Encompass Health Corp Q3 FY2020 Earnings Call

Good morning, everyone, and welcome to Encompass Health Third Quarter 2020 Earnings Conference Call. At this time, I would like to inform all participants lines will be in a listen-only mode. After the speakers’ remarks, there will be a question-and-answer period. Operator provides instructions for participants. Today’s conference call is being recorded. If you have any objections, please disconnect at this time. I will now turn the call over to Crissy Carlisle, Encompass Health's Chief Investor Relations Officer.

Thank you, operator and good morning, everyone. Thank you for joining Encompass Health Third Quarter 2020 Earnings Call. With me on the call 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; and April Anthony, Chief Executive Officer of Encompass Home Health & Hospice. Before we begin, if you do not already have a copy, the third 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 risk and uncertainties, many of which are beyond our control. Certain risks and uncertainties, like the magnitude and impact of the COVID-19 pandemic 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 the year ended December 31, 2019, and the Form 10-Q for the quarters ended March 31, 2020, June 30, 2020, and September 30, 2020, 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 speaks 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. 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.

Thank you, Crissy, and good morning to everyone. We have a proven track record of working through difficult situations. Since 2009, we have successfully managed through an economic recession, regulatory changes, sequestration and Medicare payment freezes and cuts and now, we can add a global pandemic to that list. Our teams are doing an extraordinary job in managing through the various COVID-19 challenges. While our operating environment remains difficult due to the pandemic, we remain confident in the prospects of both of our business segments and in our ability to overcome these challenges. It's what we do. We adapt, we persevere, and we continue to grow. Let's talk first about our Inpatient Rehabilitation segment. Our Inpatient Rehabilitation volumes recovered substantially in the third quarter of 2020. While total discharges were down 1.5% compared to the third quarter of 2019, this number improved significantly from the 10.7% decrease in volumes we experienced in the second quarter of 2020. The remaining lag to returning to prior year volumes primarily is related to orthopedic and lower extremity joint replacement cases. Many of our markets continue to have limited elective surgeries, particularly with elderly patients with complex medical conditions. These patients are the ones that tend to need inpatient rehabilitative services post surgery. To put this in perspective, full same-store discharges for the third quarter of 2020 decreased by 1,311 patients, compared to the same period of 2019. In the third quarter, we treated 1,316 fewer orthopedic and lower extremity replacement patients than we did a year ago, accounting for the entire same-store Q3 decline. We also continued to experience COVID-related challenges in certain geographic markets, specifically, Florida, where we have twelve inpatient rehabilitation hospitals. We experienced a 12.8% year-over-year decline in patient discharges in Florida in the third quarter of 2020. Factors such as limited elective surgeries and restrictions on when positive COVID patients can be transferred from an acute hospital to a post-acute setting played a significant role in this volume decrease. It's important to remember that these factors are temporary responses to the pandemic and are not indicative of structural shifts in the market. Net revenue per discharge is being positively impacted by the temporary suspension of sequestration and by a higher acuity patient mix resulting from the pandemic. We saw the acuity of our patients increase in the second quarter of 2020 and continue in the third quarter, and we expect this trend to continue in the fourth quarter. As you can see on Page 10 of the supplemental slides that accompanied our earnings release, our expenses did increase as a percent of revenues, primarily due to the COVID-19 pandemic. Our hospital teams have done a tremendous job managing our most significant cost, labor. For the third quarter of 2020, our employees per occupied bed, which we use as a metric to measure our efficiency was 3.44, compared to 3.48 in the third quarter of 2019. This is evidence that our technology and real-time data, combined with our clinical know-how makes us a best-in-class operator in any environment. We know how to effectively and efficiently manage our hospitals and can adjust our staffing levels to our volumes. We've also taken aggressive actions to obtain what we believe are adequate supplies of personal protective equipment, even at the elevated utilization levels associated with the pandemic. While some facilities in the post-acute space have faced significant challenges with COVID-19, our inpatient rehabilitation hospitals have been able to help recovering patients return to their independence. These patients, many of whom spent time on ventilators, have endured extended stays in acute care hospitals. They are extremely weak and require intense multidisciplinary rehabilitation to regain both their strength and cognitive abilities. Since April, we have treated over 3,000 recovering COVID patients, returning 80% back to the communities following the rehabilitation. In the fourth quarter of 2020, we expect limitations on elective procedures in certain markets to continue to impact volume growth, but we believe these volumes will return. It's a matter of when, not if. We remain confident in the long-term outlook for our hospitals. So much so, that we've continued to expand our national footprint throughout this pandemic. We have opened three new hospitals thus far in 2020 and we expect to open another one in Toledo, Ohio, in mid-November. In addition, by year-end, we expect to have added approximately 120 beds to existing hospitals with 89 of those already added. For 2021, we've announced plans to build eight new hospitals. We've also announced eight new hospitals scheduled to open in 2022 and we're not done making that. All of this fully demonstrates our commitment and confidence in our future. Let's move now to our Home Health and Hospice segment. Our Home Health volumes recovered