Encompass Health Corp

NYSE:EHC

Earnings Call Transcript 2022-Q2

[Operator]

Good morning, everyone, and welcome to Encompass Health's Second Quarter 2022 Earnings Conference Call. [Operator Instructions]

I will now turn the call over to Mark Miller, Encompass Health's Chief Investor Relations Officer.

[Mark Miller, Chief IR Officer]

Thank you, operator, and good morning, everyone. Thank you for joining Encompass Health's second quarter 2022 earnings call. With me on the call today are Mark Tarr, President and Chief Executive Officer; Doug Coltharp, Chief Financial Officer; and Patrick Darby, General Counsel and Corporate Secretary.

Before we begin, if you do not already have a copy, 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, like those relating to the spin-off of Enhabit Inc. and its impact on our business and stockholder value as well as the magnitude and impact of COVID-19 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, the Form 10-K for year ended December 31, 2021, and the Form 10-Q for the quarter ended June 30, 2022, 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 earnings release and as part of the Form 8-K filed yesterday with the SEC, all of which are available on our website. [Operator Instructions]

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

[Mark Tarr, President and CEO]

Mark, thank you, and good morning, everyone.

The strategic review of Encompass Home Health & Hospice business culminated in the spin-off of Enhabit on July 1 to be an independent publicly traded company. Enhabit reported its Q2 results yesterday after the market close and has its earnings call following this call. Accordingly, we will not be commenting on Enhabit's Q2 results. Q2 was another solid quarter for our inpatient rehabilitation business. Demand for our services continues to grow.

Our value proposition is resonating across payers, and we are gaining share in what remains an underserved market. Our de novo and bed addition strategies are increasing the availability of the highly specialized services we provide to meet this rising demand. Our commitment of substantial capital to these capacity expansions underscores our confidence in the future prospects of the IRF business.

We opened three de novos in Q2, making that six year-to-date. We'll open three more de novos in the second half of 2022, bringing the total to 9 openings for the year. We expect a similar number of openings in 2023. We added 38 beds to existing hospitals in the quarter, raising the year-to-date total to 67. We expect to add a total of approximately 90 beds to existing hospitals in 2022 and additional 100 to 150 beds in 2023.

Our total discharges grew 4.9% in the quarter and 1.6% on a same-store basis. This was on top of 18.7% total discharge growth and 16.9% growth on a same-store basis in Q2 2021, resulting in an impressive 2-year CAGR. As has been the case for the past several quarters, the continued strong demand for our services in a tight labor market for skilled clinicians necessitated elevated utilization of agency staffing and sign-on and shift bonuses.

As we had foreshadowed on our Q1 call, we did see sequential improvement in contract labor costs during Q2, with both the number of contract labor FTEs and the negotiated rates declining. Consistent with our Q1 comments, we chose to redeploy a portion of the contract labor savings into sign-on and shift bonuses for our internal FTEs.

Contract labor plus sign-on and shift bonuses totaled $56.9 million in Q2 compared to $63 million in Q1 and $28.7 million in Q2 2021. Our Q2 agency rate per FTE was approximately $222,000 compared to approximately $240,000 in Q1 of 2022.

We responded to the challenging labor market conditions for skilled clinical resources in a number of ways, including adding substantial resources to our talent acquisition team. We have built a centralized recruitment function now comprising over 60 professionals. This strategy is gaining headway.

Same-store net new RN hires were 276 for the first half of 2022 as compared to 117 in the same period last year. For the second half of 2022, we expect sign-on and shift bonuses to remain elevated as we continue to hire more RNs and use existing staff to fill in gaps. This will facilitate a decrease in our utilization of contract labor. Assuming normalizing industry conditions, we expect agency rates to decline further.

However, the pace of the decline remains uncertain as agency rates remain highly variable, and the extension of the public health emergency may prolong the duration of elevated rates. CMS last week issued the 2023 final IRF rule. For IRFs, the final rule will implement a net market basket update of 3.9%. We estimate that taken as a whole, the final rule will result in a net increase of approximately 4% for our Medicare payments beginning October 1, 2022. As a reminder, this increase does not include the impact of sequestration.

