Encompass Health Corp

NYSE:EHC

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, everyone, and welcome to Encompass Health’s Second Quarter 2018 Earnings Conference Call. At this time, I would like to inform all participants that their lines will be in a listen-only mode. After the speakers’ remarks, there will be a question-and-answer period. [Operator Instructions]. Today’s conference call is being recorded. If you have any objections, you may disconnect at this time.

I would now turn the call over to Crissy Carlisle, Encompass Health’s Chief Investor Relations Officer.

[Crissy Carlisle, Chief Investor Relations Officer]

Thank you, operator, and good morning, everyone. Thank you for joining Encompass Health’s second quarter 2018 earnings call. With me on the call in Birmingham today are Mark Tarr, President and Chief Executive Officer; Doug Coltharp, Chief Financial Officer; Barb Jacobsmeyer, President, Inpatient Rehabilitation Hospitals; Patrick Darby, General Counsel and Corporate Secretary; Andy Price, Chief Accounting Officer; Ed Fay, Treasurer; and Julie Duck, Senior Vice President of Financial Operations. April Anthony, Chief Executive Officer of Our Home Health and Hospice segment, also is participating in today’s call via phone.

Before we begin, if you do not already have a copy of the second quarter earnings release, supplemental information and related Form 8-K filed with the SEC, are available on our website at encompasshealth.com. On Page 2 of the supplemental information, you will find the Safe Harbor statements, which are also set forth in greater detail on the last page of the earnings release.

During the call, we will make forward-looking statements, which are subject to risks and uncertainties, many of which are beyond our control. Certain risks and uncertainties that could cause actual results to differ materially from our projections, estimates and expectations, are discussed in the company’s SEC filings, including the earnings release and related Form 8-K and the Form 10-K for the year ended December 31, 2017, and the Form 10-Q with the quarter ended March 31, 2018 and June 30, 2018 when filed. We encourage you to read them.

You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented which are based on current estimates of future events and speak only as of today. We do not undertake a duty to update these forward-looking statements. Our supplemental information and discussion on this call will include certain non-GAAP financial measures. For such measures, reconciliation to the most directly comparable GAAP measure is available at the end of the supplemental information, at the end of the related press release, and as part of the Form 8-K filed yesterday with the SEC, all of which are available on our website.

Before I turn it over to Mark, I would like to remind everyone that we will adhere to the one question and one follow-up question rule to allow everyone to submit a question. If you have additional questions, please feel free to put yourself back in the queue.

With that, I’ll turn the call over to Mark.

[Mark Tarr, President and Chief Executive Officer]

Thank you, Crissy, and good morning to everyone joining today’s call. The second quarter was another strong quarter for Encompass Health, with solid operating and financial results in both segments. Consolidated revenue and consolidated adjusted EBITDA, both increased 10.5% and adjusted earnings per share increased 39.4%. These solid results reflect the strength and sustainability of our business model that focuses on serving the most rapidly growing segment of the U.S. population.

Doug will review the details of our financial and operating performance in just a few minutes. I will spend my time providing a brief update on our strategic initiatives and focusing on regulatory developments, including post rules for inpatient rehabilitation and home health. During the second quarter, we continued to make significant progress on our key strategic initiatives. Beginning with growth and capacity, on May 1st, we completed the acquisition of Camellia Healthcare, which added 18 hospice and 14 home health locations to our portfolio. The integration of Camellia is on track, and as expected, training and other integration expenses impacted our cost of services and productivity in the second quarter.

We also opened three home health locations in Georgia, Alabama and Idaho and acquired one hospice location in Nevada. In our inpatient rehabilitation segment, we began operating our new 34-bed hospital in Shelby County, Alabama in April and began operating our new 38-bed hospital in Hilton Head, South Carolina in June. Later this year, we expect to open new inpatient rehabilitation hospitals in Murrells Inlet, South Carolina and in Winston-Salem, North Carolina, with North Carolina being a new state for us.

We also remain focused on those strategic initiatives that help us ensure we consistently provide high-quality, cost-effective care and position us for success in the evolving health care industry. We continue making great progress in terms of clinical collaboration, which is resulting in lower discharges to skilled nursing facilities and improved patient satisfaction in our overlap markets. Our clinical collaboration rate for the second quarter was 33.2%, an increase of 460 basis points over the prior year and consistent with the increase we experienced in the first quarter of 2018. This provides us further evidence of the efficacy of our TeamWorks clinical collaboration initiative.

We remain focused in achieving our near-term objective of a 35% to 40% range. Our rebranding and name change is also going well. On July 1st, we completed the second wave of transitioning our field assets to our new brand. At this time, approximately 40% of our hospitals and agencies have transitioned to the new brand, with our next wave scheduled for October 1st.

We also continued our work with the Post-Acute Innovation Center to develop advanced analytics and predictive models to enhance clinical outcomes and reduce cost of care across a broader episode of care. We are actively using care management tools at our hospitals in Tyler, Texas as part of the hip fracture pilot with CHRISTUS Trinity Mother Frances. We are continuing the onboard additional data to enhance the patient longitudinal record and make other enhancements based on feedback from the Tyler project.

