hospitals that approach full occupancy.

And every hospital is different, but on average in our Company, on the typical HealthSouth hospital, you get up to 85% you are approaching -- and that is the average occupancy -- you are approaching really full capacity because you have got gender issues. You have got infection control issues that you have to deal with. You have got peak times that you also have to deal with.

And so what we try to do is stay ahead of the constraints by adding beds. And as Mark talked -- said a minute ago, when we add those beds we have been very successful in doing so and continuing to be able to grow.

So the occupancy level is one that is pretty much in-line with what we would expect. And as we bring new hospitals on, clearly that may drop a little bit, as you saw earlier on this line -- on this chart. You go back into Q3 2011 and you go back into the fourth quarter, we had some new hospitals coming on, so you had the new beds. They weren't necessarily filled. Now you are starting to see them fill up.

We have got new hospitals coming online next year. It will add to the bed count. It will change the overall occupancy level for the Company. But we feel very good about the fact that if we build the beds, we are able to fill them.

Okay, thanks.

Kevin Fischbeck, Bank of America.

Actually this is [JoAnna Dodrick] for Kevin today. I have one follow-up and one question. So the first follow-up is actually related to the recent -- to the most recent question. Basically, given that you had mentioned that the discharge growth was helped by the recently added beds and also de novos, do you have a sense, you know, or you can provide us with the same-store occupancy growth year-over-year?

The same-store occupancy. We don't have that right now. We can get that to you.

Or a sense of growth in discharges if you would sort of exclude --.

For sure. We always give you the same-store discharge growth. We have been doing that for quite a few -- I mean, as long as we have been reporting. So if you go to page 4 of the supplemental slides, you can see that the discharge growth was 6% overall and same-store discharge growth was 5%.

Right, but I would assume that the same-store growth includes the benefit of the recently added beds. Like you were saying that those beds that were added 18 months ago, they are already in the same-store number.

Yes, that is definitely true. The same store -- what we define new store is any hospital that has been open for 12 months or less. So once you get into that 12 months and one day you anniversary into same store.

Right, so I guess that is why it would be interesting to know the same-store occupancy, but you don't have it handy here, so maybe I could follow-up about that later.

Sure, yes.

But then the other question I have is around your assumptions behind the merit increases in 2013 and 2014. So I guess the basic question is, are you assuming the status quo, so to speak, in labor market, because to the extent that there is market improvement in terms of labor market, the assumptions could change? So can you comment on how you view those merit increases assumptions that you talk about in your slides on slide 22?

Sure. The pricing for our labor is going to be sensitive to market conditions. And at this point we do believe that that 2.25% to 2.5% is a pretty good number to use. Frankly, as we look at the previous slide, and if you look at some of the assumptions there in terms of what the pricing might be, that may be, especially you go out into 2014, we are not sure that the productivity adjustment is going to exactly be that 110. It seems like it is coming down.

So we try to base our merit increases on the kind of rate increases we get from Medicare. We are able to do a little bit more than that because we are able to pick up the slack, if you will, through the volume increases. But for the most part we feel pretty good that those are assumptions that can be used in your model. You may want to bump that number up if you feel that is a little bit light, but at this point we feel pretty good with those.

It just comes to mind, this question, because definitely it feels like, at least in the midterm, there is some downward pressure on rates. Like you mentioned the productivity adjustment on the reform, but if the markets -- if the labor markets really improve there could be some upward pressure there. So I guess that is why what you are doing on your volumes is very important here.

But then this question came from this idea that trying to offset the margin compression with volume growth could be difficult because there is the incremental margin on the new volume. So would you agree that you need volumes to grow 2 to 3 times the pricing, or the cost growth for that matter?

I don't think that is right. If you go to page 23, you can see that, gosh, since 2008 we have had very significant growth in our volumes. Don't forget the demand -- the underlying demand for inpatient rehabilitative services is approximately 2% overall in the country. In our markets it is a little bit north of that. So you have this underlying demand curve that is very compelling. It is not sensitive to fluctuations in the economy.

And then on top of that, we feel pretty good about the fact that we are able to provide a higher quality level of care, which allows us to take that market share on a pretty consistent basis.

So we feel pretty good about where we are positioned, and think that volume growth is going to be able to continue. And we feel that the business model that we've put together is going to allow us to withstand just about any kind of hit that may be coming at us from Washington.

It seems like you may be drawing too tight a correlation as well between conditions in the general labor market and the conditions in the health care labor market, because you haven't had nearly the degree of unemployment with regard to health care labor that you have in the general market. As a result, when and if the economy eventually improves to the point where that unemployment rate comes down and puts pressure on wages, it is unlikely that you will see the same degree of that in health care.

Recognize as well that within the health care services and provider community the bulk of our employees are already pretty well-compensated, when you look at the combination of their salaries and the benefit package. And again, I think where you're likely to see the acceleration in the future is areas where the competition for those jobs has been greatly increased by the pool of unemployed applicants and they're at a much lower overall wage scale.

The only other last comment would be, we are picking up in the marketplace that other providers are, in fact, either freezing their merits, they are reducing their benefits. They are taking steps to reduce their labor costs, and that certainly is going to accrue to our benefit, because we have never taken a benefit away. We have provided consistent merit increases. So we feel pretty good about where we are from a labor standpoint. Feel very good about the quality of our employees and don't see this as a negative at all.

Great, thank you so much for the color. I appreciate it.

And there are no further questions at this time.

Thank you. As a reminder, we will be attending the Goldman Sachs leveraged finance health care conference on May 1 in New York City; the Deutsche Bank annual health care conference on May 8 in Boston; and finally, the BOAML health care conference in mid-May in Las Vegas. If you have additional questions, we will be available later today. Please call me at 205-969-6175. Thank you. Lynn.

Thank you. This concludes today's conference. You may now disconnect.