Earnings Call Transcript - ENSG Q4 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the Ensign Group, Inc. Fourth Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I will now hand the conference over to Mr. Keetch.

Chad Keetch, Investor Relations

Thank you, and welcome, everyone, and thank you for joining us today. We filed our earnings press release yesterday, and it is available on the Investor Relations section of our website at ensigngroup.net. A replay of this call will also be available on our website until 5:00 p.m. Pacific on Friday, March 3, 2023. We want to remind any listeners that may be listening to a replay of this call that all statements are made as of today, February 3, 2023, and these statements have not been or will be updated subsequent to today's call. Also, any forward-looking statements made today are based on management's current expectations, assumptions and beliefs about our business and the environment in which we operate. These statements are subject to risks and uncertainties that could cause our actual results to materially differ from those expressed or implied on today's call. Listeners should not place undue reliance on forward-looking statements and are encouraged to review our SEC filings for a more complete discussion of factors that could impact our results. Except as required by federal securities laws, Ensign and its affiliates do not undertake to publicly update or revise any forward-looking statements where changes arise as a result of new information, future events, changing circumstances or for any other reason. In addition, the Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenues. Certain of our wholly owned independent subsidiaries, collectively referred to as a service center, provide accounting, payroll, human resources, information technology, legal, risk management and other services to the other operating subsidiaries through contractual relationships with such subsidiaries. And in addition, our wholly owned captive insurance subsidiary, which we refer to as the insurance captive, provides certain claims made coverage to our operating companies for general and professional liability as well as for workers' compensation insurance liabilities. Ensign also owns Standard Bearer Healthcare REIT, Inc., which is a captive real estate investment trust that invests in health care properties and enters into lease agreements with certain independent subsidiaries of Ensign as well as third-party tenants that are unaffiliated with the Ensign Group. The words Ensign, company, we, our and us refer to the Ensign Group, Inc. and its consolidated subsidiaries. All of our operating subsidiaries, the Service Center Standard Bearer Healthcare REIT and the insurance captive are operated by separate wholly owned independent companies that have their own management, employees and assets. References herein to the consolidated company and its assets and activities as well as use of the terms we, us, our and similar terms we may use today are not meant to imply nor should it be construed as meaning that the Ensign Group has direct operating assets, employees or revenue or that any of the subsidiaries are operated by the Ensign Group. Also, we supplement our GAAP reporting with non-GAAP metrics. When viewed together with our GAAP results, we believe that these measures can provide a more complete understanding of our business, but they should not be relied upon to the exclusion of GAAP reports. A GAAP to non-GAAP reconciliation is available in yesterday's press release and is available in our Form 10-K. And with that, I'll turn the call over to Barry Port, our CEO.