We also continued our work to develop a 90-day post-acute readmission prediction model to identify patients at risk for readmission across all post-acute settings. Phase I of this project used birth and home health data, while Phase II of the model development will incorporate acute and other post-acute data sets into a longitudinal patient record.

Turning now to the regulatory front. In April, CMS released its 2019 proposed rule for inpatient rehabilitation facilities. This implemented, as proposed, we estimate the rule would increase our Medicare reimbursement rates by approximately 1.2% in fiscal year 2019. The 2019 proposed rule also included a proposal to implement budget-neutral changes to the patient assessment and case mix system for rehabilitation hospitals in the fiscal year 2020. A system that will be based on data collected over a one-year period from the new care patient assessment tool, which has been running through currently with the established functional independence measure, or FIM tool.

We have worked individually as well as part of our Trade Association to provide constructive feedback to CMS and Congress on this proposal and why it should not be implemented at this time. The proposed new functional assessment items were developed under the Impact Act. That law was enacted to collect clinical data and information to examine the feasibility of implementing new payment methodologies such as a post-acute care perspective payment system and not to change existing site-specific post-acute payment systems.

We certainly appreciate the ongoing efforts of HHS and CMS to reduce regulatory burdens, which is why CMS proposed these changes. However, in this instance, the benefits of collecting only one set of patient assessment data do not outweigh the burdens of collecting two sets. As too little is known about the accuracy, consistency or efficacy of the data and their ability to be used for payment policy purposes, we expect CMS to release the final rule for fiscal year 2019 soon.

On July 2nd of this year, CMS published the 2019 proposed rule for home health. As part of this rule, we were pleased to see our first Medicare reimbursement rate increase in nearly a decade coming out right in 2019. The 2019 proposed rule includes a net market basket update of 2.1%, but, as in prior years, it incorporates case mix reweightings that are redistributing payments based upon most recent changes in resource used by payment rule. Based on our current patient mix, we estimate 2019 proposed rule would result in a 1.6% increase in our reimbursement rates or our home health business. In addition, we were pleased to see that CMS proposed to allow home health agencies to include the cost of remote patient monitoring as an allowable cost in cost reports. It caused many providers in an industryhave borne for years.

This implemented, as proposed, these costs would be factored into a home health agencies cost per visit and thus the margin going forward. In addition to the payment updates for 2019 and as required by the Bipartisan Budget Act of 2018, CMS is proposing to replace the current home health prospective payment system with a new system called the patient driven groupings model, or PDGM.

Consistent with the directive of the Bipartisan Budget Act, PDGM includes 30-day payment period and is intended to be budget neutral, albeit reliant on soon behavioral changesto achieve this status. We continue to support the movement away from volume-based payment mechanisms to those based on patients need and acuity. However, PDGM is pretty similar to HHGM in all respects, with one exception. And we remain concerned that elements of it, such as non-accounting for the relative intensity of care between initial and subsequent 30-day periods could result in unintended consequences related to Medicare beneficiaries access to care.

As we have done in the past, we will continue to work individually and via our trade associations to provide constructive feedback to CMS and we are hopeful CMS will seek additional industry input, perhaps by reconvening the technical expert panel or TEP, which met only once in this process. It remains too early to asses potential impact of PDGM on our business in 2020.

Much is likely to change in the details of the rule, our approach to the business and our patient mix between now and then. CMS is proposed behavioral assumptions totaling approximately 6.4% related to coding specificity and looper classifications, which will be implemented as a reduction in payment in order to achieve budget neutral implementation of the PDGM. We will prepare ourselves for these resumed behavioral changes.

In addition, and based on our 2016 data, assuming no changes to the rule, our push to the business and our patient mix, which are all very big assumptions and all unlikely to transpire, the estimated impact to our home health business is an incremental 5.4% reduction. We have approximately 18 months and both the current and subsequent rule-making processes to prepare for any resulting changes to the payment system. And as we have demonstrated repeatedly in the past, we are still at adapting.

Finally, on May 29, CMS announced its intentions to restart the pre-claim review demonstration in home health, no earlier than October 1, 2018. The new version of the pre-claim review, now called the review choice demonstration, or RCD, differs from the original program. The review choice demonstration gives home health agencies three options to participate, a pre-claim review, a post-payment review and a minimal post-payment review with a 25% payment reduction on all claims. We believe RCD city is better than the previous program, primarily by providing a way for providers to come off the program for good performance.

Basically, the provider achieves a 90% affirmation rate on pre- or post-claim reviews and provide or become subject only to periodic spot checks. The program will be implemented in a staggered manner, starting in Illinois, then expanding to Ohio and North Carolina, and later to Texas and Florida. On a combined basis, our home health locations in these states represented approximately 47% of our 2017 home health Medicare revenues. We believe we are prepared for this demonstration and have been working with Palmetto, the MAC-included in the demonstration to better automate the review process as much as possible.

