Encompass Health Corporation (NYSE:EHC) Q4 2022 Earnings Call Transcript

Encompass Health Corporation (NYSE:EHC) Q4 2022 Earnings Call Transcript February 8, 2023

Operator: Good morning, everyone, and welcome to Encompass Health’s fourth quarter 2022 earnings conference call. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. I will 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 2022 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, 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 company’s earnings release and related Form 8-K, the Form 10-K for year ended December 31, 2022, 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. 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?

Mark Tarr: Thank you, and good morning, everyone. Fourth quarter was a very strong finish to 2022, driving our full year results to the top end of our guidance range. Patient volume remained a particular bright spot, with Q4 discharge growth of 7.3%, contributing to a full year discharge growth of 6.8%. Continued vigilance on labor management, and a solid contribution from our 2022 de novos, facilitated Q4 year-over-year adjusted EBITDA growth of 16.4%. For fiscal year 2022, we were able to overcome an increase of approximately $70 million in contract labor and sign-on and shift bonuses, $16 million in net pre-opening and new store ramp up costs at our de novos, and double-digit second half inflation in food and utility costs, to generate a year-over-year increase in adjusted EBITDA.

And we did so while continuing to strengthen our competitive position. We invested nearly $600 million in CapEx in our business in 2022. This includes upgrades to many of our legacy hospitals, in many instances reducing or eliminating semi-private rooms and shared bathrooms, as well as building replacement hospitals in two key strategic markets, Huntsville, Alabama, and Tustin, California. We also continued to invest in our facility-based technology through initiatives like our Tableau onsite dialysis rollout. We now offer in-house dialysis in 41 of our hospitals, and will continue the rollout in 2023. Reducing our reliance on third party providers in obviating patient transport to receive this service, leads to fewer disruptions to therapy schedules, and improved patient outcomes and satisfaction.

It also reduces our cost for these services. A central element of our strategy is investing in capacity expansions to meet the needs of a significantly underpenetrated and growing market for inpatient rehabilitative services. In 2022, we opened nine de novo hospitals, the most ever in a single year for us. These facilities exceeded our expectations by contributing $4 million in four-wall EBITDA in Q4. We also added 87 beds to existing facilities, leading to a net 4.4 increase in licensed beds in 2022. As we’ve mentioned previously, we are increasingly utilizing prefabrication alternatives to contain design and construction costs and increase our speed to market. Our use of prefabrication has progressed from head walls to bathrooms to exterior walls, and in 2022, Uber modules, which are two-patient rooms adjoined by a corridor.

We anticipate piloting full hospital prefabrication beginning in Q3 of this year, with anticipated cost savings of almost 15%, and speed to market gains of 25%, as compared to conventional construction once the program is fully ramped. We complimented these investments in our business with the return of nearly $100 million to our shareholders through the cash dividend on our common stock. The strength and consistency of our free cashflow generation, allowed us to fund these investments and shareholder distributions, primarily with internally-generated funds. Our leverage in Q4 was 3.4 times, unchanged from Q3, and our liquidity remained strong. Evidenced by our strong consistent discharge growth, our value proposition continues to resonate across our constituencies.

Within our payer mix, we further consolidated the gains made, with Medicare Advantage achieving 4.1% discharge growth in 2022. Our Q4 same-store Medicare Advantage discharges, were 41% higher than Q4 of 2019. The normalization of patient flows through healthcare, facilitated 8.6% discharge growth, and Medicare fee-for-service. We do believe that Q4 volumes benefited from early and aggressive flu season as well. None of this success has been accomplished without more than 30,000 dedicated associates. The past three years have been complicated, with a lingering pandemic, tightening labor market, burgeoning inflation, and the strategic alternatives view for our home health and hospice business. Our team has consistently arisen to meet these challenges and to seize opportunities.

Our value proposition, and our operating strategy, have been further validated, and we remain highly optimistic about the long-term prospects of our business. As is our custom, today we are also providing our initial guidance for 2023. Our revenue guidance reflects our expectations of continued high single digit growth, driven this year by both volume and pricing gains. We also expect solid adjusted EBITDA growth. Given continued uncertainty around the trajectory of further labor cost improvements and the impact of inflation elsewhere in our cost structure, we believe it is prudent to exercise some caution in establishing our initial guidance range. Our 2023 guidance includes, revenue of $4.68 billion to $4.76 billion, adjusted EBITDA of $860 million to $900 million, and adjusted EPS of $2.87 to $3.16.