substantially in the third quarter of 2020. While same-store admissions were down 4.6%, compared to the third quarter of 2019, they improved significantly from the second quarter of 2020 when we saw a 17.3% decrease in admissions. And we came out of the quarter stronger than we entered it with year-over-year same-store admissions growth of 2.2% for the month of September. We achieved this success even with our year-over-year admissions related to elective procedures down approximately 20%. Additionally, continued facility access restrictions have negatively impacted the volume of patients admitted onto our service who reside in assisted or independent living facilities. These admissions are down approximately 40% year-over-year. We also continue to experience COVID-related challenges in certain geographic markets, specifically in Texas, where admissions were at 95% of our 2019 levels in the third quarter of 2020, mostly due to limited elective procedures. While admissions in Florida dipped to 91% of historic levels in August, they rebounded nicely in September to finish the quarter above 100% of Q3 2019 admissions. Even in the face of restricted access to some of our historic referral sources, and with limited elective procedures in many of our markets, we continue to perform at a high level. Cost controls remain strong in Home Health with our cost per visit down almost 4%, in spite of COVID-related expenses associated with PPE and staff in quarantine. Our most significant decline in volume has been in the physical therapy discipline due to the decline in elective procedures and being shut out from assisted living facilities. To adjust for this, in May, we made a shift in our compensation structure for therapists, lowering each therapist’s base pay by 20%, and in turn, lowering their productivity expectations for each pay period by 20%. This change allowed us to save cost and do so in a manner that did not result in any broad furloughs, layoffs or terminations. We plan to keep this compensation structure going forward as it allows us to better flex our therapy staffing and allows our therapists to earn additional compensation by exceeding their productivity levels. Although the pandemic has made some collaboration efforts more difficult and necessarily virtual in nature, we believe there is a strong interest in partnering with Encompass Health Home Health & Hospice segment among ACOs and Medicare Advantage payers seeking value-based payment arrangements. We have partnered with more than 100 Medicare shared savings program ACOs around the country, adding nine new ACOs to this list in the third quarter of 2020. A recent analysis of 2019 claims data revealed that we grew our share of ACO beneficiaries by 16% in 2019 versus 2018, whereas the rest of the home health industry remained flat year-over-year. Similarly, our continued efforts to enter value-based payment arrangements with Medicare Advantage payers yielded the addition of two new contracts in Q3 with more discussions ongoing and anticipated to result in additional contracts over the coming quarters. With the combination of the industry-leading hospital readmission rates resulting in more healthy days at home for our patients, success in prior risk-based payment arrangements and a commitment to scale and density at the regional level, Encompass Health is the clear choice for organizations engaged in risk-based payment models for America's seniors. And after several months of unusually slow M&A activity in the home care sector, we are encouraged that the pipeline of acquisition opportunities is rebuilding, particularly for hospice. Despite the pandemic, we are continuing to find new and effective ways to provide care to our patients and support our clinicians in both business segments. Reducing readmissions remains a focus for us. As many of you know, our ReACT model focuses on preventing acute care transfers while patients are in our inpatient rehabilitation hospitals. This month, we rolled out our Readmissions Prevention program, which uses information from more than 400,000 patients who have been through our inpatient rehabilitation hospitals or home health agencies to estimate a patient's risk of hospitalization after discharge. We use this score, combined with social determinants of health and our clinical judgment to estimate and act on a patient's overall probability of being hospitalized and hopefully prevent a readmission from occurring. In our overlap markets, our hospital and home health teams are working together to ensure a smooth transition to the home and have established clinical protocols to help mitigate the need for both emergency care and hospitalization for high-risk patients. This is another way we are using data from our electronic medical records from both segments to predict a potential decline in health status and act in a timely manner to prevent it. This is good for patients and payers. While many uncertainties continue to exist, our visibility has improved and we have more information and experience in managing our operations during the pandemic. Therefore, we had issued guidance for the fourth quarter of 2020. You can see this guidance in our earnings release, as well as on page 17 of the supplemental slides that accompanies the release. We expect to be in a position to provide full year 2021 guidance and a longer-term outlook when we report our Q4 and full year 2020 earnings at the end of January. While many uncertainties still exist, our company is well-positioned to drive long-term growth. As I mentioned at the beginning of my comments, we have a proven track record of adapting to and working through challenges including this pandemic. Our business fundamentals aren't changing. In fact, the pandemic has created an even stronger awareness of the high level of care we provide in our inpatient rehabilitation hospitals and the value of our home health and hospice service lines. And as the population ages, the demand for our high-quality care will increase. I believe our future is bright. Before I end, I want to thank all of our employees who continue to make Encompass Health a leader in integrated healthcare. 2020 has been an unprecedented year. Our nation has been through a lot and yet our employees have continued to care for our patients, striving for better outcomes, compared to those of other care settings. I can't thank them enough and I know our patients are grateful for their efforts too. With that, I'll turn it over to Doug.