While the rate update in the IRF rule is positive relative to current reimbursement rates, it does not adequately compensate for our elevated operating costs. On the regulatory front, on July 1, CMS sent a report to Congress on a prototype for unified Post-Acute Care Prospective Payment System, or PAC PPS, as required by the IMPACT Act of 2014. CMS did not make legislative recommendations to Congress as to what should happen with the prototype and cautioned that substantially more analysis and research are required.

For these and other reasons, it is too early to elevate or evaluate any potential impacts to our business from the PAC PPS. On July 20, we announced that our Board of Directors declared a quarterly dividend of $0.15 per share to be paid in October.

The decline from our recent historical rate is in response to the completion of the spin-off of Enhabit and reflects our continued commitment to a robust de novo hospital strategy. We are affirming our guidance issued on June 7 for 2022 IRF revenue, adjusted EBITDA and adjusted EPS. The key considerations underlying this guidance can be found on Page 18 of the supplemental slides.

With that, I'll turn it over to Doug.

[Doug Coltharp, CFO]

Thank you, Mark, and good morning, everyone.

In Q2, our IRF business generated revenues of approximately $1.063 billion and adjusted EBITDA of $196.4 million. Adjusted free cash flow was $166.8 million with year-to-date adjusted free cash flow of $290 million, up approximately 21% over the first six months of 2021. The key trends we experienced in the last several quarters largely continued in the second quarter of 2022.

As Mark discussed, we continue to see good volume growth that combined with a modest 1.3% increase in revenue per discharge to produce our 6.1% revenue growth in the quarter. As has been the case for the past several quarters, staffing challenges did not limit volume growth but did result in the continuation of elevated costs.

The Q2 contract labor plus sign-on and shift bonuses of $56.9 million that Mark alluded to was comprised of $35.1 million in contract labor and $21.8 million in sign-on and shift bonuses. Contract labor expense in Q2 declined approximately $6.8 million or 16% from Q1, and we experienced sequential declines in contract labor expense and FTEs for every month in Q2. Contract labor FTEs, which had peaked at 749 in March, declined to 597 in June, a 20% decline. Contract labor rates also declined during the quarter.

The Q2 2022 agency rate per FTE was approximately $222,000 as compared to approximately $240,500 in Q1. Rates also declined sequentially every month in Q2. Agency rates peaked at approximately $243,300 in February and declined 40% to approximately $209.3 million in June. Revenue reserves related to bad debt increased 50 basis points to 2.2%, primarily due to the impact of payer mix shifts to Medicare.

Advantage and managed care, which have longer collection times and higher patient payment responsibility. Medicare contractors have also recently resumed the Targeted Probe and Educated initiative for IRF providers. The resumption of TPE adds additional uncertainty to our near-term bad debt reserve requirements.

As a result, within our affirmed 2022 guidance, we are increasing our expected revenue reserves related to bad debt from 2% to a range of 2% to 2.2%. I would also like to point out that IRF year-to-date free cash flow is $290 million, and our full year 2022 expectation is for a range of $280 million to $380 million. The large difference between first half and second half free cash flow relates to cash tax payments, changes in working capital and capital expenditures, which are skewed to the second half of the year.

And with that, we'll now open the line for questions.

[Operator]

[Operator Instructions] Our first question will come from Andrew Mok with UBS.

[Andrew Mok, UBS]

Hi, good morning. I know you held the full year guidance, but just wanted to better understand how the quarter tracked against internal expectations. And then I think there's still a meaningful ramp in earnings in the back half of the year. Is there anything that you would call out besides labor as driving that sequential improvement?

[Doug Coltharp, CFO]

Yes. So I would say that - and I think it's evidenced in the fact that we're affirming our guidance, that second quarter was very much in line with our expectations pretty much across the board. I think of the puts - in terms of the puts and the takes that are going to drive improved results in the second half of the year, on the positive side, we expect continued year-over-year discharge growth. You've got the swing in the new store impact, which was a significant drag on EBITDA in the first quarter and turns modestly - or in the first half and turns modestly positive in the second half.

