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HLS > SEC Filings for HLS > Form 10-Q on 26-Oct-2012All Recent SEC Filings

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Form 10-Q for HEALTHSOUTH CORP


26-Oct-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") relates to HealthSouth Corporation and its subsidiaries and should be read in conjunction with our condensed consolidated financial statements included under Part I, Item 1, Financial Statements (Unaudited), of this report and our audited consolidated financial statements for the year ended December 31, 2011 and Management's Discussion and Analysis of Financial Condition and Results of Operations which are included in our Annual Report on Form 10-K for the year ended December 31, 2011 (the "2011 Form 10-K"). As used in this report, the terms "HealthSouth," "we," "our," "us," and the "Company" refer to HealthSouth Corporation and its subsidiaries, unless otherwise stated or indicated by context.
This MD&A is designed to provide the reader with information that will assist in understanding our condensed consolidated financial statements, the changes in certain key items in those financial statements from period to period, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our condensed consolidated financial statements. See "Cautionary Statements Regarding Forward-Looking Statements" on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors, to the 2011 Form 10-K.
Executive Overview
Our Business
We operate inpatient rehabilitation hospitals and provide specialized rehabilitative treatment on both an inpatient and outpatient basis. As of September 30, 2012, we operated 99 inpatient rehabilitation hospitals (including 2 hospitals that operate as joint ventures which we account for using the equity method of accounting), 26 outpatient rehabilitation satellite clinics (operated by our hospitals, including one joint venture satellite), and 25 licensed, hospital-based home health agencies. In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. While our national network of inpatient hospitals stretches across 27 states and Puerto Rico, our inpatient hospitals are concentrated in the eastern half of the United States and Texas.
Our core business is providing inpatient rehabilitative services. We are the nation's largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. Our inpatient rehabilitation hospitals offer specialized rehabilitative care across a wide array of diagnoses and deliver comprehensive, high-quality, cost-effective patient care services. The majority of patients we serve experience significant physical and cognitive disabilities due to medical conditions, such as strokes, neurological disorders, hip fractures, head injuries, and spinal cord injuries, that are generally nondiscretionary in nature and which require rehabilitative healthcare services in an inpatient setting. Our team of highly skilled nurses and physical, occupational, and speech therapists working with our physician partners utilize proven technology and clinical protocols with the objective of returning patients to home and work. Patient care is provided by nursing and therapy staff as directed by physician orders while case managers monitor each patient's progress and provide documentation and oversight of patient status, achievement of goals, discharge planning, and functional outcomes. Our hospitals provide a comprehensive interdisciplinary clinical approach to treatment that leads to a higher level of care and superior outcomes.
For 2012, our focus has been, and will continue to be, on providing high-quality, cost-effective care while seeking to invest our strong cash flows from operations in compelling growth opportunities in our core business. We will also continue to consider repurchases of our preferred and common stock, common stock dividends, and, if warranted, further reductions to our long-term debt (subject to changes in our operating environment). Thus far in 2012, we:
continued development of the following four, publicly announced de novo hospitals;

         Location           # of Beds   Construction Start Date Expected Operational Date
Marion County, Florida
(Ocala)                         40              Q4 2011                  Q4 2012
Littleton, Colorado (South
Denver)                         40              Q2 2012                  Q2 2013
Stuart, Florida (a joint
venture with Martin Health
Systems)                        34              Q2 2012                  Q2 2013
Southwest Phoenix, Arizona      40                TBD                      TBD


         received certificate of need approval to build a 50-bed inpatient
          rehabilitation hospital in the greater Orlando, FL market;


         acquired 12 inpatient rehabilitation beds in Andalusia, Alabama from a
          subsidiary of LifePoint Hospitals in order to add beds at our existing
          hospital in Dothan, Alabama;


         acquired the 34-bed inpatient rehabilitation unit of CHRISTUS Santa
          Rosa Hospital - Medical Center. The operations of this unit have been
          relocated to and consolidated with our existing hospital in San
          Antonio, Texas;


