Earnings Call Transcript - SEM Q2 2023

Operator, Operator

Good morning, and thank you for joining us today for Select Medical Holdings Corporation's Earnings Conference Call to discuss the Second Quarter 2023 Results and the company business outlook. Speaking today are the company's Executive Chairman and Co-Founder, Robert Ortenzio; and the company's Executive Vice President and Chief Financial Officer, Martin Jackson. Management will give you an overview of the quarter and then the call will open for questions. Before we get started, we would like to remind you that this conference may contain forward-looking statements regarding future events or the future financial performance of the company, including without limitation statements regarding operational results, growth opportunities and other statements that refer to Select Medical's plans, expectations, strategies, intentions and beliefs. These forward-looking statements are based on the information available to management of Select Medical today, and the company assumes no obligation to update these statements as circumstances change. I will now like to turn the conference over to Mr. Robert Ortenzio. Please go ahead, sir.

Robert Ortenzio, Executive Chairman and Co-Founder

Thank you, Operator. Good morning, everyone. Welcome to Select Medical's earnings call for the second quarter of 2023. Before I discuss each of our four operating divisions, I want to share some updates and comments. As you may know, we announced our preliminary estimate of certain financial results for the second quarter on July 19, related to our plans to refinance some of the company's debt. We completed that refinancing on July 31, and Marty Jackson will provide more details shortly. On August 1, U.S. News & World Report released its annual list of best hospitals, and I am happy to report that our Kessler Institute for Rehabilitation and six of our partnered inpatient rehab hospitals are among the best in the nation for 2023/2024. Kessler Institute is ranked third; California Rehab Institute is 21st; Baylor Scott & White Institute for Rehabilitation in Dallas is 22nd; Ohio Health Rehabilitation Hospital in Columbus is 34th; Cleveland Clinic Rehabilitation Hospital is 38th; TriHealth Rehabilitation Hospital in Cincinnati is 46th; and Banner Rehabilitation Hospital in Phoenix is 48th. This marks the 31st consecutive year that Kessler Institute has been recognized among the best for rehabilitation, and the third year in a row for Baylor Scott & White Dallas and Ohio Health. This acknowledgment reflects the dedication of our teams and the quality at each of these institutions. Financially, we had another strong quarter with all four of our operating divisions surpassing last year's revenue. Overall revenue increased by 6%, and adjusted EBITDA rose by 21% compared to the same quarter last year. The full reinstatement of Medicare sequestration and CARES Act grant income from the previous year posed challenges when compared to last year, equating to $4.8 million for Medicare sequestration and $15.1 million for CARES grant income. For the quarter, total adjusted EBITDA was $219.5 million, up from $181 million the year before. Our consolidated adjusted EBITDA margin was 13.1% for Q2, compared to 11.4% last year. If we exclude grant income and the impact of Medicare sequestration from the previous year, our prior year's adjusted EBITDA was $161.1 million with a margin of 10.2%. The critical illness recovery hospital division saw the most significant performance increase compared to last year, with a 227% rise in adjusted EBITDA, alongside an 8-point reduction in the salary, wages, and benefit ratio relative to revenue. The CIRH division's salary, wages, and benefit ratio to revenue stood at 56.7%, within our target range, along with a $43 million cut in agency expenses compared to the same quarter last year. As noted last quarter, Marty Jackson will provide further details on improvements in labor for critical illness. This division also had notable advancements, with three openings this past quarter. In May, we opened two hospitals in Tucson, Arizona, and Alexandria, Virginia. In June, we acquired a 60-bed critical illness hospital in Richmond, Virginia. This quarter, we recorded $5.1 million in startup losses for our new critical illness recovery hospitals. We have plans to open a critical illness recovery hospital, a distinct part rehabilitation unit in Chicago, with our joint venture partner Rush University System for Health in Q2 of 2024. Additionally, we have a robust pipeline of growth opportunities under consideration. The inpatient rehab hospital division continued to perform strongly, exceeding last year's quarter revenue and adjusted EBITDA. As mentioned in Q1, our development pipeline remains promising, with a 36-bed