Now, moving to guidance. As a result of our strong performance in the first half of the year, we are raising our full-year guidance ranges as follows. We're increasing net operating revenues from a range of $4.11 billion to $4.21 billion, to a range of $4.2 billion to $4.275 billion. We’re increasing adjusted EBITDA from a range of $845 million to $865 million to a range of $865 million to $880 million and we’re increasing adjusted earnings per share from a range of $3.30 to $3.45 per share to a range of $3.45 to $3.58 per share.

With that, I will turn it over to Doug.

[Doug Coltharp, Chief Financial Officer]

Thank you, Mark and good morning everyone. As Mark highlighted, Q2 was another strong quarter for our company as both of our business segments generate solid revenue and earnings growth, and we leveraged our corporate G&A expenses. Our Q2 consolidated revenues and adjusted EBITDA, both increased 10.5% over Q2 last year and adjusted EPS, which benefited from a lower effective tax rate, increased 39.4%.

Cash flow generation remains strong in Q2 as well, driven by adjusted EBITDA growth in favorable working capital changes, primarily related to improved collection of accounts receivable. Adjusted free cash flow for the first half of 2018 was $281.4 million, an increase of 10.8% over the first half of last year.

The strength of our free cash flow generation in the first half allows us to fund the purchase of the Home Health Holdings rollover shares in Q1 and the Camellia acquisition in Q2, while still modestly reducing our leverage ratio to 3.0x at the end of the second quarter. The strength of our balance sheet and the consistency in our cash flow generation were factors considered by our Board of Directors in raising the quarterly cash dividend on our common stock to $0.27 per share and replenishing our common stock repurchase authorization to $250 million. These actions notwithstanding, the prioritization of free cash flow utilization remains the high-quality growth opportunities we see present in both of our business segments.

Moving on to the segment results. IRF segment revenue increased 7.3% over Q2 2017, driven by volume and pricing growth. Discharge volume increased 5.2% with same-store growth of 3.6%. Net revenue for discharge increased 2.5%. The increase in revenue per discharge was higher than expected due to lower bad debt, which is now compounded of revenue in favorable prior period price adjustments. Our revenue reserve related to bad debt in Q2 was 1.2% as compared to 1.6% in Q2 2017.

As can be seen on Slide 21 of the supplemental slides, new prepayment claims denials in Q2 declined both sequentially and year-over-year. As we discussed on prior calls, we attribute the reduction in ADR activity to the implementation of TPE across in all MACs into the transition of our largest MAC contract from Cahaba to Palmetto.

We are very pleased with the year-to-date experience we have had with our MACs regarding ADRs. But we still do not have enough experience with Palmetto or TPE to assess the sustainability of the bad debt levels realized over the past several quarters. Additionally, we have still seen no progress on resolving substantial backlog of claims with approximately $160 million for our company alone that are awaiting adjudication at the ALJ level.

Accordingly, our updated guidance assumes bad debt revenue reserves of 1.6% to 1.9% for the second half of the year. IRF segment adjusted EBITDA for Q2 increased 7.2% to $223.5 million, driven by strong revenue growth and effective labor management. Expense ratios in the quarter benefited from the lower revenue reserve related to bad debt as well as the favorable retroactive price adjustments. Q2 SWB as a percent of revenues declined 80 basis points to 49.9%. Labor productivity improved during the quarter, evidenced by a year-over-year decline in EPOB from 3.46 to 3.43. SWB also benefited from a reduction in expenses related to worker’s compensation.

Our group medical expense for the first half of 2018 increased a modest 2.2% over the first half of last year. Given the favorable performance we experienced in group medical expense during 2017, which occurred with adding significant changes to our program structure, or beneficiary population, we entered 2018 assuming group medical expenses would be mean reverting and increased in the range of 8% to 12%.

In the first half of 2018, we continue to benefit from a relatively low incidence of high-dollar claims in the absence of any significant new pharma solutions. Nonetheless, we believe it is still prudent to assume an increase in group medical expenses for the second half of the year. Our other operating expenses in Q2 increased as a percent of revenues by 70 basis points. This was primarily attributable to an increase in contracted services. Recall that we touched upon this in our Q1 call as well as an increase in provider tax expense, which can be a bit unpredictable.

Moving now to our Home Health and Hospice segment, Q2 revenues increased 23.5% with home health up 19.1% and hospice up 67.5%. Revenue growth in the quarter was aided by the acquisition of Camellia, which we completed on May 1st. Segment revenue growth was driven by volume as home health per episode declined 0.2%. Pricing was somewhat better-than-expected, however, as the impact of Medicare reimbursement rates was partially offset by the favorable resolutions of our prior period ZPIC audit.

Home health admissions for Q2 increased 10.4%, with 5.1% in same-store and episodes increased 17.5% with 11.1% same-store growth. Please recall that home health is comping against the 13.3% same-store admissions increase in Q2 2017, which benefited from improvements in the former care’s health agencies.