Barry Port, CEO

Thank you, Chad, and thank you for joining us today. We were pleased to announce yesterday another record quarter. These results demonstrate yet again that our local leaders and their teams continue to be the examples of post-acute excellence as they wade through the evolving landscape in each of their markets. They have again achieved record results in spite of the continued disruption in labor markets. Remarkably, we saw continued improvement in occupancies, skilled revenue and managed care revenues. We are particularly pleased that we achieved sequential growth in overall occupancy for the eighth consecutive quarter, with same-store transitioning operations increasing by 2.9% and 4.3%, respectively, over the prior year quarter. As of the end of the quarter, our same-store occupancy reached 77.8%, and we continue to get closer to our pre-COVID occupancy levels, which was at 80.1% in March of 2020. We are amazed by the commitment of our caregivers and their continued endurance and strength. We've also been very pleased with the progress we've made in improving our skilled mix. As those who have followed us know, growth in skilled mix only happens after our local teams demonstrate over and over that they can achieve successful outcomes for sicker patients that need more advanced care. During the quarter, our same-store operations grew their skilled mix revenue by 9.1% over the prior year quarter. Additionally, in the wake of the pandemic, there's been a lot of noise around potential shifts to home-based care or lack of support for inpatient post-acute services from hospitals and managed care providers. But when compared to pre-COVID levels, our skilled mix has remained elevated, showing just how important high-quality post-acute services are within the continuum of care. We've always been confident that our skilled mix would continue to be strong but we are very pleased to see this continuous fundamental growth and skilled mix as it demonstrates the increasing and sustainable demand for skilled post-acute services without a significant impact from COVID. We continue to be impacted by the labor environment, but we are very encouraged by the improvement in several key internal performance areas that show that these issues are stabilizing. For example, we continue to see the rate of wage inflation slowing down as we've experienced two quarters in a row of slower wage growth. In addition, while our use of agency labor is still high, higher than we'd like it to be, we are encouraged to see several markets becoming less and less reliant on agency labor. In addition, we also expect that as wage inflation moderates that our need for agency labor will also continue to decrease. Lastly, we are also very pleased to see improvements in our employee turnover due to our leaders' relentless effort to create an employee-focused culture that aligns with our collective core values. Recently, the federal government extended the state of emergency to April 2023, which keeps in place many of the regulatory and other reforms of assistance helpful to patient care. Additionally, the government has indicated that the PHE will end in May of 2023. We also continue to benefit from FMAP bolstered Medicaid funding in several states, some of which will end or phase out throughout the year. However, this federally supported funding will be replaced in large part with appropriate state-based funding, ensuring a relatively smooth transition. In addition to occupancy growth and continued skilled mix improvement, one major aspect of our company's resilience has been and continues to be our local leaders' ability to acquire struggling operations and transform them into facilities of choice for their communities. This ability, combined with a strong balance sheet allows us to increase the number of acquisitions we do in times of uncertainty when many operators are choosing or being forced to exit the industry. With the 17 acquisitions that we completed on February 1, we have now added 37 affiliated operations since July 1, 2022. We remain confident that our operating model will continue to allow each operator to form their own market-specific strategy and adjust to the needs of their local medical communities, including methods for attracting new health care professionals into our workforce and retaining and developing existing staff. These transitions will take time, particularly given the higher-than-normal reliance on agency staffing prior to the acquisition. But with each new operation, we are creating new opportunities for the next generation of leaders and look forward to working together to help each operation reach its enormous clinical and financial potential. I want to speak briefly about our ability to execute on the acquisition of a larger portfolio. In November, we announced that we agreed to acquire 20 California buildings that have been operated by North American health care, which we will operate. Just two days ago, we closed the transaction, and we're very excited and encouraged with how things have gone so far. Over the last few months, we've had several investors ask us about our ability to execute on larger acquisitions while reminding us that the last larger deal we closed was the Legend transaction in Texas, which was a similar size. Those that were following us back in 2016 will remember that the Legend transaction took several quarters to produce the results we expected. We were very open about the lessons we learned that made that transition a little more challenging than we anticipated. But as we look back, we worry we haven't done a good enough job at telling the massive success story that the Legend operations have become. Those operations have been contributing a significant amount to our earnings for several years now and are currently achieving a lease to EBITDAR coverage of 2.1 times. To give an even clearer picture, the EBITDAR growth from acquisition until the end of 2022 has increased by over 160%. We certainly made some missteps early on in our approach to the Legend acquisition, but even with those short-term setbacks, we would not be as strong as we are today in Texas without them, and we'll definitely do that deal over and over again. I'd point to this example not to suggest that we expect the exact same results in this new portfolio. I do so only to underline how we look at acquisitions, including larger portfolios. We never acquire something for its short-term impact. We acquire a single building or 17 if and when we see significant opportunity to create lasting long-term value for our portfolio. For the last several months, we have been preparing for these additions and have been implementing lessons learned in 2016 and 2017. All transitions take time, and we expect these will be no different, but we are thrilled and grateful to have the opportunity to work together with our new partners in this California portfolio as well as the other geographies and look forward to the contribution they will make to this organization over the next 20 years. As we evaluate our expanding portfolio, we see more organic growth potential within our existing portfolio than ever before. As we relentlessly follow and protect the cultural fundamentals that got us here, we are confident that we will continue to consistently produce world-class clinical and financial performance. We are very humbled by what we were able to accomplish in 2022 while dealing with so many unusual challenges. But we also know we can still do much better and are excited about the potential within our portfolio as we continue to apply our proven locally driven health care model. We are issuing our annual 2023 earnings guidance of $4.60 to $4.74 per diluted share and annual revenue guidance of $3.55 billion to $3.62 billion. The midpoint of this 2023 earnings guidance represents an increase of 12.8% and over our 2022 results and a 28.3% higher than our 2021 results. We are excited about the upcoming year and are confident that our partners will continue to manage and innovate through all of the lingering challenges on the labor front. And when we consider the current health of our organization, combined with our culture, and proven local leadership strategy, we feel we are well positioned to have another outstanding year in 2023. Next, I'll ask Chad to discuss our recent growth.