inpatient rehab hospital in Fort Wayne, Indiana, expected to close in Q3, in partnership with CHS. We've also partnered with Atlanta Care to construct a new rehabilitation hospital in Southern New Jersey, called Bacharach Institute for Rehab, pending regulatory approval, with an expected opening in 2025 or 2026. We foresee robust performance throughout this year. Concentra also achieved remarkable performance, exceeding last year's revenue, EBITDA, and patient volume. During the quarter, Concentra completed two transactions. The acquisition of Holland Medi Center in Michigan included a standalone clinic and a mobile unit, expanding our footprint about 30 miles from Grand Rapids into Holland, Michigan. Additionally, Concentra acquired One Source Occupational Medicine, integrating it into our nearby clinic in Tulsa, Oklahoma. Concentra has four signed leases for new de novo locations expected to open in Q4 2023, along with a strong pipeline of acquisitions and de novos being evaluated. This quarter, our outpatient rehabilitation division also surpassed prior year revenue and patient volume, entering a joint venture partnership with Atlanta Care in South Jersey, contributing 13 clinics where we are the managing partner and majority owner. The division added eight clinics this quarter through acquisitions and de novos, maintaining a robust growth pipeline with 27 executed leases for de novo clinics set to open in the second half of 2023, alongside numerous additional acquisition and development opportunities under review. We saw increases of 5% in net revenue, 2% in occupancy rates, and significantly a 227% rise in EBITDA for the critical illness recovery hospital division, marking an extremely successful quarter. Our occupancy stood at 68%, up from 67%. The case mix index shifted from 1.29 to 1.26, with nursing agency rates decreasing by 31% and utilization dropping by 44% year-over-year. Rates fell by 7% with consistent utilization since Q1 2023. Orientation hours declined by 14% year-over-year but rose by 24% compared to Q1 2023 as we continued to onboard full-time nurses. Nursing sign-on and incentive bonuses dipped by 35% year-over-year and 25% sequentially. Our adjusted EBITDA margin was 11.4% for the quarter, up from 3.7% in Q2 last year, with labor improvements contributing to this positive change. On the regulatory front, CMS recently issued the final LTAC rules for fiscal year 2024, effective October 1, which includes a 3.6% increase in the federal base rate, higher than proposed. The high-cost outlier threshold increased by $21,355, lower than the proposed increase. The final rule also updated the MS-LTAC-DRG relative weight and expected lengths of stay. Our inpatient rehab hospital division reported a 5% increase in net revenue, with patient volumes up 1% and rate per patient day rising by 4%. Occupancy decreased slightly to 84% from 86% last year. The adjusted EBITDA margin for inpatient rehab reached 23% for Q2, compared to 21.8% last year. Last week, CMS released the final inpatient rehab rules effective October 1, indicating a 3.7% increase in the standard payment amount, also higher than previously suggested. The high-cost outlier threshold rose by $2,103, slightly less than the proposed change. Updates were made to CMG relative weight and average length of stay values in the final rule as well. Concentra's net revenue grew by 6%, driven by a 2% increase in volume and a 6% rise in rate. Work comp net revenue per visit improved by 2%, and employer services rate went up by 9%. Concentra's adjusted EBITDA margin for the quarter was 21.5%, up from 21% in the same quarter the previous year. Our outpatient rehab division saw a 6% increase in net revenue, with patient volumes rising by 11%, though rates dropped from $103 to $100 per visit year-over-year. The volume increase spanned multiple markets, aided by initiatives to enhance clinical productivity. However, the rate decline stemmed from decreases in the outpatient Medicare fee schedule and changes in payer mix. The outpatient division's EBITDA dipped slightly by $751,000 from last year, and their EBITDA margin was 10.8% this quarter versus 11.7% in the same quarter last year. Earnings per fully diluted share reached $0.61 for the second quarter, compared to $0.43 in the same quarter last year. Regarding our capital allocation, our Board of Directors declared a cash dividend of $0.125 payable on September 1, 2023, to shareholders of record as of August 15, 2023. This past quarter, we did not engage in any share repurchases under our authorized program. We will continue to assess options for stock repurchases, debt reduction, and development opportunities. This concludes my remarks, and I will now turn it over to Marty Jackson for additional financial details before we open the floor for questions.

