Encompass Health Corporation (NYSE:EHC) Q4 2023 Earnings Call Transcript

Encompass Health Corporation (NYSE:EHC) Q4 2023 Earnings Call Transcript February 8, 2024

Encompass Health Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, everyone, and welcome to Encompass Health’s Fourth Quarter 2023 Earnings Conference Call. [Operator Instructions]. Today’s conference call is being recorded. If you have any objections, you may disconnect at this time. I’ll now turn the call over to Mark Miller, Encompass Health’s Chief Investor Relations Officer.

Mark Miller: Thank you, operator, and good morning, everyone. Thank you for joining Encompass Health’s fourth quarter 2023 earnings call. Before we begin, if you do not already have a copy, the fourth quarter earnings release, supplemental information and related Form 8-K filed with the SEC are available on our website at encompasshealth.com. On Page 2 of the supplemental information, you will find the safe harbor statements, which are also set forth in greater detail on the last page of the earnings release. During the call, we will make forward-looking statements, which are subject to risks and uncertainties, and many of which are beyond our control. Certain risks and uncertainties, like those relating to regulatory developments as well as volume, bad debt and labor cost trends that could cause actual results to differ materially from our projections, estimates and expectations are discussed in the company’s SEC filings, including the earnings release and related Form 8-K, and the Form 10-K for the year ended December 31, 2023, when filed.

We encourage you to read them. You are cautioned not to place undue reliance on the estimates, projections, guidance and other forward-looking information presented, which are based on current estimates of future events and speak only as of today. We do not undertake a duty to update these forward-looking statements. On the supplemental information — our supplemental information and discussion on this call will include certain non-GAAP financial measures. For such measures, reconciliation to the most directly comparable GAAP measure is available at the end of the supplemental information at the end of the earnings release and as part of the Form 8-K filed yesterday with the SEC, all of which are available on our website. I would like to remind everyone that we will adhere to the one question and one follow-up question rule to allow everyone to submit a question.

If you have additional questions, please feel free to put yourself back in the queue. With that, I’ll turn the call over to Mark Tarr, Encompass Health’s President and Chief Executive Officer.

Mark Tarr : Thank you, Mark, and good morning, everyone. The fourth quarter was a strong finish to a great 2023 for our company. I’ll discuss key highlights for the year, and then Doug will provide details about our Q4 results and 2024 guidance. Our 2023 revenue increased 10.4% and driven by strong volume growth with total discharges up 8.7%, inclusive of same-store growth of 4.8%. Our strong volume growth continues to provide evidence that our value proposition is resonating with referral sources, payers and patients. Our 2023 adjusted EBITDA increased 18.5%, driven by revenue growth and prudent expense management. Persistent vigilance on premium labor utilization facilitated a 32.9% decrease in contract labor plus sign-on and shift bonuses.

On a dollar basis, these premium labor expenses decreased $67.3 million from $204.3 million in 2022 to $137 million in 2023. We reduced contract labor FTEs from an average of 547 in 2022 to 425 in 2023 and contract labor FTEs as a percent of total FTEs from an average of 2.2% to 1.6% over the same period. Other operating expenses as a percent of revenue declined by 50 basis points from 15.3% to 14.8%, owing in part to scale efficiencies. The strong growth in adjusted EBITDA facilitated an adjusted free cash flow increase of 54.6% to $525.7 million. We continue to invest in capacity expansion to meet the needs of a significantly underserved and growing market for inpatient rehabilitation services. In 2023, we invested more than $350 million in growth CapEx, opening eight de novos with a total of 395 beds and adding 46 beds to existing hospitals, a net 4.1% increase in licensed beds.

We also continue to invest in our facility-based technology through initiatives like our Tablo on-site dialysis rollout. We now offer in-house dialysis capabilities in 83 of our hospitals and we’ll continue the rollout to new locations in 2024. We complemented these investments in the growth of our business with a return of approximately $60 million to our shareholders through cash dividends on our common stock. Our strong free cash flow generation allowed us to fund these investments and shareholder distributions with internally generated funds, all while reducing our net leverage to 2.7 times at year-end 2023 from 3.4 times at the end of 2022. Review Choice Demonstration, or RCD, began on August 21 in Alabama. Our company was well prepared to address the administrative requirements of this program.