We've got the pricing increase that will be implemented in Q4 and then the continuation of improving labor costs, given the trend lines that I just outlined in my comments. Weighing against that are the full implementation of sequestration, which began on July 1 and then the anticipated increase or the uncertainty around the bad debt reserve. Andrew, I would suggest that those are the primary considerations.

[Andrew Mok, UBS]

Got it. That's helpful. And then a lot of hospital operators are now forecasting lower inpatient demand in the back half of 2022. Just wanted to better understand what you're seeing in the market and whether any of that slowing inpatient utilization is having downstream impacts to your discharge growth.

[Mark Tarr, President and CEO]

It's Mark. We've not seen a negative impact. I think that given our ability to have the growth that we did in the second quarter, particularly compared against the very difficult prior year comp, I think if anything, we've seen more in the marketplaces are resuming to - from an acute care standpoint, kind of resuming to the more normalized business pattern with referral patterns looking similar to 2019 versus the last couple of years with COVID. Certainly, elective procedures have come back in place nicely as well. So we're not really seeing anything that we would see that would impact negatively in the second half of the year.

[Operator]

Our next question will come from Kevin Fischbeck with Bank of America.

[Joanna Gajuk, Bank of America]

Good morning. Actually, this is Joanna Gajuk filling in for Kevin. So I guess on the contract labor - so first a follow-up and then a question, but a follow-up on the contract labor, you said that you still continue to decline and you've seen it. So do you expect these levels to return all the way back to 2019? Or you think as you exit the year, it's still going to be - continue to be elevated? How should we think structurally about - is the business model changing here? Or should we assume that there should be normalization into next year?

[Doug Coltharp, CFO]

I don't think anybody really knows the answer to that, Joanna. There's certainly a lot of uncertainty about it. We do see, as we pointed out and provided some very tangible evidence, we do see that both based on market conditions and the proactive steps that we've been taking to address staffing, that the utilization of the cost of contract labor is improving.

I don't believe that we'll get back to 2019 levels by the time that we exit 2022. How long it takes to get back to those levels, assuming that we ever do, remains to be seen. But we do expect continued sequential improvement through the back half of the year.

[Mark Tarr, President and CEO]

As we noted, the net new RN hires of 276 for the first half versus the 117 in prior year, I mean, that shows the progress that we're making right now with our ability to hire nurses, which plays very favorable into the contract labor reduction story.

[Doug Coltharp, CFO]

And bear in mind, that 276 is same store. So on top of that, we were able to recruit sufficient nursing staff to address all of our new hospital openings in the first half.

[Joanna Gajuk, Bank of America]

Yes. Because actually, that was my second question because here it sounds like you keep opening and you keep start getting more - both de novos but also additional beds. So it sounds like they are no really major issues because of staffing these new beds and new buildings. Is that the way to think about it?

[Doug Coltharp, CFO]

That's correct. Staffing constraints have not impacted the timing with which we're bringing new capacity on board. And as we referenced in our remarks, nor have staffing constraints in any way limited our volume as a whole.

[Mark Tarr, President and CEO]

We've been very pleased with the new de novo hospitals and the new markets we're entering with the receptivity of the staff towards having a new hospital and, in some cases, rehabilitation environment that did not previously exist.

[Doug Coltharp, CFO]

We did experience some modest delays in bringing on a couple of the de novos, and that was 100% attributable to, actually, constraints within the agencies that are required to provide approvals on a state and local basis and they were experiencing some of their own staffing shortages. But nothing on our end was delaying the opening of new capacity.

[Operator]

Our next question will come from Brian Tanquilut with Jefferies.

[Brian Tanquilut, Jefferies]

Good morning. I guess just to follow up on the questions on contract labor. So maybe, Doug, as I think about the sign-on or shift bonuses that you've paid, I mean, it kind of flattened out from Q4 to Q2. How should we be thinking about that trend for the back half of the year and into next year?

[Doug Coltharp, CFO]

Yes. We would expect that to improve from the current run rate as well but at a much more modest level than contract labor. So you really don't have an opportunity much there for rate reduction, and it's really just then about the volume that you're utilizing. And we think it's a pretty good trade right now to increase that number of net RN hires.

