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.

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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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