         entered into a letter of intent to acquire Walton Rehabilitation
          Hospital, a 58-bed inpatient rehabilitation hospital in Augusta,
          Georgia. This transaction is expected to close in the first quarter of
          2013;


         broke ground on a replacement hospital for HealthSouth Rehabilitation
          Hospital of Western Massachusetts which is currently leased;


         purchased, in conjunction with our joint venture partner, the land and
          building previously subject to an operating lease associated with our
          joint venture hospital in Fayetteville, Arkansas;

added 77 beds to existing hospitals;

repurchased 46,645 shares of our convertible perpetual preferred stock;

         amended the joint venture agreement related to St. Vincent
          Rehabilitation Hospital which resulted in a change in accounting for
          this hospital from the equity method of accounting to a consolidated
          entity. The amendment revised certain participatory rights held by our
          joint venture partner resulting in HealthSouth gaining control of this
          entity from an accounting perspective;


         amended and restated our credit agreement to, among other things,
          increase the size of our revolving credit facility from $500 million to
          $600 million, eliminate the former $100 million term loan ($95 million
          outstanding), extend the revolver maturity from May 2016 to August
          2017, and lower the interest rate spread by 50 basis points to an
          initial rate of LIBOR plus 1.75% (see "Liquidity and Capital Resources"
          below); and


         completed a registered public offering of $275 million aggregate
          principal amount of 5.75% Senior Notes due 2024 at a public offering
          price of 100% of the principal amount, the proceeds of which were used
          to repay amounts outstanding under our revolving credit facility and
          redeem 10% of the outstanding principal amount of our existing 7.25%
          Senior Notes due 2018 and our existing 7.75% Senior Notes due 2022 (see
          "Liquidity and Capital Resources" below).

In the three months ended September 30, 2012, discharge growth of 4.2% coupled with a 4.4% increase in net patient revenue per discharge generated 8.7% growth in net patient revenue from our hospitals compared to the same period of 2011. Discharge growth was comprised of 2.5% growth from new stores and a 1.7% increase in same-store discharges. Approximately 130 basis points of discharge growth from new stores resulted from the consolidation of St. Vincent Rehabilitation Hospital beginning in the third quarter of 2012, as described above. This revenue growth combined with improved operating leverage and labor productivity to result in a $15.3 million, or 19.3%, increase in operating earnings (as defined in Note 23, Quarterly Data (Unaudited), to the consolidated financial statements accompanying the 2011 Form 10-K) in the third quarter of 2012 compared to the same quarter of 2011. In the nine months ended September 30, 2012, discharge growth of 4.4% coupled with a 3.3% increase in net patient revenue per discharge generated 7.8% growth in net patient revenue from our hospitals compared to the same period of 2011. Our discharge growth included a 2.9% increase in same-store discharges during the first nine months of 2012 compared to the same period of 2011. This revenue growth combined with improved operating leverage and labor productivity to result in a $23.9 million, or 9.2%, increase in operating earnings in the first nine months of 2012 compared to the same period of 2011. Net cash provided by operating activities was $302.2 million for the nine months ended September 30, 2012 compared to $213.2 million for the same period of 2011. Net cash provided by operating activities increased for the nine months ended September 30, 2012 compared to the same period of 2011 due primarily to increased Net operating revenues, improved operating leverage, and a decrease in interest expense. See the "Results of Operations" and "Liquidity and Capital Resources-Sources and Uses of Cash" sections of this Item.
We believe the demand for inpatient rehabilitative healthcare services will continue to increase as the U.S. population ages, and we believe this demographic factor aligns with our strengths in, and focus on, inpatient rehabilitative care. Unlike many of our competitors that may offer inpatient rehabilitation as one of many secondary services, inpatient rehabilitation is our core business. We also believe we can address the demand for inpatient rehabilitative services in markets where we