[Brian Tanquilut, Jefferies]

Got it. Okay. And then maybe, Mark, as I think about the inpatient rehab growth target that you set out, 6% to 8% discharge CAGR through 2026, without the noise of Enhabit in the background anymore, maybe just any thoughts on how you are able to see the makeup of that? I know you're obviously adding a lot of de novos and a lot of JVs. So just maybe any color on how to get to that 6% to 8% over the next four years.

[Mark Tarr, President and CEO]

I mean, we're very enthusiastic about the runway there with the demographic tailwind. We brought on eight de novos last year, which previously that was the high. This year, we'll be bringing on nine. We've already stepped that up for next year as well.

The bed addition strategy on top of the de novo strategy, I think, plays very favorable in our ability to grow this business and take advantage of the opportunities that are out there in the marketplace. So between the continued demand and our ability to go out and add capacity to meet that demand, we've got a really nice runway ahead of us.

[Doug Coltharp, CFO]

And it'll be a little uneven as you saw, for instance, in this quarter, depending on the comps that you're up against. But generally speaking, you smooth it out over time, you expect something in the 2.5% to 3% range to come from same store, with the balance being contributed by new store.

[Operator]

Our next question will come from John Ransom with Raymond James.

[John Ransom, Raymond James]

Good morning. So Doug, you won't like this question, I'm just going to tell you, but it's the one I'm getting so I got to ask it. So the whole Enhabit process, I think, has kind of, at least to this point, looks a little disappointing. And so within the bounds of what you can tell us, how is it that the vanilla spin ended up being Plan A and some type of spin merger sale couldn't have resulted? I mean, I think it's around 8.5x EBITDA now and the numbers have come down a couple of times, as you know. So just what can you tell us to say, "Hey, this really was the best option and other things either weren't forthcoming. Are we just - for tax reasons or other reasons, we decided to go the route we did."

[Doug Coltharp, CFO]

John, it's a very fair question. And I know the process took a lot longer than most folks had anticipated. Let me tell you, it took a lot longer than we had anticipated at the outset as well. And the length of time that the process took was really a result of two factors: one is, we had pretty volatile market conditions that occurred during the course of that process. And they shifted a couple of times.

Some of those COVID-related and some of those were just generally market oriented. The other thing is that our Board wanted to make sure that we conducted an extremely thorough evaluation. And then we looked at every one of those alternatives and you enumerated a number of them to choose the one that was going to generate the best long-term value for our shareholders, and the Board is confident in the decision they made.

They also recognize that based on prevailing market conditions and just the way that spins work, that this wasn't going to be something where the efficacy of the chosen transaction should be judged in a 1-month or 2-month or even a 6-month period but it will stand the test of time. And so yes, it looks like Enhabit is off to a challenging start. Their call follows this one. They can address their operating results separately, but this is not done yet.

[Mark Tarr, President and CEO]

John, I'll add, it's Mark. I mean, a number of us are shareholders, and we continue to have a great deal of confidence in that team at Enhabit. So look forward to the future.

[Doug Coltharp, CFO]

John, does that address your question sufficiently?

[John Ransom, Raymond James]

I mean, I think that's all you can say. So that's - I think that's fine. Now my other question, this is the happier question is, you guys have been bogged down on this process, a lot of drama, a lot of time. Now that you're not - if we're sitting here a year from now, two years from now, what is different with legacy EHC that might not otherwise been the case if you were still wrestling with Enhabit?

[Mark Tarr, President and CEO]

Well, I think we've articulated some of it here. We're very excited about what the future holds, about the opportunity for us to continue to grow in the IRF business. As you know, John, it's an area that we know quite well. We have a team here that's been built to contribute and develop that growth. And so I think we're very excited about what the future holds.

[Doug Coltharp, CFO]

Yes, I think it just becomes a more focused story, John, maybe one that is a bit easier for those on the outside to understand. And we'll be able to highlight the great returns that we're getting on invested capital, the superiority of our clinical results, the efficiency of our operating model and maybe really highlight some of the additional capabilities we're bringing to bear to the benefit of our patients and the caregivers who are involved with regard to new technologies and new clinical protocols.