Hospice admissions increased 61.3% in Q2 with 35.2% same-store growth. We continue to seek opportunities to add scale to our hospice business and the Camellia acquisition is a nice step in that direction. Home Health and Hospice segment adjusted EBITDA for Q2 increased 26.8% to $41.6 million. Cost of services as a percent of revenue increased 50 basis points, primarily due to merit increases, changes in patient mix and Camellia integration expenses. To support an overhead cost as a percent of revenue decreased by 120 basis points, primarily due to operating leverage on revenue growth.

And now, we’ll open the line for questions.

[Operator Instructions]. And your first question comes from Matt Larew with William Blair.

[Mark Tarr, President and Chief Executive Officer]

Hey, good morning Matt.

[Doug Coltharp, Chief Financial Officer]

Good morning, Matt.

[Matt Larew, William Blair]

Hi, good morning guys. Thank you for taking my question. First wanted to ask about same-store IRF discharges, which have averaged around 4% over the last three quarters. Just hoping you could maybe give us additional color on what is driving that and then put it into the context of the longer-term target of 2%, yeah, so just any comments on that would be helpful?

[Doug Coltharp, Chief Financial Officer]

Yeah. I’ll start first and then ask Barb Jacobsmeyer to weigh in and put insights. We’ve been very pleased with the execution of our sales and marketing teams, and across the portfolio of our hospitals. And I think that they’ve done an excellent job in articulating the value proposition, particularly when it comes to boasting on the outcomes that we achieved with particularly high-equity level of patients in our hospitals. We’ve talked a lot about the stroke population and our ability over the years to shift away from the lower acuity patient and be able to deliver excellent outcomes on the stroke population. I think those are all really gaining traction and allow us to take market share from, not only other IRFs in the marketplace from also those sniffs that historically had been the recipient of a number of these referrals. But I’ll ask Barb to weigh in as well.

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

Yeah. you know that we had a nice increase in our Medicare Advantage growth, and to Mark’s point, a lot of that is going out, talking about the value proposition and our ability to not only get the patient home, but make sure that they remain at home, which prevents those readmissions. So we’re hoping us to be able to not only have our sales force out there with the referral sources of the acute care hospitals, but also with the payers that are ultimately approving these admissions.

[Doug Coltharp, Chief Financial Officer]

And Matt, we’ve been reluctant to change the target for – I can say that the target of the expectations with regard to discharge growth, based solely for instance, on the demographic tailwind that we pointed to, because as we’ve described before, the average age of the patient that we’re treating in our IRFs is 76, and the vanguard of the baby boomer generation has just turned 72.

So although we believe we are starting to benefit from that demographic trend, we think that the bulk of the impact is still in front of us. That said, we were very pleased with the same-store discharge growth and the total discharge growth that we experienced in the first half and every quarter will give us another data point, as we think about what the true long-term expectations ought to be.

[Matt Larew, William Blair]

Okay. Thanks for those comments and sticking here with the IRFs and Barb, maybe I just want you to comment about one year out from the announcement of the Post-Acute Innovation Center and obviously, you’ve given us nice updates on the Tyler, Texas pilots. Could you just maybe give us an update again, with what’s going on there? And then plans for further pilots? I know there’s something you’ve discussed in the past. Just another update, Barb, would be helpful on that?

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

Sure. So we continued the work to increase the data analytics that we have, not only as we look at narrowing the networks of the downstream providers that we used from our IRF setting, but also as we look to the help the acute care hospitals to determine the best setting for the patient’s to go to, looking at what is the potential for that patient’s readmission. So that it’s maybe – they would have thought in the past that, that patient would go to skilled. it may make more sense with the physician’s supervision at the IRF setting, if they can prevent a readmission for those patients to receive the care to IRF setting. So, we’re continuing the dialogue with additional acute care hospitals like we did with Trinity Mother Frances to offer the ability to help them with their post-acute navigation.

[Mark Tarr, President and Chief Executive Officer]

And Matt, as you might expect, this concentration is going to start, primarily, first with our existing joint venture partners.

[Doug Coltharp, Chief Financial Officer]

So Matt, we’re – I’ll just want to do very quick, we’re very pleased with progress we’re making there in Tyler. As you know, as we discussed, longer-term, we see the ability, not only to roll this out to other marketplaces, but also to have other diagnostic categories roll up under the same tool, where we can bring value to not only one marketplace, one diagnostic category, but cover a number of different assets or facets of care.

[Mark Tarr, President and Chief Executive Officer]

Now, we’ll say this, with regard to extrapolating this and that is certainly in our near-term plans, we’re applying the same philosophy that we have purposely, every other strategic initiatives we’ve pursued, which is getting it right is better then getting it fast.

[Operator]

And your next question comes from Matthew Gillmor with Robert Baird.

[Mark Tarr, President and Chief Executive Officer]

Good morning, Matthew.

[Doug Coltharp, Chief Financial Officer]

Good morning, Matt.

[Matthew Gillmor, Robert Baird]

Hey, good morning everyone. Hey, I wanted to ask about the organic bed additions for the IRFs and how that’s impacting the volumes? And I think you all targeted something like 100 beds to add to existing facilities, and last year, you did above that 166. And the question really is, given the strong volume trends, and it seems like those beds are filling up. Is there an opportunity to increase that target and how would you go about assessing that?