Thanks, Mark, and good morning, everyone. Let me reiterate what Mark just said, we are very proud of our team’s response to the ongoing pandemic, and we're very pleased with the resiliency our organization has demonstrated. This is evidenced in the continued improvement of our financial results. For Q3, our consolidated net revenues increased 1.1% over Q3 2019 to $1.174 billion and our consolidated adjusted EBITDA for Q3 was essentially flat to the prior year period at approximately $230 million. Even in these challenging times, our business continues to generate strong cash flow. Our Q3 adjusted free cash flow of $124.1 million increased 13.2% over Q3 2019, bringing our year-to-date adjusted free cash flow to approximately $367 million. Our strong and consistent cash flow supports our complementary strategies of investing in growth opportunities and making shareholder distributions. Through the first three quarters of 2020, we have made approximately $159 million in growth investments and provided approximately $89 million in shareholder distributions. We continue to proactively manage our capital structure to ensure adequate liquidity and flexibility to navigate our business through any challenges and to capitalize on the attractive growth opportunities we see in all three of our service lines. In late September, we again accessed the debt markets, raising $400 million in senior unsecured notes with a coupon of 4.625% maturing in 2031. This transaction settled in early October and thus is not reflected on our end-of-Q3 balance sheet. The proceeds from this offering will be used together with approximately $300 million of cash on hand to retire the balance of our 5.75% senior notes due in 2024, resulting in both lower interest expense and a longer duration of our debt capital. Our net leverage at the end of Q3 was 3.6 times, and we finished the quarter with no amounts drawn on our $1 billion revolving credit facility. Both of our business segments have continued on an upward trajectory following the nadir in our volumes reached in mid-April. This has been accomplished in spite of the COVID case surges in some of our most important markets. Beginning with the IRF segment, total revenue increased 3.1% over Q3 2019 as inpatient growth of 3.8% was partially offset by a 25.3% reduction in outpatient and other. The decline in outpatient revenues stems from permanent unit closures in 2019 and the intermittent suspension of certain units in response to the pandemic in 2020. Q3 discharges declined 1.5% with a 2.8% drop in same-store discharges, partially offset by new store contributions. Much of the same-store decline was attributable to our facilities in Florida and to a lesser extent Texas, where the effects of the pandemic have been high. As can be seen on Page 6 of the supplemental materials, our patient census increased throughout the quarter. We continue to see strong growth in our Medicare Advantage business with MA discharges increasing 40.6% in Q3. As Mark stated, we continue to experience higher patient acuity in Q3. The increase in average acuity, together with the Medicare sequestration suspension were primarily responsible for our 5.4% increase in revenue per discharge. The higher acuity drove an increase in our average length of stay, which partially offsets this pricing benefit. Our revenue per patient day for Q3 increased 2% over the prior year. IRF segment adjusted EBITDA for Q3 of $209.2 million declined less than 1% from Q3 2019. Our hospitals continue to manage labor productivity and operating expenses very effectively during the quarter. These efforts notwithstanding, the effects of the pandemic caused staffing and wage benefits in Q3 to increase 20 basis points as a percent of revenue over the prior year period and supplies to increase 80 basis points as a percent of revenue. Home Health & Hospice segment revenue in Q3 declined 5.1% from the prior year period. Home Health revenue decreased 6.5%, based on the 3.3% decline in admissions, and a 2.3% drop in revenue per episode. The decrease in revenue per episode is primarily attributable to the implementation of PDGM, the effects of which have been exacerbated by the pandemic. Home Health revenue per episode in Q3 benefited from the suspension of the Medicare sequestration, as well as the increase in admissions late in the quarter. Our Q3 Hospice revenue increased 1.6%. Hospice same-store admissions in Q3 were up 15.8%, but patient days declined 2.1% due to a lower average length of stay resulting from a change in our patient mix. During Q3, the percentage of our referrals from institutional settings, which typically have a lower average length of stay increased, while the percentage of referrals from senior living facilities, which typically have a higher length of stay decreased. This is due to access restrictions in many senior living facility referral sources owing to the pandemic. Within Home Health, our continued focus on labor productivity, combined with compensation structure changes implemented earlier this year drove a 270 basis point reduction in cost of services for Q3. Business per episode declined from 17.3% in Q3 2019 to 16.4% in Q3 2020 and cost per visit declined $75 from $78 in the prior year period. This effective cost management led to segment-adjusted EBITDA in Q3 of $51.8 million, an increase of 2% over Q3 2019. As Mark stated, we have issued guidance for Q4. The guidance and the key considerations on which it is based can be found on Pages 17 and 18 of the supplemental materials. The Q4 guidance includes an adjusted EBITDA range of $225 million to $240 million, as compared to $238.2 million achieved in Q4 2019. As noted on Page 18, adjusted EBITDA in Q4 last year benefited from $9.5 million of items we do not expect to repeat this year. And now operator, we'll open the line for questions.