[Operator]

Our next question will come from Pito Chickering with Deutsche Bank.

[Pito Chickering, Deutsche Bank]

Good morning, guys. Thanks for taking the questions. Labor expenses are pretty volatile right now with all the moving pieces here. And this may be an exercise in futility as you're subbing out contract labor costs and sign-on bonuses and shift bonuses. But if we exclude contract labor and exclude sign-on bonuses and exclude shift bonuses, what are the hourly full-time employee rates in 2Q? How did that compare sequentially versus first quarter? And where are you still seeing pressure or relief in those hourly rates?

[Doug Coltharp, CFO]

With those, it's kind of interesting because we really began pretty aggressively, in Q3 of last year, making market adjustments for the internal FTEs to remain competitive. And so as we move in the back half of the year, we really expect that on that base of internal FTEs, we're going to see a pretty normalized level of increase. So call it something in the 3.5% to 4% range.

[Pito Chickering, Deutsche Bank]

Because there's still so many moving parts year-over-year, I guess. If I just think sequentially 1Q, 2Q, are the - is the average hourly full-time employee rate, is that stable?

[Doug Coltharp, CFO]

Yes. So it was a little bit elevated in the second half because you weren't anniversarying that yet, but as we move into the second half, the comparisons get more favorable. And we've really done what we needed to do with regard to market adjustments. Now you're looking at just a more normalized merit cycle, which is slightly elevated over where it was, say, pre-2021 but not significantly.

[Pito Chickering, Deutsche Bank]

Yes, perfect. And then sort of two more questions on that. On the contract labor, you did give the number of FTEs in June. I guess any color that you can give us on how much that costs in June or the run rate?

[Doug Coltharp, CFO]

I did mention the rates in June so the rate was down to $209.3 million in June. I don't want to give you a - we're not going to give a number on a monthly basis. We don't want to get into that habit. We continue to report it on a quarterly basis.

[Pito Chickering, Deutsche Bank]

Yes. Fair enough. Two more quick ones here. The accounting for sign-on bonuses, is that realized over time or is that all upfront?

[Doug Coltharp, CFO]

It's all upfront.

[Pito Chickering, Deutsche Bank]

All right, perfect. And then the last question is, as you track the ROIC sort of in the last 18 months for the bed add-ons versus, say, 2017, 2019, do you find that the ROIC or the bed add-ons on the new projects, as they ramp, is identical or similar to where it was sort of previous to 2019?

[Doug Coltharp, CFO]

Yes. So - and it does depend on which vintage you're looking at. I will say that one of the things that we're experiencing right now is as we evaluate new projects, we've got elevated construction costs so the investment is going up. And right now, labor costs are elevated. So that does impact particularly the early years of the P&L.

I will say that as a result, within our aggregate pipeline, there have been a couple of projects because of specifically difficult conditions in a particular market where construction labor costs may be impacted that we decided to stand down, not cancel, but stand down on a couple of projects. It's been a very limited number out of the total pipeline that is typically comprised of about 50 projects. I think we're talking about less than a handful.

By and large, what we're able to see is even when we model in the elevated construction costs and assumptions about the trajectory and labor costs, we're still seeing projected returns that exceed by a pretty good margin our weighted average cost of capital, and that's why we're continuing to move forward with the capacity additions. And then of course, any time we can add a bed addition to either an existing facility or a recent de novo that just serves to turbocharge the return.

[Operator]

[Operator Instructions] Our next question will come from Matthew Borsch with BMO Capital Markets.

[Matthew Borsch, BMO Capital Markets]

Thank you. Could I just ask about - now that you're operating with a very strong focus on the inpatient rehab area, and I realize that ultimately reached the conclusion that Home Health was not strongly synergistic enough to make it - make sense to hold on to that, are there other areas that you might look at that you could see a synergistic that you'd be willing to share? And are you thinking about acquisitions at this stage? And if so, what types of things would you look at?

[Doug Coltharp, CFO]

Matt, we're constantly scanning the landscape and decide if there are any compelling businesses that ought to be added to our portfolio, either because there's a gap in our existing model or because the new capability is required to take us to the next level.