Chad Keetch, Investor Relations

Thank you, Barry. As we expected, we continue to add to our growing portfolio and are very excited about the 12 new operations we added during the quarter. These newly acquired operations include three skilled nursing operations in South Carolina, one skilled nursing operation in Arizona; six skilled nursing operations in Texas; and two skilled nursing operations in Colorado, totaling an additional 1,505 new operational beds. We always place the highest priority on growth opportunities within our existing footprint and are very excited about the additions to some of our most mature markets like Arizona and Colorado. Each of these operations was very carefully selected and will bolster our ability to fulfill the needs of our health care partners and geographies we didn't previously or it simply enhances our service offerings and markets we have been in for years. We are also particularly excited about completing our first set of acquisitions in South Carolina since we entered that state several years ago. As we said before, entering new states is challenging and can often take time to gain the trust of the local health care community. Each of these operations in South Carolina is off to a great start, and we hope that we will be able to continue to build the Ensign footprint in the Mid-Atlantic region. In addition, we also completed the previously announced acquisition of 20 skilled nursing operations in the state of California that have been operated by North American health care. The real estate assets are all owned by Sabra Health Care REIT and have been added to our long-term triple-net master lease with them. As we said when we announced this transaction last November, we are honored that Sabra will be entrusting us with the operation of this portfolio and are very excited to expand our growing relationship with them. These California operations are a perfect fit with our existing footprint in some of our strongest and most mature markets, as well as giving us an opportunity to move into the Bay Area. As we evaluated the size and scope of the 20 building portfolio, there were three operations located in the Sacramento area that were geographic outliers for us. In addition, given the size and scope of the remaining 17 operations and the amount of resources that are necessary to transition that many operations at one time, we determined that the best course of action was to partner with another like-minded operator on those three operations. So as of February 1 and with Sabra's consent, we entered into a sublease for the three Sacramento operations with Aspen Healthcare. In total, Ensign affiliates will operate 17 of the 20 buildings, adding 1,462 operational beds to Ensign's portfolio and Aspen will operate three of the 20 buildings, representing 245 operational beds. Just a side note, these subleased operations will not contribute to our overall performance. Aspen is a very reputable operator that currently operates 34 skilled nursing facilities in California. We have enormous respect for Aspen as an operator and believe that they are in a great position to build on the quality reputation these buildings already enjoy. They also have a strong balance sheet and have provided the company level guarantee of their obligations under the sublease. As an aside, while this is not a situation where we own the real estate, as we've discussed for some time now, part of our strategy with our internal REIT is to expand our ability to take on larger acquisitions while sharing part of the portfolio with other talented operators. And preparations for future deals, Standard Bearer REIT had previously engaged in several discussions with Aspen about splitting up the portfolio in a similar way. So when this opportunity came along, the foundation that we had built with Aspen made this a very smooth process. We look forward to working with them and doing additional deals with Aspen and other operators like them. As for the 17 facilities that we will be operating, our local leaders in California with the support of the service center have been working tirelessly to prepare for this transition. While the transaction is larger than our typical tuck-ins, our locally driven approach to acquisitions allows us to rely on the dozens of CEO-caliber leaders we have in these markets to direct the transition of each operation in the same way we execute a one or two building acquisition. We are also extremely grateful to Sabra for their support during this period. We have been so impressed with the Sabra team and it's truly a pleasure to work with the real estate partners that really get it. We also want to thank North American for their cooperation during this very complicated process. Due to the uniquely public nature of this transaction, we were very grateful to be given early access to these operations during the pre-transition phase. We look forward to working together with the outstanding leaders and teams already in place in these operations to build a strong clinical and build on the strong clinical and operational reputations they have earned in their communities. As we evaluate growth from last year in cents, which including these recent California acquisitions totaled 46 new operations, we can see that our discipline is paying off. While there were literally several hundred opportunities over the last 12 to 18 months, we remain patient and careful to stick to our fundamental growth principles. As with any transition, it will take time for these operations to contribute to the bottom line. However, these operations are coming to us with a solid foundation of clinical and operational strength. And when combined with an infusion of Ensign cultural and operational principles, we are confident that these operations will thrive and become solid contributors to each of their markets and clusters. During the year, Standard Bearer added 10 new real estate operations, all of which will be leased to an Ensign affiliated tenant, and Ensign affiliates entered into 39 new long-term leases with third-party landlords, as this recent activity illustrates the ratio between leased and owned will vary depending on the circumstances. We are, first and foremost, focused on the operational health of all our acquisitions. So when it makes sense and pricing is right, we will opportunistically purchase the real estate. But at the same time, when attractive long-term leases come our way, we'll sign those too. And as we've shown over our 23-year history, there will be many opportunities to do both. Looking forward, we are preparing for even more growth in 2023. While we expect the pace of our closings to slow for the coming months, we continue to see a wide range of large, medium-sized and small portfolios. The past couple of years have been very difficult for skilled nursing operators, and we see evidence of that in low occupancy and high utilization of contract labor and poor clinical and financial health of the facilities that we have recently acquired. As a result, we still expect that there will be lots of opportunities that will arise throughout the year. But as we said before, we will continue to stay true to our strategy of disciplined growth.

