Encompass Health Corporation (EHC) Earnings Call Transcript & Summary

Okay. Well, good afternoon, everyone. Thanks for sticking with us today here on the second day of, I believe, our 41st Annual Growth Stock Conference and the second and hopefully last virtual style. My name is Matt Larew, I cover health care delivery services here at William Blair. I'm here today with members of the Encompass Health management team, including Mark Tarr, the CEO; Doug Coltharp, CFO; Barb Jacobsmeyer, who runs the inpatient rehab business; and Crissy Carlisle from Investor Relations. So thank you to all, all of you for being with us today. Encompass Health, as many of you know, is one of the leading integrated post-acute care companies in the country, certainly with a leading inpatient rehab portfolio and a complementary home health and hospice business. Before we jump into questions, I just want to point out the compliance note. And that for a complete list of disclosures, you can visit our website, which is williamblair.com.

So to start, well, we don't have a deck to walk through today. But given that this is a generalist growth stock conference, I do think there's some value in just providing a brief overview of the company. Maybe if you could just give us a quick take on the history of the company, the markets you participate in and how both those markets and how you've participated in them has evolved over time.

Sure. Well, Matt, first, let me say, we're delighted to be here with you today. And for those of you that aren't familiar with the Encompass Health story, let me give you some of the highlights. As Matt said, we're a national leader in post-acute care. We provide that care in both a facility-based setting and a home-based setting. We have a -- from a geographic standpoint, we have a national footprint that includes 39 states and Puerto Rico. So we had good coverage there. We operate the company in 2 operating segments. The first segment being inpatient rehabilitation facilities, or IRFs, you may see the -- for short. We have the IRF segment accounts for about 77% of our consolidated revenues. That segment is made up of 139 rehabilitation hospitals, of which 52 of those are joint ventures with acute care hospital systems. And that's been a good business model for us that we've had now in place for over 30 years in terms of our -- when our first joint venture facility was established. At that scale, it makes us the nation's largest owner-operator in terms of the patients treated, revenues and number of freestanding hospitals. We're asked quite often in terms of what that means in terms of market share. And about 30% of the Medicare patients receiving IRF-level care this year will receive those in an Encompass Health facility. So we're quite proud of that. If you think about the types of patients that we treat or the diagnostic categories, just to name a few, stroke and neuro makes up about 40% of our total discharges. Other common diagnostic categories would be hip fractures or other orthopedic complications. And then those hospitals that we have that have affiliation with a trauma center also have a fair number of brain injuries and spinal cord injuries. So we are proud of the fact that we can handle a high-acuity patient. We're also proud of the fact that we have really set ourselves apart with our expertise, particularly among the stroke and neurological patients. In terms of just our hospitals, for those of you that aren't familiar with what a rehab hospital is, it's licensed as an acute care hospital. It's a specialty track within that licensure. We don't have ERs. We don't have operating rooms. But nonetheless, if you walk through our hospital, it would look very similar to what you would see in just the general medicine floor in an acute care hospital med surg. We're required to provide 24/7 nursing coverage. In terms of other staffing expertise, we have physiatrists, the full complement of attending and consulting physicians. We also have physical therapists, occupational therapists, speech therapists. And some hospitals have respiratory therapists that provide the care. And we do a minimum of 3 hours a day of therapy in our hospital. So it's a fairly intensive program that we provide. On the second segment, which make up the home health and hospice, which is the balance of our revenues or 23% of our consolidated revenues, that is split up -- between 80% of that is home health and 20% is hospice. With that scale, it makes us the fourth largest provider of Medicare-certified home health services with 241 locations. I guess, it's actually 250 now since we announced the Frontier acquisition of this week. And then in terms of services provided, that'd be skilled nursing. We also have a full complement of therapeutic services relative to physical therapy, occupational therapy as well as speech. So that's kind of an overview of the 2 operating segments. We see our competitive strengths that differentiates us from the other providers in the space. One is our clinical outcomes in both segments. We exceed the national averages, the national databases that are kept on each. We're the most cost-effective provider in both segments, in terms of just managing our cost effectiveness. We have extensive use of technology, whether that's our clinical information system and our rehab hospitals that we have begun to extract data from. That helps us with our predictive modeling and other analytic opportunities or the Homecare Homebase, which is the predominant system used in the home health industry. We like to see ourselves as being the super users. And then we have a very strong financial position, a very strong balance sheet that we also think provides us with a competitive advantage. All of the strategy that we have around growth is -- has the underlying fact of the strong demographic tailwind. Our average age patient in our hospitals is 76, at 77. And on home health, if you look at the growth rate of that particular age cohort, you see that's about a 5% CAGR. It's just -- it's a matter of fact, as we all get -- as we all age and get older, the likelihood of the fact that we'll need some type of inpatient rehabilitation is greater. So that continues to drive the demand for our services. And there's also been a time where you had this increasing demand but a very flat capacity. There's not been a lot of people that have been adding beds of capacity in the IRF sector. So that also helps drive the rationale for our de novo growth that you see and we'd like to talk about. If you think about just our longer-term growth targets, which we put from 2020-2025, it's 8% to 10% CAGR for net operating revenues and adjusted EBITDA. And then 5% to 7% CAGR for adjusted free cash flow. So that is -- that's a mouthful in a short period of time. But hopefully, that gives your listeners a bit of an overview of the 2 segments that we operate in.

