Select Medical Holdings Corporation (SEM) Q1 2012 Earnings Report, Transcript and Summary

Good morning and thank you for joining us today for Select Medical Holdings Corporations earnings conference call to discuss the first quarter 2012 results and the company's business outlook. Speaking today are the company's CEO, Robert Ortenzio; and the company's Executive Vice President and Chief Financial Officer, Martin Jackson. Management will give you an overview of the quarter highlights and then open the call for questions. Before we get started, we would like to remind you that this conference call may contain forward-looking statements regarding future events or the future financial performance of the company, including without limitation, statements regarding operating results, growth opportunities and other statements that refer to Select's plans, expectations, strategies, intentions and beliefs. These forward-looking statements are based on the information available to management of Select Medical today, and the company assumes no obligation to update these statements as circumstances change. At this time, I will turn the conference call over to Robert Ortenzio.

Thank you, operator. Good morning, everyone. Thanks for joining us for Select Medical Holdings' First Quarter Earnings Conference Call for 2012. As is our custom, for our prepared remarks, I'll provide some overall highlights for the company and our operating divisions. And then I'll ask Marty Jackson to provide some additional financial details before we open the call for questions. Earnings per fully diluted share increased 31.8% to $0.29 in the first quarter compared to $0.22 in the same quarter last year. Net revenue for the first quarter increased 7.3% to $744 million compared to the same quarter last year. During the quarter, we generate approximately 74% of our revenues from our specialty hospital segment, which includes both our long-term acute care and inpatient rehab hospitals. And 26% from our outpatient rehabilitation segment, which includes both our outpatient clinics and our contract services. Net revenue on our specialty hospitals for the first quarter increased 6.4% to $553 million compared to the same quarter last year. The increase was driven primarily by increases in Medicare patient volumes and revenue from contracted labor services provided to the Baylor joint venture during the quarter. Our patient days in the first quarter increased 2.7% to 343,021 days, and overall occupancy rates were 73% in the first quarter compared to 72% in the same quarter last year. Specialty hospital net revenue per patient day was up slightly, $1,525 in the first quarter compared to $1,514 per patient day in the same quarter last year. The increase in net revenue per patient day was driven primarily by an increase in our non-Medicare net revenue per patient day. During the first quarter, approximately 85% of our inpatient revenue came from our LTACs, and 15% from our inpatient rehabilitation hospitals. Net revenue on our outpatient rehab segment for the first quarter increased 10.2% to $190.9 million compared to the same quarter last year. Revenue in our clinic-based business, including our owned and managed clinics, increased 5.1% in the first quarter compared to the same quarter last year. The increase was driven by both volume growth in our owned clinics and revenue from contracted labor services provided to the Baylor joint venture. For our owned clinics, our net revenue per visit was flat at $103 per visit, and patient visits increased 1.2% compared to the same quarter last year. Excluding the effect of the clinics transferred to the Baylor joint venture, patient visits would have been up 3.5% compared to the same quarter last year. Revenue in our contract services business increased 27.6% in the first quarter compared to the