currently do not have a presence by constructing or acquiring new hospitals. For additional discussion of our strategy and business outlook, see the "Business Outlook" section below.
Reclassifications
As of January 1, 2012, we reclassified our Provision for doubtful accounts from operating expenses to a component of Net operating revenues for all periods presented.
During the third quarter of 2012, we negotiated with our partner to amend the joint venture agreement related to St. Vincent Rehabilitation Hospital which resulted in a change in accounting for this hospital from the equity method of accounting to a consolidated entity. The amendment revised certain participatory rights held by our joint venture partner resulting in HealthSouth gaining control of this entity from an accounting perspective. The consolidation of St. Vincent Rehabilitation Hospital did not have a material impact on our financial position, results of operations, or cash flows.
See Note 1, Basis of Presentation, and Note 2, Investments in and Advances to Nonconsolidated Affiliates, to the condensed consolidated financial statements included in Part I, Item 1, Financial Statements (Unaudited), of this report for additional information.
Litigation By and Against Former Independent Auditor As discussed in Note 9, Contingencies, to the condensed consolidated financial statements included in Part I, Item 1, Financial Statements (Unaudited), of this report, the arbitration process continues in the pursuit of our claims against Ernst & Young LLP and the defense of their claims against us. The rules of the American Arbitration Association (the "AAA") require that all aspects of the arbitration remain confidential. Since the beginning of the arbitration in July 2010 and through September 30, 2012, there have been approximately 105 days of hearings, generally in four-day blocks of time.
On October 12, 2012, the AAA panel ordered a temporary stay of the arbitration. We requested that the panel review and consider the ongoing proceedings in another case, In re State of Alabama Department of Revenue v. HealthSouth Corporation, et al., which the Supreme Court of Alabama agreed on August 17, 2012 to hear on appeal. The In re Alabama case is itself unrelated to the Ernst & Young arbitration but does involve an issue of Alabama law that is in dispute in the arbitration. The issue is whether, under Alabama law, the wrongdoing of disloyal employees can or should be imputed to the employer. The Supreme Court is scheduled to hear oral arguments on November 7, 2012.
We can provide no assurances as to the timing of the resumption or the conclusion of the arbitration. However, we remain confident in our claims and are committed to aggressively and diligently pursuing them to conclusion. Stock Repurchase Authorization
In October 2011, our board of directors authorized the repurchase of up to $125 million of our common stock. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. Repurchases under this authorization, if any, are expected to be funded using cash on hand and availability under our revolving credit facility. There has been no activity under the Company's common stock repurchase authorization since its inception. Our board of directors also granted discretion to management to repurchase from time to time, subject to similar conditions, warrants issued pursuant to the warrant agreement, dated as of January 16, 2004, with Wells Fargo Bank Northwest, N.A., as warrant agent, and up to $125 million of our convertible perpetual preferred stock. Likewise, this authority does not require the purchase of a specific number of warrants or shares, has an indefinite term, and is subject to termination at any time by our board of directors. See Note 20, Earnings per Common Share, to the consolidated financial statements accompanying the 2011 Form 10-K for additional information regarding these warrants. As discussed in Note 4, Convertible Perpetual Preferred Stock, to the condensed consolidated financial statements included in Part I, Item 1, Financial Statements (Unaudited), of this report, we repurchased 46,645 shares of our preferred stock for $46.5 million during the first nine months of 2012.


Key Challenges
As we continue to execute our business plan, the following are some of the
challenges we face:
         Reduced Medicare Reimbursement. On August 2, 2011, President Obama
          signed into law the Budget Control Act of 2011, provisions of which
          will result in an automatic 2% reduction of Medicare program payments
          for all healthcare providers effective upon executive order of the
          President in January 2013. We currently estimate this automatic
          reduction, known as "sequestration," will result in a net decrease in
          our Net operating revenues of approximately $34 million annually in
          2013. Additionally, concerns held by federal policymakers about the
          federal deficit and national debt levels could result in enactment of
          further federal spending reductions, further entitlement reform
          legislation affecting the Medicare program, or both. We cannot predict
          what alternative or additional deficit reduction initiatives or
          Medicare payment reductions, if any, will ultimately be enacted into
          law, or the timing or effect any such initiatives or reductions will
          have on us. If enacted, such initiatives or reductions would likely be
          challenging for all providers, would likely have the effect of limiting
          Medicare beneficiaries' access to healthcare services, and could have
          an adverse impact on our financial position, results of operations, and
          cash flows.