Recall that under RCD, every Medicare claim is reviewed for documentation and medical necessity. The affirmation rate target set by CMS under RCD is 80% of claims submitted during the first six months of our affirmation rate remains above that level. Turning to objectives for 2024. We continue to build and maintain an active pipeline of de novo projects, both wholly owned and joint ventures with acute care hospitals. We expect to open 6 de novos in 2024 as well as a 40-bed freestanding hospital licensed as a satellite location on an existing hospital that will be accounted for as a bed addition. To date, we’ve announced an additional 11 de novos with opening dates beyond 2024. We anticipate adding approximately 150 beds to existing hospitals in 2024, including the aforementioned satellite and 80 beds to 120 beds per year from 2025 through 2027.

We continue to focus on enhancing patient outcomes by investing resources and clinical innovations. One such innovation is our fall prevention model, which combines predictive modeling with our core clinical practice protocols. Our fall prevention model was initiated in 2021, and we have since seen our fall rates per 1,000 patient days improved 24%. We have an array of additional clinical innovations and enhancements underway, which are intended to advance our ability to consistently produce quality outcomes for medically complex high-acuity patients in need of inpatient rehabilitation care. Now I’ll turn it over to Doug.

Doug Coltharp : Thank you, Mark, and good morning, everyone. As Mark stated, Q4 was a strong finish to 2023. Revenue for the quarter increased 9.6% over the prior year, driven primarily by volume growth. Total discharges grew 8.3%, inclusive of 5.3% same-store growth. Volume strength was broad-based across geographies and patient mix and exceeded our expectations. Q4 adjusted EBITDA also increased 9.6% over the prior year as the contribution from increased volume and favorable operating expenses was partially offset by an incremental bad debt reserve. Our 2023 de novos outperformed in Q4, generating approximately $1 million in adjusted EBITDA compared to our expectation of approximately $2.5 million to $4.5 million of net preopening and ramp-up costs.

The favorable performance relative to our expectations was driven primarily by the joint venture de novos. For the full year of 2023, our de novo net preopening and ramp-up costs were $6.6 million. Within our 2024 guidance considerations, we are anticipating $15 million to $18 million of de novo net preopening and ramp-up costs. The year-over-year difference is largely attributable to the timing of new hospital openings and the balance between joint venture and wholly owned de novos. We continue to see improvement in year-over-year premium labor costs. Q4 contract labor plus sign-on and ship bonuses totaled $30.6 million compared to $35.4 million last year. Within premium labor costs, Q4 contract labor was $17.7 million and sign-on and shift bonuses were $12.9 million as compared to $19.7 million and $15.7 million in Q4 of 2022.

On a sequential basis, premium labor decreased by $2.7 million. Our Q4 adjusted EBITDA included approximately $6.8 million in favorable reserve adjustments for workers’ comp and general professional liability insurance. On a full-year basis, 2023 included approximately $11.2 million in favorable reserve adjustments for these self-insured programs. These reserve adjustments are out of period as they relate to claims prior to 2023. Our Q4 adjusted EBITDA also benefited from favorable trends in group medical claims under our self-insured program. Q4 revenue reserves related to bad debt as a percent of revenue increased 170 basis points to 4.1%, and as a result of an approximately $22 million reserve related to appeals pending before the Departmental Appeals Board in various federal district courts.

These appeals relate to claims denied primarily prior to 2018 and under review programs that are different from TPE and RCD. We now have a full year of experience at the departmental Appeals Board and have updated our reserve assumptions given our experience to date. After giving effect to minority interest, the Q4 adjusted EBITDA impact of this incremental bad debt reserve was approximately $16 million. Adjusted free cash flow for the quarter increased 103.3% to $93.5 million due to higher adjusted EBITDA, lower maintenance CapEx and favorable changes in working capital. Moving on to guidance. Our 2024 guidance includes net operating revenue of $5.2 billion to $5.3 billion, adjusted EBITDA of $1.015 billion to $1.055 billion, and adjusted earnings per share of $3.77 to $4.06.