[Doug Coltharp, Chief Financial Officer]

Yeah. So, there’s no doubt that the organic bed additions are helping with the discharge growth, but as some of our colleagues here are quick to point, the bed additions – the organic bed additions, where we do a bed expansion, that’s in response to demand that exists in the market. So that incurs, because our folks in the field are doing the right things to sell our value proposition for the demand existing we’re able to backfill with that.

As we’ve mentioned previously, we do a constant assessment across our entire portfolio of occupancy levels and perceived change in our market-by-market basis in the competitive dynamic to determine, where there are opportunities for bed expansions. The ability to do a bed expansion specific market is also influenced by things like whether or not there are specific certificate of need, or license requirements associated with that and whether or not there any physical constraints on the plant, which we’re operating. We think the existing target of about 100 beds per year for right now is the right one, but we also believe that as we start to see the benefits of this increasing demand for our services, because of the demographic tailwind that, that number could go higher in the future.

[Mark Tarr, President and Chief Executive Officer]

All the de novos that we build, have the potential, we build them with the intent of having potential to add that to a construct accordingly, buy enough land that would accommodate bed expansions as well. So as Doug said, we are constantly evaluating opportunities from those both near-term and long-term.

[Doug Coltharp, Chief Financial Officer]

If you look back over the last 10 years, in spite of the fact that we’ve been increasing our capacity in the IRF segment. The overall supply of licensed IRF beds in the U.S. has been relatively flat. And that just doesn’t align with what we see happening demographically. So, we think they’re going to be opportunities for further capacity expansions in the future.

[Matthew Gillmor, Robert Baird]

Got it. Thanks. And as a follow-up, I did want to ask about the group of model changes on the home health side for 2020? And I appreciate all the comments that Mark made. And I – the question I had was, as you think about the rate impact that you’re talking about, I think you said a little over 5%. Do you have a number or maybe, some sort of indications, you can give us in terms of how much of that could be offset through evolving your patient mix? Just wanted to understand what your ability was to offset with changing the mix?

[Mark Tarr, President and Chief Executive Officer]

I’m going to let April Anthony weigh in on that?

[April Anthony]

Yes, it’s probably just a touch early to have the details. We’re still working through our modeling, with the rules just coming out in early July to understand the full impact on a kind of diagnosis-by-diagnosis, patient-by-patient basis. But our anticipation, based on our study of the rule so far in our initial indication is that as we can increase our percentage of referrals from the acute care hospital, that will be a key a mitigating factor, because if you look at the inherent elements of the rule of some post-discharge patients from the hospital to receive notably in more reimbursement than the patients coming out of the community. And so we think the continued growth in that program, the good news is, our sales force has been doing a strong job growing that percentage of our population.

So, I think over the course of next 18 months, we have a lot of opportunities to continue to expand that. The other area of concern to some extent is the significant decrease in reimbursement that we’re seeing in some of the – not all therapy episodes, particularly some of the high-volume therapy the patient needs. and so in those instances, we’re going to have to really look at our care-planning approach and determine if there are other ways that we can put plant the effort of the therapist, with more nursing or aid services and find a better way to sort of balance some of that care. I would say, at this point, we have to be pretty general in our responses that we think over the course of the next few weeks, we will continue to have more and more information and be able to get much more granular level of response.

[Operator]

And your next question comes from Kevin Fischbeck with Bank of America.

[Mark Tarr, President and Chief Executive Officer]

Good morning, Kevin.

[Joanna Gajuk, Bank of America]

Good morning. Actually this is Joanna Gajuk filling in for Kevin today.

[Mark Tarr, President and Chief Executive Officer]

Hi, Joanna.

[Joanna Gajuk, Bank of America]

Thank you so much for taking the questions here. So, actually I wanted to expand the topic of the groupings model proposal. And I appreciate the comments about it’s still too early and you have given us some of the ideas around the – I guess changing a little bit sales forces, maybe, focus more on to acute and the therapy, I guess provision. So, on that front, because we also worry a little bit about the labor cost, right?

So now, I guess, if you might need fewer therapists, that’s I guess good, but then you might need more of these additional home health aids or other forms. So can you talk about how that would kind of change the labor cost dynamic for the home health business, given that you might be changing, I guess the type of care providers that you might have acquired going forward?

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

Certainly, if our mix shifts a little bit more towards nursing and away from therapy, it will inherently drive our cost down; our cost per visit for nursing is notably cheaper than our cost per visit for therapy. Frankly, it’s one of the issues that we are bringing forth to CMS and our comment is that we believe the way they have allocated cost between disciplines by using cost reported data instead of using Bureau Labor Statistics data is resulting in a flaw in their model. And one of the things we’ll be pointing out in our comments, likely both this year and possibly opportunity to do so again next year, it’s not fully resolved.