Operator provides instructions for the question-and-answer session. And your first question comes from the line of Whit Mayo of UBS.

Hey. Thanks for all the color this morning. I wanted to start with just the Home Health volumes. If we adjust for the assisted living, the senior referral declines, what would the year-over-year volumes be? If we just isolate, the 40% decline strikes me as very high and I get that COVID makes forecasting difficult. But I am curious maybe to hear from April, any experiences that you could share in markets outside of Florida or Texas that might be trending more favorably? And does that make you more negative or optimistic on the outlook for volumes going forward?

Good morning, Whit.

Hi, Whit.

Yes, Whit. The assisted living and independent living community impact has been pretty significant and pretty consistent across the country. We haven't really had certain regions that have just come in openly welcoming. It's been pretty much a lockdown consistently across the country. As things began to ease up in the late July to August timeframe, we started to get a little bit greater access. But now, as we move into a period of spike, it definitely feels like we are again seeing, particularly in certain markets in the Northeast, some lockdowns and they're saying, we'll let your nurse in, but not your therapist, we'll let your nurse in and hospice, but we won't let your chaplains or social workers in. It's been a mixed bag market-by-market. I think that market is probably one that we think is going to continue to be challenging for a bit. What we've done, though, is create some mitigating opportunities by really going out and using that disruption to look for some new sources of revenue. We've got a much increased flow from alternative surgery centers that are starting to pick up some of these electives and, in the area of electives, we are seeing a lot more positive movement pretty consistently month-by-month: July, August, September, even into the first three weeks of October where it looks like our decline in electives is down as we compare to pre-COVID levels, down only about 12% from where it was in the January-February timeframe. So, we are pretty encouraged about the trajectory that we are seeing everywhere other than assisted living and independent living, which continues to be a roller-coaster, but still consistently on the downside.

So just to be clear, if we could exclude the assisted living referrals, is there a number to think about in terms of how the business would be declining or increasing right now?

I don't have that information right off the top of my head, but we can certainly look at that detailed information and try to get back to you with something.

Okay. And just one last one, just for both businesses, the monthly ADC disclosures are helpful. Is there any spot number Doug, to kind of look at for October at this point, just to get a sense of how we may be trending versus what appears to be a better September exit rate?

Trend line is good.

Okay. I'll take that. Thanks, guys.

Your next question comes from the line of Kevin Fischbeck of Bank of America.