However, we believe the steps we have taken to reduce our debt and corresponding debt service obligations coupled with our efficient cost structure and substantial owned real estate should allow us to absorb, adjust to, or mitigate any potential initiative or payment reductions more easily than most other inpatient rehabilitation providers. In addition, we have decided for the current year to replace the annual merit increase typically provided to nonmanagement employees in October of each year with a one-time, merit-based, year-end bonus to be paid in December 2012. We believe this action will enhance our flexibility to address and mitigate the expected impact of sequestration and potential additional Medicare payment reductions in 2013 and beyond. See also the "Results of Operations - Salaries and Benefits" section of this Item.
Changes to Our Operating Environment Resulting from Healthcare Reform. On March 23, 2010, President Obama signed the Patient Protection and Affordable Care Act (the "PPACA") into law. On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010, which amended the PPACA (together, the "2010 Healthcare Reform Laws"). On June 28, 2012, the Supreme Court of the United States upheld the constitutionality of the 2010 Healthcare Reform Laws, with the exception of the provisions for the mandatory expansion of Medicaid coverage by the states. The 2010 Healthcare Reform Laws remain subject to continuing legislative scrutiny. We cannot predict the outcome of any future legislation related to the 2010 Healthcare Reform Laws, but we have been, and will continue to be, actively engaged in the legislative and regulatory process to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care.

Many provisions within the 2010 Healthcare Reform Laws have impacted or could in the future impact our business. Most notably for us are the reductions in our annual market basket updates. In accordance with Medicare laws and statutes, the Centers for Medicare and Medicaid Services ("CMS") makes annual adjustments to Medicare reimbursement rates by what is commonly known as a market basket update. The reduction in effect from October 1, 2011 through September 30, 2012 and again from October 1, 2012 through September 30, 2013 is 0.1%.
In addition, the 2010 Healthcare Reform Laws require the market basket update to be reduced further by a productivity adjustment on an annual basis. The productivity adjustments equal the trailing 10-year average of changes in annual economy-wide private nonfarm business multi-factor productivity. The productivity adjustment effective from October 1, 2011 to September 30, 2012 was a decrease to the market basket update of 1.0%, while the productivity adjustment effective from October 1, 2012 to September 30, 2013 is a decrease to the market basket update of 0.7%.
On July 25, 2012, CMS released its notice of final rulemaking for fiscal year 2013 (the "2013 Rule") for inpatient rehabilitation facilities under the prospective payment system ("IRF-PPS"). The 2013 Rule is effective for Medicare discharges between October 1, 2012 and September 30, 2013. The pricing changes in this rule include a 2.7% market basket update that has been reduced by 0.1% under the requirements of the 2010 Healthcare Reform Laws discussed above, as well as other pricing changes that impact our hospital-by-hospital base rate for Medicare reimbursement. Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the rule's release, incorporates other adjustments included in this rule, and the productivity adjustment discussed above, we believe the 2013 Rule will result in a net increase to our Medicare payment rates of approximately 2.1% effective October 1, 2012, before applying the effect of sequestration.


The 2010 Healthcare Reform Laws and their impact or potential future impact to us are discussed in more detail in Item 1, Business, "Healthcare Reform," and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, "Executive Overview," to the 2011 Form 10-K, as well as Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, to our quarterly reports on Form 10-Q for the quarterly periods ended March 31, 2012 and June 30, 2012.
Given the complexity and the number of changes in these laws, as well as the implementation timetable for many of them, we cannot predict their ultimate impact. However, we believe the above provisions are the issues with the greatest potential impact on us. We will continue to evaluate and review these laws, and, based on our track record, we believe we can adapt to these regulatory changes.

