Encompass Health Corporation (EHC) Earnings Call Transcript & Summary

Thank you for joining us today. It's my pleasure to introduce Encompass Health. Encompass is the largest operator of inpatient rehab facilities in the country. Presenting today, we have Doug Coltharp, who's the CFO; as well as Mark Miller, who is the Chief Investor Relations Officer. And we're going to jump right into questions, right?

So I guess one of the things that I've been struggling with and hoping to kind of get an answer to this week is it seemed like providers across the board were reporting really good volumes, almost all of a sudden. Is there anything that you would attribute the strength in volumes to this quarter? Why did everything seem to come back in Q1?

Yes. First, for us, the volumes have been strong for a period of time. You go all the way back to the first quarter of last year, we had 7.6% volume growth, including 3.8% in same-store and that kind of continue for the balance of 2022. We were very pleased with volume growth, 9.4% in Q1. It was comprised of many of the things that we have been seeing. We continue to gain share in the very high acuity categories. Stroke was up almost 7%. Neurological, which is our largest clinical category was up just 2%. But we saw outsized growth in some of the other areas that have been lagging for a period of time. Overall, they make up a smaller percentage of our patient mix. But for instance, LEJR was up almost 27% in the quarter. We can't pinpoint exactly what the cause of that was, although that is normally reflective of kind of a resumption of normalized flows through the health care system in general and also of increased activity amongst the population into holding on those just a bit more. In terms of normalized flows, we believe that the conditions that are treated in our facilities are nondiscretionary in nature. However, there are some of those categories and the joint replacement as an example, where although you're eventually going to need it, you can defer the timing for a period for a while. So we think as things generally open back up and concerns in the senior population diminished a little bit, folks who had maybe deferred on some of those procedures pushed forward. We also saw incidents of things like spinal cord injury and hip fractures that are typically associated with the senior population and getting back into their regular lifestyle again. So those things tend to arise more frequently when that portion of the population is traveling and engaging in activities that they probably ceased or at least decreased the frequency of during the pandemic.

And what does that mean for you when you get more normalized volumes and its lower acuity volumes coming back? I mean, you're talking about mix shift, is that a good, bad from a margin perspective?

Any volume is good volume. So we'll absolutely take that. We had anticipated that after running at very high levels of acuity for much of the last 2 years that we'd see some moderation in that, that certainly played a fact, if you look at on a year-over-year basis, or CMI, which is the best indication of acuity that we have, a higher number indicates higher acuity, dropped from 1.47 in Q1 of last year to 1.45. There were 2 factors that played into it. The lesser of the 2 factors was the change in the mix that we just talked about, picking up greater growth in some of those categories. The other factor that contributed was a significant decrease in the number of COVID patients that we saw from Q1 of last year. Now, COVID is not a primary diagnosis for treatment in an IRF, but it can be a comorbidity. And that comorbidity increases the CMI. Just to give you a sense as to how that plays off, if you're replacing a patient who last year coded with COVID with an LEJR patient this year, the average COVID patient last year had a CMI of 1.50, and an average LEJR patient has an average CMI, a lot of averages in there, of 1.13.

So I guess when we think about that normalization, where do you think we are? When you look at these lower acuity things you said, they're back, are they all the way back in Q1? Are they halfway back in Q1? Or just the room to go here.

Our volumes across all of those categories are up above where they were in 2019, but we had a lot of additional capacity where we think we're taking market share. I'd say, flows feel like they're normalized but we are still very optimistic about our ability to see volume growth for the balance of the year and into the future.

Okay. Is it -- would you think that this is going to be the high point from a growth perspective? Like was there an easy comp off of Q1 and just the COVID disruption?

While that was true for a lot of other providers in acute care hospitals, as I referenced earlier, we had 7.6% discharge growth in the first quarter of last year. So we don't think it was a result of easier comparisons.

Okay. And then I guess the other broad topic that's been on people's minds is just labor. So can you just give us an update on how levering to [Technical Difficulty].

