Encompass Health Corp quarterly report, Q2 FY2019

Encompass Health Corporation — Q2 2019 Form 10-Q

Business context and reporting period. Unaudited results for the three and six months ended June 30, 2019, compared with the corresponding 2018 periods. Encompass Health provides inpatient rehabilitation and home health and hospice services across 37 states and Puerto Rico. Inpatient rehabilitation generated about 77% of second-quarter revenue; home health and hospice generated about 23%.

Financial performance

Metric	Q2 2019	Q2 2018	Six months 2019	Six months 2018
Net operating revenue	$1,135.0 million	$1,067.7 million	$2,259.0 million	$2,113.7 million
Income from continuing operations	$111.0 million	$113.0 million	$236.7 million	$218.7 million
Net income attributable to Encompass Health	$91.2 million	$91.8 million	$193.5 million	$175.6 million
Diluted EPS	$0.92	$0.92	$1.94	$1.76
Segment Adjusted EBITDA	$283.0 million	$265.1 million	$559.3 million	$522.4 million

Second-quarter revenue grew 6.3%; six-month revenue grew 6.9%. Revenue growth reflected pricing and volume gains in inpatient rehabilitation and volume growth in home health and hospice.
Second-quarter operating expenses rose 8.2%, faster than revenue, to $964.5 million. Salaries and benefits increased 7.7%; general and administrative expenses increased 40.4%, in part due to stock appreciation rights costs. Total operating expenses were 85.0% of revenue, versus 83.5% a year earlier.
Inpatient rehabilitation revenue increased 4.7% in Q2 and Segment Adjusted EBITDA increased 4.7%. Discharges rose 3.7%, while revenue per discharge increased 1.5%.
Home health and hospice revenue increased 12.0% in Q2 and Segment Adjusted EBITDA increased 18.0%. Home health admissions rose 11.2%; hospice admissions rose 29.3%.
Six-month consolidated Adjusted EBITDA, as defined for the credit agreement, was $495.1 million versus $454.9 million. This is a non-GAAP measure and differs from total segment Adjusted EBITDA.
Operating cash flow was $305.3 million for the first half, down from $385.5 million. Investing cash outflow was $191.6 million, including $155.8 million for property and equipment; financing cash inflow was $40.5 million. Cash, cash equivalents and restricted cash totaled $287.7 million at period end, including $221.7 million of unrestricted cash and cash equivalents.
Long-term debt, including current maturities and finance lease obligations, was $2,757.7 million at June 30, versus $2,514.4 million at year-end. The balance-sheet presentation also included $291.0 million of operating lease liabilities. Approximately $326 million was available under the revolving credit facility as reported. The company reported compliance with its leverage and interest coverage covenants; actual covenant ratios are not stated in the filing text provided.
Current assets were $844.9 million and current liabilities were $752.9 million. These figures include restricted cash and current operating lease liabilities.

Material changes and unusual items

Q2 net income attributable to the company declined slightly despite revenue growth; six-month net income increased 10.2%. Higher salary and benefit costs, stock appreciation rights expense, and other expenses weighed on quarterly results.
In June, the company redeemed $100 million of 5.75% senior notes due 2024 for about $102 million, funded with cash and revolver capacity. It recorded a $2.3 million early debt extinguishment loss.
The company paid $46.4 million in Q2 toward a $48 million settlement of a DOJ investigation and related qui tam lawsuits concerning alleged Medicare and Medicaid claims practices. The settlement agreement provides a civil liability release for the company and its subsidiaries on the covered matters.
On July 1, 2019, after quarter-end, the company acquired Alacare Home Health & Hospice for $217.5 million, funded with cash and revolver borrowings. It expects an income tax benefit with an estimated present value of about $30 million.
Management investors gave notice in July to sell an additional 5.6% interest in the home health and hospice business; the company expects to pay about $163 million in Q3. It also expects about $55 million of Q3 cash payments for exercised stock appreciation rights. These are additional anticipated cash demands.
The company adopted the new lease accounting standard on January 1, 2019, adding approximately $349 million of assets and $347 million of liabilities at adoption.
The company expects to consolidate Yuma Rehabilitation Hospital beginning July 1, 2019, and estimates an approximately $20 million gain in Q3 from the transaction and remeasurement of its existing interest.

Outlook, risks and management commentary

Management described its outlook as positive, citing aging demographics, expected Medicare enrollment growth, and opportunities for organic growth, new facilities and acquisitions. No full-year revenue or earnings guidance is provided in the filing text.
For fiscal 2020, management estimated Medicare payment rates for inpatient rehabilitation could be flat to down 0.25%, based on the proposed IRF rule. For home health, it estimated an approximately 2.8% incremental Medicare payment reduction under proposed PDGM assumptions, excluding any additional reduction related to CMS behavioral assumptions. These are estimates based on proposed rules, not final outcomes.
Planned 2019 capital expenditures were approximately $375 million to $445 million, including $160 million to $170 million described as nondiscretionary. The company also expected about $50 million in home health and hospice acquisitions, excluding Alacare.
The quarterly dividend was increased to $0.28 per share in July, from $0.27, payable October 15, 2019. The company repurchased approximately $44 million of shares in the first half; about $206 million remained under its authorization at June 30.
Key risks include Medicare and other reimbursement changes, proposed PDGM and CARE Tool implementation, the Home Health Review Choice Demonstration, audits and delayed claims appeals, staffing availability and costs, competition, acquisition integration, and litigation or regulatory proceedings. The company said there were no material changes to the risk factors in its 2018 Form 10-K.

Important facts for investors to verify

Track final CMS rules and realized reimbursement, volume and revenue-per-episode trends against management’s 2020 estimates.
Assess the effects of Alacare financing and the expected Q3 payments for redeemable noncontrolling interests and stock appreciation rights on debt, liquidity and cash flow.
Monitor operating cash flow conversion, receivables and labor costs, given lower first-half operating cash flow and salaries and benefits rising faster than revenue.
Review the final Yuma consolidation accounting and whether the estimated Q3 gain is realized.
Confirm covenant headroom and revolver availability after the acquisition and other cash obligations; the filing text does not provide clear actual covenant ratios.