Morning, Kevin.

Good morning, Kevin.

Good morning. Actually, this is Joanna Gajuk filling in for Kevin today. So appreciate taking the question here. Thank you very much for the explanation of the volume trends in Home Health. Can we talk a little bit about pricing trends in Home Health? It worsened a little bit, it was down about 2% after being down 1% in Q2 year-over-year. Can you flag any items there? Is there any change in mix or anything around PDGM, which is probably hard to parse out? Any color you can provide on that will be great.

Sure. The revenue per episode is affected pretty significantly by electives. Elective procedures like joint replacements tend to be one of the higher revenue sources even under PDGM, although under PDGM that category is worth less than it was under the prior payment system in 2019. So, when we see the decline in electives and we compare 2019 to 2020, you have to look at a combination of two factors. One, PDGM would have made those procedures worth less than they had been in the prior year; and secondarily, in 2020 we've also got a lower proportion of those procedures. So, it's a combination on the rate side of both the PDGM implications and the proportional decrease that we see in elective procedures, which are relatively high revenue sources. Does that make sense?

Yes, that makes sense. And if I can just follow-up on the commentary on the other segment, on the inpatient rehab, obviously very impressive plans and new development plans for the IRF segment. Is it fair to say that you are not seeing much of a slowdown there in terms of any of these COVID case spikes in some of these markets in terms of actually completing these projects on time?

We do not. We think the basic fundamentals on the IRF side of the business continue to be strong, both near-term and long-term. We see COVID as just a near-term challenge for us that we will get through. If anything, COVID has given us an opportunity in marketplaces to show the caliber of the high level of acuity care we can provide to our patients. So, we don't see any impact with COVID on our development efforts.

Great. Thank you.

Your next question comes from the line of Matt Larew of William Blair.

Hey, Matt.

Good morning, Matt.

Hey, good morning. Doug, thanks for all the detail on the guidance for Q4. I did want to ask about the pricing side. The last couple quarters have been very strong for IRF and now moving into the IRF calendar year that starts in October, you get a pricing boost. Could you help us understand or quantify to some extent what acuity and sequestration benefit were in the quarter? Maybe that can give us a window onto what pricing growth might look like in the fourth quarter for IRF?

Yes. The sequestration is straightforward, that's the 2% you see. With regard to pricing, it's a little difficult to separate out the amount specifically related to patient acuity that may be driven by COVID. A few things are going on with regard to acuity that are COVID-related. First, a portion of the patients are recovering from COVID and there is an extra comorbidity payment that comes along with those patients that will boost revenue per episode. But you've also got the change in patient mix because we're seeing relatively the same number of stroke and neurological patients, but we've dropped those lower acuity orthopedic patients that Mark talked about. We expect those trends likely to continue in the fourth quarter. If you combine those items, and add the element of Section GG adoption effects, together we think those were responsible for about 190 basis points of the lift in revenue per episode for Q3.

Matt, just a little bit more color. If you think about case mix index, we ran for a number of years right at about 1.36 to 1.37. Starting this year in Q2 and carried into Q3, we ran 1.44 and 1.42. So it's indicative of the acuity that we are seeing coming out of acute care hospitals. Remember, about 9% of our admissions into our IRFs come directly from acute care hospitals. These patients are sicker and whether they are specific to COVID or not, we're just seeing a higher acuity across the board.

Thanks, Mark. And then speaking about 2021, you mentioned you'll give guidance early next year. But I think about half the locations in terms of IRF coming on board next year are in Texas and Florida. Any reason at this point to think that the on-ramp of those facilities might be any slower? And you said you are going to update the long-term plans and my takeaway is that nothing about your long-term outlook has changed, at least qualitatively?

With regard to the ramp up of the new facilities, most are scheduled to come on board in Q3 of next year; some open late in Q2. It's our expectation and hope that we will be largely on the other side of the effects of the pandemic by that time. So, we're not really anticipating anything different with regard to the ramp up. And absolutely, nothing has changed regarding our enthusiasm and commitment to the long-term growth prospects of the businesses that we are in. We will continue on the course that we have started with regard to development of an increased de novo pipeline in the IRF segment.

Okay. Thank you.

Your next question comes from the line of Brian Tanquilut of Jefferies.

Good morning, Brian.

Hey, Brian.