That's a helpful setup to the rest of the discussion. And the first place I'd like to go to that discussion is asking a few questions around COVID. And so the first quarter results and some of our survey work that we've done suggests that I think volumes at large seem to be largely back to pre-COVID levels, but there's quite a variety in there depending on the specific service line, not just with Encompass, but within the industry. So we've seen those trends continue to improve throughout May. So would just be curious if that's consistent with what you're seeing, and maybe the areas of your business that have been particularly strong return and then others that you're still waiting to come back to where they were pre-COVID.

Yes. So at the end of the first quarter and then the K that we subsequently filed, we've seen the population as a whole start to gain confidence in seeking health care. And I attribute that to the increased vaccination rates. We've seen it in our business in terms of the number of COVID patients that we're treating has drastically declined. That has helped us as we looked at the impacts. For instance, when we were in the peak of the pandemic, we had as many as 30 hospitals that had some sort of cap on volume, because of rooms that we had to have isolated patients in. That limited our capacity. We had hospitals that had a number -- a substantial number of staff out on quarantine to where we had to cap the volume because we didn't have the staff to treat them. Both of those factors have declined now to an immaterial number. Just last week, we had, I think, 2 hospitals that had some sort of capping due to staffing. So we've seen a diminished impact from COVID, which has also, from an external standpoint, we've seen the number of elective procedures increase in each successive month throughout the year. We have seen the number of elective referrals, particularly to our home health has continued to increase. We've seen it in our hospitals as well. We've been quick to say that a 76 or 77 year old is probably not going to be the first to seek out elective procedures, but we do think that we're starting to see them enter that fold as well. So all of those are contributing factors to starting to see our volume levels get back, if not ahead of where we were pre-pandemic. Some of the trends in terms of the types of patients we're being referred from acute care hospitals are reaching back to some -- a normal pattern. And we're very glad to see things are starting to get back to maybe a 2019 or certainly before the pandemic impacts that we saw last year.

That's great. And so Mark, you referenced there some of the turmoil that you and others in the industry have had to deal with over the last year or plus. But COVID also led to some meaningful opportunities for companies that were able to act quickly to meet changing end market demand. So just curious if there are things you could point to in terms of changes in end market dynamics, customer behaviors or preferences or perhaps your relationships with customers, or your own competitive position and capabilities that emerging from COVID, you think, will be helpful to the company long term?

Yes. So I'm very proud of the way the company handled itself during the midst of the pandemic. And by that, I mean that we came out early on. Once we had determined that we could effectively treat COVID patients, we were there for referral sources. And we were taking COVID patients and showed the willingness and the capability of treating COVID patients early on when others in post-acute sector either wouldn't accept COVID patients or showed the inability to effectively treat those COVID patients. And so I think we continue to establish our profile of having the ability of treating a high-acuity level patient. We continue to establish our goodwill with the referring acute care hospital systems, whether they were our partner in a formal manner or an informal manner. We were there to be part of the answer and part of the solution as part of the pandemic. And I think that has definitely continued to show as we have worked our way out of the pandemic in terms of long-standing referral relationships with acute care hospital systems. And it also gave us a chance to show the MA plans what we could do with rehabilitation patients and gave us a chance to get exposure to some payers from a value proposition standpoint, that maybe we did not have a chance in the past, but gives us a chance to have relationships going forward and continuing to show what we can do through our quality outcomes.

And so thinking about just the back half of 2021 here, as vaccination deployment continues, we've seen CDC recently change guidelines around requirements for vaccinated individuals. What do you see as the biggest growth drivers for the back half of '21? Yes, I note on the first call, you mentioned the restriction of facility access for things like SNF [ southside ]. And of course, partly just a little bit due to elective procedures. So there's certainly a lot going on in the end markets, but just curious if I think about the back half of the year specifically, what items are you targeting off for key growth drivers?