same quarter last year. This increase was a result of the addition of new contracts. During the first quarter, approximately 74% of our outpatient revenue came from our owned and managed clinics, and 26% from our contract services. Overall adjusted EBITDA for the first quarter increased by 3.1% to $109.1 million compared to $105.7 million in the same quarter last year. With overall adjusted EBITDA margins at 14.7% for the first quarter compared to 15.3% margins in the same quarter last year. Specialty hospital adjusted EBITDA for the first quarter was $100 million compared to $100.4 million in the same quarter last year. Adjusted EBITDA margins for the specialty hospital segment were 18.1% compared to 19.3% in the same quarter last year. Decline in adjusted EBITDA in the quarter was primarily the result of increased labor cost in the quarter, offset by lower bad debt expense compared to the same quarter last year. Outpatient rehabilitation adjusted EBITDA for the first quarter increased 5% to $22.5 million compared to $21.4 million in the same quarter last year. Adjusted EBITDA margins for the outpatient segment decreased to 11.8% in the first quarter compared to 12.4% in the same quarter last year. For the clinic portion of our business, adjusted EBITDA was up 3.3% to $18.6 million, and adjusted EBITDA margins were down 20 basis points to 13.2% compared to the same quarter last year. The decline in clinic margins is primarily due to labor costs associated with contract labor services provided to the Baylor joint venture. Excluding this effect, margins in our clinic-based business would have been 13.8% in the first quarter. For our contract services, adjusted EBITDA was $3.9 million and margins were 7.8% in the first quarter compared to $3.4 million of adjusted EBITDA and margins of 8.7% in the same quarter last year. Our contract services margin declined as a result of increased labor cost associated with new contracts, as well as the productivity declines that resulted from regulatory changes that were effective starting the fourth quarter. We're generally pleased with our results for the quarter and continue to look for opportunities to improve the operating performance of the company as we progress throughout the year. I also wanted to provide a couple of updates since our fourth quarter earnings call in February. As most of you are probably aware, CMS released the proposal for LTAC hospitals for fiscal year 2013 on April 24. I want to emphasize, these rules are proposed and subject to a comment period and could change. The proposed rules are less onerous than I believe the market had anticipated and I believe provide the LTAC industry with stability in the near term. The 3-year phase in and the budget neutrality adjustment, a 1-year extension of the 25% rule are positive. The big challenge that remains is the adoption of new standards to better define our patient population. Last year, progress was made in that regard with Senator Roberts and Senator Bill Nelson, introduced the bill that has now been cosponsored by a dozen U.S. senators. That bill was based on principles developed over a year or more by the American Hospital Association. Select has been pleased to support that bill. I'm sure there will be questions on the proposed rules, so I will limit my prepared comments to that. I also wanted to mention that during the first quarter, in conjunction with our joint venture partner, Baylor Health System, our Baylor joint venture acquired a majority interest in 2 inpatient rehab hospitals in the greater Dallas-Fort Worth area. With this acquisition, the Baylor JV now operates 4 inpatient rehab hospitals, 3 managed units and 34 outpatient clinics. I'll now turn it over to Marty Jackson, our Chief Financial Officer, to cover some additional financial highlights for the quarter and full year.