Hey. Good morning, guys. Just a follow-up on Matt's question. For the growth algorithm, without going into guidance for next year, if I use Q4 guidance as a baseline, is it right to assume that you should be able to grow on top of that? What would be the drivers of that growth for 2021?

Putting aside continuing effects of the pandemic, we have added capacity over 2019 and 2020 that provides room for organic growth. Bed additions in 2019 and another 120 beds in 2020 are vehicles for same-store growth in 2021. We would also expect recovery in some of the harder hit markets as COVID works through. So, we think there are good prospects for growth, particularly in the back half of 2021.

And a question for April: how are you thinking about your PDGM mitigation efforts? The guidance for Q4 calls for a 2% to 3% headwind from PDGM and initially we thought mitigation would get to zero mid-year to exit 2020. Is anything changed? Also, the sustainability of that $75 cost per visit — you changed your comp structure, is that the right number going forward?

On PDGM mitigation, I'm proud of what we've done. Despite challenges, revenue was down 5% while earnings were up 2%, which speaks to mitigation. Some strategies planned for PDGM have been difficult during the pandemic. For example, expected behavior changes related to certain clinical categories have gone the other way. So, some strategies in place in January have been particularly difficult in a COVID environment. However, we've done other things, notably the compensation adjustment, which improved cost per visit. I think within therapy we'll continue to see those savings as we maintain the comp plan. However, nursing staffing across the country is particularly challenged and we are seeing compensation rates go up. We expect to see some increases in cost per visit in the nursing disciplines that may mitigate some of the therapy-side savings. So, probably a little bit of cost climb as we move into 2021 and throughout the year.

All right. Got it. Thank you.

Your next question comes from the line of Matthew Gillmor of Baird.

Good morning, Matt.

Hey, Matt.

Hey. I was hoping to ask about the fourth quarter guidance. It's a relatively wide EBITDA range, which is understandable given the pandemic. Can you give some sense for what you are assuming from a volume standpoint within the guide so we can understand your approach?

The wildcard and reason for the broader range is the impact of any COVID surges on volumes. The top end of the range assumes continuation of the gradual volume recovery experienced through Q2 and Q3, and the bottom end assumes some pullback.

Okay.

We came out of Q3 stronger than we went into it and are pleased with the progress in September and momentum carried into October. The wildcard is the COVID surge, but we are pleased with the momentum through Q3 and into Q4.

The other factor adding variability to Q4 EBITDA is self-insurance accruals. We had $7 million in positive accrual adjustments in Q4 of 2019. This year is difficult to predict. In Q2 we had a lift from lower claims activity in group medical and workers' comp. We expected claims to pick up in Q3 for different reasons. As the medical system opened, deferred demand came back including some elective surgeries for employees and their families, and we also saw a larger number of workers' comp claims related to employees who acquired COVID at work. These claims tend to be short-term and lower payout. We are not sure what to expect for claims activity in Q4 and against the favorable accrual adjustments in 2019 this creates variability which is reflected in our broader EBITDA range for Q4.

Okay. And a follow-up on Medicare Advantage mix in IRF: MA volumes are up 40% which is a big acceleration. Some plans were waiving preauthorization requirements. Any insight into the sustainability of that trend?

Higher MA volume in Q3 driven by both an increase in referrals and a higher conversion rate. For Q3, referrals were up 23% and admits were up 38% based on a 170 basis point increase in the conversion rate. That was largely without preauthorization waivers in place for most markets during Q3. Preauthorization requirements have essentially been reinstated and we expect them to remain into Q4. We expect normalization in payer mix in Q4 which means MA growth rate will remain high but come down. I'd estimate MA discharge volume growth in Q4 closer to the 15% to 20% range — elevated versus 2018-2019 but sustainable into 2021.

Okay. Thanks a lot.

Your next question comes from the line of A.J. Rice of Credit Suisse.

Good morning, AJ.

Good morning, AJ.

Hey. How are you? First, I see slide 20 that talks about the acquisitions and de novos. I think you still have $50 million to $100 million in M&A in 2020. Is that new and does that mean you see something in the fourth quarter coming? You had $97 million on de novos year-to-date and at one point you expected $180 million to $190 million — is that impacted by COVID pacing? Will there be a bolus of them coming in the fourth quarter?