A list of considerations underpinning these guidance ranges can be found on Page 13 of the supplemental slides. I also want to note that we are planning to host an Investor Day in New York City on September 27 of 2023. At that meeting, we’ll provide more detailed insight into key elements of our strategy, including de novo hospitals, clinical technologies, and labor management. We’ll also provide investors with the opportunity to hear from an array of our teammates within the senior management ranks. Please mark your calendars for September 27. Details will follow in the days ahead, and we hope to see you there. With that, I’ll turn it over to Doug, to provide some further details on our operating results.

Doug Coltharp: Thank you, Mark, and good morning, everyone. As Mark stated, we are very pleased with our Q4 results. Revenue for the quarter increased 9.1% over the prior year to $1.14 billion, and adjusted EBITDA increased 16.4% to $232.7 million. We continued to see strong volume growth in Q4. Discharges grew 7.3%, which combined with a 2.2% increase in revenue per discharge, to drive 9.6% inpatient revenue growth. On a same-store basis, discharges grew 4.2%. For the full year 2022, discharges increased 6.8%, and that was on top of 8.7% growth in 2021. In 2021, when the clinical labor market began tightening, and contract labor and shift bonuses started to rise, we made the strategic decision to continue to admit appropriate patients regardless of the financial burden to our company.

This allowed our hospitals to provide value to our patients, referral sources, and payers. As a result, we are experiencing gains in market share. We made further progress on reducing labor costs in Q4. Our Q4 contract labor, plus sign-on and shift bonuses of $35.4 million, was comprised of $19.7 million in contract labor, and 1$5.7 million in sign-on and shift bonuses. Contract labor expense in Q4 declined approximately $5.1 million or 20.6% from Q3, $10.3 million or 34.3% from Q4 2021, and $22.2 million or 53% from the peak in Q1 2022. We experienced sequential declines in contract labor expense and FTEs for every month in Q4, and in fact, for every month since last March. Contract labor FTEs for December were 325 compared to 749 in March.

Our contract labor expense is fairly concentrated, with approximately 50% of the spend occurring in 20 hospitals. Agency rates ticked up in Q4 versus Q3. This was due in part to the premium pay associated with holiday shifts. The Q4 agency rate for FTE was $211,000, compared to $205,000 in Q3. Agency rates remain market-specific and highly variable. Reducing contract labor expense remains a key focus for us, and we expect year-over-year improvement in 2023, albeit with some uncertainty around the trajectory of these costs. Our December contract Labor FTEs of 325 was in the range of 300 to 350 we had estimated in our Q3 earnings call as an exit level for 2022. The seasonality of our business and capacity growth via new hospital openings and bed expansions, may lead to some incremental needs for contract labor FTEs. Sign-on and shift bonuses decreased $8.5 million sequentially to $15.7 million in Q4, from $24.2 million in Q3.

This represents a decline of $5.7 million from Q4 of €˜21. Sign-on bonuses declined by approximately $700,000 from Q3. Much of the Q4 sign-on bonus spend was tied to new hires in Q3 and prior. We saw an approximately $8 million decline in shift bonuses sequentially. You’ll recall that in Q3, shift bonuses were elevated to cover periods of unexpectedly high clinical staff PTO usage during the summer. We have also made significant progress standardizing the process around shift bonus utilization and rate. We expect year-over-year improvement in sign-on and shift bonuses in 2023 as well, but there remains a tradeoff between our utilization of these bonuses and our objectives for reducing contract labor FTEs. Specifically, shift bonuses paid to existing associates, and sign-on bonuses paid to new hires, provide a positive arbitrage against current contract labor rates.

As such, we expect the year-over-year improvement in sign-on and shift bonuses in 2023, to be less pronounced than the anticipated improvement in contract labor. Our efforts in hiring and retaining clinical staff remain our best option for mitigating contract labor and shift bonuses. For the full year of 2022, we had net same-store RN hires of 427. As we have discussed previously, we have made significant investments in our in-house recruiting capabilities. This includes the establishment of a centralized recruiting function and a significant expansion of dedicated resources. Our centralized talent acquisition team is now comprised of 73 associates. We have also increased our investment in marketing support for our recruiting efforts. As a result, recruiting and relocation cost in Q4 increased to $7.8 million from $3.2 million in Q4 ’21.

And for the full year 2022, this investment increased to $24.5 million, as compared to $12.7 million in 2021. These expenses are included in our other operating expenses. Food cost per patient day increased 15.9% from Q4 2021, and 0.7% from Q3 2022. Utilities cost per patient day increased 16.1% from Q4 ’21, and declined 11% from Q3 of €˜22. Sequential decline in utilities cost per patient day was primarily attributable to seasonal weather patterns. We anticipate continued inflationary pressures in the first half of 2023, before lapping the larger increases in the second half of the year. Our de novo and bed addition strategy continues to generate solid growth and contribute to share gains. Our de novos performed exceptionally well in Q4, contributing $4.2 million in adjusted EBITDA.