The key considerations underlying our guidance can be found on Page 13 of the supplemental slides. With that, we’ll open the line for Q&A.

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Q&A Session

Operator: [Operator Instructions]. And we’ll take our first question today from Kevin Fischbeck with Bank of America.

Joanna Sylvia Gajuk : Actually, this is Joanna sowing for Kevin today. There’s too many — so many things going on at the same time. So, we got to do this way. So, I guess my question around volumes because you highlighted volumes also came in better than your internal expectations and obviously, very robust growth year-over-year. So, I guess the question is, is that sustainable? What do you assume for same-store volumes growth in 2024 guidance? And I guess I understand you mentioned that the strength was broad-based geographically, but can you talk about maybe whether there was any category that stood out or maybe the payer as well and flu, I guess, or any impact kind of seasonal in Q4? Thank you.

Mark Tarr: Joanna, this is Mark. I’ll take a shot at this first. We — as you know, we saw a nice volume growth across all 8 of our geographic regions. And we — I think there’s a number of things. One, we continue to see where we have taken market share from nursing homes. I think that going back to last two years or three years, we’ve proven ourselves very capable of taking a higher acuity patient and having great outcomes with them. So that is — has been a primary driver to us. I think that it’s no secret that the acute care hospitals have seemed to had strong volumes, which we get the downstream impact from that. Relative to program mix, it was another quarter of continued growth in our stroke program and other neurological conditions.

We did see some pickup on a small base in our orthopedic categories. But nonetheless, we did see a percentage increase in lower extreme drug placements and other orthopedic as well. So, it was very broad-based in terms of our overall growth, and we’re confident that we’re building a good foundation.

Doug Coltharp: Just to add a couple of other things to round out your question. In terms of the expectations for volume growth in 2024, if you kind of parse through the guidance considerations, you get a range of the discharge growth that is kind of in line with our longer-term target of 6% to 8%, obviously coming off a number of strong years. The low end of the range would be slightly above that to the rest of the range is solidly within that. And in terms of the breakdown between same-store and new store, we obviously have the 8 units that we opened this year that will be a new store. And so that’s a bit of a tailwind there. And it’s worth recognizing that if you look at the four-year CAGR in same-store growth that extends from 2019 to 2023, that’s north of 5%.

So, we continue to demonstrate very positive numbers there. But it’s not to suggest that we’re going to be in a position to generate 5% same-store growth on a year-over-year basis. There will be some fluctuations from year-to-year. The patient mix was very broad-based, as Mark mentioned. We did continue to see outsized growth in some of the smaller categories like ortho, but saw in excess of 5% growth in neurological and just about 5% growth in stroke. So those are good numbers. And then finally, as it relates to payer mix on a year-over-year basis, we saw the Medicare Advantage payer mix increased by 90 basis points. But importantly, about 50 basis points of that growth came out of general managed care and another 20 basis points or 30 basis points came out of Medicaid.

So those were both representing a positive trade out of our lowest reimbursement categories into a higher reimbursement category.

Operator: Next, we’ll hear from Pito Chickering with Deutsche Bank.

Kieran Ryan : You’ve actually got Kieran Ryan on here for Pito, same idea as Joanna earlier, lots of calls. I wanted to ask on margins. It looks like the guidance is implying about year-over-year contraction on your reported 2023 figures, maybe a little bit less than that when adjusting for the reserve, the benefits and the de novo outperformance. But just broadly, when we think about what could drive margins lower year-over-year. How should we think about these headwinds from labor and the de novos compared to the fixed cost leverage that you should get on this very strong volume growth you’re seeing?

Doug Coltharp: Well, Kieran, I think you hit exactly on it, which is we’ve got all in and assume 4% to 5% increase in SWB per FTE. And so, what’s driving that is an assumed 4% to 5% increase in general internal SW per FTE and then the benefits of getting some leverage with volume growth across assumed relatively constant premium labor cost is being offset by an increase and benefits cost, which is largely attributable to the fact that we had such a favorable outcome this year. And so that next to the 4% to 5% for an SWB increase. And then it’s a pretty significant swing going from a little over $6 million in net preopening costs for 2023 to assume $15 million to $18 million in 2024. And that’s got a number of factors implied in it.

