EHC

Business Context and Reporting Period

Company: HealthSouth Corporation (Note: Filing text identifies registrant as HealthSouth; request metadata references Encompass Health Corp, which is the successor name).

Reporting Period: Fiscal year ended December 31, 2008.

Overview: HealthSouth is the nation's largest provider of inpatient rehabilitative healthcare services. As of December 31, 2008, the company operated 93 inpatient rehabilitation hospitals, 6 freestanding long-term acute care hospitals (LTCHs), 49 outpatient rehabilitation satellites, and 25 home health agencies across 26 states and Puerto Rico. The company employs approximately 22,000 individuals.

Strategic Focus: Due to the 2008 economic downturn and credit market volatility, the company shifted its primary strategic emphasis from growth to debt reduction and deleveraging. Growth initiatives were limited to disciplined bed expansions and acquisitions requiring minimal initial cash outlays.

Key Financial Metrics

Note: Net Income for 2008 includes a $121.3 million gain from the UBS Settlement and a $70.1 million income tax benefit. Operating Earnings improved significantly due to revenue growth and cost management, despite a Medicare pricing roll-back.

Material Changes vs. Prior Period

• Revenue Growth: Net operating revenues increased 6.0% to $1.84 billion, driven by a 7.0% increase in inpatient discharges (107,780 total) and same-store discharge growth of 6.1%. This volume growth offset the negative impact of the Medicare pricing "roll-back" effective April 1, 2008.
• Debt Reduction: The company reduced total debt by approximately $228 million in 2008. This was achieved through the sale of the corporate campus ($43.5 million), an equity offering ($150 million), and federal income tax refunds ($46 million).
• Settlement Gains: A significant non-recurring gain of $121.3 million was recorded from the settlement of litigation with UBS Securities, LLC. This included $100 million in cash and the release of a $31 million loan guarantee judgment.
• Discontinued Operations: Results from discontinued operations dropped significantly from $455.1 million in 2007 to $17.6 million in 2008. The 2007 figure included a $513.7 million post-tax gain from the divestiture of surgery centers, outpatient, and diagnostic divisions.
• Interest Rate Swap Loss: Loss on interest rate swap increased to $55.7 million in 2008 from $30.4 million in 2007 due to changes in market expectations for interest rates.

Guidance, Outlook, and Risks

Management Outlook:

• Debt Priority: Reducing long-term debt remains the primary objective for the foreseeable future. The company intends to use the majority of net cash proceeds from the UBS settlement and future tax refunds to pay down debt.
• Volume Growth: Management believes it can sustain discharge growth of at least 4% annually, driven by an aging population and the stabilization of patient volumes following the 60% compliance threshold freeze under the 2007 Medicare Act.
• Cost Management: The company expects meaningful improvement in the non-productive component of salaries and benefits in 2009 following benefit plan refinements effective January 1, 2009.

Key Risks and Contingencies:

• High Leverage: The company remains highly leveraged. A downturn in earnings could impair the ability to comply with financial covenants (leverage and interest coverage ratios) in its Credit Agreement.
• Reimbursement Risk: Approximately 67.2% of revenues are derived from Medicare. The company faces ongoing risk from the Medicare pricing roll-back (effective through September 30, 2009) and potential future reductions in reimbursement rates.
• Regulatory Compliance: The company is subject to a Corporate Integrity Agreement (CIA) with the HHS-OIG expiring in 2009. Failure to comply could result in exclusion from federal healthcare programs.
• Staffing Shortages: Shortages of nurses and therapists may require increased utilization of expensive temporary personnel, impacting margins.
• Litigation: The company remains a defendant in various lawsuits, including derivative litigation against former auditor Ernst & Young and former CEO Richard M. Scrushy, and a dispute with General Medicine regarding a $376 million consent judgment.

Investor Verification Checklist

• Debt Covenant Compliance: Verify the company's current leverage ratio and interest coverage ratio against the requirements of its Credit Agreement to ensure no default risk.
• UBS Settlement Disbursement: Confirm the timing and final allocation of the $100 million UBS settlement proceeds, specifically the portion retained for debt reduction versus amounts paid to plaintiffs' attorneys and securities litigation plaintiffs.
• Medicare Reimbursement Trends: Monitor the impact of the Medicare pricing roll-back expiration in late 2009 and any new CMS regulations on reimbursement rates.
• Staffing Costs: Track the ratio of salaries and benefits to net operating revenues to assess the impact of labor shortages and temporary staffing costs on profitability.
• Outstanding Litigation: Review the status of the General Medicine lawsuit and the derivative litigation against Ernst & Young and Richard M. Scrushy for potential material liabilities.
• Capital Expenditures: Verify adherence to the disciplined capital expenditure budget ($70-$85 million for 2009) and the focus on low-cash-outlay development projects.