Edited Transcript of EHC earnings conference call or presentation 8-Feb-19 2:00pm GMT

Our supplemental information 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 supplemental information, at the end of the related press release and is part of the Form 8-K filed yesterday with the SEC, all of which are available on our website.

(Operator Instructions) With that, I'll turn the call over to Mark.

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Mark J. Tarr, Encompass Health Corporation - CEO, President & Director [3]

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Thank you, Crissy, and good morning to everyone joining today's call. Fourth quarter was another strong quarter for Encompass Health and a great conclusion to 2018. Before I get into the specifics of our financial results, I wanted to address one item highlighted in our earnings release. We have accrued a loss contingency of $48 million related to an investigation by the Department of Justice regarding alleged, improper or fraudulent Medicare and Medicaid claims. As we previously disclosed, this investigation has been pending since 2013, and we've cooperated fully. We are not aware as any evidence of fraud, falsity or wrongdoing. However, based on recent discussions with DOJ and having considered the burdens and distractions associated with continuing the investigation and the likely cost of future litigation, the company now estimates a settlement value $48 million. Although, we are hopeful we can conclude these matters, discussions are ongoing, and we can provide no certainty about the nature, timing or likelihood of a settlement. Given the sensitive and confidential nature of the discussions, we can't say more about it at present.

Now let's move on to our financial results.

Doug will cover the fourth quarter in his comments, I'm going to comment on the full year. During 2018, our company increased consolidated revenues by 9.3% and consolidated adjusted EBITDA by 9.5%. This growth was driven by strong organic volume growth in both of our business segments. Same-store discharge growth in our inpatient rehabilitation segment was 2.8%, and the same-store admission growth in our Home Health was 5.6%. The growth in adjusted EBITDA, along with favorable working capital changes, resulting in -- primarily from improved collections of accounts receivable, yielded $538.1 million in adjusted free cash flow for the full year, an increase of 14.8%.

We used our free cash flow to fund growth opportunities in both of our business segments and to invest in our strategic initiatives. Relative to growth, we opened 4 new hospitals and expanded our existing hospitals by 26 beds. The 26 number was less than our target of 100 beds, but remember that we added 166 beds in 2017, and we expect to add 150 or more beds in 2019 to our existing hospitals. We also added 23 home health locations and 22 hospice locations, with the majority of those coming from the acquisition of Camellia Healthcare in May. In terms of our strategic initiatives, in 2018, we completed our rebranding and name change, advanced our use of data analytics, continued the development of post-acute solutions and increased clinical collaboration between our 2 segments. Our clinic collaboration rate for 2018 was 34%, an increase of 450 basis points over 2017 and the number of Encompass Health IRF patients to receive the benefits of clinical collaboration increased 20%. Remember, the primary objectives of clinical collaboration, are to improve the patient experience and outcomes and to reduce the total cost of care across a post-acute episode. We continue to see increasing evidence these objectives are being achieved. Coordination between our IRF and home health teams is resulting in lower discharges to skilled nursing facilities and higher discharges to home in overlap markets. And within our overlap markets, patient satisfaction scores are increasing, while hospital readmission rates are decreasing. Our priorities for 2019 build on momentum carrying over from 2018. In 2019, we continue to be focused on growth. We have 4 new hospitals scheduled to open in 2019, including 1 in Boise Idaho, which is a new state for us. We also have $50 million to $100 million earmarked for home health and hospice acquisitions. We will also focus on continuing to build our stroke market share. In 2019, we're excited to officially launch our 3-year strategic sponsorship with the American Heart Association/American Stroke Association. This sponsorship allows us to bolster stroke awareness through provider, patient and community education, highlighting the 2016 AHA/ASA guidelines that strongly recommend stroke patients be treated in an inpatient rehabilitation hospital rather than a skilled nursing facility. With 112 of our inpatient rehabilitation hospitals holding stroke-specific certifications from the Joint Commission, we believe we are well positioned to continue to build market share in stroke. We will use data analytics to determine where stroke patients are being discharged in each of our markets, and we will present patient outcome data for those patients to providers and payers to demonstrate our value proposition.

