Encompass Health Corp annual report, FY2015

Business context and reporting period

HealthSouth Corporation (the registrant named in this filing; now associated with Encompass Health) filed this Form 10-K for the fiscal year ended December 31, 2015. It operated inpatient rehabilitation hospitals and home health and hospice services in 34 states and Puerto Rico. The 2015 results include major acquisitions; Encompass was acquired on December 31, 2014, Reliant on October 1, 2015, and CareSouth on November 2, 2015. Accordingly, year-over-year growth is not wholly organic.

Financial and operating metrics

*The filing defines operating earnings as a non-GAAP-style measure excluding specified interest, tax, debt-extinguishment, and other items. Reported operating expenses were 81.2% of revenue, versus 79.3% in 2014. Adjusted EBITDA was approximately 21.6% of revenue. Medicare represented 74.9% of consolidated revenue in 2015, making reimbursement policy and audit outcomes particularly consequential.

Inpatient rehabilitation revenue was $2,653.1 million, up 11.6%; discharges rose 10.9%, including 3.2% same-store growth, while net patient revenue per discharge rose 1.1%. Segment Adjusted EBITDA was $691.0 million, up 3.9%. Home health and hospice revenue was $509.8 million and segment Adjusted EBITDA was $83.1 million; comparisons with 2014 are not meaningful because the acquired Encompass business was not included in 2014 results.

Fourth-quarter 2015 revenue was $879.3 million, operating earnings were $135.5 million, net income was $65.8 million, and net income attributable to HealthSouth was $47.0 million. Diluted EPS for the quarter was $0.49.

Material changes versus prior comparable period

• Revenue increased substantially, primarily from the addition of Encompass for a full year and acquisitions of Reliant and CareSouth, together with higher inpatient rehabilitation volumes.
• Profit attributable to HealthSouth and diluted EPS declined despite higher revenue. Higher salaries and benefits, interest expense, doubtful-account provisions, and acquisition-related costs contributed; the 2014 comparison also included a $27.2 million gain on consolidation of Fairlawn.
• Operating cash flow rose, but cash use for investing increased to $1,129.8 million, including $985.1 million net cash used for business acquisitions. Cash flow from financing was $639.9 million.
• Debt increased materially. The company issued senior notes and amended its credit agreement to help fund acquisitions; it reported $436 million of availability under its $600 million revolving credit facility at year-end.
• Medicare denials and delays weighed on working capital: accounts receivable increased to $507.1 million from $374.6 million. The provision for doubtful accounts rose to $47.2 million from $31.6 million.

Outlook, risks, contingencies, and unusual items

• Management described its outlook as positive, citing aging demographics, expected Medicare enrollment growth of approximately 3% annually, and its scale and care-quality positioning. It anticipated longer-term deleveraging through EBITDA growth and allocating some free cash flow to debt reduction; this is not a guarantee.
• Management expected 2016 capital expenditures of $185 million to $230 million, including $95 million to $110 million described as nondiscretionary. It estimated 2016 cash income taxes of $20 million to $40 million.
• For 2016 reimbursement, management estimated an approximately 1.6% net increase in inpatient rehabilitation Medicare rates before sequestration and an approximately 1.7% net decrease in home health rates before sequestration. Medicare sequestration remained a 2% reduction unless changed by law.
• CMS’s home health value-based purchasing model began in nine states in 2016, with payment adjustments tied to quality performance. New quality-reporting, discharge-planning, and post-acute data requirements may raise costs or affect reimbursement.
• The DOJ investigation remained unresolved. Subpoenas involving 11 hospitals concern alleged improper or fraudulent Medicare and Medicaid claims and admission-related practices, including compliance with the 60% rule. The company said it could not predict the timing or outcome; the filing does not provide a clear estimate of potential loss.
• Medicare audit appeals were taking more than three years. Medicare Administrative Contractor denials in the prepayment review process totaled $126.1 million of patient receivables at year-end, versus $62.2 million a year earlier. The company reported $79.0 million of new denials and $15.0 million of collections on previously denied claims in 2015.
• Other key risks include dependence on government reimbursement, changes to payment systems, staffing shortages and rising labor costs, acquisition integration, competition, professional-liability claims, and information-system and cybersecurity incidents. The company reported no goodwill impairment in 2015 and said it was in compliance with its credit agreement’s financial covenants at year-end.
• Unusual 2015 items included $22.4 million of losses on early extinguishment of debt and a $7.5 million expense for government, class-action, and related settlements. The company also completed the forced conversion of its remaining preferred stock into common shares.

Most important facts for investors to verify

• How much of 2015’s revenue and Adjusted EBITDA growth came from acquisitions versus same-store performance, and whether acquired operations meet expected returns.
• Trends in Medicare denials, appeal success and collection timing, including the adequacy of the doubtful-account provision and the effect on cash conversion.
• Debt, capital-lease obligations, covenant headroom, interest expense, and the feasibility and pace of management’s stated deleveraging plans.
• Final outcomes and any financial exposure from the DOJ investigation, other legal matters, and ongoing Medicare and Medicaid audits.
• Actual 2016 reimbursement changes, quality-based payment adjustments, capital expenditures, and integration progress compared with management’s estimates.