Thanks, Bob. For the first quarter of our operating -- for the first quarter, our operating expenses, which include our cost of service, general and administrative costs and bad debt expense, increased 8.1% to $636.2 million compared to the same quarter last year. As a percentage of our net revenue, operating expenses for the quarter were 85.5% compared to 84.9% in the same quarter last year. Cost of services increased 9.7% to $611.6 million for the first quarter. As a percent of net revenue, cost of services was 82.2% for the first quarter compared to 80.4% in the same quarter last year. The primary driver behind the increase in cost of services was an increase in our labor cost. We experienced a relative increase in labor cost associated with contracted labor services provided to the Baylor JV, which had a 40 basis point impact on our cost of services in the quarter. In addition, our relative labor cost in our specialty hospitals, specifically our LTACs, were higher as we did not adequately adjust our staffing level to correspond with the lower acuity patient population we treated during the quarter. This is compared to the same quarter last year. Our overall case mix index, which is how we measure acuity in our LTAC hospitals, was 1.185 during the first quarter compared to the case mix index of 1.207 in the first quarter last year. G&A expense was $14.2 million in the first quarter, which as a percent of net revenue was 1.9% compared to $16.6 million, or $2.4 million of revenue for the same quarter last year. The primary reason for the decline in G&A is relative to a gain on the sale of assets in this quarter. Excluding this gain, G&A would've been 2.3% of net revenue in the first quarter. Bad debt as a percent of net revenue was 1.4% for the first quarter compared to 2.1% for the same quarter last year. The decrease in bad debt as a percent of revenue occurred across both of our operating segments, however, the majority of the decrease is attributable to favorable collection experience with accounts receivable associated with the Regency Hospitals and their lower respective reserve requirements compared to the same quarter last year. As Bob mentioned, total adjusted EBITDA was $109.1 million for the first quarter and adjusted EBITDA margins were 14.7% compared to adjusted EBITDA of $105.7 million, and 15.3% adjusted EBITDA margins in the same quarter last year. Depreciation and amortization expense was $16.2 million in the first quarter compared to depreciation and amortization expense of $17.2 million in the same quarter last year. The decline in our depreciation and amortization expense is in result of decreases in depreciation expense related to the assets acquired from HealthSouth, which have now been fully depreciated. We generated $2.5 million in equity and earnings during the quarter, this is primarily attributable to our earnings from the Baylor JV. This compares a loss in the same quarter last year of $73,000. Net interest expense was $23.9 million in the first quarter, down from $25.6 million in the same quarter last year. The reduction in interest expense is related to lower interest rates on portions of debt we refinanced during the second quarter of last year, as well as lower average debt levels compared to the same quarter last year. The company recorded income tax expense of $27.6 million in the first quarter, which represents an effective tax rate of 39.3% compared to an effective tax rate of 42.9% in the same quarter last year. The decline in our effective tax rate is primarily the result of a higher effective tax rate in the same quarter last year associated with the hospital exchange completed in January of 2011. Net income attributable to Select Medical Holdings was $41.5 million in the first quarter and fully diluted earnings per share was $0.29. We ended the quarter with $1.4 billion of debt outstanding and $9.3 million of cash on the balance sheet. Our debt balances at the end of the quarter include $836.2 million of term loans outstanding; $55 million in revolver loans; $345 million of the 7 5/8 senior subnotes; $167.3 million of Hold Co senior floating rate notes and the balance of $10 million consists of other miscellaneous debt. Operating activities provided $8.2 million of cash flow in the first quarter compared to operating activities using $5 million of cash during the first quarter of last year. The provision of operating cash flow in the first quarter this year was primarily the result of cash earnings and increases in income and deferred taxes offset in part by increase in accounts receivable and decreases in accrued expenses. Overall, we experienced an increase in days sales outstanding, or DSO, 57 days compared to 53 days at the end of December 2011. The increase is primarily related to the timing and settlement of our Medicare accounts for services provided at our specialty hospitals. Our 57 day DSO at the end of the first quarter is consistent with our experience at the end of the first quarter last year. Investing activities used $3.1 million of cash flow in the first quarter. The use of cash was related to property improvement and equipment purchases of $11.8 million and an additional investment in the Baylor JV to facilitate the acquisition of the 2 inpatient rehab hospitals at $7.8 million, offset by proceeds from the sale of assets of $16.5 million. Financing activities used $7.9 million of cash in the first quarter. The use of cash resulted from $25.7 million in repurchase of the common stock, $2.1 million amortization payment on our term loan and $1.1 million in distributions to noncontrolling interest. This was offset in part by $15 million in net borrowings on our revolving credit facility, $3.5 million in net borrowings of other debt and $2.5 million in proceeds for bank overdrafts. During the first quarter, we repurchased 3,203,692 shares of our common stock in the open market for a total cost of $25.7 million. Through March, we have spent a total of $142.6 million of the $250 million authorized under the share repurchase program. I would like to close by reaffirming our 2012 business outlook initially provided in our January 6 press release. This includes a net revenue on the range of $2.85 billion to $2.95 billion; adjusted EBITDA in the range of $390 million to $410 million; and EPS in the range of $0.86 to $0.94 per share. This concludes our prepared remarks. And at this time, we'd like to turn it back to the operator to open the call up for questions.