Spencer Burton, COO

Thanks, Chad. As Barry and Chad have indicated, an important part of our story has been our local leaders' ability to acquire struggling operations and transform them into Ensign-caliber operations. Those of you who are familiar with Ensign's history know that our organization was born in challenging times, and our model has proven time and time again that industry challenges present great opportunities to innovate and thrive. While there continues to be significant growth potential in our same-store facilities, because of recent acquisition growth, the two facility highlights I want to share today are operations in our transitioning category. These examples illustrate the post-acquisition turnaround process that continues to be so fundamental to our long-term success. The first highlight is surprise rehabilitation, located in the Phoenix, Arizona Metro area. This 100-bed facility was a new build that had been shuttered due to the prior owner's struggles with local licensing and regulatory authorities. When it was acquired in August of 2019, the facility had no residents and no staff. With the support of our cluster partners and the strong Bandera resource team, CEO, Brian Lorenz, COO, Heather Rucker; and Executive Director, Derek Bowen, systematically began building a team that shared their vision. Their vision attracted great health care professionals and soon their centers and reputation were growing. The team worked relentlessly on developing high clinical standards and improving staff competency. As a result, the facility has increased its capacity to successfully treat high-acuity patients, including those needing ventilators and other respiratory care. Despite the challenging acuity, Heather and her team have attained and maintained a five-star overall rating from CMS as well as a five star score for quality measures. These clinical accomplishments have been made possible through the Surprise team's commitment to creating a unique environment where people want to work. These efforts not only resulted in reduced staff turnover but also led to less reliance on agency staff despite being in an extremely competitive labor environment. This employee-centric culture also enabled Surprise Rehab to innovate in ways that would have been impossible for most facilities. For example, in 2021, as health care staffing challenges reached a crescendo, the team created a CNA training school that has been recognized as a model throughout Arizona. This program has already produced over 150 new CNAs at Surprise and has been duplicated by other Ensign affiliates in Arizona to produce over 500 graduates to date. With its strong quality outcomes and healthy culture, financial outcomes have naturally followed. For example, the facility ended 2020 at 57% occupancy. This number grew to 85% in 2021, and the facility ended 2022 averaging over 95% occupied for the entire year. With high occupancy and skilled clinical staff, the Surprise team was able to fine-tune their skilled mix, and in Q4 at over 98% skilled days. As you would expect, total revenues increased, and EBIT improved 73% in Q4 2022 over the prior year quarter. Growing a facility from 0% to 95% occupancy is an impressive feat in normal times. But to do it in the midst of a global pandemic and unprecedented health care staffing challenges is truly incredible. While the Surprise highlight demonstrates the incredible outcomes that are possible in a fully transitioned operation, our second facility highlight provides a glimpse into a facility that's at an earlier stage in the transition process. The Oaks at Lakewood is an 80-bed skilled nursing and rehabilitation center located near Tacoma, Washington. Prior to acquisition in mid-2021, this facility was plagued with physical plant issues, a historically poor reputation in its community, low occupancy and was utilizing large amounts of agency nursing staff. However, Executive Director, Kasey Bradburn and DON, Erlinda Calsado saw the facility's potential and together with their cluster partners began establishing a positive culture and inspiring hope of what the facility could become. While there have been many long hard days, their diligence and their discipline in doing the right things has started to pay off. Today, the Oaks at Lakewood is rated four stars by CMS and is gaining the respect of the local provider community. Turnover is down markedly from 2021 levels. During the last two quarters, the facility has not utilized a single shift of agency labor despite occupancy improving from 79% in Q4 of 2021 to 86% in the fourth quarter, with skilled Medicare days improving by 91% during that same period. This occupancy growth has translated to a 27% revenue increase for Q4 2022 over the prior year quarter. Because of the facility's success in eliminating costly agency staff, EBIT has improved by 56% over Q4 2021. While acquisitions are difficult and they require a significant investment from our local operators, these two examples demonstrate just how rewarding the work can be. We hope that these examples help illustrate some of the many different levers that our local operators are pulling in order to meet the needs of their health care continuum partners. With that, I'll turn the time over to Suzanne to provide more detail on the Company's financial performance and our guidance.

