Encompass Health Corp Q3 FY2023 Earnings Call

Good morning, everyone, and welcome to Encompass Health's Third Quarter 2023 Earnings Conference Call. Today's call is being recorded. If you have any objections, you may disconnect now. I will now hand it over to Mark Miller, Encompass Health's Chief Investor Relations Officer. Please proceed.

Thank you, operator, and good morning, everyone. Thank you for joining Encompass Health's Third Quarter 2023 Earnings Call. Before we begin, if you do not already have a copy, please refer to the third quarter earnings release and supplemental information on our website at encompasshealth.com. On Page 2 of the supplemental information, you will find the safe harbor statements, which are also detailed on the last page of the earnings release. During this call, we will make forward-looking statements that are subject to risks and uncertainties, many of which are beyond our control. Certain risks and uncertainties, such as those related to regulatory developments, volume, bad debt, and labor cost trends, could cause actual results to differ significantly from our projections, estimates, and expectations, as discussed in the company's SEC filings included in the earnings release and related Form 8-K, the Form 10-K for the year ended December 31, 2022, and the Form 10-Q for the quarters ended March 31, 2023, June 30, 2023, and September 30, 2023, when filed. We encourage you to read them. Please do not place undue reliance on the estimates, projections, guidance, and other forward-looking information presented, which are based on current estimates of future events and reflect the situation 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. Reconciliation to the most directly comparable GAAP measure is available at the end of the supplemental information and the earnings release, as well as in the Form 8-K filed yesterday with the SEC, all of which can be accessed on our website. I want to remind everyone that we will follow a 1 question and 1 follow-up question rule to allow all participants to submit a question. If you have additional questions, please feel free to rejoin the queue. With that, I'll turn the call over to Mark Tarr, Encompass Health's President and Chief Executive Officer.

Thank you, Mark, and good morning, everyone. We're very pleased with our third quarter results, driven by continued strong volume growth and a substantial year-over-year reduction in premium labor costs. Our third quarter revenues increased 10.8% and adjusted EBITDA increased 21.6%. Q3 total discharges increased 7.3%, with same-store discharges up 4.3%. Our strong volume growth continues to underscore our value proposition to referral sources, payers and patients. Our patient acuity continues to broaden with more normalized patient flows through the health care system. Surcharges were up 5.8% year-over-year, while knee and hip replacement and fracture of the lower extremity discharges grew approximately 14% in the aggregate year-over-year though of a relatively small base. Given the strong demand for inpatient rehabilitation services, we have continued to invest in capacity additions. We opened one 40-bed de novo in the third quarter, bringing us to 6 de novos year-to-date. We also added 26 beds to existing hospitals in the third quarter for total capacity additions of 340 beds over the first 9 months of 2023. Based on favorable weather conditions and construction efficiencies, we are accelerating the opening of our Fitchburg, Wisconsin hospital from first quarter of 2024 to fourth quarter of 2023. As a result, we now plan to open 2 de novos in Q4 and add 5 beds to existing hospitals, resulting in a total of 441 beds for the year. Three of our bed addition projects originally scheduled for 2023 have shifted to 2024 due in each case to local permitting issues. As a result of this shift, we have to add more than 150 beds to existing hospitals in 2024. We continue to build and maintain an active pipeline of de novo projects both wholly owned and JVs with acute care hospitals. We currently have announced 18 de novos with opening dates beyond 2023. During Q3, we again met the increasing demand for our services while reducing contract labor and sign-on and shift bonus expenditures. Contract labor was down approximately $6 million or 24% from Q3 of 2022 while sign-on and shift bonuses decreased approximately $10 million or 41% from Q3 of 2022. For the second consecutive quarter, our talent acquisition efforts resulted in over 200 net same-store RM hires. Please be mindful that hiring results may vary significantly from quarter-to-quarter based on seasonality and other factors. Review Choice Demonstration, or RCD, began on August 21 in Alabama. Recall that under RCD, every claim is reviewed for documentation and medical necessity. We elected pre-claim review, as we believe it allows for a more iterative process and the potential for real-time adjustments. Our results thus far are encouraging. The affirmation rate target set by CMS under RCD is 80% of claims submitted during the first 6 months and our affirmation rate is well above that. Given our Q3 results and expectations for Q4, we are updating our 2023 guidance to include net operating revenue of $4.77 billion to $4.8 billion, adjusted EBITDA of $940 million to $955 million and adjusted earnings per share of $3.41 to $3.52. The key considerations underlying our guidance can be found on Page 12 of the supplemental slides. Now with that, I'll turn it over to Doug for further color.