Recall that we had expected the de novos to break even in the fourth quarter after experiencing administrative delays in openings and hurricane-related disruptions in Q3. Much of the overachievement in Q4 was attributable to our Naples and Cape Coral de novos, which rebounded from Hurricane Ian much faster than anticipated. We plan to open eight new hospitals in 2023 and add approximately 80 to 100 beds to existing hospitals. Three de novos totaling 149 beds are scheduled to open in March, with an additional 50-bed hospital scheduled to open in April. As such, a significant portion of the estimated $10 million to $12 million in net pre-opening and ramp-up costs for 2023, is expected to be incurred in the first quarter. As you may have noted on Page 18 of our supplemental materials, we have changed our expectation for annual bed additions from a range of 100 to 150 to a range of 80 to 120.

There are two reasons for this revision. First, we have been increasing the initial bed count in our de novos. The average number of initial beds in our de novos opened in 2018 through 2020, was 42. That average increased to 44 for the 2021 de novos, and 46 for the 2022 class. The average number of beds in the de novos we expect to open from 2023 through 2025, is 49. The larger initial footprint creates incremental leverage on the core infrastructure of the hospital, thus serving as a partial mitigant to higher construction costs, and effectively front-end loads future period bed growth. You may recall that I spoke about this in response to a question on our third quarter earnings call. The increase in the initial size of new hospitals has effectively boosted the number of beds associated with our de novo strategy by an average of approximately 56 per annum.

Our market density strategy is also a factor here. In certain large and growing markets, we have chosen to open an additional hospital instead of adding beds to an existing hospital. This allows us to better serve the market by overcoming geographic barriers and traffic patterns and placing the new beds closer to incremental referral sources. We have successfully deployed this strategy in markets like Dallas and Houston, and are now doing so in certain other markets, including most recently, Tampa, and Orlando. I’ll also note that our 2022 maintenance capital expenditures of 238.4 million, was higher than the estimate of $195 million to $215 million cited in our Q3 earnings report. Relief of supply chain bottlenecks and mild weather in many northern markets, allowed us to proceed with several projects that we had assumed would be delayed.

As you can see on Pages 14 and 15 of the supplemental materials, we expect both maintenance and discretionary CapEx in 2023 to be consistent with 2022. With that, we’ll open the lines for Q&A.

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Q&A Session

Operator: And we’ll take our first question from Kevin Fischbeck with Bank of America. Please go ahead.

KevinFischbeck: Good morning. Great. Thanks. I guess the main question I had was around labor costs. I guess the actual wage inflation itself looked a little bit low. And then I guess when we – in one of your supplementals, you have the number of net same-store nurses added, like it was negative in the quarter after some pretty strong hires in the first three quarters of the year. So, would love to get a little more color about, I guess, maybe what happened in Q4. And if you’re still talking about sign-on shift bonuses, why does the core wage growth kind of drop down to three?

Doug Coltharp: Yes. So, Kevin, I think in terms of the internal SW per FTE, that has been running right about 3%, and some of that has to do with the fact that we made a series of market adjustments really beginning in the latter part of 2020 that have now anniversaried. So, we think that that, for internal SW per FTE, is a good estimate. We do note that benefits, which typically make up about 10% of SW&B, is expected to increase by about 5% in 2023, and that’s just the cost that we’re seeing, the inflation that we’re seeing in group medical expense. With regard to the hiring in Q4, your observation is correct. We did take a step back. The good news is, it wasn’t on the hiring front. So, if you look at Q4 of 2022, our hires, gross hires for RNs was 530, and that compares to 310 in Q4 of last year, so an increase of 220.

Unfortunately, it was more than offset by terminations during the quarter, which were 562 as compared to 264 of Q4 of 2021, so an increase of 298. So, that took us from a Q4 €˜21 net positive 46 to a decrease of 32 in Q4 of’ 22. Virtually all of that was attributable to increased terminations within first-year RNs. That rate rose to 45.3% this year versus 36.6% in the €˜21 quarter. We think that was a bit of an aberration because for the full year, our termination rate for first year hires actually improved year-over-year from 45% to 41%. So, a lot of detail in there, Kevin. We did take a step back. We don’t think that necessarily portends that we’ll have a higher termination rate moving into 2023. Frankly, some of that appeared to be tied to bonus-hopping based on increased volumes tied to flu volumes in some of the acute care hospitals.

And again, we don’t necessarily think that that’s going to be a persistent trend.