Martin Jackson, CFO

Thank you, Bob. Good morning, everyone. Consistent with the previous three quarters, I'd like to provide some additional details on our progress regarding labor costs in the critical illness recovery hospital division. This past quarter, we saw a sequential reduction from Q1 to Q2 in our total RN agency costs and RN agency rates, while agency utilization remained steady. We achieved reductions of 7% in RN agency costs and 7% in the hourly rate for agency RNs, decreasing from $83 to $77. Our agency utilization remained at 18% over the last three quarters. There were slight fluctuations in agency rates and costs as the quarter progressed, with rates moving from $79 in April to $78 in June. The RN agency costs were $7.9 million in April, $7.4 million in May, and $6.7 million in June, and agency utilization was 19% in April and May, dropping to 17% in June. Additionally, we saw a 25% reduction in nursing sign-on and incentive bonuses compared to the prior quarters, while our hospital administrative salaries, wages, and benefits remained consistent with Q1. This quarter, the number of orientation hours increased sequentially from Q1 2023 by 24%, averaging 40,000 hours per month throughout the quarter. Overall, our SW&B to net revenue ratio slightly increased from Q1 to 56.7%, up from 56.3%, which remains within the targeted range we previously communicated. Moving on to our financials, in Q2, equity and earnings of unconsolidated subsidiaries were $10.5 million, compared to $6.2 million in the same quarter last year. Net income attributable to non-controlling interests was $13.6 million, up from $11.1 million in the previous year. Interest expense was $49 million in the second quarter, an increase from $41.1 million in the same quarter last year, primarily due to rising interest rates compared to Q2 2022. At the end of the quarter, we had $3.8 billion in outstanding debt and $101.2 million in cash on our balance sheet. This total debt includes $2.1 billion in term loans, $345 million in revolving loans, $1.2 billion in our 6.25 senior notes, and $77.1 million in other miscellaneous debt. We ended the quarter with a net leverage ratio of 5.06 times under our senior secured credit agreement. As of June 30, we had nearly $250 million available on our revolving credit facility. As Bob previously mentioned, we completed a refinancing transaction on July 31, amending and extending our $2.1 billion term loan B and increasing our senior secured revolving credit facility by $60 million, from $650 million to $710 million. Both the term loan and the revolver have been extended for two years, maturing on March 6, 2027, with an early maturity trigger if more than $300 million of senior notes remain outstanding as of May 15, 2026. The refinancing term loan is priced at SOFR plus 300 basis points, with a step down of 25 basis points if our net leverage ratio falls below 4 times. The revolver is priced at SOFR plus 250 basis points, also with a step down if the net leverage ratio drops below 4 times. It's worth noting that the 1% SOFR interest rate cap on our $2 billion term loans will remain effective through September 30, 2024. Our $1.2 billion of 6.25 senior notes will mature on August 15, 2026. In the second quarter, operating activities generated nearly $235 million in cash flow; our days sales outstanding was 52 days as of June 30, 2023, compared to 53 days on June 30, 2022, and 54 days as of March 31, 2023. Investing activities utilized $66.8 million in cash in the second quarter, including $59.5 million for property and equipment purchases and $7.3 million for acquisition and investment activities. Financing activities used $150.6 million for the quarter, consisting of $115 million in net payments on our revolving line of credit, $14.3 million in net payments on other debt, and $15.9 million in dividends on our common stock. As mentioned earlier, we did not repurchase any shares under our Board authorized repurchase program during this quarter. The program remains active until December 31, 2023, unless extended or terminated earlier by the Board. We're adjusting our business outlook for 2023, expecting revenue to be in the range of $6.55 billion to $6.7 billion, adjusted EBITDA between $795 million and $825 million, and fully diluted earnings per share in the range of $1.77 to $1.94. Select Medical anticipates adjusted earnings per share to be between $1.86 and $2.03, excluding losses from early retirement of debt and related costs and tax effects. Capital expenditures are projected to be in the range of $190 million to $210 million for 2023. This concludes my remarks, and I will turn it over to Marty Jackson for further financial details before we open the call for questions.

Justin Bowers, Analyst

Hi, good morning everyone. Bob, just wanted to clarify one thing on the LTAC. Is the next de novo or JV coming online in 2024 or is there anything left in the rest of the year this year?

Robert Ortenzio, Executive Chairman and Co-Founder

Just RUSH is the one that's next based on deals that we've announced. So anything else that we would do before that we've not announced yet.