         Maintaining Strong Volume Growth. As discussed above, the majority of
          patients we serve experience significant physical and cognitive
          disabilities due to medical conditions, such as strokes, neurological
          disorders, hip fractures, head injuries, and spinal cord injuries, that
          are generally nondiscretionary in nature and which require
          rehabilitative healthcare services in an inpatient setting. In
          addition, because most of our patients are persons 65 and older, our
          patients generally have insurance coverage through Medicare. However,
          we do treat some patients with medical conditions that are
          discretionary in nature. During periods of economic uncertainty,
          patients may choose to forgo discretionary procedures. We believe this
          is one of the factors creating weakness in the number of patients
          admitted to and discharged from acute care hospitals. Because
          approximately 94% of our patients are referred to us by acute care
          hospitals, if these patients continue to forgo procedures and acute
          care providers report soft volumes, it may be more challenging for us
          to maintain our recent volume growth rates.


         Recruiting and Retaining High-Quality Personnel. Our operations are
          dependent on the efforts, abilities, and experience of our medical
          personnel, such as physical therapists, occupational therapists, speech
          pathologists, nurses, other healthcare professionals, and our
          management. In some markets, the lack of availability of medical
          personnel is an operating issue facing all healthcare providers,
          although the weak economy has mitigated this issue to some degree. We
          have maintained a comprehensive compensation and benefits package to
          attempt to remain competitive in this challenging staffing environment
          while also being consistent with our goal of being a high-quality,
          cost-effective provider of inpatient rehabilitative services.

Unlike certain other post-acute settings, patients treated in inpatient rehabilitation hospitals require and receive significantly more intensive services because of their acute medical conditions. This includes 24-hour per day, seven days per week supervision by registered nurses. As part of our efforts to continue to provide high-quality inpatient rehabilitative services, our hospitals are utilizing more certified rehabilitation registered nurses ("CRRNs"). We encourage our nursing professionals to seek CRRN certifications via salary incentives and tuition reimbursement programs. While these incentive programs increase our costs, we believe the benefits of increasing the number of CRRNs far out-weigh such costs and further differentiate us, in particular our quality of care, from other post-acute providers.
Recruiting and retaining qualified personnel for our hospitals will remain a high priority for us. See also Item 1A, Risk Factors, to the 2011 Form 10-K.
Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring licensure or certification of our hospitals, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new beds to existing hospitals. Ensuring continuous compliance with these laws and regulations is an operating requirement for all healthcare providers.

Reimbursement for our inpatient rehabilitation services is discussed above and in Item 1, Business, "Sources of Revenues," to the 2011 Form 10-K. A portion of our outpatient services are reimbursed under Medicare's physician fee schedule. By statute, the physician fee schedule is subject to annual automatic adjustment by a sustainable growth rate formula that has resulted in reductions in reimbursement rates every year since 2002. However, in each instance, Congress has acted to suspend or postpone the effectiveness of these automatic reimbursement reductions. For example, under the CMS notice of final rulemaking for the physician fee schedule for calendar year 2012, released on November 1, 2011, a statutory reduction of 27.4% would have been implemented. However, Congress passed on December 23, 2011, and President Obama signed into law, an extension of the current Medicare physician fee


schedule payment rates from January 1, 2012 through February 29, 2012, and again in February 2012, they acted to extend the current Medicare physician reimbursement rates through December 31, 2012, further postponing the statutory reduction. On July 6, 2012, CMS again released a notice of proposed rulemaking for calendar year 2013 that would reduce outpatient service payments by the sustainable growth rate formula. If Congress does not again extend relief as it has done since 2002 or permanently modify the sustainable growth rate formula by January 1, 2013, payment levels for outpatient services under the physician fee schedule will be reduced at that point by more than 26%. We currently estimate that a 26% reduction, before taking into account our efforts to mitigate these changes, would result in a net decrease in our Net operating revenues of approximately $8 million annually and may lead to our closure of additional outpatient satellite clinics. However, we cannot predict what action, if any, Congress will take on the physician fee schedule and other reimbursement matters affecting our outpatient services or what future rule changes CMS will implement.
Effective October 1, 2012, all inpatient rehabilitation facilities are required to submit data for the IRF Quality Reporting Program to CMS. Beginning October 1, 2014, and each subsequent fiscal year thereafter, failure to submit the required quality data will result in a two percentage point reduction to the applicable facility's annual market basket increase factor for payments made for discharges occurring during that fiscal year. Our hospitals are prepared for . . .

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