Suzanne Snapper, CFO

Thank you, Spencer, and good morning, everyone. Detailed financials for the quarter and year are contained in our 10-K and press release filed yesterday. Some additional highlights include the following for the year. GAAP diluted earnings per share was $3.95, representing an increase of 15.5%, and adjusted diluted earnings per share was $4.14, an increase of 13.7%. Consolidated GAAP revenues and adjusted revenues were both $3.025 billion, an increase of 15.1%. The GAAP net income was $224.7 million, an increase of 15.4%, and adjusted net income was $235.7 million, an increase of 13.8%. For the quarter, GAAP diluted earnings per share was $1.06, an increase of 23.3%, and adjusted diluted earnings per share was $1.10, an increase of 13.4%. The GAAP net income was $60.5 million, an increase of 24.1%, and adjusted net income was $62.7 million, an increase of 14.1%. Other key metrics as of December 31 include cash and cash equivalents of $316.3 million, cash flow from operations of $272.5 million, and $593 million of availability on our revolving line of credit. We continue to provide additional disclosure on Standard Bearer, which is now comprised of 103 properties owned by the Company and are leased to 75 affiliated skilled nursing and senior living operations as well as 29, which are senior living operations that are leased to the Pennant Group. Each of these properties is subject to triple-net long-term leases and generated rental revenues of $19.4 million for the quarter, of which $15.6 million was derived from the Ensign affiliated operations. Also, Standard Bearer produced $13 million in FFO and had an EBITDA to rent coverage ratio of 2.4 times. We continue to delever our portfolio, achieving a lease-adjusted net debt-to-EBITDAR ratio of 1.98 times, a decrease of 2.13 times from last year. We also own 108 assets, 84 of which are unlevered with significant equity value that provide us with even more liquidity. During the quarter, we increased our cash dividend to $0.0535 per share for the 20th consecutive annual dividend increase. Given our strength, we plan to continue our 20-year history of paying dividends into the future. We also want to address the current status of the state of emergency and reimbursement matters. Recently, HHS extended the public health emergency for another 90 days. Separately, enhanced FMAP funding was approved and will be stepped down through 2023. Additionally, the White House has made several comments that it intends to end the PHE on May 11, 2023. As Barry mentioned, we will be providing our annual earnings guidance of $4.60 to $4.74 per diluted share and annual revenue guidance of $3.55 billion to $3.62 billion. We have evaluated multiple scenarios and based on the strength in our performance and the positive momentum we've seen in occupancy and strong skilled mix as well as some additional strength in Medicaid and managed care programs, it gives us confidence that we will be able to achieve these results. Our 2023 guidance is based on diluted weighted average common shares outstanding of approximately $57.7 million, a tax rate of 25%; the inclusion of acquisitions anticipated to close in the first quarter of 2023, the inclusion of management's expectations for FMAP, grants, Medicare and Medicaid funding and reimbursement rates net of provider tax, with the primary exclusion coming from stock-based compensation. Other additional factors that could impact quarterly performance include variations in reimbursement systems, delays and changes in state budgets, seasonality in occupancy and skilled mix, the influence of the general economy and census and staffing, the short-term impact of our acquisition activities, variations in insurance goals, surges in COVID-19 and other factors. And with that, I'll turn it over to Barry.

