EHC

Business Context and Reporting Period

This Form 10-K covers HealthSouth Corporation (now Encompass Health Corp) for the fiscal year ended December 31, 2007. The company is the largest provider of inpatient rehabilitative health care services in the United States, operating 94 inpatient rehabilitation hospitals, 6 long-term acute care hospitals (LTCHs), 60 outpatient satellites, and 25 home health agencies. In 2007, the company strategically repositioned itself as a "pure-play" inpatient rehabilitation provider by divesting its surgery centers, outpatient, and diagnostic divisions.

Key Financial Metrics

Note: The 2007 Net Income includes a significant $454.6 million gain from discontinued operations related to the divestitures of non-core divisions. Operating earnings from continuing operations increased by approximately $62.5 million compared to 2006.

Material Changes vs. Prior Period

• Divestitures: The company completed the sale of its outpatient division (to Select Medical), surgery centers division (to an affiliate of Texas Pacific Group), and diagnostic division (to an affiliate of The Gores Group). These transactions generated net proceeds of approximately $1.14 billion, which were primarily used to reduce debt.
• Debt Reduction: Total debt decreased from $3.4 billion in 2006 to $2.0 billion in 2007. This reduction was achieved using proceeds from divestitures and a $440 million federal income tax recovery from the IRS.
• Income Tax Recovery: The company settled federal income tax issues for tax years 1996-1999, receiving a $440 million cash refund (including interest). Approximately $405 million was used to pay down long-term debt.
• Settlements: The company made final payments on its Medicare Program Settlement and SEC Settlement in 2007, allowing the redirection of operating cash flow.
• Regulatory Relief: The "75% Rule" compliance threshold was permanently set at 60% by the 2007 Medicare Act, providing relief from previous regulatory uncertainties regarding patient mix.

Guidance, Outlook, and Risks

Outlook: Management expects to focus on growing the inpatient rehabilitation business through bed expansion, consolidation, and acquisitions in 2008 and 2009. The primary financial focus for 2008 remains debt reduction using free cash flow. Management anticipates flat to slightly down pricing in 2008 due to a Medicare pricing "roll-back" effective April 1, 2008, but expects volume increases to offset this due to the stabilized 60% compliance threshold.

Risks and Contingencies:

• Leverage: Despite debt reduction, the company remains highly leveraged. A downturn in earnings could impair the ability to comply with financial covenants in its Credit Agreement.
• Reimbursement: Approximately 67.5% of revenues are derived from Medicare. Changes in reimbursement rates or regulations (such as the pricing roll-back) pose significant risks.
• Staffing: Shortages of nurses and therapists are driving up labor costs, which are difficult to pass on to payors due to fixed reimbursement rates.
• Legal: The company remains subject to various lawsuits, including potential qui tam cases under the False Claims Act, and must comply with a Corporate Integrity Agreement (CIA) with the HHS-OIG.

Investor Verification Checklist

• Verify the final closing status of the surgery centers divestiture, specifically regarding the Illinois facilities pending regulatory approval as of year-end.
• Confirm the impact of the Medicare pricing "roll-back" (effective April 2008) on 2008 revenue projections versus volume growth expectations.
• Review the company's ability to maintain compliance with the 60% patient mix threshold under the new 2007 Medicare Act.
• Assess the adequacy of reserves for self-insured risks and ongoing litigation, particularly regarding the Corporate Integrity Agreement obligations.
• Monitor the company's leverage ratios and covenant compliance given the remaining $2.0 billion debt load and scheduled principal payments of $68.3 million in 2008.