[Operator Instructions] Your first question comes from the line of Kevin Fischbeck with Bank of America.

Okay. I was wondering if you could provide any color on the subpoenas that were also announced last night. Any color on exactly what is being looked at and what you think the impact might be?

Yes, Kevin. Yes, I really can't add much more other than what's in the disclosure. As you can see from the disclosure, it's pretty recent and we're cooperating and we get these from time to time. And I really can't say much other than what's in the disclosure and that is really, it contains all facts that we know at this point. Obviously, anytime you get these, your first suspicion is that they are part of a qui tam, we don't know that for sure. So all you can do is just respond to the information and then wait until you get more color on it and at this point, we really don't.

Okay. And you were right, you're going to get some questions on the LTAC proposed rule. Does your guidance include the impact of that in Q4?

It does. It does.

Okay. And the commentary from CMS about putting in patient assessment criteria. Do you have any sense of what that might look like and how similar that might be to the bill that the industry has provided? And I guess, do you have any sense of whether CMS looks at this as replacing the 75% rule -- oh, sorry, 25% rule, and therefore, they've categorized that as maybe cost administering $170 million. Did they feel like they have to come up with something that saves a similar amount of money or how do you think they're looking at that?

Kevin, let me make sure I understand. Is part of your question wrapping in the budget neutrality adjustment that's spread over 3 years?

No, I think, I mean, I'm under the impression that if CMS was to go forward with its view, absent a bill from the industry, that they would put the budget neutrality adjustment in, but also look to put patients as a criteria in on top of that. Correct me if you view it differently, but I'm some kind of assuming the budget neutrality happens and the year delay and the 25% rule is more, in my view, to give CMS time to replace the 25% rule, is something more appropriate around patients assessment criteria. I'm just trying to figure out where CMS is headed on that? Are they going to come up with something that's in line with what the industry was proposing in their bill or do you think it will be more restrictive, less restrictive? Do you think they have some sort of idea about savings when they comp with that?

Okay. Yes, I understand your question. And your question is right on the mark. I mean, it is exactly the question. There is some narrative in the rule after they go through the payment changes and the extension of the 25% rule that is subject to interpretation. I mean, I think what they say exactly is that they could soon be in a position to propose a revision to their payment policies that would make the 25% rule unnecessary. So that is open to some interpretation. And I think one interpretation is that, perhaps, they are looking at patient facility criteria, maybe similar to or different than the industry or the Roberts-Nelson bill or what the AHA has been talking about. And that would be one interpretation. I think another scenario maybe that they view this, the LTAC, as part of their discussed realignment of the post-acute care sector that we've seen some commentary around. It's been referred to as bundled payment, there's a site neutral proposal out there. So I think that it is the $100 question of exactly which direction they're heading, and I don't know at this time. I don't know -- I can't say that I know exactly which direction they're heading on that. But I think the narrative that was in the proposed rule is pretty constructive because, I think that they showed a willingness to put off the 25% rule, which is crude and onerous and the budget neutrality adjustment to be spread over 3 years and some indication that they are looking at some policy options on the LTACs. But that's as far as I would go in terms of interpreting it. I don't want to be overly optimistic or pessimistic. I think the rule that we got on its face is good but there's obviously still a lot of work to do.

Okay. Now, that's helpful. And then last question here, you mentioned a couple times in the commentary around the higher contracted services cost to the Baylor joint venture. How do we think about that expense? Is that an expense that's going to be a run-rate or is that something that is higher right now but you expect to get more leverage on over time?

Kevin, that's a very good question. We think it's really going to be on a run-rate basis. And actually, with the 2 global hospitals that we acquired, it's probably going to be a little bit higher than that.

And next question comes from the line of Gary Lieberman with Wells Fargo.

Maybe just a follow-up on the LTAC rule, the stated increase in the proposed rule, calculated at 1.9% increase for the industry. Have you guys had a chance to take a look at how the rule would impact Select specifically?

Sorry, say that again, Gary? The --

In the proposed LTAC, in the proposed rule, the stated increase that CMS calculated for the industry, I believe, was 1.9%. Can you guys comment, if you think you would receive a similar increase or it would be different for you?

Yes, I think, Gary, remember, with this proposed rule, there's a couple of different things going on here. There's the basket increase, there is the deduct associated with the efficiency improvement, there is the Obamacare deduct, and that's really applicable for October through December. And then starting in January, you have the deduct associated with DNA and then you've got the re-waiting for a short stay outlier, and then the labor adjustment that's made. I'm assuming you're saying after all of those, what is the overall impact to us?

Yes, that's what the question is. I mean, I'm not certain -- it wasn't clear exactly what the timing for when CMS calculated all the impacts would take place. I assume they were assuming that the budget neutrality wouldn't happen until January 1 and with that, under those assumptions, what they said was it would was increased 1.9%. So, yes, I'm just asking if you guys have had a chance to take a look at what the overall change would be with reimbursement under the rule?