Barry Port, CEO

Thanks, Suzanne. We want to again thank everyone for joining us today and express our appreciation to our shareholders for their confidence and support. We know that this year will be not without some unique challenges; however, we're encouraged by our operational strength and our core business. As always, we want to recognize our talented field leaders for their heroic efforts, along with those of our nurses, therapists, and other frontline care providers who continue to provide an industry-leading example of life enriching service to our residents, coworkers, and our communities. We're also appreciative to our colleagues at the service center who are working tirelessly to support our operations, enabling us to succeed in spite of the challenges we faced. Thank you for making us better every day. We'll now turn the Q&A portion of our call. Carmen, can you please instruct the audience on the Q&A procedure?

Operator, Operator

And it comes from the line of Ben Hendrix with RBC Capital Markets. Your line is open.

Ben Hendrix, Analyst

I just wanted to ask about your skilled mix momentum. Clearly, we're seeing evidence of your higher acuity capabilities, but also some COVID and respiratory impacts in there as well. How should we think about steady-state mix for your same-store portfolio? And then from a modeling standpoint, how should we think about skilled mix evolving through the year?

Barry Port, CEO

Sure. I'll speak generally about it and let Suzanne provide any additional insights she may have. As we compare our current skilled mix to where we were both last quarter and last year, as well as pre-COVID, we are quite confident in the strength and momentum we are building. Our goal is to advance in our ability to attract sicker patients, which is essential for us to be the best resource for our hospitals and managed care partners. This drives our need to be adaptable to their requirements, including the capability to care for more acute patients. In terms of COVID's impact this quarter, it was slightly higher than the same quarter last year but comparable to last quarter. We see that, although there was more COVID activity this quarter than the same quarter last year, the difference is not significant. This suggests that on a steady state basis, even during quarters with little COVID impact, we are still fundamentally in a stronger position than we were going into the pandemic. This momentum continues, and we are encouraged by it. Do you have anything to add to that, Suzanne?

Suzanne Snapper, CFO

No. I think you said it really well. I think one of the things that we've been noticing for the last couple of quarters is a little bit less dependent on the waivers and maybe that COVID and our skilled mix isn't as aligned. And so that, I think, as Barry mentioned, I think we're really excited for where we are and the relationships that we've made throughout the entire year with our managed care partners continue to be strong and as we continue to see that portion of the skilled mix build.

Ben Hendrix, Analyst

Just a quick follow-up. You've mentioned that states have been supportive of the PHE roll off and the soft landing there. But are there any quarterly cadence considerations we should keep in mind as we approach the second half of the year?

Suzanne Snapper, CFO

Yes, that's a great question. We have the announcement regarding the end of the Public Health Emergency, with the White House leaning towards a May date. As we consider this, we are planning to secure additional funding from states that have been supportive through that May date. Just as a reminder, those states are California, Arizona, and Texas. During our last call, we mentioned that California has distanced itself from any ties to the state of emergency and has committed to being supportive for the remainder of the year, which is reassuring. Arizona has also made thoughtful moves, considering how to allocate more funding towards the rate, and we've already started to see some of that funding materialize. Texas has been evaluating the Public Health Emergency and has introduced some grants that we expect to come in throughout the year. We do see a potential gap between the end of the state of emergency and when the grants may not be sufficient until the beginning of September. Overall, we feel positive about how the states are aligning and anticipate a combination of ongoing funding, additional rate increases, and the grant programs established by the states. Barry, did I miss anything?

Barry Port, CEO

I think that's it, Ben. Ultimately, our guidance indicates that we feel quite confident despite some minor uncertainties from state to state. Overall, we believe there is a clear path for us to avoid significant issues with state reimbursements as FMAP decreases. As we mentioned earlier, it doesn't just disappear; it gradually decreases. Even with that reduction, if there were no specific issues in Texas, for instance, I don't believe that would affect our outlook for the year at all.

Operator, Operator

One moment for our next question please. And it comes from the line of Tao Qiu with Stifel. Please proceed.

Tao Qiu, Analyst

Congrats on closing the North American transaction. So Barry, I really appreciate the comment on the performance of the Legend portfolio. So, on the North American assets, I think Sabra has reported that their EBITDAR rent coverage for these assets have been about 1.1 times. So it sounds like this should be accretive on day one. Are these California assets different from Legend or your typical turnaround opportunities if you look at them from either occupancy, skill mix or cost-saving potential? And how long do you think it would take you to get your stabilization? And as a follow-up, could you also comment on the leadership pipeline and the current capacity to take on more assets?