Another area of focus in 2019, is our continued development of post-acute solutions. Our post-acute solutions leverage our clinical expertise, large post-acute data sets, EMR technology and strategic partnerships to drive improved patient outcomes at a lower cost of care across the entire episode care. In 2018, we developed a 90-day post-acute readmission prediction model and began piloting it at 2 of our hospitals. In 2019, we will continue to refine the model and deploy to additional EHC hospitals. These enhanced capabilities are facilitated by the investments we've made in the IT platforms in both of our business segments as well as our strategic relationships with Cerner and MetaLogics. With these growth and operational initiatives underway, we are reaffirming our 2019 guidance as communicated last month. Full year 2019 guidance for net operating revenue is between $4.5 billion and $4.6 billion, while full year guidance for adjusted EBITDA is between $925 million and $945 million. Full year adjusted EPS guidance is a range of $3.71 to $3.85 per share. 2019 will also include a focus on reimbursement payment model changes scheduled to become effective in 2020 for both of our business segments. As we've discussed previously, beginning October 1, 2019, CMS will remove the functional independent measure or FIM tool from the IRF patient assessment instrument. FIM tool will be replaced by a new patient assessment tool called the CARE tool. This new patient assessment tool has been used concurrently with the established functional independent measure since the CMS fiscal year 2017. Guidance from CMS on the new functional assessment tool continues to be released as questions from the industry are brought forward.

Our efforts in 2019 to prepare for the implementation of a new payment system will include improving the documentation that captures each patient's functional abilities. One of the ways we will do this is by using data analytics to compare the functional status of patients measured using the FIM tool to patients using the CARE tool. We will measure the correlation between our hospitals as they use the CARE tool to ensure consistent patient assessments across our staff or inter-rater reliability.

All this data can be shared with CMS to address implementation concerns and could be used to refine our education efforts on specific hospitals. Our primary area of concern with the new payment system is the accuracy and completeness of the data used to build the new payment system as it is likely to require CMS to make substantial changes with the case mix groups or CMGs, relative weights and average length of stay values or the IRF-PPS. We expect to know more about the changes to case mix groups and the new systems impact on our pricing once the fiscal year 2020 proposed rule for IRFs is released in late April or early May.

In home health, CMS is replacing the current home health prospective payment system with the patient-driven groupings model or PDGM. Among other changes, this system will revise the current 60-day episodic payment to 30-day payment periods. Reimbursement under this new system also relies more heavily on a patient's clinical characteristics and eliminates therapy service-use thresholds. In addition, to achieve budget neutrality, CMS assumes behavioral changes will offset a 6.4% reduction in the base rate.

We will spend 2019 preparing ourselves for these changes. Our preparation will include the continued use of technology to generate objective, evidence-based care plans and to drive incremental efficiencies in administrative support functions. We don't expect to have any additional updates regarding PDGM until the calendar year 2020 proposed rule for home health is released in late June or early July. We will continue to work individually, and as part of our trade associations, to provide feedback to CMS and Congress on both new payment systems, but we assume these payment systems will go in place as is and are preparing now. If these systems go in effect as currently designed, their implementation could make 2020 a little bumpy for providers. However, that does not change the long-term outlook for our company, which is predicated on demographic trend driving increasing demand for the services we provide.

We believe, we are well positioned as a company to work through these changes, and we have a proven track record of being able to do so. We have successfully managed through economic recessions, regulatory changes, sequestration and Medicare payment freezes and cuts, growing adjusted EBITDA in 39 of the last 40 quarters. We provide necessary services to an aging population and consistently produce high quality patient outcomes in a cost-effective manner. As the population continues to age, the demand for our facility and home-based services will grow, and we will meet that demand with enhanced capabilities and expanded capacity. With that, I'll now turn it over to Doug.