Thanks, Mark, and good morning, everyone. As Mark stated, we are very pleased with our Q3 results. We continue to see significant improvement and year-over-year premium labor costs. Our Q3 contract labor plus sign-on and shift bonuses of $33.3 million was comprised of approximately $18.9 million in contract labor and $14.4 million in sign-on and shift bonuses. This compares favorably to $24.8 million in contract labor and $24.2 million in sign-on and shift bonuses in Q3 last year. Contract labor utilization declined year-over-year and sequentially. Q3 contract labor FTEs of 388 represented a 19% decline from Q3 '22, and an 18% decline from Q2 of '23. Contract labor FTEs as a percent of total FTEs was 1.5%, a 40 basis point decline from Q3 '22 and a 30 basis point decline sequentially. Agency rates declined year-over-year and were up modestly sequentially. Our Q3 '23 agency rate for FTE was approximately $192,700, down from approximately $204,600 in Q3 '22. I'll remind you that rates are impacted by the license level of the clinician utilized as well as by geographic specific market conditions. Sign-on and shift bonuses decreased $9.8 million or 41% from Q3 '22 and were roughly flat sequentially. As we consider contract labor and shift bonuses for Q4, it is worth noting that holiday coverage typically requires premium pay rates. Partially offsetting the benefit of lower premium labor costs in Q3 was an increase in our internal SW per FTE rate. This rate, which excludes contract labor and sign-on and shift bonuses increased 6% over Q3 '22, similar to the level of increase we saw in Q2. The increase was attributable to proactive market adjustments primarily for nurses, higher compensation for new hires and planned merit increases. These actions are contributing to our success in new hiring and improvement in turnover. Our updated guidance assumes a continuation of this trend in Q4. In line with expectations, EPOB for the quarter was 3.41, an increase from 3.39 in Q3 '22 and from 3.38 in Q2 '23. Revenue reserves related to bad debt increased 20 basis points to 2.2% as a result of write-offs of older claims denied by the Departmental Appeals Board, which we have elected not to appeal the Federal District Court. Our de novo embedded addition strategy continues to generate solid growth and contribute to share gains. Our de novo has performed exceptionally well in Q3, contributing $900,000 in adjusted EBITDA. This brings year-to-date net preopening and ramp-up costs to $7.6 million. We still expect full year preopening and ramp-up costs to be $10 million to $12 million due to the opening of 2 hospitals in Q4 and the cost we expect to incur in Q4 for hospitals scheduled to open in the first half of 2024. As can be seen on Page 14 of the supplemental information, the acceleration of our Fitchburg opening into 2023 and the progress on a number of pipeline projects scheduled for 2024 and 2025, has led to an upward revision of our 2023 de novo capital expenditures estimate to $315 million to $325 million. Year-to-date adjusted free cash flow of $432.2 million represented a 47% increase from the first 9 months of 2022. As can be seen on Page 13 of the supplemental information, we have updated our assumptions for certain cash flow items, contributing to an increase in our 2023 adjusted free cash flow estimate to $445 million to $500 million. Finally, we ended Q3 with a net leverage ratio of 2.8x, down from 3.4x at the end of 2022. Our balance sheet and liquidity remain well positioned. With that, we'll open the lines for Q&A.

At this time, we will open the floor for questions. We ask that you limit yourself to 1 question and 1 follow-up question. Our first question will come from Kevin Fischbeck with Bank of America.

I would like to ask about labor. There's been considerable progress with contract labor expenses and sign-on bonuses. However, the overall wage outlook has increased, and we’ve observed sequential increases in contract labor wages for a few quarters now. How would you describe the current labor market, and what are your thoughts on managing labor pressures into next year, especially considering this year has seen a decrease in contract labor costs?

Kevin, this is Mark. As you know, we've made great progress on the contract labor side and the premium pay categories. I would characterize it as still a very tight market out there. Certain markets are a little bit more challenging than others to find staff. We've done a really great job in terms of our recruitment of RNs, which is the most challenging segment of our staffing base at this point. But I think we put systems in place and have the initiatives at our hospitals to be successful going into next year, and compete very strongly in this really tight market.

Yes. To add a couple of points to that, what you're observing in the sequential increase in rates is mainly due to our reduced reliance on contract labor. This has led to a concentration of higher license levels in more expensive and tighter geographies. Some of this is somewhat self-sustaining. Looking ahead to 2024, we anticipate that premium labor will either remain stable or improve. We have successfully reduced our contract labor full-time equivalents to 1.5%, which is still above the pre-pandemic level of just under 1%. We do believe there’s an opportunity for further progress, but at the very least, we don't see it rising above that level. Regarding the 6% increase in staffing workforce per full-time equivalent we've experienced this year, we believe it reflects our ability to hire 402 net new registered nurses cumulatively over the last two quarters. We feel we've reached the appropriate level to attract new talent, and our turnover rates have also decreased. Given these factors, we don't expect to face another 6% increase on top of this year's 6%. We anticipate that labor inflation will significantly moderate next year.