In 2023, we had a much heavier weighting towards the first half of the year in terms of openings, and we’re anticipating for 2024. And five of the eight facilities that opened in 2023 were joint ventures, including a couple of those that were with existing joint venture partners. So those ramped faster than the balance that we’re anticipating in 2024. But those are the two primary factors that could create a little bit of rub on the margin. And as we have said repeatedly, we are an EBITDA and an EBITDA growth story. We are not necessarily a margin story. We’ll always seek to gain leverage as we’re growing volume. But the most important thing that we can do is get out there and provide extremely high-quality care to more patients who are in need of inpatient rehabilitative services, and we continue to believe that the market is underserved.

Kieran Ryan: Appreciate that. And then just a quick follow-up on the labor side. 55 net RN hires in 4Q, solid, obviously, down a bit from the last two quarters where you’re up in the 200 range. But should we think about this as kind of the right pace as to what you’re targeting heading into ’24, given where volumes are running and that you’ve already cut down contract labor down to that 1.5%, 1.4% of FTEs? Or do you see it accelerating further from here?

Mark Tarr: We’re actually very pleased with that number in Q4. If you look back at prior year, that was a negative net. And if you think about the period of the year that’s extremely difficult to hire new staff it’s around the holidays and particularly in Q4. So, our Town acquisition team has been very successful in helping to support the hospitals as well as the new ramp-ups and finding and hiring nurses. We’ve talked about in past calls, too, that we have a real focus on retention in our hospitals to retain the nurses that we already employ with a particular focus on those that have been hired in the last year or so. So, we’re very pleased with the progress that we’ve made and are hiring of RNs and would accept this year to be another strong year with that.

Doug Coltharp: Yes. We can’t necessarily assume the run rate that we saw in new hires in Q4 is going to stay steady across all four quarters in 2024 because there will be some seasonality to that. But as Mark said, we’re very pleased there. With some specifics on turnover, our RN turnover for all of 2023 was down 500 basis points from 2022 and therapy, which has always been best of class and low from a turnover perspective, was down 130 basis points on a year-over-year basis. So, a combination of new hires and reducing turnover rate is really allowing us to manage those premium labor costs better. Now frankly, the 1.4% that we saw in terms of contract labor, FTEs as percentage of total FTEs in the fourth quarter was better than we had anticipated.

We assume that we get kind of a stabilization point around 1.5%. As we’ve noted previously, we had run just below 1% pre the Q3 of 2021 when the spike occurred for the overall industry. We’d like to see continued progress towards that number, but it’s just very hard to predict. Embedded in our guidance assumptions for 2024 is that from a total dollar perspective, premium labor cost in 2024 remain relatively consistent with the run rate that we established in Q4, which was down an aggregate of $2.7 million sequentially from Q3.

Operator: Our next question will come from Ben Hendricks with RBC Capital Markets.

Unidentified Analyst : This is Mike Murray on for Ben. So, it sounds like internal SWB per FTE growth is expected to moderate in 2024. And after a few years of acceleration. Just broadly, can you talk a little bit more about the labor market and what you’re seeing for wage inflation? And do you think this will continue to moderate moving forward?

Doug Coltharp: As I said, Mike, we’ve got — the internal SWB per FTE assumption is an increase to 4% to 5%. And frankly, that’s probably a point higher on both ends of the range than I was thinking about at the end of Q3. What we are seeing is that although overall labor market conditions are improving, it’s important to really stay on top of market adjustments. And as we’re bringing in these larger number of new hires, if they’re coming in at a market rate that is different than what we’re paying the [indiscernible] workforce, we’ve got to make sure that there’s parity across that. We — again, across all of the metrics that we’ve cited, we’re seeing improving labor market conditions. We’re optimistic that, that will improve, particularly as we progress into the second half of 2024, but it’s difficult to bank on that. So, we went with a set of assumptions that things reflect the current environment and no further improvement as we progress through the year.