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Douglas E. Coltharp, Encompass Health Corporation - Executive VP & CFO [4]

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Thank you, Mark, and good morning, everyone. Q4 was another strong quarter with regard to our operating financial results. Our Q4 consolidated revenues increased 8.6%. Adjusted EBITDA increased 6.5%, and adjusted EPS increased 14.3%. We had an exceptionally strong year in terms of cash flow generation with adjusted free cash flow for 2018 of $538.1 million, up 14.8% over 2017. The growth in cash flow was driven by the increase in adjusted EBITDA in favorable working capital changes, primarily related to improved collections of accounts receivable. Our strong cash flow generation during 2018 facilitated $267 million in capacity expansions across both business segments and allowed us to fund $100 million in common stock dividends and $65 million in home health holdings rollover share purchases, while reducing funded debt by $63 million.

We ended the year with our leverage ratio at 2.8x, down from 3.1x at the end of 2017. And with our balance sheet well positioned,

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continued investments in capacity growth, strategic initiatives and shareholder distributions.

During 2018, we achieved our objectives for growth investments, opening 4 new IRFs and consummating a $144 million of home health and hospice acquisition. These investments furthered our strategic positioning by increasing the number of IRF and home health overlap markets from 76 to 81 and building the scale of our hospice service line, which grew revenues by 66% in 2018, and now it sees $115 million in annual revenues.

Moving to the results by business segment. IRF revenues grew 5.4% in Q4, driven by discharge growth of 3.6%, 1.9% same-store and a 2.2% increase in net patient revenue per discharge. Same-store discharge growth in Q4 was negatively impacted by approximately 50 basis points due to the continued disruption in the Panama City, Florida market attributable to Hurricane Michael. The revenue reserve related to bad debt increased by 50 basis points to 1.5% in Q4, primarily due to new prepayment claims denials and post-payment reserves for Medicare Advantage contractual claims reviews with one managed care organization. New prepayment claims denials for Q4 reached the highest level since Q3 2017, primarily due to TPE activity at MACs other than Palmetto. Our experience resolving claims through the TPE process remains generally positive, and we still do not have a sufficient track record with TPE to suggest that the level of the new prepayment claims denials experienced in Q4 represents a new run rate. Once again, little to no progress has been made resolving the enormous backlog of claims through the ALJ appeals process.

The Medicare Advantage contractual claims review was a new event. Our discussions with the MCO regarding these reviews have thus far been productive, and we are cautiously optimistic this will not be a chronic situation.

Nonetheless, our experience in Q4 '18 on both prepayment and post-payment claims denials informs the 2019 guidance consideration of reserve related to bad debt and a 1.4% to 1.6% range.

IRF segment adjusted EBITDA for Q4 increased 2.2% to $211.7 million. Revenue growth for the quarter was partially offset by increases in SWB and other operating expenses as a percent of revenue. SWB increased by 80 basis points over Q4 '17 to 51.7%, primarily due to increased group medical costs and to a lesser extent, the ramp-up of new stores. We talked a lot about our expectations for group medical cost to normalize during 2018, and the second half of the year served to validate that assumption.

We ended 2018 with group medical costs of 9.3% for the year, with the increase most pronounced in Q4 due to both an increase in claims activity and a favorable reserve adjustment in Q4 2017.

Our 2019 guidance considerations, including increase of 6% to 8% in benefits expense, which we believe is in line with the expected level of healthcare cost inflation.

Our labor productivity improved for the quarter as EPOB decreased to 3.48% from 3.50% in the prior year. The deleveraging in the other operating expense line was driven by the incurrence of repairs and maintenance costs in our Panama City, Florida Hospital, which was damaged by Hurricane Michael.

Turning now to our home health and hospice segment. Q4 revenue increased 21.3% with strong growth in both the home health and hospice service lines. Home health revenue growth was driven by volume as admissions for Q4 increased 10.7% with same-store up 5.4% and new store growth resulting largely from the acquisition of Camellia. We continue to make good progress on the integration of the Camellia acquisition and are pleased with the results we have generated thus far. Similar to our IRF segment, we estimate that the disruption to the Panama City market negatively impacted same-store admissions growth by approximately 50 basis points in Q4.