There has been an impact on pacing related to COVID this year. We still expect the de novo range to fall into $180 million to $190 million in 2020, which means we'll be busy in Q4 with numerous projects. On Home Health, as Mark mentioned, the acquisition pipeline has picked up, more oriented toward Hospice than Home Health. The $50 million to $100 million reflects optimism that we will be able to get a deal or two done in Q4.

Okay. And a follow-up: there have been studies and some legislative proposals about potentially rolling back behavioral adjustments in PDGM. Any momentum? Do you think, as we come out of this election season, prospects have improved for favorable developments?

I do think we're having good conversations and they are data-driven in Washington. I would not expect changes to affect the 2021 rate; the rate proposal is expected soon. But I do think we're in a good position to have the 2022 rate adjusted. Data from Dobson and DaVanzo and others strongly support that the behavioral assumptions were not well founded and have not proven accurate even considering COVID adjustments.

Interesting. Okay. Thanks a lot.

Your next question comes from the line of Ann Hynes from Mizuho Securities.

Good morning, Ann.

Hey, Ann.

Hi, good morning. My first question is about the eight new hospitals opening in 2021. From an EBITDA contribution perspective, should we view that class as being a negative EBITDA drag or positive? And can you remind us with de novos how to view EBITDA contribution and margin expansion over the first two years after you open the de novo?

I would expect that class to be EBITDA negative in 2021. Our pre-opening expenses typically begin about six months in advance and run about $1 million per facility. With regard to ramp up, refer to our investor reference materials; earliest four-wall positive EBITDA typically happens around nine months and usually within 18 to 20 months depending on market circumstances.

Thanks. My second question: can you address other key headwinds and tailwinds we haven't discussed yet, in particular ongoing PPE costs?

We would normally be further along in the budgeting process for 2021. We've deferred the budgeting timeline by about two months because assumptions could change depending on the course of the pandemic. That's why we're not giving more color on 2021 today. Regarding expenses, we think we've got a good handle on expenses right now. If the pandemic continues into the first half of 2021, the run-rate we are experiencing now is a proxy for what we'll see in the first half. As we move beyond the pandemic in the second half, we would expect to realize some efficiencies in labor and supplies costs.

Check slide 25 in the earnings slide book for expanded PPE cost detail. We are in a much better position now than six to eight months ago regarding PPE, and our team has done a great job finding secondary suppliers to meet demand needs.

I did see that slide. I was wondering if you think PPE will be a headwind for all of 2021 and into 2022, or is this extra cost more transitory in nature?

The bulk of it is probably transitory, though none of us in healthcare are going back to pre-COVID normal. There will be some heightened use of PPE that stays with us going forward, and in this organization we believe that's prudent.

All right. Thanks.

Your next question comes from the line of Pito Chickering of Deutsche Bank.

Hey. Good morning, guys. A couple quick questions for April. Some moving parts about cost per visit as it relates to nursing disciplines going forward. Conceptually, should we view the $75 per visit as a starting point and grow it at 3% or 5% over the next 12 months? Or can you help conceptualize how that works?

As Doug mentioned, our budgeting process is ongoing. There are significant staffing challenges that will drive some cost increases. We are not seeing that broadly everywhere yet, but in certain markets we are. It's reasonable to assume a modest steady increase in nursing discipline costs throughout 2021. If the pandemic eases quicker, we may see some nurses return to the market and ease the pressure, but assume a modest steady increase in nursing costs in 2021.

Okay. And visits per episode were relatively unchanged in Q3 versus Q1. I would have assumed MetaLogics rollout would reduce visits. How should we think about visits per episode declining over the next 12 months?

Our deployment of the MetaLogics tools was delayed during the pandemic; we didn't get it fully deployed until about June. It takes time to change practice and get people comfortable, especially since deployment was virtual versus hands-on. We have not scraped the surface of the opportunity with MetaLogics and will continue to see improvement quarter-over-quarter as we get it fully integrated into processes and practice.

Last quick one: what percent of your business is tied to assisted living? In 2019, what percent of your growth came from that type of business?

I don't have specific data right in front of me, but AL/IL communities have historically represented about 15% to 20% of our total patient volume. In the COVID world that category is somewhere in the 20% to 25% range given the dynamics we discussed.

All right. Great. Thanks so much guys. Nice quarter.

Your next question comes from the line of Frank Morgan of RBC Capital.

Good morning, Frank.