Justin Bowers, Analyst

Got it. And then just on outpatient, given the landscape over the last year or so, is the plan for you guys to sort of stay the course with your JV approach and sort of building around your existings, or is there any appetite to do something with greater scale?

Robert Ortenzio, Executive Chairman and Co-Founder

I would say at this point there is no appetite to do anything on a broader scale. We feel really good about our opportunities for creation of value by adding incrementally in markets where we have a presence and also snapping outpatient onto our many joint venture agreements that are growing pretty rapidly. So I would say to you that we are probably not in the market for a bigger transaction in the outpatient space.

Justin Bowers, Analyst

Okay. Thanks. And Marty, healthy free cash flow generation in the first half especially in 2Q. How are you guys thinking about CapEx in the second half and then just given the attractive spread in T-bills versus the rate cap how should we think about the deleveraging going forward through September 2024? Is that just more of a function of the EBITDA growth or is there going to be some pay down along the way?

Martin Jackson, CFO

Yes, Justin. Regarding the free cash flow, we expect to see a decrease in our revolver balances, which should result in completely eliminating any borrowings by the end of 2024. We will continue to pay down debt, so you can anticipate a reduction in leverage not only from increased EBITDA but also from this debt reduction.

Ben Hendrix, Analyst

Thank you very much. Just a follow-up question on your LTAC final rule comments. We're definitely glad to see that outlier threshold come down from the proposal, but it still seems like a pretty significant hike. How are you thinking about the financial impact of that to your critical illness segment from 3Q to 4Q and then into next year? Thank you.

Martin Jackson, CFO

Yes. There is no doubt that the increase in the high cost outlier number will present some challenges, but we are focused on finding ways to address that.

Ben Hendrix, Analyst

Okay. And then just overall the rate increase 3.5% or thereabouts, how does that translate do you think for Select Medical specifically kind of given your case mix and thanks.

Martin Jackson, CFO

Ben, could you clarify that question regarding how it relates to the segment from 3Q to 4Q and then into next year? Thank you.

Ben Hendrix, Analyst

Yes, how do you expect the rate update to differ for Select compared to the finalized 3.5%?

Martin Jackson, CFO

No, we anticipate it will be in that neighborhood for us. You can expect to see increases for our Medicare dollars increase by that percent. I think that's a good number to use in your model.

Ben Hendrix, Analyst

Yes.

Martin Jackson, CFO

I think you'll see better increases on the commercial side. We've been in that negotiated rates range of over 5 percent. For Medicare, I believe it's around 3.5 percent, with a deduction of approximately 0.2 percent for efficiency improvements.

Robert Ortenzio, Executive Chairman and Co-Founder

Yes, Ben, the LTAC business is complex. The recent final rules bring a lot of adjustments; the high cost outlier threshold affects us, along with the rate increase. Our business mix, including the case mix index and the proportion of respiratory and pulmonary cases, also influence our operations. Moving forward from these rules into next year, we will analyze all these factors to optimize our strategies and aim for growth in this segment.

Ben Hendrix, Analyst

Got you. Thank you. And just quickly, finally, do you expect this, the high cost outlier to drive any industry disruption that could create a consolidation opportunity for you guys?

Robert Ortenzio, Executive Chairman and Co-Founder

I do not.

Kevin Fischbeck, Analyst

All right. Great. Thanks. Maybe just to stay on Medicare rates, do you have a similar comment on IRFs? What do you think the kind of net rate to you guys will be on the IRFs rule?

Robert Ortenzio, Executive Chairman and Co-Founder

Yes, I mean, I think that we were pretty satisfied with the LTAC rule and/or the rehab rule. And I think we've got a little bit of a tailwind on the final rule there as we're looking forward to Q4 and into next year, Kevin.

Kevin Fischbeck, Analyst

Okay. And then obviously a lot of progress on SW&B. Wanted to get a sense from you guys where you thought you were in that progress. We all love baseball analogies, so like what inning are we on the improvement there? Is there much to go still from here, or is this the right way to think about SW&B heading into 2024?