And so I think you're specifically referencing the [indiscernible] contract labor market maybe to a lesser extent to utilize signing shipset [indiscernible]. And so again, you sort of say before that giving in Q3 of 2021, first one to see the expression in labor supply. And also if that the increase in rates, we made a very concise decision. We can pursue all of the volume that you can get out there almost [indiscernible] in the cost of spend [indiscernible] for a hospital CEOs and we've been pursuing that albeit increasing discipline about how we utilize those categories of labor along the way. We hit a peak in terms of the cost of those categories of labor in Q1 of last year. And we ended last -- first quarter of last year with about 750 contract labor FTEs. We then made sequential progress in every quarter and in every month, as a matter of fact, through the balance of 2022. When we got to the end of 2022, just looking at the seasonality of the capacity that we had added through the course of the year, we felt like we might see a slight increase in those numbers in Q1. And in fact, both categories were relatively flat. Encouraging, I think, was that the contract labor FTEs we were using, the number of those went up, but the rate came down pretty significantly. The peak rate on an annualized basis was $240,000 in Q1 of last year, and the average for Q1 of this year was $182,000. So that's certainly indicative of some loosening in the marketplace. Much of the capacity -- much of the FTE increase from Q4 to Q1 was attributable to volume increases and the capacity that we brought on. The statement that we made in our earnings call here recently was we felt like that was a reasonable proxy. We spent about $20 million in the quarter on contract labor. We spent another $15 million on sign-on and shift bonuses. And the statement we made is that those didn't represent the height of our aspirations, that they were probably a pretty good proxy for the quarterly run rate through the balance of this year. If that were to transpire, the year-over-year savings in those 2 categories would be somewhere between $50 million and $55 million. So it's a pretty significant reduction even as the capacity is going up and the volume is growing as well. What we are expecting to see in Q2 is that the number of contract labor FTEs will come down, but those are coming out of the easier-to-fix markets, if you will. And so those easier-to-fix markets have carried the lower rate. So even as some of those FTEs come out there, they're going to be replaced in markets where the rate is a little bit higher, and you're going to have some increase in markets where we've added capacity. So again, we're hopeful that, that number will come down through the course of the year. But in terms of what informed our guidance and said it's relatively flat. It is markedly different from market to market and markets get fixed for a while, and you turn your attention to somewhere else, and then it kind of gets a little bit more difficult. A great example is this market, Las Vegas. We have 3 hospitals that serve the Las Vegas market. And last year was an enormously challenging year for all 3 of those hospitals just based on competition for skilled labor in this marketplace. So we had significant increases in contract labor expenses last year. We visited our largest of those 3 hospitals yesterday afternoon. And the CEO told us that he is currently running at 0 contract labor. Anecdotally as well, I guess a specific example, he commented that during the course of 2022, they had 8 RNs who left our facility to take employment, pursuing higher wages in acute care hospitals and local acute care hospitals. And by the end of the year, all 8 of them had returned to our employee. So things are definitely getting better, but there are stubborn pockets that are out there. The Northeast remains challenging, particularly around the Boston area. Chicago land is challenging as well. Those are 2 markets I would point to specifically.

So it's interesting that the actual use of FDA comes kind of stable-ish from Q4 to Q1, but the bill rates came down. Like usually, you think, well, it should both be coming down or both be coming up. Is there any reason why that happened, why you get lower bill rates but still see similar demand?

It's very market-specific.

Okay. And then I guess one of the things that we've been doing is trying to put this into context. So when you think about the improvement that you've had, where are you versus like 2019? Are you still well above that?

Yes. So if you just look at contract labor FTEs as a percentage of our total FTEs, in 2019, it was less than 1%, 0.9%, and that had been pretty consistent for a long number of years and was really kind of -- it's hard to manage it very aggressively below that point. And in Q1 of last year, which again was the peak, contract labor FTEs were 2.8% of our workforce. And in the first quarter of this year, it was 1.8%. So we're kind of about halfway back.

Is there a time line for when you think it could get back to...