Yes, we have had an opportunity to take a look at that and it's well below 1% for us. And a lot of that has to do with just the DRGs that we have and the re-waiting.

From an overall -- I think that's from an overall standpoint. I think also, maybe part of your question is this, sometimes the headline number that CMS gives on what they estimate the percentage increase or decrease, it differs greatly from what some companies say is the impact to them. I don't think that we dispute necessarily the impact that CMS is saying in their headline, but there's so many components of it that when it comes -- when you wash it all out, I think our view of the total impact is as Marty stated.

Okay. No, that's why I'm asking the question.

Yes, I mean, Gary, just to give you a historical background, last year, they talked about -- I believe they talked about a 1.8% increase for the industry. And I think what we had talked about was 72 basis point increase for us.

Right. Okay. That's helpful. And then maybe moving to the improvement in the equity income. You talked about the Baylor JV. Can you talk about that in more detail? Are those operational improvements that you've seen there that has caused the profit to increase or what was that from?

Well, if you recall, we did the Baylor JV at the -- on April 1 of last year. So on a year-over-year same quarter comparison, there is no comparison. So in the second quarter, we did see some startup of the JV expenses in it, but yes, I mean, the JV with Baylor is actually performing nicely. We think there still continues to be some room for operating improvement and we're very pleased with it.

Okay. And then maybe the final question would be just, you mentioned the decrease in the case mix index year-over-year, is that sort of within what you would expect from normal variability or is there something else you think that's at work there?

Yes, we believe that the reduction in the case mix index is really driven by reduced pulmonary patients. And if you take a look at what the acute care hospitals said, that they had a significant reduction in that patient population. So ours is just a follow-on to that.

And I think that if you get behind that, I think it's, in part, can be attributed to the extraordinary mild winter that we had. So you see fewer flus and consequently, fewer pulmonary patients. And it wouldn't take a lot of that for it to reduce the case mix index because those are by far, our highest acuity patients.

Your next question comes from the line of Todd Corsair with UBS.

Quick question on the 25% rules. The -- I guess I was just wondering, what share of your hospitals have -- of the LTACs have, cost reporting periods that fall in the third quarter?

Yes, there is 12 that have cost reporting periods during the time period you're talking about.

Okay. And the way you guys interpret the rule, did you see that there's -- just given the timing of implementation and everything, that there is some -- that possible with cost report periods starting there in that quarter, might be subject to the 25% rule one way or the other?

Yes, we believe that way the rule is written, the proposal is written that those -- that class of hospitals in the industry is disadvantaged by subject to the rule.

But for you guys, it's just that small minority.

It's 12 hospitals, so you can assume that within those 12, we may have some that would have an impact and maybe others that would not. But if the impact was material, we would've called that out separately. So you can assume that we took that into account when Marty reaffirmed guidance.

Great. That's helpful. And since we got this historically, I might as well ask it now. Any change in your thinking with regard to those floating rate notes on the balance sheet?

Todd, we like those floating rate notes.

I like them too.

Your next question comes from the line of Walter Branson with Regiment Capital.

Just a couple things. So you had revenue growth associated with contracted services to the Baylor JV, as well as labor costs associated with that. Is providing those services to the JV a profitable business or is it just cost based or what?

Yes, Walter. That is strictly a pass-through. So there is no profitability into that pass-through at all. So obviously, it's going to have a negative impact on your EBITDA margins.

Right, but it didn't have any negative impact on EBITDA, is that correct?

That's correct.

Correct.

Okay. And then in terms of the balance of the year, taking into account your stock repurchase program, would expect net debt to be going up or going down?

I would anticipate, with the terrific cash flow we have, net debt to go down.

Okay. And then just finally, just to kind of follow-up on what Todd said, I think you implied it, but I want to be clear, if you were to do a refinancing at this point, you would anticipate not taking out the floaters, is that correct.

Yes, and we like the floaters very much.

With no further questions in the queue, I'll turn it back over to management for closing remarks.

Thank you, operator. Thanks, everybody, for joining us for the call, and we'll look forward to updating you with the results of our second quarter later in the year. Thank you.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.