Okay. That's helpful. Regarding volumes, there's been a lot of discussion about normal seasonality. Where do you think the industry stands in terms of IRF volumes? Are we returning to normal growth from this point? Is there any pent-up demand? How do you see this as a foundation for future growth and seasonality?

Kevin, we've commented in past quarters, and I think that holds true now, is that the pandemic gave IRF a real chance to show the difference in post-acute settings. And I believe that we have continued to take market share from skilled nursing facilities or other areas that otherwise may have taken similar types of patients. And so I think we're well positioned going forward to continue to provide value to referral sources and the payers.

As you think about our discharge growth for the second half of this year, of course, Q3 we just reported, recall that we are up against more challenging comps from last year. In the back half of last year, total discharge growth was running north of 7% with more than 4% of that coming from same store. And so we really felt like the seasonal patterns started to reestablish themselves in the second half of this year. And it feels like that is continuing this year. With regard to pent-up demand, there's no doubt that we are seeing an increased flow of some of those lower acuity hip and knee replacements that Mark described, what's offsetting some of that is a reduction in COVID patients. And so the demand that we're seeing in those categories is actually probably a little bit higher than might otherwise show through into the total discharges. But generally speaking, it feels like we're kind of back into our traditional seasonal flows.

Our next question will come A.J. Rice with UBS.

The first question was more technical. You're pointing out the $3.5 million write-off of the new project. I find it unusual that you didn't proceed with it. However, my main point is that you've updated the guidance. It appears that you're factoring that in, indicating that the actual increase in operating results is slightly more than what might seem apparent. I'd like to confirm that.

And A.J., I'm sorry, we didn't make that more clear in our materials. That write-off is below the adjusted EBITDA line. And you're right, it's less unusual in terms of the fact that we're deciding not to press forward with a de novo project and more unusual in terms of its scope. We're managing an active pipeline of approximately 50 projects and then what you don't necessarily see is there are about 20 behind that, that are in what we ineloquently describe as exploratory mode. We will from time to time than we have in the past have a project that for various reasons, sometimes it's getting hung up in the CON process, will elect not to move forward with. In almost all instances, those items are less than $1 million. We had one that was approximately $1 million. It was actually included in 3. What was unusual about this project is that we had gotten further along. It's the project in the Midwest. It was with an existing joint venture partner. We had acquired some land. We were actually doing some of the site work. And unfortunately, every time we refined our estimate for the cost to build this facility it was getting worse and worse in a way that we weren't able to use some of the other offsets we've effectively used on other projects. In addition to that, this was a particular market where the labor market conditions were moving in an adverse direction as well. So we had some difficult talks with our joint venture partner, but ultimately, we concluded together that it did not make sense to press forward at this time and so we took the write-off. I really view that as an anomaly given its size because it's unusual for us to get that far down the path before we make that kind of decision. I don't think it speaks to any lack of enthusiasm with regard to our continuing development pipeline, I do think it highlights the fact that we are disciplined in our approach.

Okay. All right. And maybe just a follow-up, I'll take a stab at this one. I know you're not going to give formal '24 guidance until you report fourth quarter or at least around the first of the year. But you talked about labor inflation moderating some of the things around volume and de novos, what, in your mind, are the puts and takes we should keep in mind as we're trying to develop forecast in any areas of particular variability as you sit right now and think about next year?

I think you've hit on the keys, which is, one, we look at volume growth heading into next year. Obviously, we'll be up against challenging comps given the good discharge growth we've had this year. But we're going to benefit from the continued maturation of 25 de novos that were added from 21 through the end of '23 and the addition of 150 beds to existing hospitals. And we do anticipate that moderating labor inflation will occur as we anniversary the 6% increase in SW, FTE, we're anticipating for '23. Those are going to be the primary drivers.

We'll take our next question from Brian Tanquilut with Jefferies.

Congrats on the quarter. Doug, I guess my first question, as I think about your revised guidance for the year and what you've reported so far in the first 3 quarters. The Q4 kind of like is a little different from typical seasonality in terms of contribution to the year. So just curious, is there anything we should be thinking about in terms of what that like sequential decline or flattening that imply on the guide for Q4.

As we enter Q4, we are clearly benefiting from the price increase, which aligns with our established seasonal flows. We anticipate that discharges from Q3 to Q4 will remain relatively stable, without a significant sequential uptick. A considerable portion of the pricing increase, just over 3%, is being consumed. We also expect a slight increase in length of stay, which is not unusual, although last year's Q4 was somewhat of an outlier. Additionally, there will be regular increases in supplies and operating expenses, some of which can be linked to seasonal trends. There's not much else to highlight, and given our strong Q3, our expectations for Q4 are not surprising.