I think the bigger question is, is 0.9% anytime in the near future going to be a realistic achievement. I don't think we know the answer to that yet. I think the real focus is going to be just continue to make incremental progress driving that 1.8% down. You've got kind of the same question around rates. I mentioned the $182,000 that we experienced in Q1, that is substantially better than more than $240,000 that we saw in Q1 of last year. 2019, it was about $146,000. Do we get all the way there? I don't know, but we think that there's incremental progress to be made beyond the $182,000.

Okay. And then what about wage rates? So are you having to increase wages at above average rate to bring that contract labor down?

Yes. So we had anticipated at the start of the year, the wage rate inflation, this is just the SW portion would be about 3% for the -- and this is not including contract labor, sign-on and ship bonuses would be about 3% for the full year. It was a little bit higher in Q1, it was close to 5%. So our assumption right now is probably going to be more in the 4% range for the full year. I don't know that we would see it inflating at that rate in subsequent years. We still think a good proxy for outer years is probably 3%. And then the smaller piece of that benefit, which makes up about 10% of the SWB line, we think that's probably going to grow in the 5% to 6% range, which is -- it's all health care benefits there.

I struck a little bit because like when I go back when we first started covering the sector 23 years ago, labor costs were growing 4% from between 2000 and 2007. That's kind of what it grew. And then we had the recession then it was 2% to 3% and then it's been high single digits. And everyone kind of keeps saying it's going to be 3% again. But like I don't know, I think over the last 23 years, I think the number has been 3% to 4% or that feels like the better rate. Like why is 3% the right number for rate growth?

If you take the period from 2010 to through 2020 for us, we never ran above 3.5%. Now you're right, it had inched up. There was a period of time when we were able to have annual merit increases, which represented the rate of underlying inflation, 2% to 2.5%. Pre-pandemic really pre the tightening in the market that started to occur in Q3 of 2021, that number was running 2.75% to 3.25%. So I do think there is precedent for it. Some of the way that we've gotten there is we have consistently built in, starting in the latter part of 2021 market adjustments. Again, visiting with our hospital CEO yesterday, he specifically commented on the fact his nursing turnover for the last 12 months or for the first quarter, excuse me, was 13%. And he said, he's been able to get there because of the market adjustments we already made in the base rate. So that's already built in and it doesn't need to be inflated in 4% or 5% per annum. It's also reflected, if you think about the proposed rule that came out last month, the proposed rule is based on a forecast of input costs, beginning in October. And so the underlying forecast CMS had for the input cost for the IRF sector is 3%.

And do you think that's reasonable? Or you were saying that, that's what you get, and that's kind of what you have to give?

Yes. It is largely in line with our estimate of future period inflation because IRFs do not benefit in periods of time like this from the forecast error that exists for SNFs. Unfortunately, you've kind of got this gap where a forecast for 2021 and for 2022 didn't pick up the accelerated wage inflation, and there's no look-back to get a catch-up on that. So do we think it's a fair rate going forward? We do. Unfortunately, there's no recouping the higher costs that we bore in the last 2 years.

Okay. So how do you deal with it? I guess -- is there a way from a margin perspective to get back to target margin? Like where are you, I guess, versus target margins? And how do you get there?

Yes. We certainly believe that there's room for margin enhancement. If you look just at 2022, part of the frustration was based on the reimplementation of sequestration and what was happening with labor market conditions. We were posting great revenue growth in each of the first 3 quarters, driven more by volume than pricing because of the reimplementation of sequestration, but we were going backwards on EBITDA basis because of labor cost. That flipped in Q4, not by a big degree, but we saw EBITDA growth that was actually larger than revenue growth and really saw it come through in Q1 of this year. We had 9.5% revenue growth and 17.5% EBITDA growth. So EBITDA margin is improving, and we expect continued improvement over here -- over the course of the year. We're currently in the high teens. I think a near-term objective is to get that north of 20%. In addition to the improving -- a more normalized pricing environment, you've got improving labor conditions. And as we get to the back half of the year, we're going to anniversary double-digit increases in food and energy costs, which will help in that regard as well. And then, of course, Azure volume is growing, particularly with a decent price increase, we're getting nice leverage against certain relatively fixed components of your cost base and each to point to there is occupancy expense.