Barry Port, CEO

Yes, that's a great question, Tao. This portfolio is excellent. We had the chance to evaluate it a few years ago, and we are excited about it. We are familiar with these buildings and have competed with them before, which gives us valuable relationships with some of the leaders there. We believe this portfolio will be a strong addition. However, I want to mention that this is not just specific to North America, but reflects broader trends we are seeing. Due to global labor challenges, most buildings, including these, are utilizing a high amount of agency labor, which is more than what we typically experience. This causes some obstacles for traditional recovery, especially since removing agency labor in the current environment is quite difficult. This challenge impacts our ability to achieve our targets promptly. That said, these buildings are in good clinical condition and have a positive culture overall. I have visited several and met some of the leaders and clinicians there. Given the clinical stability in these facilities, we see it as an advantage for our progress, but we acknowledge it will still take some time. We maintain a long-term perspective on these challenges and will approach them methodically. Additionally, from an occupancy perspective, this portfolio has a low occupancy rate in California, which is another area we will focus on. There are other cost issues that we expect to manage more easily. While we are cautiously optimistic, I won't say these will contribute positively this year, but we hope the transition will be smoother than anticipated. We're planning for them to follow our typical success pattern over the coming quarters. From a leadership pipeline standpoint, Tao, we have a solid group of administrators and aspiring CEOs, and this is as strong as it's ever been despite low unemployment, which is a positive indicator. Our growth may be a bit more measured as we integrate these 35 buildings acquired in the past six months. However, we are positioned to take on more buildings, especially in regions where our acquisition activity has been limited recently. We will remain opportunistic and adopt a measured approach, with growth likely to be more pronounced in the latter half of the year rather than in the next few months.

Tao Qiu, Analyst

Yes. And my second question is we noticed that the DSO ticked up a little bit sequentially. I think we also saw that in your 10-K. We updated the risk disclosure around the growth of the Medicaid managed care organizations and the potential delay or reduction in Medicare reimbursement. Just curious, if you have any general observations about the billing and collection trends, and for managed care in general, anything worth calling out there?

Suzanne Snapper, CFO

Yes, great question and a couple of different aspects to that. Obviously, in the current quarter for Q4, we had a lot of acquisitions. And so what we talked about, and just want to remind people, during stages of heavy acquisitions are anticipated collections will be slower. That is just a normal part of doing acquisitions as we go through the change in ownership process and transfer everything over. As we kind of look for fourth quarter, it was just a little bit slower in normal and the normal basis as well. And that really had to do with a lot of managed care organizations and a couple of states paying a little bit slower than they normally do at the end of the year. With regards to the risk factor, what we added on, we did just want to highlight that there are more and more states that are changing from a direct pay system to a managed care system. So now almost all of our large states are all in managed Medicaid states. When the program goes from just a railer direct pay to managed Medicaid, the payments do come slower to us. And so, one of our big states, California switched in 2023 to that. And so we just want to get people a heads up that we'd expect some slowdown in our Medicaid collections in the state of California due to that transition.

Tao Qiu, Analyst

Got you. And a final question, if I may. If I look at the balance sheet, right, obviously, that's under levered and you have abundant liquidity and very strong cash flow. We are forecasting somewhere around $300 million of operating cash flow and really $200 million of free cash flow for the next few years. Just curious in terms of capital allocations, what are the things that you would prioritize? I know that you have raised the dividend. You had a stock repurchase program last year. How should we think about where you would allocate capital?

Chad Keetch, Investor Relations

Yes, Tao, I can take that. This is Chad. Certainly, acquisitions would be the top of our list. We see ourselves very much in growth mode and will continue to be. And then obviously, CapEx on the physical plants is another big spend, right? And one note on the cash flows, too. When we have large or heavier periods of acquisition like we have over the last six months, that can tend to have a little bit of a drag on our cash flows and as we see AR climb a little bit with just the nature of licensing and just part of kind of the process of a transition from one operator to another. So that will actually probably impact our cash flow a little bit. I think you'll see that. But yes, I mean, as we've talked about a lot, we keep our balance sheet the way it is so that we can be ready when great opportunities arise. And as I said in my prepared part of the script, I think we expect to see additional opportunities coming up this year and next and we want to be prepared for that. So, that's how we kind of look at the balance sheet.

Suzanne Snapper, CFO

And prepared both on the operating front as well as the Standard Bearer REIT front. So, I think as we kind of look at that multifaceted ability to acquire that would definitely be our number one use of those flows.