Yes. So the back half, we factored into the back half of the year within our guidance that there would not be long-standing impacts from COVID, that things would be back to normal. So it is things such as electro procedures coming back, the fact that we have as many as 50% of our admissions into our home health come from assisting living facilities and skilled nursing facilities, we would expect to see those come back. We now have access to those settings. But the volume within those settings, their census, has not recovered back to its full point and historical highs. We think it will and we fully contemplate that we will be there and help them care for those patients as we've done in the past. But their volumes aren't back yet, but we do think that in the back half of the year, that will continue to normalize out. We think that you'll just see continued confidence in the public in accessing our health care system. I do think that there -- there is reason to believe that there have been deferred health care needs among patients, and that you'll start to see them reach back out to the health care system, and we would expect to see some of those normal patterns that we've seen in the past for both our home health and our IRFs.

And then the final one around COVID. Doug, I'm just curious if there are opportunities for Encompass to operate long term as a more efficient, higher-margin business based on efficiencies you've gained during COVID. Maybe this is an opportunity also to provide a window into some of the cost structure changes you made in response to PDGM, which just coincidently occurred during COVID.

Yes. I think where the margin opportunities existed is on the home health side, and it really is around both the -- predominantly in the business per episode, which is a direct outflow of the deployment of MetaLogics and becoming more refined in our care planning on a per patient basis. Even though we had fully deployed that module across our platform by the end of June last year, given some of the limitations on how we operated related to the pandemic, we weren't able to fully utilize it. We're making great strides this year. And I think it's showing up in the business per episode trend, and we think that there's further upside on that. Cost per visit, we -- I think we've been very good about managing. Is there a room to continue to refine that as we push up the percentage of our clinicians that are operating at the top of their license? I think there is some, but we're ahead of the pack there. And those would be the primary drivers of margin on the home health side. For both of our businesses as we transition into 2022, one of the things we're going to face on the top line is the reinstatement of the Medicare sequester. And that's going to have the impact of wiping out most of the market basket update we would see for Medicare for 2022. And when your inputs are continuing to rise at normal levels, that creates some near-term margin pressure. And then compounding that for 2022 on the IRF side is going to be the impact that comes from the opening -- preopening cost and the ramp-up cost of new hospitals, so both the 8 coming on in 2022 and then the 12 we'll be opening in 2023. On that latter point, I would expect that to reverse beginning in the second half of 2023. And there, the EBITDA benefit that we'll be getting from the openings in '21 and '22 should overcome the incremental preopening associated with hospitals beginning in the back half of '23 and should be a positive moving forward. So some puts and takes on the margin side, it's going to be tough to get margin traction in 2022. Still a little bit of a headwind in 2023. I like the longer-term trend on that as you move from '23 and beyond.

That makes sense. And I think that sequester reversal, certainly something we have in our models. But -- so the investors certainly be aware of as they're building out expectations for any Medicare operators in '22. So moving now beyond COVID. And thinking about M&A, obviously, you just closed the Frontier deal. And you had targeted $50 million to $100 million of home health M&A per year as kind of a typical number. Just curious what you're seeing in terms of the size and tilt of the pipeline, home health versus hospice. What sized assets the company is looking at? And then when this consolidation opportunity that was going to be driven by PDGM, when do you think that might really start to come into view?

Yes. So beginning in -- and we are -- this is similar to comments we have made previously. Beginning in the second half of last year, we started to see a pickup in M&A activity, predominantly in the hospice space and predominantly around some of the larger properties that were in PE adds. And you saw some of those trade rather late in the year, and they traded at pretty significant multiples. We have been involved in a number of those processes. And ultimately, they got a little too rich for us, and we didn't wind up moving forward. I think the reason that last year was focused on the hospice space is that the hospice was not subject to a major payment model change as were home health and the IRF business. And that business also was not as directly impacted by COVID. There were some issues around length of stay. But for the most part, volumes remained pretty consistent. And therefore, it was easier for buyer and seller to engage in some reasonable degree of price discovery, at least around a normalized EBITDA. We saw home health kind of join into the conversation at the beginning of this year. And we feel good about the fact that we're seeing opportunities there that are both large and small. We're one of the few players that can really capitalize on some of the smaller opportunities because of our strategy of filling in additional markets that overlap between our home health and IRF and also creating density in markets in where we have home health. We're complementing existing home health and hospice assets with the other business line. There are a number of opportunities that we think will be available that are in the range of Frontier that if the geography makes sense and if there aren't any quality issues, we'll take a look at those. The competition remains fierce on any assets of size. You've got a lot of capital that's available in this market based on the multiples of the publicly traded peers and based on the support that the PE firms are getting from the leveraged finance markets. And so we haven't seen anything but continued pressure on the margins when you're talking about any asset of scale.