Home health and hospice segment adjusted EBITDA increased 28.2% as we generated operating leverage across both cost of services and support and overhead costs. The leverage within cost of services stem from our continued focus on caregiver optimization and productivity in home health and from increased scale efficiencies in hospice. The leverage in support and overhead costs is attributable primarily to scaled economies. And while it is our practice to provide annual guidance only, we believe a few reminders about factors potentially impacting the pacing of quarterly earnings growth in 2019, particularly between Q1 and Q4, may prove useful to you. Q1 2018 benefited from the lowest revenue reserve for bad debt of the year at 1.1% and from a nonimpacted Panama City market. Q4 of 2018 conversely, had the highest revenue reserve for bad debt at 1.5% and a significantly disrupted Panama City market. As we enter 2019, the Panama City market is recovering, but is still contributing below its normalized run rate. We expect the market to continue to recover as we progress through the year.

Finally, Mark mentioned that we hope to bring on, approximately, 150 beds via bed additions in 2019. None of those beds will be online in Q1, and we expect to enter Q4 with approximately 120 of those beds operational. These factors benefiting Q4 '19, notwithstanding, the pricing impact from the transition to the CARE tool remains unknown at this time.

And now operator, we'll open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Whit Mayo of UBS.

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Benjamin Whitman Mayo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare Facilities and Managed Care [2]

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I think, we all get the clinical focus on the stroke patients and the opportunities that you see for the rehab hospitals, but PDGM seems to create a clearance center for stroke or neurological cases as well, and it seems like almost every home health operator has stressed this is a patient population that they're interested in. Is this a risk for you? Or do you see this more of an opportunity to collaborate between your rehab hospitals and home health, just trying to reconcile this?

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Mark J. Tarr, Encompass Health Corporation - CEO, President & Director [3]

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Yes, Whit, this is Mark. I'm going to make comments then ask April to expand on it. No, we see this is an absolute opportunity since 2014, in our collaboration efforts between our 2 business segments, we've been amping -- we've been increasing the opportunity from a clinical standpoint, both our hospitals and our home health agencies have well-coordinated, collaborated clinical programs that offer an opportunity to benefit the stroke patients that we have converting from our hospitals into our home health side or directly into our home health locations. So with that, let me ask April to expand on that.

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April Kaye Bullock Anthony, EHHI Holdings, Inc. - Founder and CEO [4]

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Yes, Whit, we definitely see that in PDGM there are payment shifts that are going to be more valuable for patients that have that traditional heavy nursing influence, and so we think that programs continue to align, but I want to also stress that, although, patient mix is certainly important in PDGM, we've been down this road before even in the HHRG system, when our competitors started to try to shift away, don't take any outlier diabetic-type patients, and we just continue to think that the right thing to do is to learn how to create an efficient model that allows us to take all patients and although, we will certainly do our best to drive our opportunities to bring in patients that have higher nursing acuity, patients that are more facility based, there's some obvious places to pursue. We also want to be clear that we're not going to start playing a cherry picking game, but we just think that we've got patients that qualify for home health services, that we're going to provide those services, and we're going use our operational efficiencies and our acumen in managing care plans to do so efficiently for all patients.

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Benjamin Whitman Mayo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare Facilities and Managed Care [5]

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That's helpful. And maybe just one last one on the rebranding efforts and then the costs have come in a little bit less than you had expected. Just curious, Mark, Doug, what you guys have learned through this process? What the feedback has been in the field? In the market? With your current partners, future acute partners, just maybe how this broadly ties into your post-acute strategy?

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Mark J. Tarr, Encompass Health Corporation - CEO, President & Director [6]

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Yes, Whit, as you know, we completed the rollout in January to all of our markets for the rebrand initiative, and I'll tell you, first of all our teams did a great job in rolling that out across their various marketplaces. It went extremely smooth. The feedback we've been getting back from referral sources, and our joint venture partners, and our own internal staff is that the brand initiative has initially been very successful. It has eliminated any confusion in the marketplace between -- an Encompass Health and HealthSouth. We're now under one name, one brand, and we'll help to advance our continuum from a integrated post-acute service provider.

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Douglas E. Coltharp, Encompass Health Corporation - Executive VP & CFO [7]

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Yes, Whit, It's Doug. And just to elaborate on that, one of our primary goals is just getting through the actual rebranding of the field assets was to first do no harm, in other words, not providing an opportunity in the marketplace where our competitors perceive some disruption and some confusion about the rebranding.