But we think there is a pretty significant kind of misallocation of resources. and so we certainly think that there are opportunities to improve some of those elements through the rule making process. but if in fact the answer has to be that we moved to and more heavily nursing and aid-based utilization of services, we certainly understand that, that economically is a more cost-effective approach, if we can accomplish those outcomes with those lower cost disciplines. And we haven’t had a supply issue in those disciplines, really we haven’t had – on the home health side, we really haven’t had a significant supply issue in any of our disciplines that definitely do not have particular concern about our ability to increase our proportion of nurses and aides. We seem to, because of our culture of being the best place to work, have had a good run a lots of meeting our needs from the staffing perspective on a global basis. there are always exceptions on a market-by-market basis, on a periodic basis, but not globally, do we see any concerns there.

[Joanna Gajuk, Bank of America]

Thanks, Barb. That’s what I was going to ask. I know I understand the cost per – I guess, SD would be lower when you have more nurses to spare, because I was just thinking about, whether there are any issues around shortage or things of that nature, but seems like you are not expecting to have issues kind of finding this incremental home health to replace, I guess, if need to be for the therapy provision. So I appreciate the comment. And also, any other, I guess, major push backs or major comments you plan to include in your response to CMS? I mean, any other major sort of surprising disappointments with the proposal?

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

Well, I guess I would say the second thing that we see of most significant magnitude with these assumed behavioral change that has been built into the model, that’s roughly 6.5%. We think that is, we don’t think, we know that is inconsistent with any prior year behavior that the industry has demonstrated. We go back and look over the years, the average impacting in the single year has been well below the 6% level, something more in the 2% to 3% range.

And so we think it’s a little bit disingenuous for Medicare to assume that in one year, the industry is going to react significantly as a 6.5%-kind-of baseline adjustment would suggest. And so that would certainly be something that we would comment on and propose an alternative approach that even if you do prospective adjustments that you need to face them and in a manner that’s more consistent with what passed industry behavior changes that we look like, with something again in that 2% range. So, we think that’s probably the second most significant, or really the first most significant thing and in the use of cost report data, rather than Bureau Labor Statistics part of second from a magnitude perspective. There are a number of other unwieldily issues around questionable encounters in some of the coding classifications, but those are a little bit more nuanced [ph] than the first two that I mentioned.

[Operator]

And your next question comes from Kevin Ellich with Craig-Hallum.

[Mark Tarr, President and Chief Executive Officer]

Hi, Kevin.

[Doug Coltharp, Chief Financial Officer]

Good morning, Kevin.

[Kevin Ellich, Craig-Hallum]

Good morning guys. Thanks for taking the questions. Going back to your comments about remote patient monitoring that would be allowed in cost reports, wondering if that’s factored into guidance, or how – what sort of benefit could we see in terms of how this would help with your margins next year?

[Mark Tarr, President and Chief Executive Officer]

Well, we haven’t given any guidance for next year.

[Kevin Ellich, Craig-Hallum]

True. But let’s say the final rule is implemented as is, how big of a factor is this? Is it modest?

[Mark Tarr, President and Chief Executive Officer]

I would say very modest.

[Kevin Ellich, Craig-Hallum]

Okay. That’s helpful.

[April Anthony]

And in reality, all it’s really going to do is change the future payment policy, because the ability to include the cost for remote monitoring in the cost reporting, all that really does inform CMS about the true total cost of care, which today, they have been excluding those costs. And that is a valid cost of care, albeit, not one that has historically been allowed to be considered, and so when you hear MedPAC and CMS and others, report the margins of the home health industry, there are these areas like to remote patient monitoring that had historically been excluded from our cost base and yet very much a part of how we care for patients. And so there is no immediate impact. I think it’s simply informs the regulators, those CMS, MedPAC and others about the true cost of care by allowing us to report that in the cost report. But it will not have any immediate reimbursement effect.

[Kevin Ellich, Craig-Hallum]

Thanks, April.

[Mark Tarr, President and Chief Executive Officer]

It may take some of the information out of MedPAC’s reports on the trends in home health margins.

[Kevin Ellich, Craig-Hallum]

Okay, okay. And then as your leverages have come down a little bit and cash flow remains pretty strong, could you remind us about your capital allocation priorities? And given – and also a little bit of color as to what you’re seeing on the M&A front in terms of your pipeline, there’s really been some high valuations versus some hospice deals. And wondering where you guys plan to allocate capital? Thanks.

[Doug Coltharp, Chief Financial Officer]

Yeah. I think the capital allocation remains very consistent with priorities that we have stated previously, which is we continue to believe that we have good core growth opportunities in both of our business segments. As Mark mentioned, we got two new hospitals opened up in the last quarter, we’ve got two additional openings slated for the balance of this year and we think there are going to be opportunities to add capacity both in the forms of new hospitals and bed additions on a go-forward basis. That will continue to our grow our home health and hospice business, predominantly via acquisition.

We are very pleased to be able to complete the Camellia acquisition on May 1st, again, that was roughly $135 million transaction. There are others like that, that are out there, that will be a candidate to purchase and as we stated a number of times here recently, we also have a specific objective to increase the scale of our hospice business and that is likely to happen predominantly via acquisitions as well. So we think that there are good opportunities that are out there. We feel like the development pipelines in both of our business segments remains sufficiently robust and that will be the top priority in terms of allocating both free cash flow and utilizing the levers that tilt into our balance sheet.