Operator, Operator

Thank you. One moment for our next question please. And it comes from the line of Scott Fidel with Stephens. Please go ahead.

Scott Fidel, Analyst

I wanted to follow up on the topic of operating cash flow and gain more insight into your projections for next year. You've maintained a position around $275 million for the past two years. Considering the impact of recent acquisitions, do you believe it's feasible for operating cash flow to increase in 2023 due to greater revenue scale? Or do you expect it to stay relatively stable, continuing the trend of the last two years? Additionally, what are your forecasts for capital expenditures?

Suzanne Snapper, CFO

Yes, that's a great question, Scott. When considering cash flows and the number of acquisitions we've made, the transition period can range from four months to a maximum of 18 months. As we analyze where those cash flows go, we aim to normalize them and anticipate that they will trend towards the middle of that range. After completing the licensing process, we then need to navigate the managed care process to re-credential them under our new license, which is another step that can take two to six months after the initial wait. Therefore, it's somewhat of a waiting game. As Chad mentioned regarding cash usage, we will likely need to utilize some working capital to manage these processes. We are hopeful because we have effective systems in place and expect things to proceed smoothly, though we are dependent on the individual state governments for processing times. Thus, it seems reasonable to anticipate a similar flow overall, as accounts receivable will grow.

Chad Keetch, Investor Relations

Just a little bit there. California tends to be one of the slower states too. Texas is faster than California and that's why it'll probably be a little more pronounced with this particular set of deals as well.

Suzanne Snapper, CFO

Different states have varying procedures for handling transactions. Texas tends to process things more quickly, resulting in immediate revenue loss for us. In California, we receive some cash upfront, followed by a waiting period, after which things resume. Each state has its own unique nuances, leading to fluctuations in revenue flow.

Barry Port, CEO

We haven't talked a whole lot very recently about Standard Bearer, but we mean, we've been preparing for this and are still thinking a great deal about opportunities for Standard Bearer. So having cash availability for deals that, again, may not fit our operating footprint but might be good real estate opportunities or something we always want to be ready for as well, not signaling that we have anything in the works necessarily, but we have great hopes for Standard Bearer to have some opportunities as well for growth.

Scott Fidel, Analyst

Understood. You have a strong amount of liquidity. As we aim to accurately model the operating cash flow, is it reasonable to expect that the dynamics from the fourth quarter will continue into the next quarter or two, before we see cash flow normalization in the latter half of the year? Would you consider this a reasonable baseline assumption?

Suzanne Snapper, CFO

I think that a reasonable baseline yes, a reasonable baseline assumption, knowing that we did just as much in Q1 as we did in Q4. And so, I think it's a reasonable baseline. And then as we can update you guys throughout the year, as we always do, as you see the cash come in or if we see somewhat extending with regards to the timing of the licensing process, which would make it less longer or if they tighten up and they do a great job at the states and you won't see it as pronounced in the cash flows.

Chad Keetch, Investor Relations

Got it. And then just my second question. Just interested if you can give us an update on your managed care contracting for 2023 and how you've seen your managed care rate trends sort of playing out relative to some of the inflationary dynamics? And then just interested to if you've had a chance, I'm sure you've started this for sure, to just dig into the managed care contracting at the North American facilities and whether you see opportunities to improve the managed care rates as you try to drive synergies off of those acquired properties?

Suzanne Snapper, CFO

That's a great question. We have some larger contracts that we feel positive about, especially as we've recognized that labor and overall costs have increased. One MCO provider has acknowledged this, while many others are still grappling with our rising costs. They're starting negotiations based on historical rate increases of around 2% to 3%. As we present our cost increases to them, this marks the beginning of our negotiations. We've had solid progress with a few, though some remain hesitant. The negotiation process may take a bit longer since we are requesting higher rates than they have usually accepted. However, we've seen significant success with some of the larger contracts. It's important to note that we typically have numerous smaller contracts rather than a single contract covering the entire company. This means that we receive updates throughout the year, which then influence our overall performance over that time frame.

Operator, Operator

Thank you. And with that we end our Q&A session for today. I would like to turn the conference back to Mr. Barry Port for his closing remarks.

Barry Port, CEO

Thank you everyone for joining us today, and we look forward to a great year.

Operator, Operator

Thank you. And this concludes today's conference call. Thank you for participating, and you may now disconnect.