With regard to moving into an adjacent space in the provider universe, there's nothing on our radar screen right now that suggests that it would be compelling. If you think we've already made the decision and have separated out Home Health & Hospice, so the remaining adjacencies in the post-acute space would be LTACs and SNFs.

And as we've stated before, we think that there's going to be a gradual but an ultimate progression towards some site neutrality with regard to post-acute inpatient facilities. And we think the best way to prepare for that is to continue to invest in freestanding IRFs. And we say that because even if there is no change in the patient criteria and even if the evolution is very slow, the demand for inpatient rehabilitation services in this country remains very high and very underpenetrated.

We again use as a prima facie estimate of that, the fact that if you just look at the CMS-13-eligible discharges coming out of acute care hospitals in the U.S. on an annual basis, less than 15% of those find their way into an IRF bed. So there's a tremendous white space for us to grow into. Moreover, if we do eventually move towards site neutrality for inpatient post-acute, it is our belief that the physical construction, the clinical expertise and the staffing complement that exists in the IRF model today are better positioned than either an LTAC or a SNF to adjust to those changing conditions. So that kind of addresses our thoughts on the provider community.

With regard to other services that we think could either enhance our value proposition or make us a more efficient operator, that's a constant evaluation. And when we evaluate those, we're trying to think about, A, what does it really do to position us more competitively? And B, is it something that we need to own? Or is it something we can replicate internally or buy as a vendor? So that evaluation will remain open, and I can't point to any specific service line right now that we think is a must add-on for us.

[Operator]

Our next question will come from Sarah James with Barclays.

[Sarah James, Barclays]

Hi, good morning. Can you help us understand what portion of your contract labor is related to permanent staff that is just on quarantine for testing positive? And then as we move into the phases of COVID where spread rate is higher but symptoms are lower, is there any discussion with the CDC or internally around testing frequency and quarantine length?

[Mark Tarr, President and CEO]

So let me take - this is Mark. I'll take the first portion of your question. Right now, we - given the current rates of COVID as we see in the marketplace, we're not experiencing staffing difficulties where we would be bringing in contract labor to offset quarantined staff at this point. So it is pretty much neutralized out there in the marketplace versus where it might have been in that peak period from last year or even the prior year to that.

[Doug Coltharp, CFO]

And then the second part of your question, Sarah, is yes, there is flexibility within the CDC guidelines for a member of our clinical staff who receives an exposure to COVID to still be able to work, providing that they meet certain - that they're able to pass the test.

[Sarah James, Barclays]

Great. And then just wanted to circle back on capital deployment. I know part of your strategy has always been to buy property or build footprints that are larger than you initially need to give you the flexibility to build out more space. Can you give us an idea of where you guys are in that process? Like how many of your facilities have that capacity to add rooms or add therapeutic space within existing footprint?

[Doug Coltharp, CFO]

Yes. So I would say, almost without exception, every de novo that we have brought on board in the last 10 years still has room for - maybe one or two that are exceptions, but still has room for additional capacity growth. Typically, we are buying five to seven acres of usable land to house a de novo. We're building a single-story facility that is - that can be expanded without disruption to the existing capacity that's there as well.

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It's much more of a mixed bag within our legacy hospitals. You've got a greater variety in terms of the physical construction of those and location and CON requirements and so forth. But we remain very confident in that and the ability to add 100 to 150 beds per annum to the existing base. Now some of that's going to be a little bit lumpy just based on timing.

As an example, Mark alluded in his comments and the fact that we now think just based on timing, where one project has moved from late in Q4 to early in Q1 of next year, that we're going to open up 90 beds this year, that means we'll probably be towards the high end of the range next year.

[Operator]

At this time, there are no further questions, so I would like to turn the call back over to Mark Miller for any additional or closing remarks.

[Mark Miller, Chief IR Officer]

Thank you. If anyone has additional questions, please call me at [phone]. Thank you again for joining today's call.

[Operator]

Thank you, ladies and gentlemen. This concludes today's conference, and we appreciate your participation. You may disconnect at any time.