Mark Tarr: So, Kevin, clearly – we have a focus, not only on the recruitment of nurses, but also on the retention. We put in things in place this year in terms of bonus structure. Our CEOs will be having a very strong focus on making sure that we retain the nurses that we’ve hired in the past, especially those within that first year. We’ve seen kind of a spike in nurses that turn over within the first year that we hire them. So, it’s an all hands on deck to make sure that we are putting forth a very solid orientation, that we bring these new nurses into our hospitals, have them orient with mentors, with folks that are seasoned in our hospitals so that they have a comfort level in caring for the rehabilitation patients that we have and so that they want to be there for a long time.

So, it’s both recruitment and retention. As Doug noted, I’m not taking anything away from the Q4 drop off as being alarming. I think that our strategy of having the centralized recruitment function and talent acquisition, continues to be a good move. It took a lot of the pressure off of our hospitals to keep up with this function. We aren’t staffed at the hospitals to take on this task at the same degree that we have here from a centralized function in Birmingham. So, we are very focused on both the recruitment and retention of nursing staff.

KevinFischbeck: All right, that’s helpful. I guess second question then just being, I guess in your prepared remarks, you guys said that you thought it was prudent to have some conservatism in the guidance. Is there anything in particular in here where you say this is where we kind of decided to put our finger on the scale a little bit in the area of being prudent? Or is it just broad-based?

Doug Coltharp: I would probably point to a couple of things that just really reflect some of the uncertainty. We put in an assumption of a 2.5% to 3% Medicare price increase in Q4. If you look at where the input factors have been over the last couple of years, it would certainly point to and justify a higher increase. But the nice increase that we saw in the existing fiscal year notwithstanding, we really reflected back on what we had seen over the 10 years prior, and so put that assumption in. We’ve also put in what I think is a pretty reasonable assumption with regard to the increase that we’re getting from other payers. The other factor that’s in on our guidance that may not appear immediately available to you, is that we are anticipating that we will see some normalization as we move from 2022 to 2023 in both our length of stay and our EPOB.

And so, just to give you some specifics there. For fiscal year €˜22, our length of stay was 12.7. It was actually 12.5 in Q4 of 2022. And the EBITDA flow-through is very sensitive to small changes in this metric. In fact, moving that metric by just 0.05 can have an impact of approximately $8 million to $10 million on EBITDA. We think that the 12.5 is not something that is necessarily sustainable, particularly given the acuity that we’ve been running. CMI has been hanging in there right in the kind of 1.44, 1.45 range. We’re also expecting further normalization in our EPOB. Fiscal year ’22 EPOB ran at 3.35. It was 3.38 in Q4, and you’ve probably seen in our guidance assumptions that our expectation for 2023 is 3.4. Some of that is attributable to the cumulative effect of opening 17 hospitals over two years.

This, again, is a very sensitive metric, and every 0.05 increase in EPOB translates to about $6 million to $8 million in EBITDA, depending on where you are in the guidance ranges.

Mark Tarr: It’s worth noting that 3.4 EPOB is the same EPOB level that we were running pre-pandemic in our hospitals.

KevinFischbeck: Okay, that’s great. Thank you.

Operator: And we’ll take our next question from A.J. Rice with Credit Suisse. Please go ahead.

A.J. Rice: Hi, everybody. Thanks. Maybe first just a little bit more on the pricing assumptions and where you see things evolving at this point. I guess Medicare Advantage and Managed Care together are about 26% or at least of your fourth quarter revenue. Are you seeing – I mean, you got a step-up in the underlying rate normalizing for sequestration for Medicare fee-for-service. Are you seeing a little pickup in the rate from your managed care, either MA on straight managed care, or any move to some of this value-based type of stuff? Is that becoming more a part of what you’re contracting for?

Doug Coltharp: You’ve got to break the Medicare Advantage to that which is paid on a CMG basis, and that which is paid on a per diem basis. And as we’ve talked about a lot in the past, we’ve made great progress over the last five years plus of moving more of our contracts as a CMG basis, which are tied specifically to the Medicare rate. So, right now, about 88% of our Medicare Advantage revenues are paid on CMG basis, and those move in lockstep with Medicare. The per diem contracts there, and virtually all of the managed care, are one-off contracts that have to be negotiated, most of them on an annual basis. And that’s – frankly that’s just guerilla warfare around those, and it’ll take getting into this year to see what kind of increases we’re able to wrestle from those payers.

With regard to the movement towards more value-based care and risk-sharing arrangements, we feel like we have been more ready than the payers to enter into those types of arrangements, but I would say that little traction has been made to date.