Encompass Health Corp quarterly report, Q3 FY2010

Business context and reporting period

HealthSouth Corporation’s unaudited Form 10-Q covers the quarter and nine months ended September 30, 2010. The company operated inpatient rehabilitation and long-term acute care hospitals, alongside outpatient clinics and hospital-based home health agencies. The filing identifies the registrant as HealthSouth Corporation; it does not identify it as Encompass Health Corp.

Financial performance and liquidity

• Q3 revenue rose 4.3%; nine-month revenue rose 3.8%. Management reported operating earnings of $70.8 million for Q3 and $225.0 million year to date, versus $61.0 million and $173.6 million, respectively, in 2009.
• Q3 total operating expenses were 84.0% of revenue, versus 86.0% a year earlier; nine-month expenses were 83.3%, versus 86.2%. Salaries and benefits were the largest cost, at 50.2% of Q3 revenue and 49.4% year to date.
• Operating cash flow was $269.5 million for the nine months, down from $362.1 million. The 2009 comparison included $73.8 million of net UBS settlement proceeds and $59.5 million of prior-period tax refunds; 2010 included $11.9 million of state tax refunds. Investing cash outflow was $96.4 million and financing cash outflow was $63.6 million. Cash increased $109.5 million to $190.5 million.
• At September 30, cash was $190.5 million, restricted cash $33.7 million, current assets $514.3 million, and current liabilities $390.0 million. Long-term debt, including its current portion, totaled $1,655.3 million; shareholders’ deficit was $782.3 million. The company reported compliance with its credit agreement covenants.
• October refinancing, presented as a pro forma adjustment to September 30 debt, reduced debt to $1,537.2 million, including $100 million drawn on the new revolver. The new facility provides $500 million of revolving capacity, including a $260 million letter-of-credit subfacility; $48.7 million of letters of credit were outstanding. The company estimated $351.3 million of revolver availability after the transactions and related uses of cash.

Material changes versus the prior comparable period

• Inpatient net patient revenue increased 5.3% in Q3 and 4.8% year to date. Discharges rose 2.5% and 1.9%, respectively; same-store discharges increased 0.4% and 0.7%.
• Outpatient visits declined to 258,042 in Q3 from 281,913 and to 779,115 year to date from 857,478. The company cited clinic closures, staffing constraints, competition, and, for the first quarter, severe winter weather.
• Profit improvement partly reflected much lower government, class action, and related settlement charges: $0.8 million in each 2010 period, compared with $8.5 million in Q3 2009 and $41.3 million for the first nine months of 2009.
• Provision for doubtful accounts fell to $4.3 million in Q3 from $7.8 million and to $17.1 million year to date from $25.3 million. Medicare contractors had ceased certain diagnosis-code denials in late 2009, though some denials resumed in Q2 2010.
• Three inpatient rehabilitation businesses were acquired in 2010 for aggregate consideration of $42.5 million; acquired operations contributed $4.0 million of revenue and $0.5 million of HealthSouth-attributable income from their acquisition dates through September 30.

Outlook, risks, contingencies, and unusual items

• Management targeted annual discharge growth of 2.5% to 3.5%, revising its prior 4%-plus assumption because of weak acute-care volumes. It expected to focus on organic growth, cost management, disciplined acquisitions, and debt reduction; it did not provide a specific earnings or revenue forecast.
• Management estimated approximately $80 million of 2010 capital expenditures, about $40 million considered discretionary. It estimated the FY2011 IRF payment rule would increase Medicare-related inpatient rehabilitation revenue by approximately 2.1% annually. For proposed 2011 physician-fee-schedule changes, it estimated an approximately $4 million annual revenue reduction from therapy practice-expense changes and a further approximately $6 million reduction from other changes if Congress did not intervene; CMS had issued its final rule on November 2, and the company was still assessing it.
• The October refinancing replaced lower-rate term loans with $275 million of 7.25% notes due 2018 and $250 million of 7.75% notes due 2022. Management expected higher interest expense and an approximately $12 million loss on early debt extinguishment in Q4 2010. Refinancing costs, repayment cash, and a $6.9 million swap unwind fee also reduced pro forma cash.
• Healthcare reform reduced the Medicare market-basket update from 2.5% to 2.25% beginning April 2010, with further reductions and productivity adjustments scheduled in coming years. Other principal risks include reimbursement and regulatory changes, Medicare billing compliance, staffing availability and costs, referral volumes, competition, and acquisitions.
• Two forward-starting interest-rate swaps were terminated in connection with refinancing. Q3 included a $4.6 million reclassification of accumulated losses and a $2.3 million expected settlement charge in swap losses; the $6.9 million unwind payment followed in October.
• A South Carolina jury verdict of $12.3 million was under appeal. The company recorded the full liability and a $7.7 million insurance receivable, for a $4.6 million net charge, and deposited $6.0 million during the appeal. The company also disclosed a $2.9 billion judgment against former CEO Richard Scrushy, under appeal; no amount was recognized because collection was uncertain. It recorded a $0.8 million charge related to a settlement with Scrushy’s wife and other parties.
• Other disclosed exposures include United HealthCare arbitration demands totaling $9.5 million, a General Medicine dispute with no estimable loss range, pending litigation involving the former auditor, and 48 lease guarantees with a maximum potential payment of approximately $38.8 million. The company had not accrued for those guarantees because it did not consider performance probable.
• The company maintained an approximately $876 million valuation allowance against deferred tax assets and reported $44.9 million of gross unrecognized tax benefits. Management said realization of some tax assets remained more likely than not not to occur; tax examinations and refund claims remained ongoing.

Important facts for investors to verify

• Confirm the registrant and corporate identity: this filing is for HealthSouth Corporation, while the request names Encompass Health Corp.
• Assess whether operating and cash-flow growth is sustainable after accounting for prior-year settlement proceeds and tax refunds, acquisition contributions, and new-hospital ramp-up costs.
• Track inpatient discharge trends, occupancy, outpatient volumes, and labor costs against management’s 2.5%–3.5% discharge-growth assumption.
• Review the completed refinancing’s actual cash impact, interest expense, covenant headroom, and remaining revolving-credit availability.
• Follow final Medicare reimbursement changes and the status and outcomes of significant litigation, insurance recoveries, tax matters, and potential guarantee obligations.