[Operator]

And your next question comes from A.J. Rice with Credit Suisse.

[Mark Tarr, President and Chief Executive Officer]

Hi, A.J.

[Doug Coltharp, Chief Financial Officer]

Hi, A.J.

[A.J. Rice, Credit Suisse]

First off, just when I look at the way the guidance lays out, I think year-to-date, you’ve been up EBITDA about 11%. And if I look at the second half outlook at this point, what it implies at the midpoint is about 1.5% increase. I understand what you’re saying about continued to be conservative in accruals around bad debts and health benefits. But I just wonder is there anything – is it basically, let’s just be conservative is to see that you’re unfold? Or is there anything that would make the rate of increase that you’re seeing moderate to that degree in the back half of the year?

[Mark Tarr, President and Chief Executive Officer]

A.J., you’ve hit on the 2Q assumptions, which is – it was really beginning in the second half of last year that we started to see this substantial reduction and new ADR activity, influencing the bad debt number on the IRF side, and that’s because it was in July of last year that TPE was piloted and then ultimately rolled out. And it was in August of last year, where the Cahaba contract was relapsed. And so we have made the assumption that we are not going to anniversary that favorable bad debt performance in the second half of the year. That would be in contrast to the year-to-date trend, but as we have stated, we don’t believe that we have enough data points right now to call the ball at a lower level.

We’ll continue to see how that trend develops with subsequent quarters. and then it’s really kind of a similar story on the group medical. Again, we came into this year anticipating that because 2017 medical expenses were essentially flat at the level that we had in 2016 that the odds were against us and we couldn’t put together two years like that in a row, particularly without having made any significant changes in either the structure of our benefits program, and really didn’t see any changes in the underlying beneficiary population.

Well, in the first half of the year, we were up just over 2% for group medical. That could change pretty quickly. So our guidance assumes that we’re going to get back into that 8% to 12% level of year-over-year increase to the back half of the year and those are the two primary things that are set up in the guidance as headwinds.

[A.J. Rice, Credit Suisse]

Okay. And then just quickly on maybe following up on a different way on the acquisition and commentary. First of all, obviously, you’ve had, I guess, Camellia for two or three months now. Any update, has that trended as you’ve expected or any change in your thoughts are there? And then when you think about acquisitions in the home health and hospice areas, the PDGM proposal having any impact on the pipeline, either you’re thinking about what you’re willing to pay or people’s willing – desire to do something ahead of that, any flavor for that?

[April Anthony]

Yes, let me take that second question first. So, I don’t think yet that we think the PDGM affects on the pipeline. I’d certainly think that it is possible as people begin to process the impact that role can have. We’ve had a few really small players, who can just use it as another reason to sort of throw the final straw in the haystack. But I do think that we will see some players that just begin to say that from a foundation of regulatory challenges, reimbursement challenges, cash flow challenges that there is going to be some changes from the cash flow perspective as well and how some of this 30-day reimbursement payment to happen and so forth. So, I think all of that could certainly yield to an expanded pipeline that we haven’t necessarily seen that materialize at this early stage.

[Doug Coltharp, Chief Financial Officer]

Turning back, A.J., on your first question, I think we have been really pleased with the first two and a half months here, almost three months now of the Camellia’s integration process.

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

Absolutely, and I would just echo Doug’s comment there that Camellia, I think we have been – acquisitions always result in a few surprises, and I would say our surprises in the Camellia has been pleasant ones that we’ve been pleased with what we found in the quality of the leadership team. Certainly, we’ve been able to bring in the processes and enhance some of the efforts and work together to continue to professionalize the business to match up with our Encompass locations throughout the region, but we are very pleased with where we are so far and feel like it’s going to really be a strong part of our organization as they get fully acclimated to the Encompass way of operating.

[Operator]

[Operator Instructions]. And your next question comes from Dana Hambly with Stephens.

[Mark Tarr, President and Chief Executive Officer]

Good morning, Dana.

[Doug Coltharp, Chief Financial Officer]

Good morning, Dana.

[Dana Hambly, Stephens]

Good morning. thanks for entertaining my questions. Just a follow-up on Camellia, could you give some rough direction on what you expect the growth rate in the margin profile to look like and maybe just roughly speaking kind of time to integrate that fully?

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

Yes. So, Camellia was a strong performer from a margin perspective when we required them. I don’t initially think the enhancements that we’re making are going to completely be margin driven. I think they’re going to be more long-term, sustainable, but they’re going to be based with solid replicable processes that allows us them to continue to grow. I don’t naturally anticipate that we’re going to see big-margin enhancement out of that business, simply because it was high performer when we bought it. But we just think that we’re going to sort of create stability around that high-performance and take some of the risk of volatility out of it with our approach to operations.

[Dana Hambly, Stephens]

Okay. And then my follow-up on the proposed IRF rule. I generally understand your opposition to the replacement of the functional independence measure. But could you help me understand a little bit better what the practical and financial implications would be, if that proposal were to make it into the final rule?