Good morning, Frank.

Good morning. I want to go back to AJ's question about likely M&A activity. You mentioned a pickup on the Hospice side. I would have thought more on the Home Health side. Why more Hospice than Home Health? Also, many provider calls indicate September ended on a strong note but some are seeing a COVID surge again. Any color there?

Hospice has generally been less impacted by the events of 2020 than Home Health, so it has a better run rate and it's easier to engage in price discovery between buyer and seller. Hospice was not subject to a payment system change like PDGM, and hospice volumes were less impacted by COVID. With PDGM and the pandemic occurring before providers could establish a new baseline, it's been difficult to get to a run-rate EBITDA for meaningful acquisition discussions in Home Health. Those limitations don't exist in Hospice. Also, favorable growth opportunities are reflected in higher multiples for hospice assets, so owners considering transition may find now an attractive time to do so.

Frank, our staff have done a tremendous job throughout COVID learning to treat COVID patients and taking mitigating efforts in clinical and sales and marketing settings. We've set ourselves apart by our willingness to take COVID patients into our service lines and by the outcomes we've achieved with them. This has reinforced our value proposition to referral sources and Medicare Advantage plans. Our teams have done a great job mitigating impacts.

Thank you.

Your next question comes from the line of Sarah James of Piper Sandler.

Good morning, Sarah.

Good morning. Following up on M&A: understanding PDGM disrupted what's available and stimulus money is elongating things, when do you expect the Home Health market to get back to normal as far as acquisition opportunities? And given you are leaning more into de novos, remind us the breakeven timeline or ROI differences between de novo and M&A?

For Home Health, I would say about six more months before it gets interesting again. We'll see movement as CARES Act funds are spent and advanced payments need to be repaid. I think Home Health will remain quiet into the second quarter of next year. Hospice, however, has been attractive with high multiples and less disruption; we expect acquisition activity in hospice to continue and be where most of our M&A efforts are pointed over the next six months.

On the IRF side, de novo ramp up typically achieves four-wall positive EBITDA earliest around six to nine months and usually within 18 to 20 months. With regard to returns, a few data points: our weighted average cost of capital is roughly around 8% depending on market views. We target around a 13% IRR for investments. We have a good track record of de novos meeting or exceeding that target. Acquisition multiples in Home Health and Hospice have pushed up and as multiples rise it becomes more difficult to achieve outsized returns. We remain disciplined: if you're paying 12 to 15 times for a business that isn't impaired, returns will trend closer to WACC than to 13%.

Got it. That's helpful. Thank you.

And your final question comes from the line of Andrew Mok of Barclays.

Good morning, Andrew.

Hi, good morning. I wanted to follow up on acuity trends in rehab centers. Even though acuity remains elevated on a sequential basis, both your revenue per discharge and length of stay decreased, which suggests moderating acuity. I wanted clarity on why those numbers are moving lower if you are seeing intensifying acuity? Thanks.

Sequentially, acuity and length of stay actually increased. Acuity in Q2 was about 1.49 and in Q3 about 1.52. Length of stay was near 13.2 in Q2 and 13 in Q3. I can provide more precise numbers but the trend lines are consistent with pricing.

Got it. Length of stay at 13.2 in Q2 and down to 13 in Q3. I was looking for color on why that moved lower and whether you are seeing any reversal of trends.

To clarify: length of stay was 13.2 in Q2 and 13.0 in Q3 versus 12.5 in Q2 2019 and 12.6 in Q3 2019. The year-over-year deltas reflect higher acuity of the patient mix; the specific LOS change between Q2 and Q3 is modest.

One factor earlier in Q2 that impacted length of stay was the ability to discharge patients from our hospitals to other post-acute settings was delayed because those settings were restricted on accepting patients treated for COVID. That played a role in extended length of stay earlier.

Also note the patient mix change: other orthopedic conditions as a percentage of our patients decreased 180 basis points in Q3 2020 versus Q3 2019. That affects case mix index and length of stay because the patients in house are more acute. If elective surgeries come back, that could impact CMI and length of stay.

Andrew, to add, those year-over-year increases in length of stay and CMI are reflected in pricing. Sequential changes were modest but the higher levels versus 2019 reflect higher acuity.

Got it. That's helpful. Thank you.

I'll turn the call back over to Ms. Carlisle.

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

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