Okay, that makes sense. Mark, as I reflect on your comments in the release or in the slide deck regarding pricing on the commercial side, how should we approach the commercial price trend and share price strategy as we look towards 2024?

We continue to work on payers, as we've done in past quarters with the MA contract negotiations we've had. As we move more contracts towards CMG, you're starting to see less of the differential between the fee-for-service Medicare and MA plans. I think it was down to 3% or 4% differential this last quarter. So we continue to make progress there. And I think you expect to see that going forward.

Yes, Brian, the other thing you got to call out as you think about the movement from Q3 to Q4 is the impact of the 2023 de novos. As we discussed in our comments earlier, we had a really strong quarter in Q3 where those actually contributed $900,000 in EBITDA. But we're still anticipating that the preopening and ramp-up costs for the full year will be in that $10 million to $12 million range, which implies a $3.5 million to $5.5 million swing the other way in Q4.

Our next question comes from Pito Chickering with Deutsche Bank.

You've got Kieran Ryan on for Pito. You mentioned that the hip and knee patients continue to present at a pretty good rate in 3Q, and I know you called out some strong ortho demand in the second quarter. So I guess, just could you comment on if that strength in ortho continued into 3Q, and if there's any other specialties you want to call out, whether that's neuro stroke or anything like that?

We continue to see growth in our stroke program. I think as I noted in my comments around the orthopedic, we're just kind of getting back to normalized flow that we had seen prior to the pandemic. So it's not an area that is growing off of a very large base, but we have placed a huge focus over the past several years in growing our stroke program. We've seen nice gains on that. We've seen nice gains in other neuro and continue to focus on those categories.

Again, these are some smaller categories, but brain injury increased by 8.6%. Cardiac saw a rise of 2.4%, which is a bit lower. Major multiple trauma rose by 10.4%. This quarter, as we discussed more in Q2, showed that our discharge growth was strong across various patient categories and widespread across different regions, which we find encouraging.

Awesome. And then just a quick follow-up. Would you be able to give an update on our turnover? I think you were running at 22% year-to-date after 2Q. It sounded like maybe a little bit more sequential improvement there or…

Our most recent quarter showed a turnover rate of 22% to 23%, continuing the progress we've observed. We have concentrated on reducing turnover among newly hired RMs within their first year, an area we identified for potential improvement. We are seeing positive changes in this regard. Additionally, we have focused on the orientation and onboarding of our nurses, which we believe will contribute to maintaining or further decreasing that turnover rate over time.

It’s important to note as well, we tend to focus on the nursing, but our therapist turnover on a year-to-date basis at the end of the third quarter was less than 8%.

Our next question will come from Matt Larew with William Blair.

A follow-up a bit on the patient mix question, but obviously, it was another strong quarter on the MA side, as it has been really for the last several quarters in particular. And so similar to Kieran’s question, any particular patient categories or already trends to call out on the MA side?

In aggregate, total MA discharges for the quarter increased by approximately 13%, bringing the year-to-date figure to just below 18%. In the same store for MA, the growth was 11% for Q3 and just under 15% year-to-date. We continue to observe strong growth in MA for stroke patients. One important point to note regarding the overall discharge growth in MA is that our value proposition appears to resonate with MA plans across a broader patient spectrum, and we are also seeing an expansion in patient acuity.

Okay. And then just a follow-up on the hospital that you pulled forward from 24% to 23%. What really allowed you to accelerate that opening process? Is this related to the prefabrication that you've been doing? Or is this more of a licensing or staffing issue? And depending on what it is, can you apply this to the extensive pipeline you have in place right now?

Yes. So we'll be honest with you. The single biggest factor was favorable weather patterns. But it was also then we are getting more efficient with regard to the utilization of prefabrication. So that contributed. We've been stating all along that our objective with regard to the moving to full prefabrication was to realize a 15% cost reduction versus conventional and an improvement of 25% in terms of speed to market. So we're not quite there yet on all of the projects in the pipeline, but we're making good headway.

We've had staffing in that marketplace, focusing on the construction aspect rather than just being ready to take on the first patient.

Our next question will come from Ann Hynes with Mizuho Securities.

So the ramp-up cost of $10 million to $12 million this year, is that a good number to use for 2024, would be my first question? And then secondly, is there anything on the regulatory or legislative side that is on your radar for 2024?

So Ann, on the first one, I haven't quite put a pencil to it yet for 2024, but I think it's probably a pretty good proxy since we opened 8 this year, and we're looking to open up another 8 next year.

Ann, we remain focused on regulatory matters. This includes discussions about MedPAC with site neutrality and our previous comments on RCD, among other issues. However, I would say those two items are currently my primary concerns.

At this time, we have no further questions in queue. I will turn the call back to Mark Miller for any additional or closing remarks.

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

This does conclude today's call. We thank you for your participation. You may disconnect at any time.