[Mark Tarr, President and Chief Executive Officer]

Yeah. we don’t know a lot about the financial implication. but let me talk about just the practical implementation of the tool. And first of all, we don’t know and make sure we’re clear. We don’t oppose the potential of having the care tool replace the FIM. The whole point of having a care tool is one that is a common assessment tool across the various areas of a post-acute, which we support. But we supported under the pre-FIMs that it will be data-driven that the information that they collect from this tool, which we have been using in addition to the FIM tool, now since October of 2016 I have been reporting that data.

Our main objection is that it’s just too much too soon and to roll out a new assessment tool like the care tool, it takes a lot of education for the entire nursing staff and therapy staff, which use it to assess every patient that comes in. There’s a lot of nuances relative to the use and implementation of this and working an entire group of clinicians off of the FIM tool, which has essentially been in place now for a couple of decades.

So, we think that that’s one of the areas that CMS has maybe underestimated the impact of rolling out a new tool that is as comprehensive and as involved from an operating standpoint in the industry and just having a little bit over a one year of data to change the entire system, like I said, it’s too much, too soon. So, we’d like to see a couple more years of data collected, so that CMS is going to adopt the care tool that is fully based upon the data that has been turned in by the industry and really have a tool that is going to be applicable for the long-term.

[Doug Coltharp, Chief Financial Officer]

And just following up on that, as a result for the worse case were to happen and if the rule were to get implemented exactly as it is right now, with this becoming the basis for payment in 2020. The impact would likely be relatively short-lived, because with each subsequent year of data gathered under the care tool and with each subsequent year of utilization of that as the primary tool by IRF providers such as ourselves. The data set that’s informing the reimbursement mechanism is going to get better. And the underlying characteristics of the patients, who will today, require rehabilitation services in an IRF setting and who will in future, is not going to change.

So, it will resolve itself over a period of time, but the – avoiding that kind of significant disruption potentially impacting Medicare beneficiary access to care in years like 2020, 2021, is one of the primary objectives of the feedback that we’re giving to both CMS and Congress.

[Operator]

And your next question comes from DeForest Hinman with Walthausen & Company.

[Doug Coltharp, Chief Financial Officer]

Hi, DeForest.

[DeForest Hinman, Walthausen & Company]

Hello, good morning. A couple of questions. I think in the release you mentioned that there was a retroactive price adjustment that’s impacted the same quarter results. Can you give us the size of that retroactive adjustment in that segment?

[Mark Tarr, President and Chief Executive Officer]

Yeah. the impact was about $2 million.

[DeForest Hinman, Walthausen & Company]

Okay. That’s helping. And then on Slide 30 in the deck, just clarification for me, I read it a couple of times that I just don’t get it. You’re saying that the June 30 evaluation for those rollover shares is $195 million, is that reflective of the ballpark 15% holding, or is that $195 million is reflective of 11.1%, which would be after that February transaction.

[Mark Tarr, President and Chief Executive Officer]

It’s the latter.

[DeForest Hinman, Walthausen & Company]

Okay. Thank you.

[Operator]

And your next question comes from Kevin Fischbeck with Bank of America.

[Joanna Gajuk, Bank of America]

Hi. This is Joanna. Thank you so much. I have follow-up on the IRF proposal, but I guess you were trying to answer the question, because my question was that’s the CMS estimated the cut, almost 2% cut for the full process, but you’re saying that you would view it more as a short-term less now the time is work. And my second follow-up question actually on the comment you made on the Pre-Claim Review Demonstration that was re-instituted, I guess, by CMS. So previously, you talked about income to cost that you estimated back then to be in the $1 million to $1.5 million or so. So any change to that? Does it – do you include anything in your guidance with that?

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

We don’t have a firm start date yet and…

[Joanna Gajuk, Bank of America]

All right.

[Barb Jacobsmeyer, President-Inpatient Rehabilitation Hospitals]

And because it’s not yet defined when they would move in to some of our larger markets of Texas and Florida. We have not yet put that into our estimates. We will do believe that there would be some incremental costs; some of the details with the proposal would have to come out before we wouldn’t be able to pinpoint what that would be. But we think it will be relatively small for those first three states, because we don’t have a huge volume in those states. Texas and Florida is when it will start to add up for us.

[Doug Coltharp, Chief Financial Officer]

We’re getting from here as well, Joanna, as if the scale of our home health and hospice business has continued to increase and the scale of those incremental cost to conform to this new demonstration probably aren’t increasing much. So, it’s kind of get to the point, where it will be incremental level of cost may not be worthy of the specific call-out.

[Joanna Gajuk, Bank of America]

It makes sense. Thank you so much.

[Operator]

And we have no further questions at this time. So, I would like to turn the call back over to Crissy for any closing comments.

[Crissy Carlisle, Chief Investor Relations Officer]

If anyone has additional questions, please call me at 205-970-5860. Thank you again for joining today’s call.

[Operator]

And thank you, this does conclude today’s second quarter 2018 earnings conference call. You may now disconnect your lines.