Martin Jackson, CFO

Yes, Kevin, I think throughout the balance of the year, we'll be in that 55% to 57% range. Now we see that dropping down in 2024 and 2025. And the reason being, remember, we're not just focused on the cost here; I mean SW&B as a percentage of revenue has a revenue component to it. So our commercial contracts are basically three years. The terms on those are three years. So we'll be negotiating increases in those. We're done about a third of our contracts now, so we'll be negotiating in 2024/2025 for the balance of the contracts. We anticipate as we do that, we get decent increases there. We would expect to see SW&B as a percentage of revenue continue to come down through 2025. And our focus is really to get it back to that historical rate of 52%.

Kevin Fischbeck, Analyst

Okay. That's great. So when we think about that improvement though, you're saying that the improvement is less about further declines in bill rates or utilization per se, and it's more about getting the top-line growth to kind of match inflation?

Martin Jackson, CFO

That's correct.

Kevin Fischbeck, Analyst

Okay. Great. And then maybe just one last question regarding the outpatient side. With rates being down, should we plan for this as we move into next year? I understand there is still another proposed rehab rate cut for next year, or is there anything unusual to consider? You mentioned the payer mix; is there a reason to anticipate that rates next year will improve compared to this year?

Robert Ortenzio, Executive Chairman and Co-Founder

Yes, there is. We anticipate that going into next year, we think it's going to rebound back to at least be in that $102, $203 range.

Kevin Fischbeck, Analyst

What's driving that?

Robert Ortenzio, Executive Chairman and Co-Founder

Again, contracts and improvements in some other areas in the CBO.

Unidentified Analyst, Analyst

Hi, good morning. This is MJ on for A.J. So I wanted to ask about the larger volume trends that we're seeing. Your volumes especially in IRFs and outpatient rehab are very strong. Do you see this as mostly deferred care flowing through a system, or do you see this more as more sustainable volume? Thank you.

Martin Jackson, CFO

Yes. Could you repeat that question?

Robert Ortenzio, Executive Chairman and Co-Founder

You're not coming through very clearly.

Unidentified Analyst, Analyst

Yes. I was asking about whether the volume that you're seeing on IRFs as well as outpatient rehab is a more, the deferred care flowing through the system after the pandemic, or is it more a sustainable volume?

Robert Ortenzio, Executive Chairman and Co-Founder

I believe that the business regarding IRFs and outpatient care is quite sustainable in this post-pandemic environment. The demand for both IRF and outpatient services is strong. For companies like ours, it mainly involves navigating local markets, managing competition, and negotiating rates. However, I don't see any systemic volume issues in either of these areas.

Martin Jackson, CFO

Yes. We don't believe it's due to pent-up demand from the pandemic. We expect to see continued increases like this.

Robert Ortenzio, Executive Chairman and Co-Founder

Yes. There's lots of things that can affect it in local markets; for example, staffing challenges that large systems continue to have, can oftentimes or sometimes affect their surgical volumes. And if surgical volumes, particularly on the orthopedic side are impacted in a local market, we're going to certainly see some pull through negative on that. But overall, when we look nationally, we see a return to a pretty strong business. Does that answer your question?

Unidentified Analyst, Analyst

Got it, thanks. I have one more question about LTAC pricing. I believe revenue per patient day increased by 4.5% and sequestration might be a challenge, along with a decrease in acuity mix. Why is pricing rising, and what can we expect in the latter half of the year?

Robert Ortenzio, Executive Chairman and Co-Founder

Well, I can tell you one thing on the acuity mix. In the winter months, when we tend to see more pulmonary, the acuity mix will go up. I don't think you should look at the acuity or the case mix index reduction that we commented on as being any kind of systemic signal or reduction in acuity of our patients. In fact, we continue to see increased acuity in our critical illness hospital. So I think that will continue to remain strong. And as you know, there is some seasonality in our business.

Martin Jackson, CFO

Yes. I think the other thing is, as you know, we're paid on a DRG, so to the extent that the length of stay goes down, which it did during the quarter, that's going to have a positive impact on the rate.

Operator, Operator

Thank you. I am currently showing no further questions at this time. I'd like to hand the conference back over to Mr. Robert Ortenzio for closing remarks.

Robert Ortenzio, Executive Chairman and Co-Founder

Closing remarks, thanks, everybody for joining us and look forward to updating you again next quarter.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.